Jul. 27, 2011

Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices

The United States District Court for the Southern District of New York recently issued judgments in favor of three bankrupt hedge funds in fraudulent conveyance actions against investors that redeemed within two years of the funds’ bankruptcy filings.  The hedge funds were members of the Bayou group of hedge funds, which – as the hedge fund industry knows well – was a fraud that collapsed in August 2005, resulting in bankruptcy filings by the Bayou funds and related entities in May 2006.  These judgments are very important for hedge fund investors because they illustrate what appears to be a direct conflict between bankruptcy law and hedge fund due diligence best practices.  In short, hedge fund due diligence best practices currently counsel in favor of redemption at the first whiff of fraud on the part of a manager.  However, bankruptcy law appears to require a hedge fund investor to undertake a “diligent investigation” when it obtains facts that put it on inquiry notice of insolvency of the fund or a fraudulent purpose on the part of the manager.  The immediacy of a prompt redemption is directly at odds with the delay inherent in a diligent investigation.  How can hedge fund investors reconcile the practical goal of prompt self-help with the legal obligation of a diligent investigation?  To help answer that question, this feature length article surveys the factual and procedural history of the Bayou matters, then analyzes the arguments and outcome in the recent Bayou trial.  The primary question at the trial was whether certain investors that redeemed from the Bayou funds could keep their redemption proceeds based on “good faith” defenses to the Bayou estate’s fraudulent conveyance actions.  In the absence of a court opinion, the Hedge Fund Law Report analyzed the 142-page transcript of the closing arguments, as well as the motion papers filed by the parties and four prior bankruptcy court and district court opinions.  This article embodies the results of our analysis.  The article concludes by identifying five ways in which hedge fund investors may reconcile hedge fund due diligence best practices with the seemingly draconian outcome in these recent Bayou judgments.

Fourteen Due Diligence Lessons to Be Derived from the SEC’s Recent Action against a Serial Practitioner of Hedge Fund Fraud

On July 13, 2011, the SEC issued an Order making findings and imposing remedial sanctions against an individual hedge fund manager.  The Order describes a career involving modest and infrequent investment successes, and predominantly characterized by repeated, serial and egregious frauds.  The diversity and audacity of the frauds make for lurid reading, but the relevance of the Order for the Hedge Fund Law Report and our subscribers resides in the due diligence lessons to be derived from the factual findings.  This article details the factual findings in the Order, then extracts 14 distinct due diligence lessons from those facts.  Many of our institutional investor subscribers will read the factual findings and say, “This could never happen to me.”  And they may be right.  But we never cease to be amazed by the level of sophistication of investors caught up in even the most crude and simple frauds.  Perhaps this is because our industry is based on trust, and despite the salience of fraud, fraud remains (fortunately) the exception to the wider rule of ethical conduct.  Perhaps it is because frauds that look simple in retrospect were difficult to discover in the moment.  Regardless of the reason, hedge fund investors of all stripes and sizes can benefit from ongoing refinement of their due diligence practices.  And we continue to believe that the best way to refine due diligence practices is to look at what went wrong in actual cases and to revise your list of questions and techniques accordingly.  Here is a useful test for hedge fund investors: read the facts of this matter, as described in this article, then pause to ask yourself: Would our current due diligence practices have discovered all of these facts and caused us to pass on this investment or to redeem?  If the answer is yes, you can stop reading.  But if the answer is no – that is, if your due diligence practices may have missed any aspect of this fraud – we strongly encourage you to read and incorporate our fourteen lessons.  We would also note that we have undertaken similar exercises with respect to prior SEC actions.  That is, we have reviewed allegations of hedge fund manager fraud and detailed the due diligence steps that may have uncovered such frauds.  All of our thinking on this topic is available in the “Due Diligence” section of our Archive.

Second Circuit Decision Sends CSX and Hedge Fund Suitors TCI and 3G Back to District Court to Examine When Funds Formed a “Group” to Acquire CSX Stock, Leaving Unresolved the Issue of Beneficial Ownership of Shares Referenced in Cash-Settled Total-Return Equity Swaps

In 2006, hedge funds sponsored by The Children’s Investment Fund Management and 3G Capital Management (respectively, TCI and 3G, or the Funds) believed shares of railroad giant CSX Corporation (CSX) were undervalued and sought to “unlock” that value by influencing CSX management.  The Funds acquired positions in CSX both directly and through cash-settled total-return equity swaps that referenced CSX stock.  See “IRS Directive and HIRE Act Undermine Tax Benefits of Total Return Equity Swaps for Offshore Hedge Funds,” Hedge Fund Law Report, Vol. 3, No. 12 (Mar. 25, 2010).  Unable to persuade CSX management to change its policies, in January 2008, the Funds commenced a proxy fight.  In response, CSX sued the Funds for violating the disclosure requirements of Section 13(d) of the Securities and Exchange Act of 1934.  CSX argued that the Funds were the beneficial owners of the CSX shares that the Funds' counterparties had acquired to hedge the swap contracts and that the Funds had been operating as an undisclosed “group.”  The District Court agreed and enjoined the Funds against future violations of Section 13(d) but refused to prohibit the Funds from voting their shares at the CSX meeting.  See “District Court Holds that Long Party to Total Return Equity Swap May be Deemed to have Beneficial Ownership of Hedge Shares Held by Swap Counterparty,” Hedge Fund Law Report, Vol. 1, No. 14 (Jun. 19, 2008).  Each of the parties appealed different parts of the District Court’s decision, and on July 18, 2011 – almost three years after the appeal was argued – the Second Circuit issued its long-awaited decision in the matter.  This article summarizes the Second Circuit’s decision.  For a summary of the original complaint in this matter, see “CSX Sues Hedge Funds TCI and 3G for Violating Federal Securities Laws,” Hedge Fund Law Report, Vol. 1, No. 4 (Mar. 24, 2008).

United Kingdom’s High Court Finds Argentina’s Sovereign Immunity Doctrine Cannot Prevent a Hedge Fund from Seeking to Enforce an American Judgment against Argentina in English Courts

In 1994, the Republic of Argentina issued a series of sovereign bonds.  The bonds contained a jurisdictional clause stipulating governance under New York law.  NML Capital Limited (NML), a Cayman Islands-based hedge fund and affiliate of New York-based Elliot Management, purchased the then-distressed bonds between June 2001 and September 2003 at about half their face value.  As previously reported in the Hedge Fund Law Report, Argentina suspended interest and principal payments on this debt in December 2001 and NML Capital filed eleven lawsuits against Argentina.  See “If a Hedge Fund Holder of Defaulted Sovereign Debt Obtains a Judgment Against the Defaulting Sovereign, What Assets Can the Hedge Fund Go After to Satisfy the Judgment?,” Hedge Fund Law Report, Vol. 4, No. 21 (Jun. 23, 2011) (also detailing one such lawsuit involving NML and Argentina in the United States District Court for the Central District of California).  In one such action, NML sued Argentina for the bonds’ full value with interest in the United States District Court for the Southern District of New York.  On December 18, 2006, the Southern District entered a summary judgment order in favor of NML and against Argentina for the sum of about $284 million.  NML sought to enforce the judgment and recover assets internationally.  NML brought a successful common law action in the English Commercial Court.  However, that judgment was reversed by the Court of Appeal (an intermediate appellate court), which held that Argentina is protected by state immunity.  On July 6, 2011, the Supreme Court of the United Kingdom unanimously overturned the decision of the Court of Appeal.  This decision provides greater certainty to hedge funds holding distressed government debt regarding their ability to seek recovery in English courts.  We summarize the background of the action and the English high court’s legal analysis.

District Court Holds that a Hedge Fund Manager Cannot Reasonably Rely on a Single Statement by the Potential Acquirer of a Corporate Division that an Acquisition Was “99.9% Done”

In December 2007, Chinatron Group Holdings, Limited (Chinatron), a distributor of mobile phones, approached plaintiff Sofaer Global Hedge Fund (Fund) for a $10 million loan.  Chinatron’s principal, John Maclean-Arnott (Arnott), claimed that Chinatron had a firm deal to sell one of its subsidiaries to defendant Brightpoint, Inc. (Brightpoint) and that the proceeds of sale would be used to repay the Fund’s loan.  The Fund claimed that, during a December 17, 2007 conference call among Arnott, Michael Sofaer and defendant Robert Laikin (Laikin), Brightpoint’s founder, Laikin told Sofaer that Brightpoint intended to buy one of Chinatron’s subsidiaries for $14 million within a few months and that the deal was “99.9% done.”  Based on those representations, the Fund lent Chinatron $10 million, which was to be repaid in three months with a $2 million “premium” and other upside potential.  Brightpoint’s acquisition, however, never proceeded and Chinatron defaulted on the Fund’s loan.  The Fund sued Brightpoint and Laikin for fraud.  The defendants moved for summary judgment.  In a scathing and entertaining decision, the District Court assessed the merits of the Fund’s complaint.  We summarize that decision.

Fontana Capital Settlement Serves as a Reminder That Hedge Fund Managers May Violate Rule 105 of Regulation M by Purchasing Securities of an Issuer in a Secondary Offering Following a Short Sale of Securities of the Same Issuer, Even If the Purchased Securities Are Not Used to Cover the Short Sale

A recent SEC Order making findings and imposing remedial sanctions against hedge fund manager Fontana Capital, LLC and its principal serves as a timely reminder that a hedge fund manager may be found to have violated Rule 105 of Regulation M when, on behalf of a fund, it engages in a short sale of securities of an issuer in the five business days prior to the pricing of a secondary offering by an issuer, then purchases shares of the issuer in the offering – even if the shares purchased in the offering are not used to cover the short sale.

Arthur Richardson Joins Prisma Capital Partners’ Risk Management Team

On July 19, 2011, Prisma Capital Partners announced that Arthur Richardson has joined the firm as risk manager.  See “Girish Reddy, Founder of Prisma Capital Partners, Discusses Starting a Hedge Fund, the Future of the Hedge Fund Industry and Techniques for Conducting Due Diligence,” Hedge Fund Law Report, Vol. 2, No. 3 (Jan. 21, 2009).

David Blass Named Chief Counsel in the SEC’s Division of Trading and Markets

On July 21, 2011, the Securities and Exchange Commission announced that David W. Blass has been named Chief Counsel and Associate Director for the SEC’s Division of Trading and Markets.  The Division’s Office of Chief Counsel provides legal and policy advice to the Commission in establishing rules on matters affecting broker-dealers and the operation of the securities markets.  The office also issues interpretations regarding matters arising under the Securities Exchange Act of 1934.

Cole-Frieman LLP & Mallon P.C. Merge to Form Boutique Hedge Fund Law Practice

On July 27, 2011, two San Francisco-based law firms, Cole-Frieman LLP and Mallon P.C., announced that their firms will merge to create Cole-Frieman & Mallon LLP.  The combined firm will be a boutique generalist firm focusing on hedge fund managers and hedge fund investors.