May 6, 2011

Treatment of a Hedge Fund’s Claims Against and Other Exposures To a Covered Financial Company Under the Orderly Liquidation Authority Created by the Dodd-Frank Act

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), heralded as the most significant new financial regulation since the Great Depression.  Title II of the Dodd-Frank Act creates a framework to prevent the potential meltdown of systemically important U.S. financial businesses.  This framework includes a new federal receivership procedure, the so-called orderly liquidation authority (“OLA”), for significant, interconnected non-bank financial companies whose unmanaged collapse could jeopardize the national economy.  The OLA will form part of a new regulatory framework intended to improve economic stability, mitigate systemic risk, and end the practice of taxpayer-financed “bailouts.”  The OLA generally is modeled on the Federal Deposit Insurance Act (“FDIA”), which deals with insured bank insolvencies, and also borrows from the Bankruptcy Code.  Notwithstanding the enactment of Title II, there will be a heavy presumption that companies that otherwise qualify for protection under the Bankruptcy Code will be reorganized or liquidated through a traditional bankruptcy case.  If, however, an institution is deemed to warrant the special procedures under the OLA, Title II will apply, even if a bankruptcy case is then pending for such institution.  As discussed in this article, the decision of whether to invoke Title II will be made outside the public view.  As a result, hedge funds that have claims and other exposures to financial companies may find the playing field shifting overnight from the relatively predictable confines of the Bankruptcy Code to the novel and untested framework of the OLA.  In a guest article, Solomon J. Noh, a Senior Associate in the Bankruptcy & Reorganization Group at Shearman & Sterling LLP, provides a high-level discussion of how the following types of claims and exposures would be handled in a receivership governed by Title II based on the regulatory rules currently proposed or in effect: (i) secured claims; (ii) general unsecured claims (such as a claim arising out of unsecured bond debt); (iii) contingent claims (such as a claim relating to a guaranty); (iv) revolving lines of credit and other open commitments to fund; and (v) “qualified financial contracts” (i.e., swap agreements, forward contracts, commodity contracts, securities contracts and repurchase agreements).  Hedge funds employing a variety of strategies – notably, but not exclusively, distressed debt – routinely acquire the foregoing categories of claims and exposures.  For situations in which those claims or exposures face a firm that may be designated as systemically important, this article highlights the principal legal considerations that will inform any investment decision.

What Are the Legal and Practical Effects of a Discrepancy between the Provisions of a Cayman Hedge Fund’s Articles of Association and Offering Documentation?

Before the recent global economic crisis impacted the hedge fund world, it was not uncommon for even sophisticated investors to subscribe for shares in corporate offshore vehicles without having first scrutinized in detail the offering memorandum, the Articles of Association and the other governing documentation of the fund.  The change in the economic climate has given rise to a heightened awareness of the need to review carefully, and in some cases to seek to negotiate, the terms of subscription.  It has also caused those who have suffered investment losses to scrutinize subscription terms carefully in order to consider whether, based on the terms upon which they invested and the terms of the Articles of Association of the fund, they have grounds for bringing proceedings to recover damages from the fund or its directors, or other service providers.  A number of the disputes that have arisen in the last few years between Cayman funds and their investors have been caused by apparent material differences in key provisions in fund documents, in particular the offering memoranda and the Articles of Association – for example, the fund’s rights to suspend redemptions, delay payment of redemption proceeds, side-pocket illiquid positions and to set aside reserves for contingent liabilities post declaration of net asset value.  The question arises: What is the effect of a provision in the offering documentation which appears to be inconsistent with the wording of the Articles?  Does the provision in the offering documentation constitute an enforceable right of the fund (for example, to suspend payment of redemption proceeds if such a provision is not provided for in the Articles) or a shareholder (for example, to require adherence by the fund to an investment policy specified in the offering document but not contained within the Articles)?  Or does such an inconsistency constitute a misrepresentation of the terms of the Articles, which may give rise to a cause of action against the fund or its directors at the suit of an investor who relied on the misrepresentation in deciding to invest or remain invested in the fund?  In a guest article, Christopher Russell and Rachael Reynolds, Partner and Managing Associate, respectively, at Ogier in the Cayman Islands, address the foregoing questions and others, and discuss relevant guidance provided by the UK Privy Council in an important recent decision.

Federal Energy Regulatory Commission Upholds Administrative Law Judge Ruling that Imposes $30 Million Penalty on Former Amaranth Trader Brian Hunter for Natural Gas Market Manipulation During 2006

Defendant Brian Hunter (Hunter) was an executive and head natural gas trader at hedge fund manager Amaranth Advisors, LLC (Amaranth).  The Federal Energy Regulatory Commission (FERC), which has jurisdiction over interstate sales of natural gas and electricity, has upheld in all respects the findings of a FERC administrative law judge who found Hunter guilty of manipulation of the natural gas market and imposed a $30 million penalty on him.  At the end of February, March and April 2006, Hunter sold large volumes of natural gas futures contracts on their expiration dates in order to drive down the settlement prices of those contracts.  Gas futures contracts trade on the New York Mercantile Exchange (NYMEX).  FERC argued that, unbeknownst to traders on the NYMEX, Hunter had amassed short positions in natural gas swap agreements that referenced the settlement prices of the gas futures contracts.  Consequently, he stood to profit from the drop in the settlement price of gas futures contracts that occurred when Amaranth dumped those contracts on their expiration dates.  Amaranth collapsed in late 2006, in large part because of the bets it had made on the natural gas market.  FERC determined that Hunter’s trading was intended to manipulate the price of natural gas futures contracts, was done knowingly and had an effect on the market for natural gas.  FERC bills this case as the “first fully litigated proceeding involving FERC’s enhanced enforcement authority under section 4A of the Natural Gas Act, which prohibits manipulation in connection with transactions subject to FERC jurisdiction.”  The trading at issue occurred only in the futures market, rather than in the physical gas market.  We summarize FERC’s decision.  See also “Federal District Court Dismisses Lawsuit Brought by San Diego County Employees Retirement Association against Hedge Fund Manager Amaranth Advisors and Related Parties for Securities Fraud, Gross Negligence and Breach of Fiduciary Duty,” Hedge Fund Law Report, Vol. 3, No. 12 (Mar. 25, 2010).

New Jersey Appellate Court Holds that Limited Partnership Agreements Covering State Pension Fund Private Equity Investments are Exempt from Disclosure under New Jersey’s Open Public Records Act

The Appellate Division of the New Jersey Superior Court has handed down a ruling preventing the disclosure of private equity limited partnership agreements (LP agreements) to union representatives who sought copies of those agreements.  Plaintiffs are two state employee unions whose pension funds were partly invested in private equity funds by New Jersey’s pension manager.  The plaintiffs sought disclosure of the LP agreements both under New Jersey’s Open Public Records Act (OPRA) and under common law principles of public access to government documents.  OPRA grants broad public access to “government records” but enumerates several exemptions from disclosure.  Cf. “Repeal of Dodd-Frank Confidentiality Protection for SEC: What Investment Advisers Lost and What Remains,” Hedge Fund Law Report, Vol. 3, No. 47 (Dec. 3, 2010).  The New Jersey Treasurer argued that the LP agreements were exempt as both proprietary commercial/financial information and as trade secrets.  The Treasurer also argued that the common law right to disclosure of the documents was outweighed by the State’s interest in preserving the confidentiality of the LP agreements.  The Court agreed with the State and prevented disclosure.  We summarize the Court’s reasoning.  For a discussion of a North Carolina case in which a nonprofit corporation was permitted to pursue its claim for records pertaining to state hedge fund investments in the context of a “pay to play” investigation, see “North Carolina Supreme Court Rules that State Pension Fund May Have to Disclose Information about Pension Fund’s Hedge Fund Investments, Including Hedge Fund and Manager Names, Identity of Manager Principals, Positions, Returns and Fees,” Hedge Fund Law Report, Vol. 3, No. 27 (Jul. 8, 2010).  See generally “Delaware High Court Affirms Order Compelling Defunct Hedge Fund Parkcentral Global to Divulge Its List of Limited Partners to Another Limited Partner in Order to Facilitate Future Litigation Against the Fund and Its Affiliates,” Hedge Fund Law Report, Vol. 3, No. 33 (Aug. 20, 2010).

European Asset Manager Seeks Recovery from LIBOR Panel Banks for Hedge Funds That Lost Income on LIBOR-Based Derivative Contracts

In a putative class action complaint filed in the U.S. District Court for the Southern District of New York on April 15, 2011, a European asset manager, FTC Capital GMBH, and two of its futures funds, FTC Futures Fund SICAV and FTC Futures Fund PCC Ltd., accused twelve banks of colluding to manipulate the London interbank offered rate (LIBOR) from 2006 to June 2009.  LIBOR generally is the published average of rates at which selected banks (including the defendants) lend to one another in the London wholesale money market.  LIBOR is a global benchmark lenders use to set short-term and adjustable interest rates for almost $350 trillion in financial contracts.  These contracts include those heavily utilized by hedge funds, such as “fixed income futures, options, swaps and other derivative products” traded on the Chicago Mercantile Exchange (CME) and over-the-counter (OTC).  If understated, as alleged in the complaint, LIBOR provides a discount to borrowers, and can cause significant losses to hedge funds that utilize LIBOR-related financial instruments.  This article explains what LIBOR is and how it is used in derivatives contracts, summarizes the material allegations in the complaint and discusses relevant reports in the business press about potential manipulation of LIBOR.

In Refco Securities Litigation, Federal Court Declines to Impute the Bad Acts of Individual Directors of a Hedge Fund Management Company to the Management Company Itself, or its Funds

On April 25, 2011, the United States District Court for the Southern District of New York rejected a special master’s recommendation to dismiss the Refco Inc. multidistrict securities litigation (MDL), noting that the special master failed to read the complaint in a light most favorable to the plaintiffs.  On December 6, 2010, Special Master Daniel J. Capra recommended dismissal of the plaintiffs’ claims, reasoning that plaintiffs were partially to blame for some of the wrongdoing at issue.  However, in the instant action, Judge Jed S. Rakoff disagreed, saying that only a few lines out of the 300-page amended complaint support such a reading.  Specifically, the judge stated: “A motion to dismiss is not designed to be a game of ‘gotcha’ that ignores the clear thrust of hundreds of pages of specific allegations in favor of a line or two here or there that is arguably inconsistent with that thrust.”  For hedge fund managers, this brief opinion is important in illustrating the extent to which a court will impute (or decline to impute) the bad acts of individual directors or officers of a hedge fund management company to the management company itself or the funds under its management.  This article summarizes the background of the action and the court’s legal reasoning, focusing on the in pari delicto doctrine and the “adverse interest exception” – or, in English, the extent to which an entity may be blamed for the bad acts of an individual.

PerTrac’s Eighth Annual “Sizing the Hedge Fund Universe” Study Identifies Trends Regarding AUM, Domicile, Currency and Performance Information Reporting for Single Manager Hedge Funds, Funds of Funds and Commodity Trading Advisors

In its recently released study entitled “Sizing the 2010 Hedge Fund Universe” (Study), software and services provider PerTrac analyzed information from ten leading global hedge fund databases to identify trends with respect to assets under management, domicile, currency and performance information reporting by single manager hedge funds, funds of funds and commodity trading advisors.  The Study generally found that the overall number of entities that existed and reported performance information to databases increased during 2010 over 2009, but that the growth was unevenly distributed among the types of entities under analysis.  Moreover, the Study highlighted the significant number of small managers, and thus, from a regulatory perspective, implicitly emphasized the increased importance of state-level hedge fund adviser registration.  See “Connecticut Welcomes You! Federal Financial Regulatory Reform Restores Connecticut’s Authority over Hedge Fund Advisers,” Hedge Fund Law Report, Vol. 3, No. 30 (Jul. 30, 2010).  This article summarizes the key findings of the Study.  Also, where relevant, this article includes links to other articles in the Hedge Fund Law Report offering concrete guidance to managers on the legal and regulatory implications of the business trends identified by the Study.  See, e.g., “Who Should Newly Registered Hedge Fund Managers Designate as the Chief Compliance Officer and How Much Are Chief Compliance Officers Paid?,” Hedge Fund Law Report, Vol. 4, No. 7 (Feb. 25, 2011).

Former SEC Prosecutor Christian R. Bartholomew Joins Weil, Gotshal & Manges

On May 3, 2011, Weil, Gotshal & Manges announced that Christian R. Bartholomew, a former senior prosecutor with the Securities and Exchange Commission (SEC), has joined the firm as a Partner in its Washington, DC office.  Bartholomew will lead the firm’s SEC enforcement and litigation efforts in Washington.

Guernsey Law Firm Babbé Hires Robert Varley

Guernsey law firm Babbé has appointed Robert Varley to its Corporate & Commercial and Funds teams.  Varley was previously Managing Partner of the Walkers Dubai office.