Financial Markets Crisis: Issues for Hedge Funds and Private Equity Funds

September 26, 2008

The Gibson, Dunn & Crutcher Financial Markets Crisis Group is tracking government responses to the turmoil that has reshaped our capital and credit markets.  The following is an update on key regulatory and legislative issues that are of particular interest to and are likely to affect hedge funds and private equity funds.

Federal Reserve Board Enhances Passive Investment Framework for Minority Investors in Bank Holding Companies and Banks

In connection with its various efforts to increase the capital and liquidity available to the banking industry, on September 22, 2008 the Federal Reserve Board (the "Fed") issued a new policy statement providing additional guidance on making equity investments in a bank or bank holding company ("BHC").  Importantly, the issuance only acts to modify certain elements in the Fed’s existing control framework and does not change any other items, including, for example, the rules relating to aggregation, attribution and acting in concert with respect to investors.

On the margin, this enhanced flexibility will benefit investors in BHCs, however, it undoubtedly does not represent the significant changes that were being sought when hedge fund and private equity fund groups petitioned the Fed to liberalize this area.  For a company, including a hedge fund or private equity fund, the policy statement describes the investment amount and certain other relationships, such as board representation, that may exist without the company being considered to control a BHC and thereby become a BHC itself under the Bank Holding Company Act ("BHC Act").

Under the guidance, a fund that is a noncontrolling minority investor ("investor") may now have a “modicum” of influence over a BHC without having a “controlling influence over the management or policies” of a BHC.  In this regard, this policy modifies the following elements in the Fed’s control framework consistent with this position.

• An investor may have at least one representative on a BHC’s board of directors.  It may also have two representatives when the investor’s aggregate director representation is proportionate to its total interest in the banking organization, the representation does not exceed 25 percent of the voting members of the board and another shareholder of the banking organization is a BHC that controls the banking organization under the BHC Act.[1]
• An investor may own a combination of voting and nonvoting shares that, when aggregated, represents less than one-third of the total equity of a BHC (and less than one-third of any class of voting securities, assuming conversion of all convertible nonvoting shares held by such investor) and does not allow the investor to own, hold or vote 15 percent or more of any class of voting securities of the BHC.[2]
• An investor may communicate and advocate with management for changes in a BHC’s policies or operations such as policies related to mergers, management changes, dividends, debt or equity financing, new business lines and subsidiary divestitures.  An investor may not make explicit or implicit threats to dispose of shares in the BHC or to sponsor a proxy solicitation as a condition of action or inaction by the BHC or its management in connection with these policy discussions.[3]

Treasury Guaranty Program for Money Market Funds

It is estimated that hedge funds hold approximately $600 billion in cash, and of that amount, $100 billion of this is held in money market funds.[4]  The Treasury Department has established a temporary guaranty program for these money market funds.  For a fee, Treasury will insure the holdings of any eligible publicly offered retail or institutional money market mutual fund for the next year.  Eligible funds include all funds that are  regulated under Rule 2a-7 of the Investment Company Act of 1940 and publicly offered and registered with the SEC.  Taxable and tax-exempt funds are eligible, and the guaranty will not affect the tax-exempt treatment of payments by tax-exempt money market funds.  The guaranty will be limited to balances that existed as of the close of business on Friday, September 19, 2008. 

Treasury intends for this guaranty to bolster investor confidence and stabilize the global economy by maintaining the standard $1 net asset value of money market mutual funds.  As Treasury has proposed it, the program will be funded out of the Exchange Stabilization Fund, which currently holds approximately $50 billion of assets.[5]

Although Treasury’s announced program did not include limits on the guaranty that would apply to a particular eligible money market mutual fund, early House and Senate drafts of broader capital markets rescue legislation would have limited the guaranty to the insurance provided to individual depositors under the Federal Deposit Insurance Act.  A House draft dated September 25, 2008 does not include an insurance limit but does limit the program to four months, which can be extended to one year upon a Treasury Secretary certification to Congress.

Challenges Posed by Prime Broker Insolvency

Our clients and friends have raised questions recently about how liquidation proceedings of U.S. prime brokers  under the Securities Investor Protection Act of 1979 (“SIPA”) would unfold, the treatment of securities and cash held in customer accounts, as well as a description of how derivative transactions, repurchase transactions and securities contracts would be treated.  Please note that this discussion applies only to accounts maintained with a U.S. office of a prime broker and that protections may differ if the accounts are maintained elsewhere.

A prime broker could file its own chapter 7 stockbroker liquidation case under the United States Bankruptcy Code without a SIPA proceeding.  However, it is likely that if an insolvent prime broker were to file for chapter 7 protection, the SIPA-created Securities Investor Protection Corporation (“SIPC”) would initiate a SIPA proceeding that would supersede the chapter 7 proceeding.  As such, we will limit the following commentary to a SIPA proceeding.

SIPA Proceeding

Under SIPA, the first step in the liquidation process would be for the SIPC to commence a liquidation proceeding in federal district court and obtain a protective order freezing the customer activity of the prime broker.  SIPC would then appoint a SIPA trustee to oversee the liquidation, which would be moved to the bankruptcy court.  The first avenue explored in the liquidation process is an attempt to transfer customer accounts to a more stable brokerage firm.  If no transfer is available, the SIPA trustee will then seek to return the customers’ assets to them.  As part of this liquidation process, with the exception of certain “customer name securities” (non-negotiable securities registered in the name of the customer) that are returned to the particular customer, the assets of the prime brokerage customers are collected into a pool of “customer property” which is used to settle the customer accounts.  Customers would file proofs of claim with the SIPA trustee who would reconcile the claims and make a pro rata distribution of the customer property to all the customers.  Any shortfall in value will be shared pro rata by all the customers. 

Under SIPA, customers receive distributions of the pooled customer property with respect to their “net equity claim.” “Customer property” includes all property, including securities and cash, that was, or should have been, set aside for the particular customer in accordance with SEC guidelines, and will include all securities that are held in “street name,” as well as any cash.  The “net equity claim” is the dollar amount of a customer’s account that would have been owed by the debtor if the debtor had hypothetically liquidated the securities positions of the customer on the date the SIPA liquidation was filed (at the then prevailing market values), minus any indebtedness of the customer to the debtor. Thus, although the customer may hold cash and securities in its account, the claim will be a dollar value claim.  We understand that it has been SIPC’s policy to return to customers securities that are held as customer property by having the SIPA trustee purchase securities rather than make cash payments for any shortfall in the number of available shares; however there is no guarantee that customers will have their original securities returned to them.

Under SEC rules, a registered broker-dealer is required to maintain physical possession and control of any fully paid securities as well as securities in excess of 140% of the customer’s debit balance.  Such fully paid and excess margin securities are not to be commingled with “house” securities and generally cannot be hypothecated by the broker-dealer absent agreement. These protections, as well as a requirement to maintain certain reserve accounts, are intended to ensure that a failed broker-dealer will be able to satisfy customer net equity claims from available customer property.  In a SIPA proceeding, the SIPA trustee has access to the SIPC fund, which will provide up to $500,000 per account to cover any shortfalls, of which only $100,000 can be used to cover shortfalls of cash held in the account, and the prime broker may also have an insurance policy with the Customer Asset Protection Company (“CAPCO”) to make up any such shortfalls, in excess of the amount covered by the SIPC fund.  The CAPCO insurance would not cover losses due to appreciation in account assets after the filing date, any losses due to a delay in payment or disruption in trading etc., and at this point, given the recent downgrade of CAPCO and without knowing with any precision the magnitude of the claims that could be asserted against CAPCO, it is unclear whether CAPCO would have the financial wherewithal to respond fully to all claims. To the extent customer property, the SIPC fund advances and CAPCO insurance proceeds are not sufficient to pay or satisfy in full the net equity claims of customers, then customers participate in the estate as unsecured creditors.  Any residual claims, where the customer has an unsecured claim against the estate, are likely to be paid out at a discount.

Derivatives with the Prime Broker

SIPA and the United States Bankruptcy Code will protect the contractual rights to terminate, accelerate and liquidate the swap transactions, securities transactions and repurchase transactions, as well as the contractual rights to close out the transactions, net them and then enforce on any collateral posted in connection with these qualified financial contracts, notwithstanding otherwise applicable restrictions on enforcing rights and exercising remedies against a debtor.  If the customer closes out the contracts while it is “in the money” and would be owed a payment by the counterparty that is not secured by collateral, the customer would be a general unsecured creditor of the counterparty and may only therefore recover a portion of the face value of the claim in a winding up.  If the claim is secured by collateral subject to a valid, perfected security interest, the customer would be a secured creditor and would be able to enforce on its collateral and set off such amounts against the claim without seeking bankruptcy court approval. 

Derivatives Between the Customer and a Third Party That Settle Through a Prime Brokerage Account

In the event that the transactions are settled through an account with a prime broker that is the subject of a SIPA proceeding, the customer should change the account to which payments or deliveries will be made, as set forth in the contracts governing the transaction.  The standard ISDA Master Agreement provides that either party may change its account for receiving payment or delivery by giving the counterparty notice at least five business days prior to the scheduled date of a payment or delivery. 

In addition, some contracts may contain provisions making the bankruptcy of the prime broker an event of default.  Under the ISDA Master Agreement, the prime broker may be a designated Specified Entity, which would give the customer the right, but not the obligation, to terminate the transactions on the bankruptcy of the prime broker, which bankruptcy would be an event of default that would allow the customer to close out and net the transactions.  These transactions would not be part of the prime broker’s estate.  If the customer was “in the money,” the counterparty would be required to make a termination payment to the customer’s account. 

Short Selling Prohibition

On September 18, 2008, the SEC issued an emergency order pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 (“Exchange Act”) prohibiting (with certain limited exceptions) any person from effecting a short sale in the publicly traded securities of certain financial firms.[6]  The SEC subsequently delegated to the relevant listing markets responsibility for posting on their respective websites their individual listed companies that are banks, savings associations, broker-dealers, investment advisers and insurance companies, whether domestic or foreign, and the owners of any of these entities  (“Included Firms”).[7]  An issuer may elect to opt-out of being an Included Firm. 

This prohibition took effect September 19, 2008 at 11:59 p.m. and is currently scheduled to expire on October 2, 2008, unless further extended by the SEC.  The SEC has authority under the Exchange Act to extend the September 18, 2008 Order until midnight on October 18, 2008.

Disclosure of Short Sale Positions

As discussed in more detail in our client alert Short Selling Update:  Global Regulators Take Additional Action, pursuant to Section 12(k)(2) of the Exchange Act, on September 18, 2008 the SEC issued an emergency order requiring hedge funds and other institutional investment managers to disclose aggregate gross short sales across all accounts effected in certain publicly traded securities each day covered by the order.[8]  Institutional investment managers who were required to file a report on Form 13F for the calendar quarter ended June 30, 2008 will now be required to file a report on Form SH on the first business day of the calendar week immediately following a week during which the investment manager effected a short sale of a security defined in Exchange Act Rule 13f-1(c) (“Section 13(f) securities”).  Investment managers may rely upon the SEC’s official list of Section 13(f) securities when determining what classes of securities are covered, however, they are not required to report short sales in options.

The SEC’s order only applies to short sales effected after 12:01 a.m. EDT on September 22, 2008; short positions taken prior to that date need not be reported.  Unless extended, the SEC’s order will terminate at 11:59 p.m. on October 2, 2008.  If the order is extended, no subsequent filings will be required where no short sales of a Section 13(f) security have been effected by the manager since the manager’s filing of the previous Form SH.  The SEC’s order also contains a de minimis exception: Investment managers do not have to report short positions if such position constitutes less than one quarter of one percent of the class of the issuer’s issued and outstanding Section 13(f) securities and the fair market value of the position is less than $1 million on every day of the reporting period.[9]

Investigations into Market Manipulation

On September 19, 2008, the SEC announced a sweeping expansion of its ongoing investigation into possible market manipulation in the securities of certain financial institutions, which will include requiring hedge fund managers and other investors with significant trading activity in financial issuers or positions in credit default swaps to disclose those positions under oath.[10]  SEC Chairman Christopher Cox stated that the investigation will look into the activity of investors with significant short positions in equity markets and positions in credit default swaps.  This expansion, according to Chairman Cox, supplements ongoing SEC investigations concerning the origination and securitization of sub prime mortgage loans, the involvement of credit rating agencies and insurers in the securitization process and the sale of mortgage-backed investments to investors.

On September 23, many newspapers reported that the Federal Bureau of Investigation has opened preliminary investigations of activity at four major businesses which either received government assistance or filed for bankruptcy protection and was continuing investigations about mortgage related issues at twenty-six other companies nationwide.

Coming in the midst of market turmoil, the SEC’s September 19 announcement stated that it had approved a formal order of private investigation authorizing its Division of Enforcement to subpoena documents and require witnesses to testify.  It also announced that FINRA and NYSE Regulation examiners would be onsite at broker-dealers to review short-selling activity.  On September 22, the Commission issued orders under Section 21(a)(1) of the Exchange Act requiring written statements from market participants regarding market positions, compliance with existing short sale rules, and details of all information shared or received about specified financial institutions.  The SEC’s use of this tool—one that has not been broadly used for several years—represents a significant escalation of its enforcement efforts in this area.  Letters requesting these sworn statements have already been issued with relatively short return dates.

Separately,  on September 18, 2008, New York Attorney General Andrew Cuomo announced that he was launching a “wide-ranging” investigation into short-selling on Wall Street.  Cuomo will use New York’s Martin Act to prosecute any short sellers engaging in any improper conduct, including, but not limited to, the spreading of false rumors.  One of Mr. Cuomo’s objectives is to stabilize the markets by “root[ing] out short sellers who spread false information.”[11] 

Gibson Dunn has assembled a team of experts who are prepared to meet client needs as they arise in conjunction with the issues discussed above.  Please contact Michael Bopp (202-955-8256, [email protected]) in the firm’s Washington, D.C. office or any of the following members of the Financial Markets Crisis Group:

Public Policy Expertise
Mel Levine – Century City (310-557-8098, [email protected])
John F. Olson – Washington, D.C. (202-955-8522, [email protected])
Amy L. Goodman – Washington, D.C. (202-955-8653, [email protected])
Alan Platt – Washington, D.C. (202- 887-3660, [email protected])
Michael Bopp – Washington, D.C. (202-955-8256, [email protected])

Securities Law and Corporate Governance Expertise
Ronald O. Mueller – Washington, D.C. (202-955-8671, [email protected])
K. Susan Grafton – Washington, D.C. (202- 887-3554, [email protected])
Brian Lane – Washington, D.C. (202-887-3646, [email protected])
Lewis Ferguson – Washington, D.C. (202- 955-8249, [email protected])
Barry Goldsmith – Washington, D.C. (202- 955-8580, [email protected])
John H. Sturc – Washington, D.C. (202-955-8243, [email protected])
Alan Bannister – New York (212-351-2310, [email protected])

Financial Institutions Law Expertise
Chuck Muckenfuss – Washington, D.C. (202- 955-8514, [email protected])
Christopher Bellini – Washington, D.C. (202- 887-3693, [email protected])
Amy Rudnick – Washington, D.C. (202-955-8210, [email protected])

Corporate Expertise
Howard Adler – Washington, D.C. (202- 955-8589, [email protected])
Richard Russo – Denver (303- 298-5715, [email protected])
Dennis Friedman – New York (212- 351-3900, [email protected])
Stephanie Tsacoumis – Washington, D.C. (202-955-8277, [email protected])
Robert Cunningham – New York (212-351-2308, [email protected])
Joerg Esdorn – New York (212-351-3851, [email protected])
Stewart McDowell – San Francisco (415-393-8322, [email protected])
C. William Thomas, Jr. – Washington, D.C. (202-887-3735, [email protected])

Real Estate Expertise
Jesse Sharf – Century City (310-552-8512, [email protected])
Alan Samson – London (+44 20 7071 4222, [email protected])
Andrew Levy – New York (212-351-4037, [email protected])
Dennis Arnold – Los Angeles (213-229-7864, [email protected])
Andrew Lance – New York (212-351-3871, [email protected])

Crisis Management Expertise
Theodore J. Boutrous, Jr. – Los Angeles (213-229-7804, [email protected])

Bankruptcy Law Expertise
Michael Rosenthal – New York (212-351-3969, [email protected])

Tax Law Expertise
Arthur D. Pasternak – Washington, D.C. (202-955-8582, [email protected])
Paul Issler – Los Angeles (213-229-7763, [email protected])

Executive and Incentive Compensation Expertise
Stephen W. Fackler – Palo Alto (650-849-5385, [email protected])
Michael J. Collins – Washington, D.C. (202-887-3551, [email protected])
Sean C. Feller – Los Angeles (213-229-7579, [email protected])

© 2008 Gibson, Dunn & Crutcher LLP

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