Dec. 19, 2013

Convertible Preferred Stock: How Preferred Is It? (Part One of Two)

Growth investors, including hedge funds, often leave value on the table when negotiating for investments in convertible preferred stock, which is the equity security of choice for investing in emerging growth companies.  Convertible preferred stock provides growth investors with two benefits.  The first is a feature of preferred stock that distinguishes it from common stock: a liquidation preference that is payable in priority to common stock if the company is sold or liquidates.  The second benefit of convertible preferred stock is what distinguishes it from straight preferred: the right to convert the investment into common stock.  This is a valuable right if the company does well enough for its common equity value to increase significantly.  In theory, these twin attributes of convertible preferred stock – enabling the investor to reduce the risk of loss and participate in upside appreciation – make convertible preferred a uniquely attractive investment tool.  Unfortunately, though, that attractiveness can be diminished by defects or gaps in the security’s documentation.  In particular, three value-sabotaging flaws – identified and discussed in this article – regularly appear in supposedly “standard” convertible preferred terms.  These flaws are of particular concern to late round investors, who often acquire their convertible preferred stock at significantly higher prices than earlier round investors.  Since most convertible preferred financings start off with a term sheet, a prospective investor should have an opportunity to identify any of these risks and propose solutions to them before the specific charter provisions for the series are adopted.  With this in mind, this two-part article series provides a roadmap with respect to such risks and provides recommendations to fully capture the benefits of convertible preferred stock investments through effective negotiation of term sheets.  Specifically, this article series addresses the four main areas of a company’s charter where the potential for value-sabotaging flaws is most acute.

Akin Gump Partners Present Overview of Recent Developments in Fund Taxation, Fund Manager Transactions and Hedge and Private Equity Fund Investment Terms

Akin Gump Strauss Hauer & Feld LLP (Akin Gump) recently presented its annual Private Investment Funds Conference.  During the conference, Akin Gump partner Stuart E. Leblang presented the annual tax update; partners Stephen M. Vine, Ackneil M. (Trey) Muldrow III and Stephen M. Jordan discussed recent trends in transactions involving equity stakes in fund manager businesses; and partners Blayne A. Grady and Burke A. McDavid addressed the current environment for hedge fund and private equity fund terms.  This article details salient takeaways from each of these sessions.

RCA Symposium Offers Perspectives from Regulators and Industry Experts on 2014 Examination and Enforcement Priorities, Fund Distribution Challenges, Conducting Risk Assessments, Compliance Best Practices and Administrator Shadowing (Part Two of Three)

Hedge fund industry experts, including regulators from the SEC and National Futures Association (NFA), recently gathered at the RCA’s Compliance, Risk & Enforcement 2013 Symposium (Symposium) to offer varied perspectives and advice on topics relevant to hedge fund managers.  This second installment in a three-part article series covering the Symposium summarizes notable points from two sessions, including: (1) the keynote address by Andrew Bowden, Director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), who outlined OCIE examination priorities for hedge fund managers; and (2) another session addressing regulatory challenges confronting managers engaged in fund distribution, including the JOBS Act, broker registration, NFA oversight of hedge fund marketing practices and the EU’s Alternative Investment Fund Managers Directive.  The first article in this series covering the Symposium summarized two sessions, one on conducting effective risk assessments for hedge fund managers (including discussions of forensic testing and testing for insider trading, order allocations and best execution), and the other incorporating current and former government officials’ perspectives on expert networks, political intelligence, insider trading investigations and prosecutions and valuation-related conflicts of interest.  See “RCA Symposium Offers Perspectives from Regulators and Industry Experts on 2014 Examination and Enforcement Priorities, Fund Distribution Challenges, Conducting Risk Assessments, Compliance Best Practices and Administrator Shadowing (Part One of Three),” Hedge Fund Law Report, Vol. 6, No. 47 (Dec. 12, 2013).  The third article will summarize key points from two sessions, one identifying regulatory risks and outlining compliance best practices with respect to use of expert networks, valuation of assets, custody and the allocation of expenses, and another providing a detailed look into fund administrator shadowing.

Annual Greenwich Associates and Johnson Associates Report Reveals Trends in Compensation of Investment Professionals at Buy-Side Firms

Greenwich Associates, LLC (Greenwich), an international research-based consulting firm in institutional financial services, in cooperation with Johnson Associates, Inc. (Johnson), a boutique financial services compensation consulting firm, have issued their 2013 report on U.S. asset management compensation (Report).  The Report is based on Greenwich’s interviews with “more than 1,000 financial professionals in equity and fixed-income investor groups at investment management firms, mutual funds, hedge funds, banks, insurance companies, government agencies, and pensions and endowments.”  Johnson used the data gathered by Greenwich, in conjunction with its proprietary compensation information and other industry data, to project trends for 2014.  Among other things, the Report broke out compensation between buy-side and sell-side firms.  The Report also broke out compensation among buy-side investment professionals, based on whether they were fixed-income or equity professionals and whether they worked at hedge fund firms or other buy-side firms.  The Report also highlighted trends in the compensation mix among buy-side professionals.  This article summarizes the key findings of the Report.  For coverage of prior years’ surveys, see “Greenwich Associates and Johnson Associates Issue Report on Asset Management Compensation Trends in 2012,” Hedge Fund Law Report, Vol. 5, No. 47 (Dec. 13, 2012); and “Compensation Survey by Greenwich Associates and Johnson Associates Highlights Trends in Compensation and Best Practices for Hedge Fund Managers and Other Investment Professionals,” Hedge Fund Law Report, Vol. 4, No. 46 (Dec. 21, 2011).

Six Implications for Bankruptcy Claims Traders, Including Hedge Funds, Arising Out of the Third Circuit’s Recent Decision Holding that Claims Subject to Disallowance under Section 502(d) Cannot Be “Washed” through Subsequent Transfers

In a recent case related to the liquidation of KB Toys Inc. and affiliated entities, the U.S. Court of Appeals for the Third Circuit (Third Circuit) held that a trade claim disallowable under Section 502(d) of the U.S. Bankruptcy Code (Bankruptcy Code) in the hands of the original claimant is similarly disallowable in the hands of a subsequent transferee.  In other words, the Third Circuit affirmed the decision of the U.S. District Court, District of Delaware holding that disallowance risk attaches to and travels with claims.  The U.S. District Court for the Southern District of New York recently reached the opposite conclusion, holding that disallowance is a personal disability of the claimant, and not an attribute of the claim itself, unless the transferee took the claim by assignment rather than by sale.  This article summarizes the legal and factual background of the case and the Third Circuit’s analysis.  The article also highlights six implications arising out of the Third Circuit’s decision for prospective claims purchasers, including hedge funds.  For further discussion of the risks faced by hedge funds participating in claims trading, 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 coverage of similar best practices helpful in managing the risk of claims disallowance under Bankruptcy Code Section 502(d) based on a seller’s avoidance liability, see “Five Steps Hedge Fund Managers Should Take to Mitigate Avoidance and Disallowance Risks After Delaware Court Finds That Avoidance and Disallowance Risks Travel with Trade Claims,” Hedge Fund Law Report, Vol. 5, No. 24 (Jun. 14, 2012).

In Messy Hedge Fund Employment Dispute, Highland Capital Accuses Former Executive’s Counsel of Extortion and Other Criminal Acts in Connection with Possession and Threatened Use of Highland’s Confidential and Proprietary Information

In a nasty divorce from its one-time general counsel and senior executive Patrick Daugherty, hedge fund manager Highland Capital Management, L.P. (Highland) has taken the gloves off and sued Daugherty’s counsel, Looper Reed & McGraw, P.C. (Looper).  Highland claims that, at the termination of his employment, Daugherty misappropriated more than 60,000 documents containing Highland’s confidential and proprietary information.  It further accuses Looper of improperly obtaining and using that information to assist Daugherty in his effort to “extort” more than $2 million from Highland.  This case underscores the need for hedge fund managers to take strong prophylactic measures to prevent the theft of such information, including any trade secrets, prior to an employee’s departure.  See “Recent Developments Affecting the Protection of Trade Secrets by Hedge Fund Managers,” Hedge Fund Law Report, Vol. 6, No. 41 (Oct. 25, 2013); “Measures Hedge Fund Managers Can Implement to Maximize Protection of Their Trade Secrets,” Hedge Fund Law Report, Vol. 5, No. 46 (Dec. 6, 2012).  The case also argues in favor of pre-employment background checks of hedge fund manager employees.  See “Six Critical Questions to Be Addressed by Hedge Fund Managers That Outsource Employee Background Checks (Part Three of Three),” Hedge Fund Law Report, Vol. 6, No. 40 (Oct. 17, 2013).  This article summarizes the factual and legal allegations in Highland’s petition, including a discussion of protective measures employed by Highland designed to protect its confidential information.  Highland previously sued Daugherty over his possession and use of that information.  See “Highland Capital Management Sues Former Private Equity Chief for Breach of Employment and Buy-Sell Agreements,” Hedge Fund Law Report, Vol. 5, No. 20 (May 17, 2012).  For a discussion of another action involving a hedge fund business divorce, see “Delaware Chancery Court, Criticizing Both Sides in Contentious Litigation, Awards $4.662 Million to Camulos Capital Hedge Fund Founder in Payment for His Fund Interest,” Hedge Fund Law Report, Vol. 5, No. 38 (Oct. 4, 2012).

Expert Panel Underscores Heightened Foreign Corrupt Practice Act Enforcement Risk Facing Hedge Fund and Other Private Fund Managers 

“Hedge funds are under the FCPA microscope now,” Lauren Resnick, a partner at Baker Hostetler LLP, warned during a recent panel discussion addressing corruption risks that private fund managers, including hedge fund managers, face.  She and her colleague Marc Kornfeld, along with James “Bucky” Canales, Chief Operating Officer of StoneWater Capital LLC, detailed how the FCPA affects the private fund industry and what hedge fund managers and others should be doing to minimize the risk of an FCPA violation, or the violation of another global anti-bribery law.  This article highlights salient points from the panel discussion.  See also “Practical Considerations for Compliance by Hedge Fund Managers with the FCPA When Evaluating and Engaging Foreign Advisors in Connection with Foreign Bankruptcy Investments,” Hedge Fund Law Report, Vol. 4, No. 34 (Sep. 29, 2011).

Jeffrey Sion Joins Dechert’s Tax Practice in New York 

On December 16, 2013, Dechert LLP announced that Jeffrey Sion has joined the firm’s financial services tax practice as a partner in New York.  See “Key Hedge Fund Tax Developments in the U.K., the European Union, Ireland, Germany, Spain, Australia, India and Puerto Rico,” Hedge Fund Law Report, Vol. 6, No. 26 (Jun. 27, 2013).  Sion was most recently a partner in and the National Tax Leader of KPMG’s investment management practice.  For insight from Dechert partners, see “Dechert Partners Aisha Hunt and Richard Horowitz Discuss Strategies and Challenges for Hedge Fund Managers Wishing to Enter the Alternative Mutual Fund Space,” Hedge Fund Law Report, Vol. 6, No. 20 (May 16, 2013); and Dechert Webinar Highlights Key Deal Points and Tactics in Negotiations between Hedge Fund Managers and Futures Commission Merchants regarding Cleared Derivative Agreements,” Hedge Fund Law Report, Vol. 6, No. 16 (Apr. 18, 2013).

The Hedge Fund Law Report Will Not Publish Issues during the Weeks of December 23 and 30, and Will Resume Its Regular Publication Schedule during the Week of January 6

Please note that the Hedge Fund Law Report will not publish issues during the weeks starting December 23 (which includes the Christmas Day holiday) or December 30 (which includes the New Year’s Day holiday), and will resume its regular publication schedule the following week, the week starting January 6, 2014.