Sep. 22, 2011

Merchant Power Regulatory Roulette

Billions of dollars of merchant power debt tied to aging, largely coal-fired, power plants is subject to escalating financial stress and attracting increasing attention from hedge fund investors.  Recent public examples include Energy Future Holdings (TXU), EME Homer City and Astoria Generating.  To a large extent, current merchant power economics and future prospects are driven by overall power demand and natural gas prices insofar as natural gas plants currently have a price advantage in many competitive power pools they have not previously enjoyed.  Thus, investment decisions regarding debt related to coal-fired merchant plants will certainly be influenced by the investor’s view as to the persistence of low-cost natural gas as well as future demand recovery.  However, the value prospects for coal-fired and other legacy plants is also being significantly impacted by certain impending, highly contested and still spinning regulatory actions, and it is critical that hedge fund managers consider this regulatory roulette in their merchant power debt investment decisions.  In a guest article, Howard L. Siegel, a partner at Brown Rudnick LLP, where he is a member of the firm’s Bankruptcy and Corporate Restructuring Group and its Energy, Utilities and Environmental Practice Group, analyzes the key regulatory considerations impacting the outcomes of investments by hedge funds in the debt of merchant power projects.

SEC No-Action Letter Outlines Alternative Recordkeeping Regime for Compliance with the Pay to Play Rule

On July 1, 2010, the SEC adopted Rule 206(4)-5 (Pay to Play Rule) under one of the antifraud provisions of Investment Advisers Act of 1940 (Advisers Act).  See “How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures and Marketing Practices in Light of the SEC’s New ‘Pay to Play’ Rule?,” Hedge Fund Law Report, Vol. 3, No. 30 (Jul. 30, 2010).  The Pay to Play Rule generally prohibits registered or unregistered investment advisers, including hedge fund managers, from providing advisory services for compensation to a government client (such as a public pension fund) for two years after the adviser or certain of its employees or third-party solicitors make a contribution to certain candidates or elected officials.  See “Key Elements of a Pay-to-Play Compliance Program for Hedge Fund Managers,” Hedge Fund Law Report, Vol. 3, No. 37 (Sep. 24, 2010).  Simultaneous with the adoption of the Pay to Play Rule, the SEC amended the recordkeeping rules under the Advisers Act to, as explained in the adopting release, “allow [the SEC] to examine for compliance with new rule 206(4)-5.”  On examinations, see “Legal and Practical Considerations in Connection with Mock Examinations of Hedge Fund Managers,” Hedge Fund Law Report, Vol. 4, No. 26 (Aug. 4, 2011).  While the general prohibition on pay to play practices of the Pay to Play Rule applies to registered and unregistered investment advisers, the related recordkeeping requirements only apply to registered investment advisers, as the SEC noted in footnote 405 of the adopting release.  Specifically, the SEC amended the recordkeeping rules to require registered investment advisers to maintain books and records containing lists or other records of four categories of information, each of which is described in detail in this article.  On September 12, 2011, the Investment Company Institute (ICI) – the mutual fund industry trade group – submitted a letter (Incoming Letter) to the SEC’s Division of Investment Management (Division) requesting no-action relief from specified provisions of the recordkeeping requirements related to the Pay to Play Rule.  In particular, the Incoming Letter noted that investment advisers are having difficulty complying with relevant recordkeeping requirements where the presence or identity of government plan investors in omnibus accounts cannot be reliably determined.  The ICI proposed an alternative recordkeeping regime that would address the identified transparency issues.  This article details: the four relevant recordkeeping requirements; the four prongs of the ICI’s proposed alternative recordkeeping regime, and the rationale for each; the SEC’s no-action letter; and the application of the no-action letter itself and the analysis in the letter to hedge funds and hedge fund managers.

Delaware Bankruptcy Court Rejects Efforts of Moll Industries’ Unsecured Creditors to Recharacterize as Equity the Secured Debt Held by Highland Capital Funds and to Hold Highland Capital Liable as Moll’s “Alter Ego”

This adversary proceeding pits the committee of unsecured creditors (Committee) of Moll Industries, Inc. (Moll) against hedge fund manager Highland Capital Management, L.P. (Highland) and several Highland funds that were secured creditors of Moll (Funds).  The Committee claimed that the Moll senior debt held by the Funds should be equitably subordinated to Moll’s unsecured debt, or recharacterized as equity, thereby eliminating the priority that the Funds would otherwise have in the bankruptcy proceeding.  The Committee also claimed that Highland was liable to Moll’s unsecured creditors because it acted as Moll’s “alter ego.”  Finally, it sought to void a security interest held by the Funds in one of Moll’s bank accounts.  Highland and the Funds all moved to dismiss the Committee’s complaint.  The Court permitted the security interest avoidance claim to proceed but dismissed the equitable subordination, recharacterization and alter ego claims.  This article provides a comprehensive discussion of the Court’s decision and analysis.

Fifth Annual Hedge Fund General Counsel Summit Covers Insider Trading, Expert Networks, Whistleblowers, Exit Interviews, Due Diligence, Examinations, Pay to Play and More

On September 13, 2011, ALM Events hosted its fifth annual Hedge Fund General Counsel Summit at the Harvard Club in New York City.  Participants at the event discussed how the changing regulatory landscape is impacting the day-to-day policies, procedures and practices of hedge fund managers.  Of particular note, discussions focused on insider trading in the post-Galleon world; best compliance practices for engaging and using expert network firms; how to motivate employees to report wrongdoing internally rather than filing whistleblower complaints; the interaction between non-disparagement clauses in hedge fund manager exit agreements and the whistleblower rule; best practices for exit interviews; best practices for responding to initial and ongoing due diligence inquiries; consistency across DDQs and other documents; standardization of DDQs versus customized answers; whether to disclose the existence or outcome of regulatory actions; how to deal with government investigations and examinations; and strategies for complying with the pay to play rule.  This article summarizes the most noteworthy points made at the event.

The “New-Age” Sukuk Market: How Investors Can Profit While Safeguarding Against Legal Risk

Financial products compatible with traditional Islamic, or Shari’ah, law are becoming increasingly prevalent in the global marketplace.  Sukuk – or asset-backed, stable income, tradable and Shari’ah compatible trust certificates – are the most common of these Islamic financial products.  Recent developments in Europe and the United States suggest that the market for Sukuk is growing.  Economists predict a record $31 billion in Sukuk to be issued this year alone.  Britain will issue its first ever Sukuk this month.  Despite the growing market for these products, investors must remain cautious.  Even the savviest buyer should be aware of the legal risks and uncertainties inherent in these financial products.  The lack of a uniform, global regulatory system, varying levels of institutional transparency and inconsistent interpretations of Shari’ah law across different jurisdictions are among the many risks that may render a Sukuk null and void.  In a guest article, Carlos F. Gonzalez and Sumeet H. Chugani, partner and associate, respectively at Diaz, Reus & Targ, LLP, analyze: the five basic tenets of Shari’ah law; relevant profit and loss sharing concepts; partnership contracts as used in this context; the relevance of local law, bankruptcy and cultural considerations; and other issues relevant to participation by hedge fund managers and other investors in the Sukuk market.

Wiretaps, Whistleblowers, Expert Networks and Insider Trading: A Conversation with Kevin O’Connor, Former Associate Attorney General of the U.S. and Former U.S. Attorney for Connecticut

Hedge fund managers remain a prime target for civil and criminal insider trading charges.  This is so for at least five reasons.  First, regulators and prosecutors have been emboldened by the May 11, 2011 conviction of Galleon Group founder Raj Rajaratnam on 14 counts of conspiracy and securities fraud.  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).  Second, wiretapping has become a viable tool for investigating insider trading by hedge fund manager personnel, and a source of persuasive evidence.  See “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?,” Hedge Fund Law Report, Vol. 4, No. 24 (Jul. 14, 2011).  Third, in the course of examinations of hedge fund managers, SEC examination personnel are looking for (among other things) evidence of insider trading that can serve as the basis of referrals to the SEC’s Enforcement Division.  See “Are Hedge Fund Managers Required to Disclose the Existence or Outcome of Regulatory Examinations to Current or Potential Investors?,” Hedge Fund Law Report, Vol. 4, No. 32 (Sep. 16, 2011).  Fourth, the staff of the SEC’s Enforcement Division can now use tools developed in the criminal context in bringing, negotiating and settling insider trading charges against hedge fund managers.  See “Entry by SEC into a Non-Prosecution Agreement with Clothing Marketer Illustrates How Hedge Fund Managers May Survive Discovery of Certain Insider Trading Violations,” Hedge Fund Law Report, Vol. 3, No. 50 (Dec. 29, 2010).  And fifth, budgetary constraints have led the SEC to place a higher priority on deterrence, and insider trading actions against hedge fund managers are thought to have a powerful deterrent effect.  See “Key Insights for Registered Hedge Fund Managers from the SEC’s Recently Released Study on Investment Adviser Examinations,” Hedge Fund Law Report, Vol. 4, No. 5 (Feb. 10, 2011).  In light of the vigor with which civil and criminal authorities are pursuing insider trading actions – and the ongoing susceptibility of hedge fund managers to insider trading charges – the Regulatory Compliance Association’s Fall 2011 Asset Management Thought Leadership Symposium will feature a session entitled “Insider Trading – The New Enforcement Paradigm.”  That RCA Symposium will take place on November 10, 2011 at the Pierre Hotel in New York.  (Subscribers to the Hedge Fund Law Report are eligible for a registration discount.)  One of the speaking faculty members expected to participate in the insider trading session is Kevin J. O’Connor.  O’Connor is a Partner at Bracewell & Giuliani and Chair of the firm’s White Collar Practice Group.  Previously, O’Connor was Associate Attorney General of the United States, the third-ranking official at the U.S. Department of Justice, and United States Attorney for Connecticut.  In anticipation of the upcoming RCA Symposium, the Hedge Fund Law Report interviewed O’Connor regarding insider trading considerations for hedge fund managers and related topics.  Specifically, our interview covered: implications for hedge fund managers of the increased use of wiretap evidence in insider trading investigations; the use of criminal wiretaps in civil proceedings; wiretaps of mobile phones and Voice over Internet Protocol lines; “tapping” of Blackberries and social media; how to incentivize internal reporting under the new SEC whistleblower rule; whether hedge fund service providers can be whistleblowers; activities other than insider trading that may serve as the basis of a whistleblower complaint; best compliance practices for engaging expert network firms; compliance training with respect to the use of expert networks; due diligence on expert network firms; and how to avoid FCPA violations when engaging third-party placement agents to solicit investments from sovereign wealth funds.  The full text of our interview with O’Connor is included in this issue of the Hedge Fund Law Report.

Primary Legal and Practical Considerations for Hedge Fund Managers Looking to Outsource Their Operational Functions

In September 2011, financial report publisher ClearPath Analysis released a report entitled “Fund Outsourcing: Assessing the Critical Issues and Considerations When Outsourcing Operational Functions as a Fund Manager” (Report).  The Report is a compilation of interviews, roundtables and white papers designed to guide fund managers through the outsourcing process.  This article summarizes the most important topics discussed in the Report including: (1) whether or not to outsource at all; (2) how to select a service provider (including how to think about track record, portfolio of clients and size); (3) the relevant legal and regulatory frameworks, including considerations under the AIFMD; and (4) how to properly manage and monitor the service provider.  For a further discussion of best practices related to outsourcing, see “BNY Mellon’s Pershing Unit Releases White Paper Detailing Best Practices for Hedge Fund Outsourcing Solutions,” Hedge Fund Law Report, Vol. 2, No. 42 (Oct. 21, 2009).

An Investment Adviser May Not Call Itself Independent If It Receives Fees from Underlying Managers

The SEC recently commenced administrative proceedings against an investment adviser that allegedly received undisclosed fees for channeling over $80 million into SJK Investment Management, LLC (SJK).  As previously reported in the Hedge Fund Law Report, on January 6, 2011, the SEC filed an emergency civil injunctive action charging SJK and its principal, Stanley Kowalewski, with securities fraud, and obtained a temporary restraining order and asset freeze against SJK and Kowalewski.  See “Thirteen Important Due Diligence Lessons for Hedge Fund Investors Arising Out of the SEC’s Recent Action against a Fund of Funds Manager Alleging Misuse of Fund Assets,” Hedge Fund Law Report, Vol. 4, No. 3 (Jan. 21, 2011).  The order in this administrative proceeding (Order) is interesting to hedge fund and hedge fund of funds managers primarily in helping clarify the circumstances in which managers may and may not claim to be “independent.”  The facts alleged by the SEC are rather egregious, and thus the Order itself does not make noteworthy new law.  However, the Order does raise close and interesting questions regarding the language of representations that hedge fund of fund managers and other investment advisers may make to investors with respect to independence; the channels through which such representations are made (including websites); how to approach disclosure with respect to conflicts and independence in Form ADV; and how to move client assets from one investment manager to another without breaching fiduciary duties or running afoul of the antifraud provisions of the federal securities laws.

SEC Deputy Director James A. Brigagliano to Join Sidley Austin LLP’s Washington D.C. Office

On September 19, 2011, Sidley Austin LLP announced that James A. Brigagliano is joining the firm as a partner in the securities and futures regulatory practice in Washington D.C.  Brigagliano comes to Sidley after serving as the Deputy Director of the Division of Trading and Markets at the Securities and Exchange Commission, where he held a series of senior policymaking and management positions.

SkyBridge Capital Hires Tatiana Segal as Head of Risk Management

On September 19, 2011, SkyBridge Capital, the global alternative investment firm, announced that it hired Tatiana Segal as a managing director and head of risk management.  See “What Is a Chief Risk Officer, and Should Hedge Fund Managers Have One?,” Hedge Fund Law Report, Vol. 2, No. 31 (Aug. 5, 2009).  Segal was previously a managing director and chief risk officer at Cerberus Capital Management.