Aug. 12, 2011

Two Key Levels of Risk Facing Hedge Funds That Buy or Sell Bankruptcy Claims

The bankruptcy claims trading market is growing at a rapid clip.  By one estimate, the global bankruptcy claims trading market grew by five times, from $8 billion in 2009 to $40 billion in 2010.  According to our sources, even with significant cash on corporate balance sheets, sovereign credit concerns are likely to lead, directly or indirectly, to corporate defaults – particularly in Europe – which will only increase the size of the claims trading opportunity set.  Claims trading is complex, interdisciplinary, obscure, laborious and largely unregulated.  In short, it is the sort of investment activity for which certain hedge funds are ideally structured and staffed; and, not surprisingly, trading by hedge funds has been a significant driver of the growth in claims trading.  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).  As hedge fund managers that participate in claims trading know, and as managers that consider entry into the claims trading market quickly find out, investment outcomes when trading claims are powerfully influenced by legal considerations.  See “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,” Hedge Fund Law Report, Vol. 4, No. 24 (Jul. 14, 2011).  And legal considerations typically apply to claims trades at two levels – the estate level and the trade level.  The chief risk at the estate level is that the ultimate value of the estate will depart significantly from the expected value of the estate at the time of purchase of a claim.  The chief risks at the trade level are that the claim will be disallowed, reduced or subordinated, or that the seller of the claim itself will become insolvent.  This article analyzes the two levels of legal risk in claims trading by examining two different sources.  First, with respect to “estate risk,” this article provides a comprehensive analysis of a recent decision by Judge Rakoff in the Madoff liquidation.  That decision generally held that the Trustee does not have standing to bring common law claims against third parties on behalf of creditors of the Madoff estate or the estate itself.  While one typically thinks of spreadsheets rather than standing when thinking about hedge fund returns, this decision may have a material impact on the value of Madoff claims, in which a robust market has developed.  (As of immediately prior to the Rakoff decision, Madoff claims were trading for 65 to 70 cents on the dollar.)  The common law claims that Judge Rakoff did not permit to proceed sought approximately $8.6 billion from deep-pocketed defendants.  Further, a significant portion of the expected value of the Madoff estate consisted (at least prior to this decision) of anticipated proceeds from similar common law claims against similarly situated defendants, i.e., large financial institutions that served as “conduits” for investments into the Madoff operation.  Moreover, Rakoff’s decision was stern, unambiguous and forcefully reasoned.  According to our sources, the decision is unlikely to be reversed or revised on appeal.  Second, with respect to trade risk, this article outlines an insightful recent article authored by Lawrence V. Gelber, David J. Karp, and Jamie Powell Schwartz, Partner, Special Counsel and Associate, respectively, at Schulte Roth & Zabel LLP.  In particular, this article outlines the relevant points from the Schulte article regarding “notional amount risk,” “counterparty credit risk” and how to mitigate both categories of risk in claim trade documentation.  In short, any hedge fund manager considering the purchase of a bankruptcy claim must ask two questions in order to assess whether to purchase and at what price: How big is the pie?  And how secure will my access to the pie be?  The purpose of this article is to highlight issues that are relevant in answering these two questions.

U.K. Supreme Court Rules That Change in Priority over Dante CDO Collateral Triggered by Lehman Bankruptcy Does Not Violate Britain’s Anti-Deprivation Bankruptcy Rule

Belmont Park Investments PTY Limited was one of several Australian institutional investors (Noteholders) that purchased notes under the “Dante” collateralized debt obligation (CDO) program sponsored by Lehman Brothers Special Financing Inc. (Lehman).  The proceeds of the Dante notes were used by a Lehman special purpose vehicle to purchase AAA rated debt instruments that were held by BNY Corporate Trustee Services Limited as collateral to secure the parties’ obligations under the CDO and a related credit default swap.  Central to this dispute were CDO and swap provisions that shifted priority to the collateral from Lehman to the Noteholders in the event of Lehman’s bankruptcy.  In related cases involving Lehman, U.S. Bankruptcy Courts had previously ruled that the priority-shifting provision was a prohibited ipso facto clause, and ruled that Lehman retained first priority to the collateral.  In contrast, the U.K. Supreme Court has now ruled that the provision does not violate the United Kingdom’s anti-deprivation rule.  We summarize the Supreme Court’s decision.  For a discussion of a related U.S. Bankruptcy Court decision, see “Bankruptcy Court Holds That a Provision in a Derivative Contract Subordinating Payments to a Bankrupt Counterparty May Be an Unenforceable Ipso Facto Clause,” Hedge Fund Law Report, Vol. 4, No. 18 (June 1, 2011).  See also “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).

Federal Court Decision Holds That a Fund of Funds Investor May Sue a Fund of Funds Manager That Fails to Perform Specific Due Diligence Actions Promised in Writing and Orally

A recent federal district court order (Order) described the range of legal claims available to an investor in a hedge fund of funds for alleged inconsistencies between the fund of funds manager’s representations and actions regarding due diligence and monitoring.  Read narrowly, the Order may merely stand for the proposition that a fund of funds manager may not promise to undertake specific actions in the course of due diligence and monitoring, accept investor money based on those representations then fail to take those actions.  Read more broadly, the Order may foreshadow a heightening of the legal standard to which hedge fund of funds managers are held when conducting due diligence and monitoring.  That is, the Order may presage a decision on the merits to the effect that fund of funds managers have a legal duty more or less consonant with industry best practices regarding due diligence.  That would constitute a significant increase in the level of legal obligations applicable to fund of funds managers, but would not enhance the commercial standard of care, which already demands best practices.

SEBI Proposes to Regulate Indian Hedge Funds

On August 1, 2011, the Securities and Exchange Board of India (SEBI) proposed a comprehensive set of draft regulations for all types of Alternative Investment Funds (AIFs), including private equity, venture capital, private investment in public equity, real estate and strategy funds (which includes hedge funds).  SEBI published the “Concept Paper on Proposed Alternative Investment Funds Regulation” in response to gaps in India’s regulatory regime and the concomitant risks to its markets.  The proposals aim to deter unfair trade practices and mitigate conflicts of interest via regulations mandating registration, imposing disclosure requirements, and setting limits on targeted investors, fund size, fund tenure, and fund strategies, including the extent of leverage and use (without investor consent) of complex structured products.  The resulting regulations, termed “SEBI (AIF) Regulations of 2011,” overhaul the regulatory regime currently in place, which had allowed funds, including hedge funds, to conduct business effectively without oversight.  See “Working Paper Analyzes India’s Approach to Hedge Fund Regulation,” Hedge Fund Law Report, Vol. 1, No. 14 (Jun. 19, 2008).  This article details the background of the regulatory environment that resulted in this concept paper, and the proposed regulations as they pertain to hedge funds.  For a discussion of a jurisdiction in which hedge fund managers commonly organize entities to access Indian opportunities, see “Hedging into Africa through Cayman and Mauritius,” Hedge Fund Law Report, Vol. 4, No. 7 (Feb. 25, 2011).

K&L Gates Continues New York Office Growth with Corporate Partner Addition

On July 27, 2011, global law firm K&L Gates LLP announced the addition of Peter J. Fitzpatrick as a corporate partner in its New York office.  Mr. Fitzpatrick provides general corporate counsel and advice to a diverse client base, including hedge funds.

James Tinworth Joins Stephenson Harwood’s Funds Practice in London

International law firm Stephenson Harwood has appointed James Tinworth as a corporate partner in the firm’s funds practice in London.