Jul. 12, 2012

Lesson from Lehman Brothers for Hedge Fund Managers: The Effect of a Bankruptcy Filing on the Value of the Debtor’s Derivative Book

Prior to its bankruptcy filing, Lehman Brothers (Lehman) was a global broker-dealer/investment bank that conducted trades and made investments on behalf of itself as well as its clients, including many hedge fund managers.  As part of this business, Lehman entered into a large number of “derivatives” transactions – such as credit default swaps, interest rate swaps and currency swaps – both for speculative and hedging purposes.  As of August 2008, Lehman held over 900,000 derivatives positions worldwide, in each case through one of its operating subsidiaries.  In many instances, Lehman’s ultimate parent entity, Lehman Brothers Holdings Inc. (LBHI), guaranteed the obligations arising out of these derivatives positions.  As of August 31, 2008, Lehman internally estimated that, on an aggregate basis, its derivatives positions had a positive net value of approximately $22.2 billion, representing a significant asset of the company.  This substantial “in the money” position abruptly turned “out of the money” as the result of LBHI’s bankruptcy filing in the early morning of September 15, 2008.  The commencement of LBHI’s bankruptcy case – the largest by far in U.S. history, with claims well exceeding $300 billion – provided a contractual basis for a large majority of Lehman’s derivatives counterparties to terminate their transactions with Lehman.  As a result, more than 80 percent of Lehman’s derivatives positions terminated as of, or soon after, the date of the bankruptcy filing.  Alvarez & Marsal, Lehman’s restructuring advisors, concluded in a three-month internal study that the losses from terminated derivatives trades cost the bankruptcy estate “at least” $50 billion.  In a guest article, Solomon J. Noh, a partner in the Global Restructuring Group at Shearman & Sterling LLP, examines what may be one of the principal reasons why Lehman’s bankruptcy filing resulted in such an extraordinary loss in value for the Lehman estate and how Congress has proposed to address this problem in any future failure of a major financial institution.  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).

How Can Hedge Fund Managers Use Luxembourg Funds to Access Investors and Investments in Europe, Asia and Latin America?

Luxembourg is a little country (or duchy) with a big presence in the hedge fund world.  Hedge fund managers looking to access investors or investments in Europe, Latin America or Asia have regularly turned to Luxembourg as a domicile for fund formation.  The tax and regulatory climate there is receptive to hedge funds and managers, the service provider industry is well developed and the jurisdiction is geographically close to key developing and developed markets.  Moreover, the growing popularity of funds organized as Undertakings for Collective Investment in Transferrable Securities (UCITS funds) and the impending effectiveness of the Alternative Investment Fund Managers (AIFM) Directive have increased both the attractiveness and complexity of Europe as an alternative investment jurisdiction – and, consequently, the relevance of Luxembourg.  In light of the importance of Luxembourg to many hedge fund managers, the Hedge Fund Law Report recently interviewed Marc Saluzzi and Michael Ferguson, President and Director, respectively, of the Association of the Luxembourg Fund Industry (ALFI).  The general purpose of our interview was twofold.  For HFLR subscribers that are not familiar with Luxembourg, the purpose was to highlight the benefits and downsides of Luxembourg as a hedge fund domicile.  For HFLR subscribers that are familiar with Luxembourg, the purpose was to illustrate the diverse ways in which hedge fund managers can access the various services available in Luxembourg, and the circumstances in which they should avoid Luxembourg – to illustrate, that is, the scope and limits of market practice in Luxembourg.  To effectuate these purposes, our interview with Saluzzi and Ferguson covered the following topics: the specialized investment fund (SIF) regime for hedge funds, including a discussion of the governance, service provider, reporting and regulatory audit requirements applicable to SIFs; a comparison of SIFs versus funds organized in Caribbean or other European jurisdictions; recent legal developments impacting Luxembourg-domiciled funds and managers; the establishment of a new limited partnership regime in Luxembourg; the cost of establishing a hedge fund in Luxembourg; necessary improvements to make Luxembourg a more attractive hedge fund destination; common mistakes hedge fund managers make when establishing funds in Luxembourg; advice for hedge fund managers establishing funds in Luxembourg; advantages and disadvantages of establishing funds and a manager presence in Luxembourg to address the AIFM Directive; the concept of “ManCos”; and the advantages and disadvantages of establishing UCITS funds in Luxembourg.

U.K. High Court of Justice Finds Magnus Peterson Liable for Fraud in Collapse of Hedge Fund Manager Weavering Capital and Weavering Macro Fixed Income Fund

In 1998, defendant Magnus Peterson formed hedge fund manager Weavering Capital (UK) Limited (WCUK).  He served as a director, chief executive officer and investment manager.  One fund managed by WCUK, the open-end Weavering Macro Fixed Income Fund Limited (Fund), collapsed in the midst of the 2008 financial crisis.  Peterson was accused of disguising the Fund’s massive losses by entering into bogus forward rate agreements and interest rate swaps with another fund that he controlled.  In March 2009, the Fund suspended redemptions and went into liquidation when it could not meet investor redemption requests.  At that time, WCUK went into administration (bankruptcy).  WCUK’s official liquidators, on behalf of WCUK, brought suit against Peterson, his wife, certain WCUK employees and directors and others, seeking to recover damages for fraud, negligence and breach of fiduciary duty and seeking to recover certain allegedly improper transfers of funds by Peterson.  After a lengthy hearing, the U.K. High Court of Justice, Chancery Division (Court), has allowed virtually all of those claims, ruling that Peterson did indeed engage in fraud.  In a separate action, the Fund’s official liquidators recovered damages from Peterson’s brother, Stefan Peterson, and their stepfather, Hans Ekstrom, who served as Fund directors, based on their willful failure to perform their supervisory functions as directors.  See “Cayman Grand Court Holds Independent Directors of Failed Hedge Fund Weavering Macro Fixed Income Fund Personally Liable for Losses Due to their Willful Failure to Supervise Fund Operations,” Hedge Fund Law Report, Vol. 4, No. 31 (Sep. 8, 2011).  This article summarizes the factual background and the Court’s legal analysis in the liquidators’ action against Peterson and others.

New York District Court Orders Insurer XL to Advance Defense Costs to Level Global Under D&O Policy

In the current environment of heightened regulatory scrutiny and vigorous criminal and civil enforcement of insider trading and other securities laws, hedge fund managers are increasingly invoking D&O liability policies to cover defense costs.  See “Hedge Fund D&O Insurance: Purpose, Structure, Pricing, Covered Claims and Allocation of Premiums Among Funds and Management Entities,” Hedge Fund Law Report, Vol. 4, No. 41 (Nov. 17, 2011).  Insurers, meanwhile, are closely analyzing whether insureds have breached terms or falsified applications.  A recent case points to the types of disputes that arise between insurers and hedge fund manager insureds.  In the case, insurance carrier XL Specialty Insurance Company (XL) sued Level Global Investors, L.P. (Level Global), seeking, among other things, a declaration that it was not obligated to pay defense costs to Level Global and its officers and directors, who are facing criminal and civil actions, because of alleged misrepresentations made by the insureds in their insurance application.  See “Insurer Initiates Action to Recover Defense Costs Advanced to Hedge Fund Manager Level Global, Claiming Level Global Made False Statements in its D&O/E&O Liability Insurance Application,” Hedge Fund Law Report, Vol. 5, No. 13 (Mar. 29, 2012).  On June 13, 2012, the United States District Court for the Southern District of New York (Court) ordered XL to advance defense costs to Level Global and its officers and directors pending the adjudication of XL’s request for a declaratory judgment of no coverage under the D&O insurance policy.  The Court’s holding in this case is a significant victory for hedge fund managers in that it appears to reaffirm the legal maxim that ambiguous insurance contracts are construed against the insurer, in this instance by mandating that insurers must advance payments for defense expenses while a court adjudicates a claim of exclusion from coverage.  This article summarizes the factual background of the case and the legal analysis the Court undertook in reaching its decision.

SEC Charges Fund Manager Jason Konior and His Firms with Operating a Pyramid Scheme Using a Purported “First Loss” Trading Program

On May 24, 2012, the SEC brought charges in Manhattan federal court against New York-based hedge fund manager Jason J. Konior and his firms, Absolute Fund Advisors, LLC and Absolute Fund Management, LLC, alleging that the defendants violated federal securities laws by operating a pyramid scheme disguised as a “first loss” trading program.  This article summarizes the factual background and causes of action contained in the complaint.

Hedge Fund Insurance Benchmarking Survey Reveals Trends and Views Concerning Insurance Purchasing, Pricing, Coverage Limits, Frequency of Claims and Quality of Claims Service

As the risks of doing business for hedge fund managers have increased, many have carefully evaluated various types of liability insurance, with a particular focus on the coverage and pricing of such products.  To assist hedge fund managers in understanding trends in the market for such insurance, enhancing risk management and discussing insurance coverage with fund investors, London-based insurance consultant and broker, Baronsmead, has released the results of its second annual hedge fund insurance benchmarking survey (survey).  The survey asked hedge fund managers and insurers to answer questions concerning: purchasing decisions related to directors and officers insurance and professional indemnity insurance, often known as errors and omissions insurance; insurance premiums, frequency of claims and quality of claims service; and risks of doing business as a hedge fund manager.  This article summarizes the key findings in the survey.

SEC People Moves: Norm Champ Named New Division of Investment Management Director; Ken Joseph Named Head of Investment Adviser/Investment Company Examination Program in New York Regional Office; Paula Drake Named OCIE Chief Counsel and Chief Compliance and Ethics Officer

In the past week, the Securities and Exchange Commission has announced that: former Office of Compliance Inspections and Examinations (OCIE) Deputy Director Norm Champ has assumed new duties as Director of the SEC’s Division of Investment Management; former Assistant Director of the Enforcement Division’s Asset Management Unit, Ken C. Joseph, will lead the Investment Adviser/Investment Company Examination Program in the SEC’s New York Regional Office; and Paula Drake will take over next month as OCIE Chief Counsel and Chief Compliance and Ethics Officer.

Hedge Fund & FINRA Attorney Kevin T. Duffy, Jr. Joins KDVG’s NYC Office

On July 10, 2012, Kaufman Dolowich Voluck & Gonzo LLP announced that Kevin T. Duffy, Jr. has joined its New York office in the firm’s Financial Services Practice.