Jan. 7, 2011

CalPERS Special Review Foreshadows Seismic Shift in Business Arrangements among Public Pension Funds, Hedge Fund Managers and Placement Agents

Over the course of 2010 and into 2011, the California Public Employees’ Retirement System (CalPERS) has been investigating and addressing whether the interests of CalPERS participants and beneficiaries were compromised by the payment of placement agent fees and related activities.  See “Three Significant Legal Pitfalls for Hedge Fund Marketers, and How to Avoid Them,” Hedge Fund Law Report, Vol. 3, No. 36 (Sep. 17, 2010).  However, what started as a review arising out of the well-publicized placement agent scandals of 2009 has expanded in scope to include a special review of the organization and operation of CalPERS itself; the “fitness” of CalPERS employees and its external investment managers; and the fee arrangements among CalPERS, its external investment managers and placement agents.  See “Indemnification Provisions in Agreements between Hedge Fund Managers and Placement Agents: Reciprocal, But Not Necessarily Symmetrical,” Hedge Fund Law Report, Vol. 3, No. 41 (Oct. 22, 2010).  In a report dated December 2010, Steptoe & Johnson LLP, the law firm leading the special review, summarizes its observations and recommendations in the foregoing areas.  The report indicates that CalPERS has already implemented many of Steptoe’s recommendations, and Steptoe expects CalPERS to implement those of the recommendations it has not yet implemented.  The Steptoe report is important for all hedge fund managers, for the following reasons.  For those managers fortunate enough to have CalPERS as a current investor, the report foreshadows likely demands from CalPERS in the areas of fees, use and compensation of placement agents, conflicts of interest, gifts and travel, employment of former CalPERS board members and staff, public disclosure of information provided to CalPERS, location and lavishness of annual meetings and other topics.  Even for hedge fund managers that do not count CalPERS as a current investor, the report is relevant.  (For a discussion of when to approach certain types of investors, see “Prime Broker Merlin Securities Develops Spectrum of Hedge Fund Investors; Event Hosted by Accounting Firm Marcum LLP Examines Marketing Implications of the Merlin Spectrum,” Hedge Fund Law Report, Vol. 3, No. 39 (Oct. 8, 2010).)  Here is why: CalPERS is the largest public pension fund in the U.S.  As of January 5, 2011, the total CalPERS fund market value was $226.5 billion, with about 14 percent, or $31.7 billion, allocated to “private equity” and other “alternative investments.”  Like Yale among endowments, CalPERS among pension funds has been and continues to be a trendsetter with respect to the terms under which institutional investors allocate capital to hedge funds.  See “Lessons for Hedge Fund Managers on Liquidity, Allocations, Marketing and More from Yale’s 2009 Endowment Report,” Hedge Fund Law Report, Vol. 3, No. 15 (Apr. 9, 2010).  That is, other institutional investors look to the actions of CalPERS as precedents in the areas of terms, fees, governance, risk management, manager selection, due diligence, mitigation of conflicts of interest and others.  Indeed, the Steptoe report is cognizant of CalPERS’ stature as an institutional investor, noting that CalPERS can, by adopting the recommendations in the report, “set a standard for other public pension funds to follow.”  (By the same token, the report takes CalPERS to task for inadequately using its “purchasing power” – our phrase, not the report’s – to negotiate lower fees with external managers.  However, the report also notes that CalPERS has recently improved in this area and obtained over $200 million in fee concessions from external managers in various asset classes.)  Given the importance of CalPERS as an investor in hedge funds, the terms it demands from external managers are likely to be demanded by other investors of comparable bargaining power (or requested by investors of lesser bargaining power).  Similarly, the concerns identified by CalPERS are likely to make their way into due diligence questionnaires of other investors.  Accordingly, this article offers a comprehensive review of the Steptoe report, along with commentary on how the report’s recommendations may alter the relationship among public pension funds, hedge fund managers and placement agents.  One of the more dramatic recommendations in the report would involve shifting a greater percentage of the compensation of external managers to performance fees, and away from management fees.  We discuss (among other things) the implications of this recommendation, and how – especially for smaller or start-up managers – this revised approach to fees can make it difficult to “keep the lights on.”

The Case for Professional Boards of Public Companies

In 2002, Congress passed the Sarbanes Oxley Act (SOX) to prevent a repetition of the corporate governance debacles at Enron and WorldCom.  All boards of public companies as well as their important committees would be comprised mainly of independent directors.  A public company’s executives would conduct a yearly assessment of internal controls, subject to a special report by its external auditors.  Six years later, many of the largest financial institutions in the U.S. had to be rescued by massive injections of federal assistance.  Yet all these institutions were SOX compliant.  Most members of their boards as well as all members of their important committees were independent.  They all had evaluated their internal controls and the reports of their auditors showed no material weaknesses in 2007.  So why were the SOX reforms so ineffective?  In a guest article, Robert C. Pozen, Chairman Emeritus of MFS Investment Management and Senior Lecturer at Harvard Business School: (1) identifies the main deficiencies of current corporate boards – too many directors and too few experts with too much emphasis on procedures; then (2) presents a new model for boards of complex global companies – a small group of professional directors with enough relevant experience and sufficient time to hold management accountable.  See also “‘Too Big To Save? How to Fix the U.S. Financial System,’ By Robert Pozen; Wiley, 480 Pages,” Hedge Fund Law Report, Vol. 2, No. 43 (Oct. 29, 2009).

U.S. District Court Dismisses Hedge Funds’ Fraud Suit Against Porsche, Holding that Anti-Fraud Provisions of U.S. Securities Laws Do Not Apply to Swap Agreements that Reference Foreign-Traded Volkswagen Stock, Even If Those Agreements Were Made In the U.S. and Governed By U.S. Law

Plaintiffs in this consolidated action are a number of domestic and offshore hedge funds that had taken significant short positions in the stock of Volkswagen AG (VW) during 2008.  Unbeknownst to those hedge funds, defendant Porsche Automobil Holding SE (Porsche) had quietly amassed, outright or through undisclosed options, the right to purchase over 75% of VW’s stock.  Porsche had never disclosed its intention to acquire such a large percentage of VW stock.  When Porsche eventually announced the true extent of its VW holdings, the plaintiff hedge funds were caught in a massive short squeeze and reportedly lost over $2 billion covering their short positions.  Both Porsche and VW are German corporations.  Although both corporations have ADRs available on U.S. exchanges, the funds achieved their short positions through securities-based swap agreements that referenced VW stock.  The funds sued Porsche and two of its executives in U.S. District Court for the Southern District of New York, claiming violations of the antifraud provisions of the Securities Exchange Act of 1934 and common law fraud.  Porsche and the individual defendants moved to dismiss the complaint for failure to state a claim upon which relief could be granted, arguing that U.S. securities laws did not apply to the swap transactions in question.  Relying on the U.S. Supreme Court’s recent decision in Morrison v. National Australia Bank, 130 S. Ct. 2869 (2010), the District Court dismissed all federal fraud claims, holding that the U.S. securities laws were not intended to apply to transactions in foreign securities, even if one of the parties is based in the United States.  We summarize the Court’s decision.  For further discussion of the ability of U.S.-based hedge funds to sue foreign corporations in U.S. courts for violations of the antifraud provisions of the U.S. securities laws, see “Are There Avenues for Recovery in United States Courts for Overseas Hedge Fund Losses?,” Hedge Fund Law Report, Vol. 2, No. 29 (Jul. 23, 2009); “Update: Are There Still Avenues for Recovery in United States Courts for Overseas Hedge Fund Losses After Morrison v. National Australia Bank Ltd.?,” Hedge Fund Law Report, Vol. 3, No. 27 (Jul. 8, 2010).

High Court Governing Cayman Islands Hedge Fund Rules That Funds Cannot Retroactively Suspend Payment of Redemption Proceeds After Their Due Date Absent Express Authority in Fund Governing Documents

In December 2008, the Cayman Islands Court of Appeal, faced with a case arising out of a redemption request by a hedge fund investor, held that, depending on the terms of a Cayman fund’s governing articles, it may suspend redemptions of investors who have submitted their redemption notices, even after the redemption date has passed.  See “Cayman Court Suggests that Hedge Fund Investor does not Have Standing to Liquidate Fund,” Hedge Fund Law Report, Vol. 2, No. 3 (Jan. 20, 2009).  On December 13, 2010, that decision, which created uncertainty as to the rights of investors following redemption requests, was overruled by the Judicial Committee of the Privy Council in London.  The case presented the question of whether an investor in a hedge fund, Strategic Turnaround Master Partnership Limited (STMP), who had requested redemption and had not received payment by the agreed-upon redemption date for payment, had standing to petition for a winding up of the fund for its failure to pay its debts to creditors, or whether it merely remained a prospective creditor and shareholder who remained bound by the fund’s governing documents.  In deciding in favor of the investor, the Privy Council established that, absent clearly expressed provisions in a fund’s governing articles to the contrary, a redemption occurs on the intended redemption date – not on the date of payment of redemption proceeds – and, as a result, the investor becomes an actual creditor at that time.  We detail the background of this important action, the Privy Council’s legal analysis and the implications of this judgment for hedge fund managers and investors.

Exculpation and Indemnity Clauses in the Hedge Fund Context: A Cayman Islands Perspective (Part Two of Two)

In an increasingly litigious world, and a world of increasing commercial failures, those sustaining losses look for others to sue.  In the hedge fund context, this will typically take the form of funds, their liquidators or their shareholders derivatively suing service providers such as the investment manager, the investment adviser and the auditors, or the fund’s former directors.  Frequently, there will be clauses in the Articles of Association or other constituent documents of the fund, or in contracts with directors or service providers, for exculpation or indemnity, or both, of which potential defendants will seek to avail themselves.  If effective, these clauses will halt a claim in its tracks against those entitled to the benefit of them, but the ambit of such clauses, and the meaning of terms contained in them, are not always clear; and even if they are clear, they are not always clearly understood.  In a guest article, the second of a two-part series, Christopher Russell and Rachael Reynolds, Partner and Senior Associate, respectively, at Ogier, Cayman Islands, present a detailed discussion of the relevant global caselaw with respect to conferring the benefit of exculpation and indemnity clauses on third parties, and offer specific drafting and structuring suggestions.  See “Exculpation and Indemnity Clauses in the Hedge Fund Context: A Cayman Islands Perspective (Part One of Two),” Hedge Fund Law Report, Vol. 3, No. 50 (Dec. 29, 2010).