Jul. 14, 2011

OTC Derivatives Clearing: How Does It Work and What Will Change?

New over-the-counter (OTC) derivatives regulations have been proposed in both the U.S. and the E.U., which once finalized will affect how market participants trade, provide margin with respect to and settle OTC derivatives.  The new regulations will have an impact on the liquidity, transparency and pricing for these products and a key component of both regimes will be the central clearing of certain standardized swaps.  If a market participant wishes to engage in a swap that is of a type that the applicable regulator has determined must be cleared, the swap must be submitted to a clearinghouse for clearing unless an exception applies.  While certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act passed by the U.S. Congress last year will become effective on July 16, 2011, most key provisions are expected to be finalized by the end of 2011.  In Europe, the new derivatives regulations proposed by the European Commission are still pending.  OTC derivatives clearing will therefore soon become a reality for most market participants in the U.S. – including many hedge funds – as well as foreign market players trading these products with U.S. counterparties.  In a guest article, Fabien Carruzzo and Joshua Little, Senior Associate and Associate, respectively, at Kramer Levin Naftalis & Frankel LLP, describe the clearing process, how hedge funds and other market participants will trade and access clearing and what will change from the current bilateral trading model.  Carruzzo and Little also address margin requirements and how trades and margin are protected in the event of default by a dealer (clearing member).  Finally, the authors provide a general overview of the documentation governing contractual relationships among market participants.

Will Hedge Fund Managers That Do Not Have To Register with the SEC until March 30, 2012 Nonetheless Have To Register in New York, Connecticut, California or Other States by July 21, 2011?

Historically, many hedge fund managers have avoided registering with the SEC as investment advisers in reliance on Section 203(b)(3) of the Investment Advisers Act of 1940, as amended (Advisers Act).  That section – often referred to as the “private adviser exemption” – provided that an investment adviser would not have to register with the SEC if it (1) had fewer than 15 clients in the preceding 12 months, (2) did not hold itself out generally to the public as an investment adviser and (3) did not act as an investment adviser to a registered investment company or business development company.  The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama on July 21, 2010 (Dodd-Frank Act) repealed Section 203(b)(3) of the Advisers Act, effective as of the July 21, 2011 anniversary of the effective date of the Dodd-Frank Act.  However, the Dodd-Frank Act also authorized the SEC to delay (beyond July 21, 2011) the registration deadline for hedge fund managers that (1) previously avoided registration based on the private adviser exemption and (2) were not eligible for another registration exception.  On June 22, 2011, the SEC exercised this authority and delayed until March 30, 2012 the date by which hedge fund managers that are no longer eligible for a federal registration exemption (as of July 21, 2011) will have to register with the SEC.  The majority of hedge fund industry participants greeted the federal registration deadline delay with a sigh of relief (although a vocal minority noted that the delay penalized managers that scrambled to prepare).  However, the federal registration relief created a state registration headache for many hedge fund managers.  Specifically, the investment adviser registration laws or rules of various states effectively incorporate the federal private adviser exemption by reference.  The federal private adviser exemption will be repealed as of July 21, 2011.  Therefore, as of July 21, 2011, states with laws or rules that incorporate the federal private adviser exemption by reference will no longer have effective registration exemptions.  Absent state-level registration deadline delays or other state-level exemptions, hedge fund managers face the prospect of required registration in various states.  What should hedge fund managers do?

Second Circuit Adopts Broad Interpretation of Bankruptcy Code § 546(e) Safe Harbor for Securities “Settlement Payments,” Ruling that Safe Harbor Applies to Enron’s Redemptions of Its Own Commercial Paper Prior to Maturity

In the months leading up to Enron Corp.’s bankruptcy, Enron drew down on its available credit lines.  It used about $1.1 billion of the loan proceeds to redeem commercial paper that it had issued prior to maturity.  Enron redeemed the paper at face value even though it was trading at a substantial discount.  Enron filed for bankruptcy in December 2001 and emerged as a reorganized entity, Plaintiff Enron Creditors Recovery Corp. (together with Enron Corp., Enron).  In 2003, Enron commenced adversary proceedings against about 200 financial institutions from which it had repurchased commercial paper in 2001.  Enron claimed that those payments could be “avoided” and recovered because they were either preferential payments of antecedent debt made within ninety days prior to bankruptcy or fraudulent transfers because Enron paid more than fair market value for the paper.  The Defendants moved for summary judgment on the ground that Enron’s payments were securities “settlement payments” protected from recovery by a safe harbor in the Bankruptcy Code.  The Bankruptcy Court denied the Defendants’ motion.  The U.S. district court reversed the bankruptcy judge’s decision and dismissed the action.  On appeal, the Second Circuit upheld that dismissal, adopting a broad interpretation of the § 546(e) safe harbor.  We provide a detailed review of the Second Circuit’s legal analysis, and of the decisions below.

Will a Criminal Court Admit into Evidence a Recorded Telephone Conversation Between a Hedge Fund Manager Charged with Insider Trading and an Alleged Co-Conspirator?

Much has been said of late about the new investigative and enforcement tools being used by the Securities and Exchange Commission (SEC), Department of Justice (DOJ) and Federal Bureau of Investigation (FBI) to combat insider trading.  See “The SEC’s New Focus on Insider Trading by Hedge Funds,” Hedge Fund Law Report, Vol. 3, No. 22 (Jun. 3, 2010).  On the civil side, the SEC has restructured its Enforcement Division into industry units, hired former federal prosecutors to serve in the Enforcement Division, authorized Enforcement Division staff to enter into non-prosecution agreements and cooperation agreements and increased its use of technology to analyze trading trends for suspect patterns.  See “SEC’s Hedge Fund Focus to Include Review of Funds That Outperform the Market,” Hedge Fund Law Report, Vol. 4, No. 14 (Apr. 29, 2011).  On the criminal side, the DOJ and FBI have incorporated into their anti-insider trading efforts tools formerly reserved for the investigation and prosecution of organized crime.  Most notably, the FBI is using wiretaps in its investigations of hedge fund managers for insider trading, and the DOJ is using the fruits of such wiretaps in its prosecutions.  The legal authority for the agencies to use wiretaps in the hedge fund context was affirmed in an important district court decision in November 2010.  See “Federal District Court Upholds the Government’s Right to Use Wiretaps to Investigate Suspected Insider Trading by Hedge Fund Manager Personnel,” Hedge Fund Law Report, Vol. 3, No. 48 (Dec. 10, 2010).  And, of course, the most notable example (to date) of the government’s successful use of wiretap evidence in an insider trading prosecution in the hedge fund context was the May 11, 2011 conviction of Galleon Group founder Raj Rajaratnam.  See “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,” Hedge Fund Law Report, Vol. 4, No. 18 (Jun. 1, 2011).  Prior to the use of wiretap evidence in insider trading investigations and prosecutions, most insider trading cases were based on circumstantial evidence.  With the advent of the use of wiretap evidence in this context, insider trading cases can now be based on direct evidence.  As some white collar defense attorneys observed, although Rajaratnam elected not to take the stand at his own trial, he nonetheless served as the prosecution’s “star witness.”  Rajaratnam’s voice appeared in hours of recorded phone calls that were played for the jury, discussing what the prosecution characterized as material nonpublic information.  For the defense, these recordings proved insurmountable.  In short, wiretapping by the government has changed the landscape of insider trading law for hedge fund managers.  But the government is not the only party that records phone calls.  With a level of frequency that keeps white collar defense lawyers up at night – although some of them are up thinking about new business rather than worrying – hedge fund managers and other hedge fund industry participants record their own phone calls.  Often, they do this for what they consider practical reasons rather than for legal or regulatory reasons.  For example, a manager that submits frequent trade orders to its brokers may record calls to create a record for any dispute over a trade error.  Or a manager may record an analyst’s calls with an expert found via an expert network for compliance reasons.  However, in the current enforcement climate, any hedge fund manager that records its own phone calls must weigh the perceived benefits of such recordings against the possibility that recorded calls will be admitted into evidence (and invariably taken out of context) in a civil enforcement action or criminal prosecution.  A June 29, 2011 Opinion by U.S. District Court Judge Jed Rakoff illustrates the legal standards that govern admission of phone calls and other communications recorded by a hedge fund manager in a criminal proceeding against a third party alleged to have provided material nonpublic information to the manager.  For discussion of other opinions by Judge Rakoff in the hedge fund context, see “A Prime Broker that Fails to Diligently Investigate the Sources of Funds in a Hedge Fund’s Margin Account May Be Jointly and Severally Liable, with the Fund and Its Manager, for Fraud by the Manager, to the Extent of Funds in the Account,” Hedge Fund Law Report, Vol. 3, No. 47 (Dec. 3, 2010); “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,” Hedge Fund Law Report, Vol. 4, No. 15 (May 6, 2011).

Seventh Circuit Holds that Secured Lenders Must Have the Opportunity to Credit Bid in Asset Sales Under a Chapter 11 Plan

“Credit bidding” refers to the ability in bankruptcy of a secured creditor to bid up to the amount of its secured claim in order to acquire the assets against which it holds a lien.  By allowing a secured creditor to bid up to the full amount, even where the fair market value of the collateral is less than the amount of the debt, the secured creditor can protect against the undervaluation of its collateral in the bankruptcy sale process.  While Section 363(k) of the Bankruptcy Code guarantees the right of a secured creditor to credit bid in sales under Section 363, absent certain extraordinary circumstances, two recent opinions from the Third and Fifth Circuits had created substantial doubt as to whether the secured creditor’s right to credit bid is, in fact, absolute.  In those appeals, arising in the context of asset sales conducted in conjunction with Chapter 11 plans of reorganization, the Third Circuit (In re Philadelphia Newspapers, LLC, 599 F.3d 298 (3d Cir. 2010)) and the Fifth Circuit (In re Pacific Lumber Co., 584 F.3d 229 (5th Cir. 2009)) held that a debtor may sell a secured creditor’s collateral free and clear of liens without providing the secured creditor with a right to credit bid in the sale process.  On June 28, 2011, the United States Court of Appeals for the Seventh Circuit confronted similar facts but reached a different legal conclusion.  We examine the background of the Seventh Circuit’s opinion, its legal analysis and the opinion’s implications for secured lenders.

Christopher Holt Named Managing Director of the Global Absolute Return Congress

Christopher Holt, founder of AllAboutAlpha.com – an online strategic information service for the hedge fund industry, currently edited by industry veteran Kristin Fox – has been named managing director of the Global Absolute Return Congress, a network of pension funds, endowments, sovereign wealth funds and asset managers.

Matthew J. Rizzo Joins Sidley Austin LLP as Private Equity Partner in New York

On July 1, 2011, Sidley Austin LLP announced that Matthew J. Rizzo has joined the firm as a Partner, resident in New York.  Rizzo will focus his practice on private equity, mergers and acquisitions and venture capital.