Apr. 25, 2014

Five Steps for Proactively Managing OTC Derivatives Documentation Risk

Lehman Brothers’ filing of a Chapter 11 petition in September 2008 sent both Lehman and its derivatives counterparties scrambling to find and make sense of the reams of documentation that governed their rights and obligations in the wake of that cataclysm.  The bewildering challenge of terminating and valuing thousands of transactions was compounded by the fact that some counterparties could not promptly locate all of their documentation, and many of those that could were surprised – both negatively and positively – by what it contained when they read it.  The consequences of the Lehman bankruptcy are now in the rear-view mirror for most counterparties, but the market now faces other serious challenges.  In particular, the OTC derivatives market is hurtling toward the brave new world of clearing, which will simplify some aspects of derivatives transactions, but not all of them.  Not only are non-cleared transactions going to persist on a substantial scale, but many users likely will have a mix of both cleared and non-cleared transactions in their portfolios.  This compounds the complexity of documentation of OTC derivatives, making it critical that market participants stay on top of their documentation.  Unfortunately, there are signs – including two recent reports – that many market participants may not be keeping pace in monitoring and managing all of the necessary details of their OTC derivatives portfolios.  As so many counterparties learned from Lehman’s bankruptcy, such disarray is a recipe for disaster.  Only by keeping a close eye on documentation – both on the trading floor and in the legal and compliance functions – can problems be minimized or avoided, and opportunities exploited.  In a guest article, Anne E. Beaumont, a partner at Friedman Kaplan Seiler & Adelman LLP, identifies five best practices that OTC derivatives users of all sizes should adopt to manage the risks and to take best advantage of the opportunities presented by their documentation – and be well-prepared for any crisis, whether it is another major counterparty collapse like Lehman, or something more modest.  See also “How Have Dodd-Frank and European Union Derivatives Trading Reforms Impacted Hedge Fund Managers That Trade Swaps?,” Hedge Fund Law Report, Vol. 6, No. 40 (Oct. 17, 2013).

Can Activist Hedge Fund Managers Provide Special Compensation to Nominees That Are Elected to the Board of a Target? An Interview with Marc Weingarten, Co-Head of the Global Shareholder Activism Practice at Schulte Roth & Zabel

Activist hedge fund managers typically seek to implement their ideas at a target company by nominating new directors and advocating for the election of those nominees.  Such nominees are more likely to be elected – and, once elected, are more likely to be effective in implementing the activist’s ideas – if they are better qualified, or, to use the activist term of art, if they are “rock stars.”  Accordingly, activists have asked how they can find rock star nominees and get the best performance out of those nominees if they are elected as directors.  At least two prominent hedge fund managers have answered this question by offering special compensation to nominees that are elected to the target board.  These managers and their supporters argue that such compensation arrangements align the incentives of activist nominees and shareholders.  Opponents argue that such special compensation arrangements engender short term thinking and result in dysfunctional boards.  To clarify the mechanics of such arrangements and to assess the merits of the arguments on either side of this debate – a debate that has real consequences for the rapidly growing volume of assets in activist hedge funds – the Hedge Fund Law Report recently interviewed Marc Weingarten, co-head (with David E. Rosewater) of the global shareholder activism practice at Schulte Roth & Zabel.  (On April 22, Schulte announced the expansion of that practice into the U.K.)  Our interview covered, among other things: the “market” for director compensation; structuring of special compensation of nominees by activists (including caps, the identity of the obligor and clawbacks); disclosure of such arrangements; the chief arguments for and against such arrangements; case studies involving the two managers referenced above; and the conflicting views of a prominent proxy adviser and law firm on a bylaw recommended by the law firm to prohibit compensation by shareholders of board nominees.  See also “How Can a Hedge Fund Manager Dislodge a Poison Pill at a Public Company?,” Hedge Fund Law Report, Vol. 7, No. 12 (Mar. 28, 2014).

Operational Due Diligence from the Hedge Fund Investor Perspective: Deal Breakers, Liquidity, Valuation, Consultants and On-Site Visits

On March 25 and 26, 2014, at the Princeton Club in New York, Financial Research Associates held the most recent edition of its annual Hedge Fund Due Diligence Master Class.  This article summarizes a series of panels at the event focusing on operational due diligence from the investor perspective.  In particular, this article covers seven categories of “deal breakers” that investors can discover in the course of operational due diligence (ODD); a three-part framework for thinking about manager liquidity; six categories of people that should serve on a hedge fund manager valuation committee; five best practices for institutional investors that elect to conduct due diligence on their own, without a dedicated ODD team; how investors can work with consultants to conduct ODD; and the three phases of on-site ODD visits.  Prior articles in the HFLR covered an overview presentation at the same event, and another series of panels focusing on operational due diligence from the manager perspective.  See “Evolving Operational Due Diligence Trends and Best Practices for Due Diligence on Emerging Hedge Fund Managers,” Hedge Fund Law Report, Vol. 7, No. 15 (Apr. 18, 2014).

When Must a Hedge Fund Manager (or Its Current or Former Employees) Preserve Evidence in Litigation or Potential Litigation Involving High-Frequency Trading Code?

Software is playing an increasingly central role in the investment processes of hedge funds, high frequency traders and other market participants.  Most of the growing body of law around trading software focuses on who owns it, when it has been stolen and the remedies for theft.  See “Recent Developments Affecting the Protection of Trade Secrets by Hedge Fund Managers,” Hedge Fund Law Report, Vol. 6, No. 41 (Oct. 25, 2013).  There is less law, and less commentary, on the application of civil procedure to trading technology disputes.  Accordingly, a recent federal court decision is uniquely interesting to hedge fund managers and others that create and own trading technology; to technology and investment professionals that leave one shop to start another; and to lawyers and others professionally focused on intellectual property issues.  A technology-based trading firm asked the court to impose spoliation sanctions on former employees who allegedly stole code from the firm, incorporated versions of that code into the trading technology of a new firm then – while aware of litigation involving the code – destroyed or erased various iterations of the code.  In a carefully drafted opinion, the court applied the law of spoliation to this dispute involving trading software code.  The court’s opinion provides valuable guidance as to when, and to what extent, a duty to preserve electronic information pertaining to proprietary software exists and the criteria for imposing an appropriate sanction for spoliation.

How Can a Hedge Fund Manager Craft an Effective Program for Foreign Exchange Trading Surveillance, Compliance and Monitoring?

Foreign exchange (FX) trading is a multi-trillion dollar market in which hedge funds are regular participants.  As in other financial markets, there is always the potential for manipulation and other abuses.  A recent program sponsored by NICE Actimize gave an overview of the FX markets, discussed regulation of those markets and provided valuable insights into how hedge funds and others that engage in FX trading may develop effective compliance and monitoring programs.  See also “CFTC and SEC Propose Rules to Further Define the Term ‘Eligible Contract Participant’: Why Should Commodity Pool and Hedge Fund Managers Care?,” Hedge Fund Law Report, Vol. 4, No. 21 (Jun. 23, 2011).

Marc P. Berger, Chief of the Securities and Commodities Fraud Task Force in the Manhattan U.S. Attorney’s Office, to Join Ropes & Gray’s New York Office

On April 24, 2014, Ropes & Gray announced that Marc P. Berger will be joining its New York office in July.  A veteran federal prosecutor, Berger helped lead the Southern District of New York’s high-profile crackdown on insider trading and numerous other corporate and financial fraud cases.  See “Ropes & Gray Partners Share Experience and Best Practices Regarding the JOBS Act, the Volcker Rule, Broker Registration, Information Barriers, Examination Priorities, Multi-Year Incentive Fees and Swap Execution Facilities,” Hedge Fund Law Report, Vol. 7, No. 4 (Jan. 30, 2014).

Fund Formation Lawyer Joins Latham & Watkins from The Carlyle Group

On April 22, 2014, Latham & Watkins announced that Tom Alabaster has joined the firm’s London office as a partner in the Corporate Department.  Alabaster joins Latham & Watkins from the New York office of The Carlyle Group, where he was senior counsel.  See “Buying a Majority Interest in a Hedge Fund Manager: An Acquirer’s Primer on Key Structuring and Negotiating Issues,” Hedge Fund Law Report, Vol. 4, No. 17 (May 20, 2011) (referencing Carlyle’s purchase of a controlling interest in Claren Road Asset Management).

Debtholder and Ad Hoc Bondholder Committee Advisers Join PSZJ in Los Angeles

Pachulski Stang Ziehl & Jones recently announced that three prominent bankruptcy and restructuring attorneys – Isaac Pachulski, Jeffrey Davidson and Gabriel Glazer – are joining the firm.  Their collective experience includes work on the Lehman Brothers bankruptcy.  See “Lesson from Lehman Brothers for Hedge Fund Managers: The Effect of a Bankruptcy Filing on the Value of the Debtor’s Derivative Book,” Hedge Fund Law Report, Vol. 5, No. 27 (Jul. 12, 2012).