Aug. 29, 2013

How and When Should Hedge Fund Managers Value Securities Used to Satisfy Redemption Requests In Kind?

Hedge fund governing documents frequently permit hedge fund managers to satisfy redemption requests in cash or in kind.  To pay redemptions in cash, managers typically use cash in the fund or – in the absence of sufficient cash on hand – sell securities to generate cash.  To pay redemptions in kind, managers typically deliver to investors portfolio securities or interests in a special purpose vehicle established to hold and gradually liquidate portfolio assets.  Managers typically use the in-kind distribution mechanism in declining or liquidity-constrained markets because sales of assets into such markets would occur at a discount, thus generating less cash than sales of the same assets over longer time horizons.  While redeeming investors are rarely enthusiastic about receiving assets rather than cash, an important argument in favor of in-kind redemptions is that they can preserve value for non-redeeming investors and thereby enable a manager to satisfy its fiduciary obligation to the fund.  Not surprisingly, redemptions in kind were a recurring theme during the credit crisis.  See “Steel Partners’ Restructuring and Redemption Plan: Precedent or Anomaly?,” Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009).  Some of the harder questions raised by redemptions in kind relate to valuation.  For example, if a manager agrees as of December 31 of a given year (the “as of date”) to distribute a certain number and type of securities to a redeeming investor, but only distributes those securities months or years later (e.g., because of a suspension of redemptions), who bears the risk of a decline in value of the securities between the as of date and the actual distribution date – the fund or the investor?  In other words, would the manager in this scenario be required to distribute more securities to the investor so that the investor receives in securities the dollar value of its fund interest on the as of date?  Or would the investor be required to internalize the decline in value of a fixed number of securities?  The answers to these questions depend on the governing documents of the fund, other relevant documents (e.g., side letters) and external law.  A recent decision from New York’s intermediate appellate court illuminates these questions and offers guidance to hedge fund managers in drafting in-kind distribution rights in fund documents and side letters.  See also “Schulte Partner Stephanie Breslow Discusses Hedge Fund Liquidity Management Tools in Practising Law Institute Seminar,” Hedge Fund Law Report, Vol. 5, No. 43 (Nov. 15, 2012).

Massachusetts Appeals Court Holds That Hedge Fund Investors Can Sue Hedge Fund Auditor Based on Payment of Taxes on Fraudulent “Phantom Income”

Can a hedge fund investor sue the hedge fund’s auditor if the fund turns out to be a fraud?  While courts have come down on both sides of this question, the thrust of the caselaw has thus far been unfavorable to investors and favorable to auditors and other service providers seeking to avoid liability.  See, e.g., “When Can Hedge Fund Investors Bring Suit Against a Service Provider for Services Performed on Behalf of the Fund?,” Hedge Fund Law Report, Vol. 6, No. 18 (May 2, 2013).  However, the Massachusetts Appeals Court (Court) recently upheld a trial court decision allowing investors in a fraudulent hedge fund to proceed with a suit against the funds’ auditor.  In particular, the Court identified various direct claims available to the hedge fund investors based on (among other things) the passing through of profits and losses to investors and the payment of taxes by investors on phantom income that did not exist.  For more on phantom income and the tax consequences of it, see “How Can Hedge Fund Managers Use Profits Interests, Capital Interests, Options and Phantom Income to Incentivize Top Portfolio Management and Other Talent?,” Hedge Fund Law Report, Vol. 6, No. 33 (Aug. 22, 2013).  The Court’s decision may create opportunities for investors in similar factual scenarios (and in disputes governed by Delaware law) to take direct action against auditors and other hedge fund service providers, at least where investors suffer a harm independent of any harm suffered by the fund.  This article summarizes the factual background of the case, the Court’s legal analysis and the implications of the Court’s decision.

U.S. District Court Upholds Hedge Fund’s Security Interest in Marc Dreier’s Art Collection

Disgraced attorney Marc Dreier swindled his victims out of nearly $400 million in a scheme involving the issuance of fraudulent promissory notes.  Elliott International L.P. and Elliott Associates, L.P. (together, Elliott), were among Dreier’s largest victims, having purchased $100 million of fake notes in Dreier’s fraud.  As part of that transaction, Dreier had granted Elliott a security interest in eighteen works of art by well-known artists such as Damien Hirst, Roy Lichtenstein, Mark Rothko and Andy Warhol (Artwork) in Dreier’s personal collection.  Following his fraud conviction, certain of Dreier’s assets – including the Artwork – were forfeited to the U.S. government.  Elliott sought to recover the Artwork on the ground that its security interest in the Artwork gave it priority over Dreier’s other victims seeking restitution from Dreier’s estate.  Not surprisingly, those other victims objected.  The U.S. District Court for the Southern District of New York (Court) recently ruled on whether Elliott was, in fact, entitled to the Artwork by virtue of the security interest that Dreier had granted.  The Court’s decision is relevant both to hedge funds that hold security interests in connection with investments and to funds that seek restitution out of forfeited assets in the event of fraud.  This article summarizes the facts of the dispute and the Court’s legal analysis.  Dreier’s victims have also been sparring in bankruptcy court.  See “Federal Judge Approves Settlement Agreements Arising out of Marc Dreier’s Criminal Fraud; Hedge Fund Victims ‘Squabble’ Over Proposed Recovery,” Hedge Fund Law Report, Vol. 3, No. 7 (Feb. 17, 2010).  One victim, Fortress Credit Corp., has tried unsuccessfully to recover from Dreier’s outside counsel.  See “Dismissal of Fortress’ Complaint Against Dechert Illustrates the Limits of a Hedge Fund Manager’s Ability to Rely on a Legal Opinion Issued by a Law Firm of Which It Is Not a Client,” Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011); and “Affiliates of Hedge Fund Manager Fortress Investment Group Sue Dechert Over Opinion Letter Endorsing Marc Dreier,” Hedge Fund Law Report, Vol. 2, No. 52 (Dec. 30, 2009).

SEC’s First Report on Initial Form PF Filings Offers Insight into How the Agency Is Using the Collected Data for Examinations, Enforcement and Systemic Risk Monitoring

The Dodd-Frank Act directed the SEC to collect data with regard to hedge funds, private equity funds and other private funds in order to assist the Financial Stability Oversight Council (FSOC) in evaluating and monitoring systemic risk.  In October 2011, the SEC created Form PF for that purpose.  The first full reporting cycle ended on April 30 of this year.  See “Challenges Faced By, Risks Encountered By and Lessons Learned From First Filers of Form PF,” Hedge Fund Law Report, Vol. 6, No. 4 (Jan. 24, 2013); and “Lessons Learned by Hedge Fund Managers from the August 2012 Initial Form PF Filing,” Hedge Fund Law Report, Vol. 5, No. 43 (Nov. 15, 2012).  The Dodd-Frank Act also directed the SEC to report annually to Congress on how the SEC “has used the data collected regarding private funds under the Dodd-Frank Act to protect investors and the integrity of the markets.”  Based on that directive, the SEC’s Division of Investment Management recently issued its first Form PF report.  The report provides an overview of the Form PF reporting regime; general data relating to initial filers; and, perhaps most interestingly, a discussion of how the SEC is using and proposes to use the data gathered, beyond providing it to the FSOC.  This article summarizes the key takeaways from the Report.

SEC Sanctions Two Dually-Registered Investment Advisers for Failing to Obtain Best Execution for Clients

On July 31, 2013, the SEC announced that it had settled charges against two dually-registered firms (i.e., firms registered with the SEC as both investment advisers and broker-dealers) arising out of their failure to seek and obtain best execution on behalf of clients.  While not directly involving hedge fund managers, these two enforcement actions are nonetheless pertinent and instructive for hedge fund managers for at least two reasons.  First, the actions illustrate the ways in which the SEC is scrutinizing dual registrants to ensure that such firms are appropriately addressing, managing and mitigating conflicts of interest arising out of the simultaneous provision of brokerage and investment advisory services to clients.  See “SEC’s National Examination Program Publishes Official List of Priorities for 2013 Examinations of Hedge Fund Managers and Other Regulated Entities,” Hedge Fund Law Report, Vol. 6, No. 9 (Feb. 28, 2013) (identifying dual registration as an emerging issue).  Second, these actions suggest a refocusing by the SEC’s enforcement staff on best execution generally, despite a dearth of recent enforcement activity in this area.  This article summarizes the factual and legal allegations in each case, as well as the sanctions levied against the defendants.  In doing so, this article provides insight into the types of acts and omissions that raise concerns for the SEC on the topics of dual registration and best execution – thereby enabling hedge fund managers to structure and operate in a way that avoids such problematic conduct.  See also “Trading Practices Session at SEC’s Compliance Outreach Program National Seminar Addresses Need for Holistic Compliance Procedures Dealing with Allocations, Best Execution and Cross Trades,” Hedge Fund Law Report, Vol. 5, No. 8 (Feb. 23, 2012).

Offshore Investment Funds Specialist Dawn Howe Joins Walkers

On August 28, 2013, Walkers announced that offshore investment funds specialist Dawn Howe has joined the firm as a partner in its Global Investment Funds Group.  Howe has expertise on cross-jurisdictional and regulatory issues affecting Cayman Islands investment funds, including issues relating to the application of FATCA and the AIFMD.  See “What Impact Will FATCA Have on Offshore Hedge Funds and How Should Such Funds Prepare for FATCA Compliance?,” Hedge Fund Law Report, Vol. 6, No. 5 (Feb. 1, 2013); “Application of the AIFMD to Non-EU Alternative Investment Fund Managers (Part Two of Two),” Hedge Fund Law Report, Vol. 6, No. 24 (Jun. 13, 2013).  See also “Speakers at Walkers Fundamentals Hedge Fund Seminar Discuss Recent Trends in Hedge Fund Terms, Corporate Governance, Side Letters, FATCA and Cayman Fund Regulation,” Hedge Fund Law Report, Vol. 5, No. 48 (Dec. 20, 2012).

The Hedge Fund Law Report Will Not Publish an Issue Next Week and Will Resume Its Regular Publication Schedule the Following Week

Please note that the Hedge Fund Law Report will not publish an issue next week, the week starting September 2, 2013, and will resume its regular publication schedule the following week, the week starting September 9, 2013.