May 17, 2012

Navigating the Insider Trading Risks in Distressed Debt Trading

The past two years have seen a dramatic increase in the number and visibility of insider trading cases brought by regulatory and enforcement authorities and private plaintiffs.  If the first few months of 2012 are any indication, this trend will continue.  Indeed, not only are enforcement authorities becoming more active in bringing such actions, they are also becoming more aggressive in their interpretation of the scope of actions which may constitute insider trading.  Thus, insider trading cases have been brought against a “tippee” who found a copy of a presentation about a buyout that a banker mistakenly left behind and against a director who is not even alleged to have traded or otherwise profited from the alleged misconduct.  To date, however, there have been relatively few attempts to pursue insider trading charges or civil claims in the context of bankruptcy claims trading, and those cases that have been brought have been largely limited to situations involving creditors’ committee members.  There are good reasons that such actions should be limited to the context of a creditors’ committee.  However, in light of the increasing activity in this area, it is worth reviewing the complexities involved in the application of insider trading laws to distressed debt trading.  In a guest article, Daniel H.R. Laguardia and K. Mallory Tosch, Partner and Associate, respectively, at Shearman & Sterling LLP, provide a comprehensive analysis of insider trading law as it applies to hedge funds that invest in distressed debt, bankruptcy claims and similar assets.

How Can Hedge Fund Managers Incentivize Employees to Report Compliance Issues Internally in Light of the SEC’s Whistleblower Bounty Program?

The “Securities Whistleblower Incentives and Protection” provisions of the Dodd-Frank Act require the SEC to pay significant monetary awards to whistleblowers that voluntarily provide “original information” leading to certain successful SEC enforcement actions.  Before the whistleblower provisions became effective on May 25, 2011, many companies expressed concern in public comments that the whistleblower program would incentivize employees to bypass internal reporting channels and report suspected wrongdoing and compliance concerns directly to the SEC.  Hedge fund managers were particularly vocal in expressing this concern because of the unique susceptibility of the hedge fund business model to bad news.  Hedge fund managers can suffer – and, with alarming regularity, have suffered – conclusive harm based on inconclusive allegations.  An examination or enforcement action triggered by a whistleblower complaint can cause hedge fund investors to redeem, and redemptions based on regulatory developments tend to beget additional redemptions.  The time from a whistleblower complaint to regulatory action to unraveling of a hedge fund business can be lightning fast; the manager’s ability to control events in such circumstances can be attenuated or nonexistent; and the harm to the business can be irrevocable.  Whether or not the manager is ultimately vindicated is often moot from a business perspective.  On the other hand, a manager’s ability to control events is dramatically increased when employees report suspected wrongdoing and compliance concerns internally.  In such circumstances, managers can, among other things: assess the credibility of the complaint; pinpoint the sources of any genuine issues; address such issues; determine whether, when and how to report the issues to investors or regulators; and otherwise act according to a game plan devised by the manager itself.  Not surprisingly, hedge fund managers are very interested in designing mechanisms to incentivize internal reporting while discouraging whistleblowing in a manner consistent with law and regulation.  This article provides a how-to guide for hedge fund managers looking to do so.  Specifically, this article discusses: background on the SEC’s whistleblower bounty program; specific actions hedge fund managers can take to incentivize internal reporting of compliance issues; guidance for hedge fund managers that want to measure the effectiveness of their internal reporting programs; and recommended actions for hedge fund managers that are confronted with internal reports of wrongdoing.

British High Court Interprets ISDA Master Agreement to Suspend Non-Defaulting Party’s Payment Obligations Until Defaulting Party Has Cured the Default

Counterparty risk has garnered significant attention among hedge fund industry participants in the aftermath of the collapse of Lehman Brothers in 2008.  Evaluating counterparty risk requires hedge fund managers to evaluate their counterparty agreements to understand, among other things, the scope of their obligations in the event that one of their trade counterparties defaults or becomes insolvent.  A decision recently handed down by the Court of Appeals of England and Wales interpreted a contractual provision contained in the International Swaps and Derivatives Association, Inc. Master Agreement (Master Agreement) that governs such obligations in relation to swaps and other derivatives effected between trade counterparties.  A central component of the case involved the interpretation of Section 2(a)(iii) of the Master Agreement, which provides that a party to a derivative contract is not obligated to make payments to the counterparty while an “event of default” is occurring with respect to the counterparty.

FSA Imposes Fine and Statutory Ban on Compliance Officer of Investment Advisory Firm for Failure to Safeguard Client Assets

Serving as the compliance officer of a hedge fund manager is becoming increasingly challenging, particularly considering the growing list of regulatory responsibilities being imposed on such compliance officers and the ominous prospect of personal liability for the failings of a manager’s compliance program.  The U.S. Securities and Exchange Commission (SEC) has made it clear that compliance officers can be held personally liable for the failings of their firms’ compliance programs in certain circumstances, as evidenced by the SEC’s enforcement action brought against Wunderlich Securities, Inc.  However, the exact scope of such personal liability continues to be a moving target.  See “Scope of Supervisory Liability of Senior Legal and Compliance Professionals at Hedge Fund Managers Remains Uncertain after SEC Dismissal of Urban Action,” Hedge Fund Law Report, Vol. 5, No. 5 (Feb. 2, 2012).  Like the SEC, the U.K.’s Financial Services Authority (FSA) is also flexing its muscles in this area, as it recently levied fines against an advisory firm and its compliance officer and imposed a statutory ban on the compliance officer for his and the firm’s failure to safeguard client assets.  The statutory ban prohibits the compliance officer from serving as a compliance officer in the future and from having responsibility for client assets.  The FSA action is noteworthy in at least two respects, both described in this article.  More generally, this article discusses the factual allegations, compliance violations and sanctions imposed against the firm and the compliance officer.

Amber Partners White Paper Highlights Key Due Diligence Points for Hedge Fund Investors Evaluating Hedge Fund Portfolio Composition and Valuation

Valuation is one of the key focal areas for many hedge fund investors because a hedge fund manager that utilizes poor valuation practices can present significant investment and operational risks.  At the same time, assessing valuation risk is often one of the most difficult tasks that a hedge fund investor faces in conducting an operational due diligence review.  This is due, in part, to the myriad investment strategies employed by hedge fund managers and the differing levels of transparency provided by hedge fund managers, which, in turn, lead to varying approaches in the presentation of portfolio information.  In April 2012, Amber Partners published a White Paper (Amber White Paper) that supplies hedge fund investors with a roadmap for assessing the level of valuation risk posed by a hedge fund manager.  Specifically, the Amber White Paper provides guidance to investors on how to evaluate the composition of a hedge fund portfolio as well as the manager’s controls over the month-end valuation process.  In addition to providing guidance to hedge fund investors, managers can also glean important lessons from the Amber White Paper on how to avoid valuation pitfalls and institute best-of-breed valuation practices.  This article details the recommendations described in the Amber White Paper.  See also “Hedge Fund Valuation Pitfalls and Best Practices: An Interview with Arthur Tully, Co-Leader of Ernst & Young’s Global Hedge Fund Practice,” Hedge Fund Law Report, Vol. 5, No. 2 (Jan. 12, 2012).

Highland Capital Management Sues Former Private Equity Chief for Breach of Employment and Buy-Sell Agreements

On April 11, 2012, Highland Capital Management, L.P. (Highland) sued its former Head of Private Equity Investing, Patrick Daugherty, in Texas state court for breach of contract, breach of fiduciary duties, tortious interference with its business relationships and defamation.  This article summarizes: the allegations; the specific provisions of the employment and related agreements alleged to have been breached; Highland’s causes of action; and the remedies requested in the Complaint.

Schulte Roth & Zabel Adds Leading Private Equity Group to New York Office

On May 15, 2012, Schulte Roth & Zabel LLP announced a major expansion of its New York office with the addition of a group of leading private equity attorneys joining the firm from Dewey & LeBoeuf LLP.

Renowned Bankruptcy Lawyer Martin J. Bienenstock Joins Proskauer from Dewey

On May 11, 2012, Proskauer announced that Martin J. Bienenstock, one of the nation’s most renowned corporate restructuring and governance lawyers, will join the firm together with colleagues.  For a recent interview with a Proskauer partner, see “Managing Risk in a Changing Environment: An Interview with Proskauer Partner Christopher Wells on Hedge Fund Governance, Liquidity Management, Transparency, Tax and Risk Management,” Hedge Fund Law Report, Vol. 5, No. 13 (Mar. 29, 2012).