Jun. 1, 2011

Implications of the Rajaratnam Verdict for the “Mosaic Theory,” the “Knowing Possession” Standard of Insider Trading and Criminal Wire Fraud Liability in the Absence of a Trade

For a decade, Raj Rajaratnam, the founder and principal partner of the much heralded Galleon Group hedge fund, forged a reputation as one of Wall Street’s most accomplished traders.  Galleon managed over $7 billion in assets at its peak and Rajaratnam’s personal wealth, estimated at $22 billion dollars at one point, made the first generation Sri Lankan immigrant one of the wealthiest individuals in the United States.  Not surprisingly then, Rajaratnam’s May 11, 2011 conviction on 14 counts of conspiracy and securities fraud has roiled the hedge fund industry.  The government’s unprecedented use of wiretapping in a securities fraud case serves notice that a powerful and invasive investigative tool will be unleashed against suspected inside traders; there are also strong indications that the unraveling of the Galleon empire and the 25 other indictments flowing from it foreshadow other charges and investigations in the New York investment sector.  As legal precedent, however, the far flung Galleon case has not generally been considered significant.  The prosecution’s theory – that Rajaratnam and his network of associates obtained confidential corporate information from company insiders and then parlayed their knowledge into millions of dollars of gains from stock transactions – is a classic insider trading scenario that has not moved the boundaries of established law.  But beyond the verdict in United States v. Rajaratnam are legitimate questions about the state of insider trading law, most of which is made by judges and bureaucrats rather than lawmakers.  For example, what is the nexus that the government must prove between illegal inside information and specific stock transactions, and what should it be?  For the white collar defense bar and the hedge fund industry, the Rajaratnam verdict also portends trouble for the viability of the “mosaic theory” that the defendant pinned his hopes on at trial.  The jury’s rejection of that defense, and Rajaratnam’s contention that Galleon’s trades were based on a “mosaic” of legitimate, non-confidential pieces of information, raises new uncertainties for a range of investment analysts whose business model depends on the accumulation of information.  Finally, as the government more vigorously pursues insider trading cases, new cutting edge claims of liability are emerging: defendants are being ensnared even when stocks were not actually bought or sold, as occurs in at least some of the December 2010 charges in United States v. Shimoon, et al.  In a guest article, former Congressman and current SNR Denton Partner Artur Davis provides a detailed analysis of: the implications of the Rajaratnam verdict for the mosaic theory; the nexus between inside information and a specific trade required for insider trading liability to attach; the judicial – as opposed to regulatory – basis for the “knowing possession” standard; practical consequences of the verdict for hedge fund investment analysis and trading; how the verdict will impact the ongoing expert networks investigation; potential strategies for a legal challenge to the theory of causation espoused by the SEC in insider trading enforcement actions; the relevance of the “honest services” doctrine for insider trading jurisprudence; and the potential for “wire fraud” charges to criminalize breaches of corporate confidentiality agreements.

Is a Hedge Fund Manager Required to Disclose the Existence or Substance of SEC Examination Deficiency Letters to Investors or Potential Investors?

Following an examination of a registered hedge fund manager by the SEC staff, the staff typically issues a deficiency letter to the manager listing compliance shortcomings identified by the staff during the examination.  See “What Do Hedge Fund Managers Need to Know to Prepare For, Handle and Survive SEC Examinations?  (Part Three of Three),” Hedge Fund Law Report, Vol. 4, No. 6 (Feb. 18, 2011).  Quickly, comprehensively and conclusively remedying compliance shortcomings identified in a deficiency letter should be a first order of business for any hedge fund manager – that is the easy part, a point that few would dispute.  However, considerably more ambiguity surrounds the question of whether and to what extent hedge fund managers must disclose to investors and potential investors various aspects of SEC examinations – including their existence, scope, focus and outcome.  More particularly, hedge fund managers that receive deficiency letters routinely ask: must we disclose the fact of receipt of this deficiency letter or its contents to investors or potential investors?  And does the answer depend on whether potential investors have requested information about or contained in a deficiency letter in due diligence or in a request for proposal (RFP)?  The answers to these questions generally have been governed by a “materiality” standard – the same standard that, at a certain level of generality, governs all disclosure questions.  The consensus guidance has been: disclose whatever is material.  But this is more of a reframing of the question than an answer.  The practical question in this context is how to assess materiality in the interest of disclosing adequately, avoiding anti-fraud or breach of fiduciary duty claims and ensuring best investor relations practices.  A recently issued SEC order (Order) settling administrative proceedings against a registered investment adviser provides limited guidance on the foregoing questions.  This article describes the facts recited in the Order, the SEC’s legal analysis and how that analysis can inform decision-making of hedge fund managers considering whether and to what extent to disclose the existence or substance of deficiency letters to investors or potential investors.  This analysis has particular relevance for hedge fund managers seeking to grow institutional assets under management by responding to RFPs.

Are Side Letters Granting Preferential Transparency and Liquidity Terms to One Investor Ipso Facto Illegal?

We recently analyzed a decision of an SEC administrative law judge (ALJ) holding that fund-level information, as opposed to portfolio-level information, can constitute material nonpublic information (MNPI) for insider trading purposes.  See “SEC Administrative Decision Holds That, For Insider Trading Purposes, Fund-Level Information, as Opposed to Investment-Level Information, May Constitute Material Nonpublic Information,” Hedge Fund Law Report, Vol. 4, No. 14 (Apr. 29, 2011).  Specifically, the ALJ held that information regarding a major fund redemption, fund management’s decision to increase cash levels and efforts to sell a large portion of the bonds in the fund’s portfolio each constituted MNPI.  Accordingly, the ALJ found that the fund manager’s recommendation to his daughter to sell fund shares while the manager was aware of the foregoing three categories of MNPI constituted insider trading under a tipper-tippee theory.  On the scope of the tipper-tippee theory, see the heading “Insider Trading Law” in “How Can Hedge Fund Managers Avoid Insider Trading Violations When Using Expert Networks?  (Part One of Two),” Hedge Fund Law Report, Vol. 4, No. 5 (Feb. 10, 2011).  As explained in our analysis, while that decision arose in the mutual fund context, it has direct relevance for hedge fund managers and investors.  One of the more provocative questions raised by the decision is: are side letters granting preferential transparency and liquidity terms to one investor ipso facto illegal?  For more on side letters, see “What Is the Legal Effect of a Side Letter That Contains Specific Terms More Favorable Than a Hedge Fund’s General Offering Documentation?,” Hedge Fund Law Report, Vol. 4, No. 16 (May 13, 2011).

Bankruptcy Court Holds That a Provision in a Derivative Contract Subordinating Payments to a Bankrupt Counterparty May Be an Unenforceable Ipso Facto Clause

On May 12, 2011, the United States Bankruptcy Court for the Southern District of New York, in its oversight of the jointly administered chapter 11 bankruptcy cases of Lehman Brothers Holding, Inc. (LBHI) and Lehman Brothers Special Financing, Inc. (LBSF), found that a provision in a derivative contract that would subordinate payments to a counterparty in the event of its bankruptcy or insolvency may constitute an unenforceable ipso facto clause, and that the termination payments provision of the relevant contract was not eligible for the Bankruptcy Code safe harbor for qualified financial contracts.  This decision reaffirmed the holding in a prior decision in the LBHI bankruptcy.  Although this decision largely follows the legal analysis in the prior decision rather than breaking new legal ground, this decision is likely to increase the negotiating leverage of the LBHI estate vis-à-vis swap and other counterparties.  More generally, the decision sheds additional light on the treatment of bankruptcy/insolvency-based termination provisions in derivatives contracts.  This article details the background of the adversary proceeding and the Court’s legal analysis.  For more on the operation of bankruptcy/insolvency-based termination provisions in qualified financial contracts under the Bankruptcy Code and Title II of the Dodd-Frank Act, see “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,” Hedge Fund Law Report, Vol. 4, No. 15 (May 6, 2011).

Fifth Circuit Rules that Hedge Fund Limited Partnership Agreement Was Unambiguous and that Portfolio Manager’s Departure Did Not Trigger Investors’ Withdrawal Rights

Plaintiffs were investors in hedge fund Tuckerbrook/SB Global Special Situations Fund, L.P. (Fund).  Sumanta Banerjee (Banerjee) was a 50% owner and managing member of the Fund’s general partner and served as the Fund’s portfolio manager.  The Fund’s limited partnership agreement permitted withdrawal in the event Banerjee ceased to be “directly or indirectly involved in the activities of” the Fund’s general partner.  The Fund terminated Banerjee’s employment as portfolio manager in March, 2008, and plaintiffs promptly requested redemption of their Fund interests.  The Fund refused and the investors sued.  The U.S. District Court granted summary judgment dismissing the investors’ complaint, ruling that Banerjee was in fact still “involved” with the general partner even though he was no longer portfolio manager.  The U.S. Court of Appeals for the Fifth Circuit recently affirmed the District Court’s decision.  We summarize the factual background of Court of Appeals’ decision, including relevant language from the limited partnership agreement, and the Court’s legal analysis.  For a discussion of the District Court’s opinion, on which the Fifth Circuit relied heavily, see “Texas District Court Rules that Hedge Fund Limited Partners’ Withdrawal Rights Were Not Triggered by Termination of Fund Principal's Employment with the Fund, where Principal Continued to Exert Influence Over the Fund as 50 Percent Owner of the Fund's General Partner,” Hedge Fund Law Report, Vol. 3, No. 13 (Apr. 2, 2010).

Does a Hedge Fund Manager Have Standing to Pursue Claims on Behalf of a Hedge Fund?

A recent decision by the United States District Court for the Eastern District of California addressed whether the typical legal arrangements between a hedge fund of funds manager and a fund under its management confer standing on the manager to bring claims on behalf of the fund against an underlying manager and other entities.  The decision is relevant for hedge fund and fund of funds managers in identifying the appropriate party to serve as a plaintiff in litigation, and for evaluating their D&O insurance and indemnification arrangements.  See “Exculpation and Indemnity Clauses in the Hedge Fund Context: A Cayman Islands Perspective (Part Two of Two),” Hedge Fund Law Report, Vol. 4, No. 1 (Jan. 7, 2011).  This article explains the relevant factual background, the constitutional requirements to establish standing in federal court and the primary lessons of the decision for hedge fund managers.

Rothstein Kass Survey Reveals Optimism on the Part of Hedge Fund Managers with Respect to Capital Raising, Talent Mobility, Seeding, Industry Consolidation, and In Other Areas

Rothstein Kass, the provider of audit, tax, accounting and advisory services to private investment funds and their advisers, recently released the results of a survey of 313 hedge fund managers conducted in January of this year.  The survey provides market color on a wide range of relevant topics, and highlights the differing perceptions among larger and smaller managers.  Topics covered by the survey include: registration; talent mobility; optimism among managers; seeding; hedge fund industry consolidation; where the next investment bubble will develop and when it will pop; leverage and liquidity; capital raising; family offices; technology; the role of consultants; fees; outsourcing; branding and communications; and anticipated areas of regulatory scrutiny.  This article summarizes the salient findings of the survey on the foregoing topics, and elaborates on the survey findings with links to relevant articles published in the Hedge Fund Law Report.

David Goldstein and Gerald Rokoff Join DLA Piper in New York

On June 1, 2011, DLA Piper announced that David Goldstein and Gerald Rokoff, both formerly of White & Case LLP, have joined the firm as Partners in New York.  Goldstein joins the firm’s global Finance Group and will lead the Investment Funds Practice.  Rokoff joins the Tax Group.  Goldstein has been quoted regularly in the Hedge Fund Law Report.  See, e.g., “As Banks Close Prop Desks and Traders Move to Hedge Funds, Hedge Fund Managers Focus on Permissible Scope of Use of Confidential Information,” Hedge Fund Law Report, Vol. 2, No. 18 (May 7, 2009); “Hedge Fund Managers Grapple with Legal and Practical Consequences of Demands from CalPERS, URS and Other Pension Funds for Better Investment Terms and Separate Accounts,” Hedge Fund Law Report, Vol. 2, No. 14 (Apr. 9, 2009).

Katten’s UK Affiliate Welcomes New Hires from Allen & Overy

On May 31, 2011, Katten Muchin Rosenman LLP announced that financial services attorneys Carolyn Jackson and Nathaniel Lalone joined the firm’s UK affiliate, Katten Muchin Rosenman UK LLP, from Allen & Overy.  See “Katten Muchin Rosenman Hosts Program on ‘Infected Hedge Funds’ Highlighting Rights and Remedies of Investors in Hedge Funds Whose Managers are Accused of Insider Trading or of Operating Ponzi Schemes,” Hedge Fund Law Report, Vol. 3, No. 12 (Mar. 25, 2010).