Mar. 4, 2010

Bill Redefining “Acquisition Indebtedness” for UBTI Purposes Could Diminish, But Likely Would Not Eliminate, Utility of “Blockers” in Hedge Fund Structures

A significant and growing proportion of the assets invested in hedge funds globally come from U.S. tax-exempt entities such as endowments, foundations, state pension funds and corporate pension funds that are “qualified” under Internal Revenue Code (IRC) Section 501(a).  Mechanically, tax-exempt entities generally invest in a corporation organized in a low-tax or no-tax, non-U.S. jurisdiction, which in turn invests in an entity that buys and sells securities and other assets.  The buying and selling entity is often organized in a tax-advantaged, non-U.S. jurisdiction as a corporation that “checks the box” for partnership treatment for U.S. tax purposes (although other structures and entity types are also used).  See “Implications of Recent IRS Memorandum on Loan Origination Activities for Offshore Hedge Funds that Invest in U.S. Debt,” Hedge Fund Law Report, Vol. 2, No. 41 (Oct. 15, 2009).  Tax-exempt hedge fund investors go through these contortions to avoid paying tax, at corporate tax rates, on so-called Unrelated Business Taxable Income (UBTI).  As explained in more detail in this article, the portion of interest, dividends and capital gains generated by a domestic hedge fund in a tax year based on “acquisition indebtedness” will constitute UBTI on which U.S. tax-exempt investors in that fund will owe tax at corporate rates.  Specifically, a domestic hedge fund’s UBTI for a tax year generally is equal to the fund’s total interest, dividends and capital gains for the tax year times a percentage, the numerator of which is the fund’s average acquisition indebtedness and the denominator of which is the average cost basis of the fund’s investments.  For example, if a domestic hedge fund had a total return (including interest, dividends and capital gains) for the tax year of $20 million, an average cost basis of $100 million and average acquisition indebtedness of $30 million, the fund would have $6 million of UBTI for the tax year.  That UBTI would be allocated pro rata to the fund’s tax-exempt investors for tax purposes.  So if the fund had two tax-exempt investors with equal investments, at a corporate tax of 35%, each would owe tax of $1.05 million on its distributive share of the fund’s UBTI for the tax year.  By contrast, if a tax-exempt investor invests in a corporation that in turn invests in a lower-tier trading entity, the UBTI created by the trading entity’s acquisition indebtedness will not flow through to the tax-exempt investor, and the investor will not owe tax on the UBTI (unless the investor’s purchase of shares in the corporation was itself financed by acquisition indebtedness).  This is because the Internal Revenue Service respects the ability of corporations to “block” UBTI.  See “IRS ‘Managed Funds Audit Team’ Steps Up Audits of Hedge Funds and Hedge Fund Managers, and Investigations of Hedge Fund Tax Compliance Issues,” Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009).  On July 31, 2009, Rep. Sander Levin (D-MI) introduced H.R. 3497, a bill that would revise the definition in the IRC of “acquisition indebtedness” to exclude debt incurred by a U.S. partnership for investments in “qualified securities or commodities.”  (Levin had introduced similar legislation in 2007.)  In short, if Levin’s bill were to become law, it would diminish the rationale for investments by U.S. tax-exempt investors in hedge funds via offshore corporations.  However, offshore corporations exist in hedge fund structures for reasons other than blocking UBTI, so even if Levin’s bill were to become law, the case for offshore corporations could remain compelling.  This article offers a more comprehensive discussion of the taxation of UBTI; tax-exempt investor attitudes towards UBTI; structuring of hedge funds to enable tax-exempt investors to avoid UBTI; the mechanics of the Levin bill; the potential impact of the Levin bill if enacted on tax-exempt hedge fund investors as well as non-U.S. investors; and the likelihood of enactment of the Levin bill.

Global Investment Performance Standards Facilitate Reliable, Apples-to-Apples Comparisons by Hedge Fund Investors, and Offer Marketing Opportunities for Hedge Fund Managers

Various factors – including the closing of investment bank proprietary trading desks and layoffs at hedge fund managers – have contributed to a quickening pace of hedge fund entrepreneurship.  See “What Is Proprietary Trading, and Why Does Its Definition Matter to Hedge Fund Managers?,” Hedge Fund Law Report, Vol. 3, No. 8 (Feb. 25, 2010).  At the same time, a noteworthy proportion of the assets that redeemed from hedge funds over the past two years are looking to return, along with new assets.  In short, both the supply of hedge fund management options and the demand for such management by institutional investors are increasing.  As a swelling pool of assets evaluates a growing number of managers, performance remains one of the key determinants of where assets get allocated.  See “How Can Start-Up Hedge Fund Managers Use Past Performance Information to Market New Funds?,” Hedge Fund Law Report, Vol. 2, No. 50 (Dec. 17, 2009).  (Performance used to be the key determinant of allocations, now it is merely primus inter pares; transparency and liquidity also loom large.  See “Hedge Funds Using 3WayNAV to Enhance Visibility into Portfolio Liquidity,” Hedge Fund Law Report, Vol. 3, No. 2 (Jan. 13, 2010); “Rolling Lock-Up Periods Enable Hedge Fund Managers to Pursue Less Liquid Strategies While Managing Investors’ Liquidity Expectations,” Hedge Fund Law Report, Vol. 3, No. 2 (Jan. 13, 2010).)  For hedge fund managers in this environment, the reliability, comparability and utility of performance data are, collectively, as important as the levels of performance.  That is, investors want to know that the numbers are accurate; they want to be able to compare them to numbers from other funds following the same strategy, funds following different strategies and funds organized in different jurisdictions; and they want to be able to plug the numbers into their own models and perform analytics.  The Global Investment Performance Standards (GIPS standards), promulgated by the CFA Institute, facilitate these three values – reliability, comparability and utility.  The GIPS standards are legally voluntary but, increasingly, practically required guidelines establishing a consistent method for presentation by investment advisers of performance and valuation data.  While not designed specifically with hedge fund managers in mind, hedge fund managers are increasingly adopting the guidelines, retaining third parties to verify their adoption and using their adoption offensively in marketing to institutional investors.  To assist hedge fund managers in determining whether the benefits of compliance with the GIPS standards outweigh the burdens, this article details: what the GIPS standards are; their specific application to hedge fund managers; recent revisions of the GIPS standards; interaction of the GIPS standards with conflicting country or state laws; specific steps required to become compliant; the third party verification regime; the benefits and burdens to hedge fund managers of compliance; and practical strategies for mitigating the burdens.

California Appellate Court Affirms $19 Million Arbitration Award Against Russel Bernard, Former Principal of Hedge Fund and Private Equity Fund Manager Oaktree Capital Management

On February 22, 2010, the California Court of Appeal for the Second District affirmed a Los Angeles Superior Court order confirming an arbitration award against Russel S. Bernard, a former principal at hedge fund and private equity fund manager Oaktree Capital Management, L.P.  In an incentive fee dispute between Bernard and Oaktree, an arbitrator had found that Bernard breached his fiduciary duty to Oaktree when, in his role as fund manager, he stalled the launch of a new fund and appropriated an investment opportunity in order to form a competing private equity fund, Westport Capital Partners.  The arbitrator awarded Oaktree $12.3 million for the management fees it lost from the delayed venture, as well as $6.7 million in attorney’s fees, costs and interest; it also refused Bernard’s demand for payment of incentive fees based on his performance before his resignation.  The appellate court “affirm[ed] the award because [Bernard] did not satisfy the narrow grounds for judicial review of an arbitration award.”  We summarize the background of Oaktree’s action against Bernard and the California appellate court’s legal analysis.

Illinois District Court Dismisses Investors’ Fraud Claims Against Hedge Fund Sitara Partners, L.P. Because of Improper Pleading and Timing of Alleged Misrepresentations

Plaintiffs invested in hedge fund Sitara Partners, L.P. (Fund) in 2005 and 2006.  After their investment, defendant Rajiv Patel (Patel), who was the Fund’s principal, allegedly promised the plaintiffs that he had invested in a diversified portfolio of “quality securities.”  In fact, on September 2, 2008, Patel made a huge bet – 90% of the Fund’s assets – on Freddie Mac, which lost most of its value after the federal government’s takeover.  Plaintiffs lost over 75% of their investment and commenced an action against Patel and the Fund’s manager, Sitara Capital Management, LLC.  Plaintiffs alleged eighteen separate counts against the defendants for fraud, violations of both state and federal securities laws, breach of contract, breach of fiduciary duty and negligence.  Defendants moved to dismiss the entire complaint.  The court dismissed all of plaintiffs’ claims except those based on defendants’ alleged sale of unregistered securities and acting as an unregistered investment adviser.  In addition to having a poorly drafted complaint, a fundamental problem was that most of plaintiffs’ claims were based on statements that Patel made after plaintiffs had already invested in the Fund, and such statements cannot form the basis of an action for securities fraud.  However, the court gave plaintiffs leave to replead most of the dismissed claims, and essentially instructed the plaintiffs on how to survive at the pleading stage.  We outline the claims made and the court’s rationale in deciding the motion to dismiss.

Due Diligence Considerations for Hedge Funds That Invest in the Equities of Bankrupt Companies: Lessons of the Energy Partners, Ltd. Bankruptcy

Hedge funds are recognizing with increasing frequency that the common stock of bankrupt companies or companies in the zone of insolvency may have post-reorganization value.  See “Interview with Mark Dalton, Alex Sorokin and Neil Wessan of Halsey Lane Holdings: Key Considerations for Distressed Debt Hedge Funds that become ‘Unnatural Owners’ of Equity Following a Reorganization,” Hedge Fund Law Report, Vol. 3, No. 6 (Feb. 11, 2010).  While investing in bankruptcy equities involves considerable risk – notably, the tangible likelihood of a complete loss of value – such investments also, in the right circumstances, offer the prospect of considerable upside.  In particular, bankruptcy equities may be attractive in at least three circumstances: (1) where creditors undervalue the assets of the debtor; (2) when an event (such as a lawsuit in which the debtor is a plaintiff) can act as a catalyst for value creation; and (3) where conditions in the relevant industry or credit markets may enable a debtor to emerge from reorganization while its bankrupt competitors do not.  See “Equities of Bankrupt Companies Offer Hedge Funds a High Risk, Potentially High Return Method of Investing in Restructurings,” Hedge Fund Law Report, Vol. 2, No. 27 (Jul 8, 2009).  However, beyond the well-known financial risk of investing in bankruptcy equities, hedge funds should be cognizant of additional legal and structural risks that can adversely affect investment outcomes, or at least complicate the process of value creation.  In this article, Gregory C. White, an Associate at business valuation and litigation consulting firm Hill Schwartz Spilker Keller LLC, tells the story of hedge funds’ participation on the equity committee in the Chapter 11 bankruptcy of Energy Partners, Ltd. (EPL), a Louisiana-based exploration and production company.  In particular, this article outlines the facts of the case as they relate to the equity committee’s involvement in the valuation of EPL, focusing on relevant terms of the debtor’s engagement letter with its financial adviser.  The article then discusses two key lessons highlighted by the EPL case for hedge funds considering purchases of bankruptcy equities.

Camulos Strikes Back with Counterclaims Against William Seibold and His Competing Investment Company

On December 30, 2009, William Seibold, an investor in hedge fund Camulos Partners LP, and an equity interest holder in hedge fund manager Camulos Capital LP and fund general partner Camulos Partners GP LLC, sued Camulos entities and controlling individuals for over $67 million in the Delaware Chancery Court.  His complaint alleged that the defendants, through a “calculated scheme and brazen abuse of power,” forced him out of the management partnership and “deprived him of millions of dollars of his investments, compensation and equity.”  See “Co-Founder of Hedge Fund Manager Camulos Partners Sues Other Co-Founder for $67 Million in ‘Unlawfully Seized’ Bonuses and Investments,” Hedge Fund Law Report, Vol. 3, No. 4 (Jan. 27, 2010).  On January 19, 2010, Camulos and its entities struck back with scathing counterclaims against Seibold, alleging that he committed multiple and serious breaches of fiduciary duty and contract, misappropriation of  proprietary information, investor-poaching, and gleaned confidential information from Camulos as he planned to create a competing investment firm.  This article summarizes the primary factual and legal allegations of Camulos’ counterclaims.

“On the Brink: Inside the Race to Stop the Collapse of the Global Financial System,” By Henry M. Paulson, Jr.; Business Plus, 478 Pages

Henry Paulson’s new memoir is, quite literally, a blow-by-blow recounting of the state of economic emergency that consumed much of his brief tenure as Treasury secretary at the end of the Bush administration.  The one-time Dartmouth offensive lineman narrates his frontline experience of the financial crisis essentially from a footballer’s perspective, as a relentless series of crushing tackles that he and his team absorbed as they desperately improvised novel blocking schemes to stave off a catastrophic loss.  Paulson’s visceral approach, in a detailed, day-by-day accounting, provides a close-up, field-level vantage point on the increasingly daring ad hoc actions he took to save what he always refers to with due reverence as “the system.”  His book is a timely reminder, as that system slowly returns to its old ways, of just how near it came to the abyss.  “On the Brink” can serve as a casebook for crisis management, demonstrating the skill and sheer endurance required to handle a total collapse of confidence in the financial markets.  This is the first high-level insider’s account of the federal response to the crisis; a very rough draft of history, but a valuable one, conveying with candor the intensity and fear of the sustained, exhausting effort to keep pace with a banking crisis whose scale had not been seen since the 1930s.  In a guest book review, noted author Joshua A. Lustig offers a comprehensive discussion and analysis of Paulson’s memoir.