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    Oct. 21, 2011

Regulatory, Tax and Credit Documentation Factors Impacting Hedge Funds’ Trade Risk in European Secondary Loans (Part One of Two)

For the majority of 2011, European secondary loan markets had buy-side traders frustrated by low liquidity, volume and deal flow, and sell-side traders were left to wonder if and when they do source, will enough friends come out and play.  Is this the calm before the storm?  Many in the distressed community believe it is, and that loans will play a significant role in the corporate distressed wave expected to hit shore in 2012 as part of €221 billion worth of European leveraged loans set to mature between now and through 2015.  The high yield market was a savior in 2011 for many borrowers whose loans were set to mature in 2013 and 2014.  However, with some of these deals already having gone sour and the pool of remaining loans deteriorating, the high yield market is not likely to save the day again.  Regardless of the capital market options, when the refinancing peak reaches its heights in Europe and the U.S. in 2014, bad loans will likely be left behind in droves.  To assist investment funds in filling their proverbial sandbags and preparing to pick up potentially lucrative pieces in the aftermath, David J. Karp, Special Counsel at Schulte Roth & Zabel LLP (SRZ), Roxanne Yanofsky, an Associate at SRZ, and Erik Schneider, also an Associate at SRZ, are publishing in the Hedge Fund Law Report a two-part series on trade risks specific to loans in the European market.  This first article will focus on certain macro issues arising in the context of European secondary loan trading, through analyzing regulatory, tax and credit documentation factors which can impact the success of a trade.  In particular, this article analyzes, among many other relevant issues: what jurisdictions and applicable lender restrictions play into a trade; whether a debt purchase subjects an investor to a withholding tax, and, if so, whether the investor can obtain the benefit of an exemption or a reduced rate of withholding tax; the requirements to accede as a lender of record under a loan agreement, including eligibility requirements, minimum thresholds and borrower consent rights; and any additional steps an investor must take to perfect its debt transfer and consequences for failing to take the requisite action.  The second article, to be published in an upcoming issue of the Hedge Fund Law Report, will look at trade issues affecting an investor at time of trade and on a more micro level, covering transfer perfections, LMA transparency guidelines, trade documentation, form of transfer and additional terms of trade.

Use by Hedge Fund Managers of Restricted Lists, Watch Lists and Ethical Walls to Prevent Insider Trading Violations

Information management is at the core of the hedge fund business.  If managed properly, information can generate outsized returns.  If managed improperly, information can lead to insider trading and other securities law charges, and criminal liability.  Hedge fund managers, accordingly, work hard to compile mosaics of information that can serve as the basis of legal trading, and that do not include material nonpublic information (MNPI).  See “Investment Research and Insider Trading on ‘Outside Information’,” Hedge Fund Law Report, Vol. 4, No. 29 (Aug. 25, 2011).  In doing so, one of the more popular and potent tools is the restricted list.  A close cousin of the restricted list is the watch list, and a related technique is the ethical wall.  This article provides a guide for hedge fund managers in creating, disseminating, updating and enforcing a restricted list.  In particular, the article discusses: the definition of a restricted list; the legal, regulatory and practical sources of the obligation to maintain a restricted list; relevant issues raised by the simultaneous management of hedge funds that invest in public and private securities; when a name should be added to and removed from a restricted list; whether subsidiaries, affiliates and various parts of the capital structure should be included in a restricted list; access to and dissemination and updating of a restricted list; two SEC enforcement actions highlighting compliance concerns that may motivate the SEC to bring an action against a hedge fund manager in this context; and eight techniques for enforcement of a restricted list.  The article also provides a chart of six fact patterns in which names may be added to a restricted list, listing, for each, the event that may require addition to the restricted list and the event that may justify removal.  In addition, the article contains a detailed discussion of “wall crossing” scenarios in the hedge fund context and concludes with a discussion of what watch lists are and how they are used by hedge fund managers.

Technical and Operational Considerations for Hedge Fund Managers in Connection with Preparing, Filing and Updating Form PF

The Financial Stability Oversight Council (FSOC) recently approved a proposed rule and guidance setting out the metrics and process it would use to designate a nonbank financial company as systemically important under the Dodd-Frank Act.  In that proposed rule, the FSOC noted that “[w]ith respect to hedge funds and private equity firms . . . less [systemic risk related] data is generally available about these companies than about certain other types of nonbank financial companies.”  Accordingly, “[b]eginning in 2012, advisers to hedge funds and private equity firms and commodity pool operators and commodity trading advisors will be required to file Form PF with the Securities and Exchange Commission or the Commodity Futures Trading Commission, as applicable, on which form such companies will make certain financial disclosures.  Using these and other data, the [FSOC] will consider whether to establish an additional set of metrics or thresholds tailored to evaluate hedge funds and private equity firms and their advisers.”  In its proposed form, Form PF calls for voluminous and detailed disclosure of financial, risk, counterparty and other information by hedge fund managers.  Understanding the scope of required information presents complicated legal challenges, and complying with the anticipated disclosure obligations presents unique operational challenges.  Accordingly, on October 25, 2011 – Tuesday of next week – Advise Technologies and the Hedge Fund Law Report will be co-sponsoring a seminar on legal and operational considerations for hedge fund managers in connection with completing, filing and updating Form PF.  The seminar will take place from 8:00 a.m. to 10:00 a.m. at the Helmsley Hotel at 212 East 42nd Street in Manhattan.  To register, click here or call 212-576-1170.  In anticipation of the seminar, the Hedge Fund Law Report interviewed Stephen Casner, CEO of HazelTree Fund Services, on how hedge fund managers can negotiate some of the more complex operational challenges presented by Form PF.  The full text of our interview is included in this issue of the Hedge Fund Law Report.

Defrauded Investors in “Life’s Good” Hedge Fund Ponzi Scheme Claim Fraud by Morningstar in Granting High Rating to Fund

Plaintiffs in this action invested several hundred thousand dollars of their retirement funds in a purported hedge fund organized and managed by defendant Robert Stinson, Jr. (Stinson).  Stinson was, in fact, operating a multi-million dollar Ponzi scheme.  On August 15, 2011, he pleaded guilty to various federal criminal charges.  Plaintiffs in this action are suing Stinson and the entities through which he operated for various counts of securities fraud and common law fraud.  More important, the Plaintiffs accuse Morningstar, Inc., which gave a “Five Star” rating to the hedge fund in which Plaintiffs invested, of, at best, acting recklessly and, at worst, knowingly facilitating Stinson’s fraud.  We summarize the investors’ complaint and provide relevant details from the earlier SEC enforcement action.

Lehman Brothers Court Holds Triangular Setoff Provisions Unenforceable in Bankruptcy

On October 4, 2011, the United States Bankruptcy Court for the Southern District of New York held that Section 553(a) of the Bankruptcy Code renders unenforceable cross-affiliate netting or “triangular” (non-mutual) setoff provisions to the extent they cover non-mutual debts between the debtor and entities affiliated with the creditor.

CDOs are Not Necessarily Bankruptcy Remote: U.S. Judge Refuses to Dismiss Involuntary Bankruptcy Proceedings Against Cayman-Based CDO, Zais Investment Grade Limited VII

On August 26, 2011, Judge Raymond T. Lyons of the United States Bankruptcy Court for the District of New Jersey issued an opinion refusing to either dismiss or abstain from the involuntary bankruptcy proceedings filed by senior noteholders of Cayman Islands collateralized debt obligation issuer (CDO) Zais Investment Grade Limited VII.  For further analysis of considerations when dealing with collateralized obligations, see “Key Legal and Business Considerations for Hedge Fund Managers When Purchasing Collateralized Loan Obligation Management Contracts,” Hedge Fund Law Report, Vol. 3, No. 13 (Apr. 2, 2010).

Federal District Court in Pennsylvania Rules in Favor of Investors in Life Settlements

In the first case interpreting Pennsylvania’s insurable interest statute in the context of stranger-originated life insurance (STOLI) schemes, a federal judge denied a life insurance company’s bid to have policies declared null and void because they were allegedly part of a STOLI scheme.  See “Delaware Supreme Court Clarifies State Law Regarding Life Settlements,” Hedge Fund Law Report, Vol. 4, No. 34 (Sep. 29, 2011).

Aisha Hunt Joins as Partner to Run Cole-Frieman & Mallon’s New Alternative Mutual Fund Practice

On October 19, 2011, investment management law firm Cole-Frieman & Mallon LLP announced the addition of Aisha Hunt to head the firm’s new Alternative Mutual Fund Practice in San Francisco.  See “Hedge Fund Managers Launching Mutual Funds in an Effort to Stay a Step Ahead of Regulatory Convergence,” Hedge Fund Law Report, Vol. 2, No. 15 (Apr. 16, 2009).

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