Sep. 29, 2011

Practical Considerations for Compliance by Hedge Fund Managers with the FCPA When Evaluating and Engaging Foreign Advisors in Connection with Foreign Bankruptcy Investments

In many emerging and opening markets, the level of apparent regulation can sometimes provide a false patina of order.  In practice, local laws and regulations are often a byzantine maze of stamps, taxes, rules, forms and other bureaucratic processes that present enormous hurdles to investing and operating in such markets.  Investments in distressed assets present special risks because nearly every stage of the investment involves interactions with foreign government officials of one stripe or another, from members of the local judiciary, to financial and securities regulators, to central government banks.  In such an environment, it is understandable that hedge fund managers turn to a variety of advisors and agents for guidance and assistance in navigating the local landscape.  However, the use of third party agents and intermediaries in foreign investments presents distinct risks under the U.S. Foreign Corrupt Practices Act (“FCPA”), which prohibits the payment of bribes to foreign government officials to obtain or retain business or a business advantage.  In particular, as U.S. hedge fund managers look to execute investment strategies in emerging markets, they must be aware of (and act in accordance with) the FCPA.  Not only does the law criminalize corrupt payments made directly to an official, it also prohibits the use of a third party agent or intermediary (regardless of the nationality or location of the agent or intermediary) to “knowingly” make such prohibited payments on behalf of a principal.  As a result, hedge funds that rely on third-party agents to assist and guide investments in foreign insolvency proceedings face a legal risk if such agents engage in corrupt activities in order to advance the business or investment interests of the fund.  In a guest article, Matthew T. Reinhard, a Member of Miller & Chevalier, Chartered, first provides a brief overview of the FCPA and how it relates to the use of third parties.  Next, Reinhard discusses practical steps hedge fund managers can take to vet their agents and protect themselves, their funds and their investors from engaging unscrupulous agents.  Finally, Reinhard discusses specific provisions hedge fund managers should include in their agreements with third parties and other steps that can be taken to guard against liability for corrupt acts by such agents.

Six Principles of Operational Due Diligence

Hedge funds have progressively moved into the mainstream of institutional investing.  While even ten years ago, hedge funds were still largely the “secret club of the super rich,” sophisticated investors such as pension funds, sovereign wealth funds and large endowments now embrace the absolute return and diversification benefits available from hedge funds.  Retail investors are also exposed to hedge funds as never before: many corporate pension schemes have added hedge fund exposure, and more generally, the movements of both stock and bond markets are now heavily influenced by hedge fund investment decisions and capital flows.  Since the 2008 market crisis – thanks in part to Bernie Madoff, Lehman and numerous funds gating and suspending redemptions – operational due diligence has become much more significant to the hedge fund selection process.  See “What Are Hybrid Gates, and Should You Consider Them When Launching Your Next Hedge Fund?,” Hedge Fund Law Report, Vol. 4, No. 6 (Feb. 18, 2011).  While performance and strategy remain central to every decision to allocate to a fund, investors large and small must also ensure that they have selected a manager with sufficient controls and infrastructure to safeguard assets.  In a guest article, Christopher J. Addy, President and CEO of Entreprise Castle Hall Alternatives Inc., focuses on several more qualitative aspects of the hedge fund due diligence process, highlighting six principles which can guide the development of an effective due diligence function.

In Continuing Battles Involving Creditors of Dynegy, Delaware Chancery Court Refuses to Enjoin Transfer of Power Plants from Existing Dynegy Subsidiaries to New “Bankruptcy-Remote” Subsidiaries

Plaintiffs in this action are the owners of four unprofitable power plants that are leased to subsidiaries of Defendant electricity producer Dynegy Holdings Inc. (Dynegy) under long-term leveraged leases.  Dynegy is the guarantor of those leases.  As one step in an unfolding plan to reorganize and restructure its outstanding debt, in July 2011, Dynegy announced that it was moving most of its power plants – but not Plaintiffs’ plants – from existing subsidiaries into new “bankruptcy-remote” subsidiaries.  Plaintiffs believed that the move would weaken the credit support for those leases.  After negotiations with Dynegy failed, Plaintiffs commenced an action seeking to enjoin Dynegy from proceeding with the restructuring.  They alleged that the transfer would violate the terms of the Dynegy guarantee and constituted a fraudulent conveyance under Delaware law.  The Delaware Court of Chancery denied their motion in its entirety.  We detail the legal analysis that led the Court to its decision.  For a related discussion of regulatory issues affecting hedge funds that trade in the debt of merchant power projects, see “Merchant Power Regulatory Roulette,” Hedge Fund Law Report, Vol. 4, No. 33 (Sep. 22, 2011).

Two Recent Federal Court Decisions Clarify the Differing Treatment under SIPA of Returned Principal and Fictitious Profits

Two recent federal court decisions – one at the circuit level and the other at the district court level, and both arising out of the Madoff Ponzi scheme – offer further clarification on the differing legal status of returns to investors in a fraud of invested principal versus returns of fictitious profits.  In turn, the differing legal status of these two categories of returns impacts the extent to which the trustee can claw back money from investors and the extent to which investors can make valid claims on the estate.  See “Two Key Levels of Risk Facing Hedge Funds That Buy or Sell Bankruptcy Claims,” Hedge Fund Law Report, Vol. 4, No. 27 (Aug. 12, 2011).  For hedge fund managers that trade Madoff claims or other bankruptcy claims, these legal decisions will impact the investment calculus.  The circuit court decision also offers important insight on the complex process of calculating “net equity” under SIPA – an issue that many hedge fund managers first encountered when trying (often with limited success) to get money out of Lehman’s failed U.S. prime brokerage business, and an issue that continues to impact the value of Madoff claims.  See generally “Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices,” Hedge Fund Law Report, Vol. 4, No. 25 (Jul. 27, 2011).

Strategies for Avoiding Insider Trading Violations: A Perspective Informed by SEC Service, Private Law Firm Practice and Work as General Counsel of a Hedge Fund Manager

The Hedge Fund Law Report publishes frequently on the topic of insider trading.  It is, perhaps, the most important topic we cover, for at least six reasons.  First, it is complex and at times counterintuitive.  Second, it is particularly difficult to apply the doctrine to the day-to-day facts of investment analysis, research and trading.  Third, while the bedrock doctrine remains relatively constant, the outside contours of the law and the fact patterns in which the law applies are changing continuously.  Fourth, insider trading considerations are pervasive: they apply across strategies and geographies, in funds and in personal accounts.  Fifth, investigative techniques and technology are evolving rapidly.  And sixth, insider trading violations – or even suspicions thereof – can promptly bring down the curtain on a hedge fund management business.  The list goes on, but the point is that for hedge fund managers, insider trading is a virtually inexhaustible topic, an ongoing concern.  Like the Hedge Fund Law Report, the Regulatory Compliance Association (RCA) regularly includes in-depth analysis of insider trading at its Symposia.  Consistent with that focus, the RCA’s Fall 2011 Asset Management Thought Leadership Symposium (to be held on November 10, 2011 at the Pierre Hotel in New York) will feature a session on insider trading.  (Subscribers to the Hedge Fund Law Report are eligible for a registration discount.)  We have interviewed various of the speakers expected to participate in the insider trading session, and we have published the full transcripts of some of those interviews.  For the transcript of our interview with Scott Pomfret, Regulatory Counsel for a Boston-based institutional money manager and a former branch chief in the SEC’s Division of Enforcement, click here.  And for the transcript of our interview with Kevin O’Connor, Partner at Bracewell & Giuliani and Chair of the firm’s White Collar Practice Group, and previously Associate Attorney General of the United States and United States Attorney for Connecticut, click here.  This week’s issue of the Hedge Fund Law Report includes a transcript of our interview with Scott Black.  Black is General Counsel and Chief Compliance Officer at Hudson Bay Capital Management LP.  He previously served as Assistant Regional Director in the Division of Enforcement of the SEC’s New York Regional Office and practiced law at Wachtell, Lipton, Rosen & Katz.  Our interview with Black covered, among other things: characteristics of a hedge fund manager that make it more likely to become the target of an insider trading investigation; steps that hedge fund managers can take to diminish the likelihood that they will become such a target; selective disclosure considerations; how hedge fund managers should respond to the increasing use of wiretaps in insider trading investigations; whether the government will use wire fraud charges to criminalize activity that would not constitute criminal securities fraud; steps hedge fund managers can take to avoid insider trading violations when talking to company insiders; best practices for engaging expert network firms; best practices for using experts, consultants, channel checking firms and others outside of the context of an expert network; steps to prevent insider trading violations when hedge fund manager personnel serve on a creditors’ committees; and the practical implications of the SEC’s recent cooperation initiative.

Delaware Supreme Court Clarifies State Law Regarding Life Settlements

The Delaware Supreme Court recently ruled on the validity of insurance policies allegedly purchased for investment purposes rather than insurance purposes.  The decision conflicts with a prior decision in New York, but is generally consistent with New York State insurance legislation subsequent to that inconsistent New York decision.  In addition to the longevity risk that historically has created both risk and opportunity in the life settlements market, regulatory risk in this area is becoming increasingly pronounced.  The SEC has focused on accounting practices on the part of at least one life settlements intermediary, and the courts have entertained challenges to the validity of policies purchased by life settlement investors.  This article is intended to assist hedge funds that invest in life settlements in appreciating the precarious and uneven legal environment in which they operate.  See also “In Blow to Opponents of ‘Stranger-Owned Life Insurance,’ New York’s High Court Rules that New York Law Did Not Prohibit a Person from Purchasing a Life Insurance Policy and Immediately Transferring that Policy to an Individual Who Does Not Have a Traditional Insurable Interest in the Purchaser’s Life,” Hedge Fund Law Report, Vol. 3, No. 39 (Dec. 17, 2010).

Greenwich Associates Announces that John Siciliano Will Assume Role of Senior Adviser

On September 28, 2011, research-based strategy management services provider Greenwich Associates announced that John C. Siciliano assumed the role of Senior Advisor to the firm’s Investment Management Practice, led by Managing Director Robert Statius-Muller.  The Hedge Fund Law Report has reported on relevant research by Greenwich Associates.  See, e.g., “Survey by SEI and Greenwich Associates Identifies the Primary Decision Factors and Concerns of Institutional Investors When Investing in Hedge Funds,” Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011); “2010 Greenwich Associates Global Custodian Prime Brokerage Study Discusses Counterparty Risk Concerns, Sources of Assets, Balance Spreading, Leverage Levels, Separately Managed Accounts and Hedge Fund Staffing Benchmarks,” Hedge Fund Law Report, Vol. 4, No. 3 (Jan. 21, 2011).