A New Statutory Exemption for Private Resales of Restricted Securities Enacted

A New Statutory Exemption for Private Resales of Restricted Securities Enacted
Frenkel Sukhman LLP
February 6, 2016

On December 4, 2015, President Obama signed into law The Fixing America’s Surface Transportation Act (the “FAST Act”), which establishes a new statutory exemption from registration under the Securities Act of 1933, as amended (the “Securities Act”), for private resales of restricted securities buried among other securities and non-securities law provisions. New Section 4(a)(7) of the Securities Act exemption codifies a private resale exemption similar (but not identical) to the informal “Section 4(a)(1-1/2)” private resale exemption which was developed over time by the securities bar through court rulings and SEC no-action letters.

The new Section 4(a)(7) provides an exemption from registration for certain private resale transactions meeting the following requirements:

• Each purchaser is an “accredited investor” as defined in Rule 501 under the Securities Act;
• No “general solicitation” or “general advertising” is used in connection with the offer or sale;
• The seller is not the issuer or a subsidiary of the issuer;
• The securities are not part of an unsold allotment to, or a subscription or participation by, an underwriter of the security or a redistribution;
• The securities have been authorized and outstanding for at least 90 days prior to the date of the resale; and
• Certain information has been provided by the seller to the purchaser.

Mandatory information disclosure is one key element in which the Rule 4(a)(7) exemption differs from the informal 4-1/2 exemption and the one which would likely be most difficult to implement in transactions involving startup or small companies due to the requirement of preparing GAAP financials.  All issuers who are not reporting companies under the Securities Exchange Act of 1933 (the “Securities Exchange Act”) would also need to consider using confidentiality agreements to protect their proprietary information and address issues raised by material non-public information if they agree to cooperate with the transferor of restricted securities and permit disclosure of such information to the transferee.  In the case of a transaction involving the securities of a non-reporting issuer, among certain other categories, the seller and the prospective purchaser are entitled to receive from the issuer, at the request of the seller, current information about the issuer, including, but not limited to:

• the issuer’s name;
• the issuer’s address;
• the title and class of the security to be sold;
• the par value of the security;
• the total number of shares outstanding as of the end of the issuer’s most recent fiscal year;
• the name and address of the transfer agent or other person responsible for the transfer of such security;
• the nature of the issuer’s business;
• the names of the issuer’s officers and directors;
• the names of any person that will receive commission or other remuneration in connection with the sale;
• the issuer’s most recent balance sheet and profit and loss statement and similar financial statement for the two preceding fiscal years during which the issuer has been in business, prepared in accordance with GAAP; and
• if the seller is an affiliate, a statement regarding the nature of the affiliation accompanied by a certification from the seller that it has no reasonable grounds to believe that the issuer is in violation of the securities laws or regulations.

The new Section 4(a)(7) exemption is not available if the seller, or any person who will receive a commission or other remuneration in connection with offering or selling the securities, is subject to the “bad actor” disqualification under Rule 506(d) under the Securities Act or statutory disqualification under Section 3(a)(39) of the Securities Exchange Act. In addition, the new exemption is available only for securities of an issuer “engaged in business” and not in an organizational stage or in bankruptcy or receivership, and not a “blank check”, “blind pool” or “shell company” or special purpose acquisition company.

Any securities acquired in accordance with the Section 4(a)(7) exemption will be deemed to have been acquired in a transaction not involving a public offering and will be deemed to be “restricted securities” within the meaning of Rule 144 under the Securities Act and “covered securities” for state securities law (“blue sky”) purposes. The resale transaction will not be deemed to be a “distribution” for purposes of Section 2(a)(11) of the Securities Act.

The new Section 4(a)(7) exemption is presumably not exclusive of other available resale exemptions (i.e. pursuant to Rule 144, Rule 144A or Rule 904). The statutory safe harbor the new rule offers presents certain advantages over the conditions of those exemptions but has its own burdensome limitations not imposed by the other rules. Its enactment promises to give holders of restricted securities a wider choice in structuring exit transactions and possibly bring about greater liquidity to secondary markets. However, every resale situation must be analyzed on the basis of its own facts and circumstances to determine which exemption would fit the parties to the transaction best, including in light of the contractual requirements for transfer imposed by the currently existing private placement documentation. Finally, it is not entirely clear whether a seller may still rely on the common law exemption known as Section 4(a)(1-1/2) in the event it does not comply with Section 4(a)(7) or other statutory exemptions. There is no legislative history on point and the SEC has not addressed this issue yet.

Issuers should consider updating their organizational documents in connection with the provisions governing securities compliance requirements for permitted transfers in order to accommodate resales of restricted securities pursuant to the new exemption.  Although issuers are not parties to secondary securities transactions, they have normally imposed certain contractual requirements (including legal opinion from a securities counsel to the transferor with respect to the availability of an exemption from registration for the proposed transaction) as conditions to recognizing the transfer.  With the possibility for a greater involvement of issuers in the resale process due to the informational requirements of the new statutory exemption, it is in the issuers’ interest to define clearly the rights and obligations of all parties concerned.

Frenkel Sukhman LLP advises its fund and other clients in the financial services and other industries on securities law compliance issues and represents issuers and holders of restricted securities in private placement issuance and resale transactions on the regular basis.

U.S. Fund Managers to File BEA Form BE-11 for Foreign Funds and Portfolio Holdings

Among various federal filings U.S.-based private fund managers have to make, questionnaires generated by the little-known unit of the U.S. Department of Commerce, Bureau of Economic Analysis (“BEA”), have maintained a low profile.  This is likely to change this year with the renewed interest on the part of BEA as well as other federal agencies with jurisdiction over U.S. fund managers in disclosure and enforcement matters.

BEA is responsible for the administration of several annual surveys, which are mailed to the previously identified “U.S. Reporters.”  However, the U.S. law requires every entity subject to the provisions of the International Investment and Trade in Services Survey Act to self-report and make necessary filings with BEA even if they have not previously received initial requests to return completed surveys from BEA.  One of such annual surveys relates to the equity investments made by U.S. entities in foreign entities (while others relate to foreign investment in U.S. entities).

Many U.S. fund managers with non-U.S. master (or other) funds, foreign equity portfolio interests and certain other foreign holdings may be subject to this filing obligation.  Investment managers newly registered with the U.S. Securities and Exchange Commission (“SEC”) under the amended registration requirements of the 1940 Advisers Act will need to ramp up their compliance with all applicable U.S. filing requirements, including those imposed by BEA.  In particular, they will need to determine urgently whether or not they, as investment managers, or their U.S. feeder funds or special purpose vehicles may be required to file Form BE-11, the 2011 Annual Survey of U.S. Direct Investment Abroad.

To answer whether a filing of Form BE-11 is obligatory, a fund manager that is a U.S. person, would need to determine whether it owns, directly or indirectly, at least 10% of the voting securities of a “foreign affiliate” if such foreign affiliate meets certain thresholds.  These thresholds are based on the foreign affiliate’s assets, sales or net income being greater than $60 million (positive or negative) for majority or minority-owned foreign affiliates.  If the assets, sales or net income are greater than $25 million, but not greater than $60 million (positive or negative) for foreign affiliates established or acquired by the U.S. reporter in the most recent or current fiscal year, an exemption may apply.

One of the difficulties of making this determination lies in the nature of private investment funds as Form BE-11 as are all other annual surveys utilized by BEA seem to have been conceived with a view toward conventional operating companies with direct foreign investments rather than asset managers and other financial intermediaries.  The concept of sales, for example, translates only roughly into management fees.  Further, a variety of different foreign forms of business organization commonly used in investment fund structures, complicates the application of the definition of foreign ownership.  Generally, limited partnership interests are not considered “voting securities.”  Hence, a U.S. entity holding limited partnership interests in a foreign limited partnership (such as a Cayman master fund, for example) would not need to file Form BE-11.  However, a U.S. general partner of such foreign entity would be deemed to hold voting securities in that entity and will be required to file absent an exemption.  Those foreign master funds that are organized as corporations or stock companies with various classes of shares may present special problems in determining U.S. control of their voting securities.  The same approach would apply to foreign portfolio companies held by U.S. fund entities to the extent there is greater than 10% ownership of such companies’ voting securities.

Form BE-11 was due to be filed on May 31 of this year; however an extension request could be filed to apply for more time to make this filing.  BEA provides a ready-made Extension Request Form for this purpose.  Filers expecting to file fewer than 50 forms (each per foreign affiliate) may request an extension to June 29, 2012 while those expecting to file up to 100 forms may request an extension to July 31, 2012 and those expecting to file more than 100 forms may request an extension to August 31, 2012.  We understand that BEA’s policy is to grant extension requests which have been timely filed but BEA will consider late requests with an explanation for delay as well.  BEA also provides a form to declare exemption from the obligation to file Form BE-11 (Claim for Not Filing) in the event a U.S. entity received a request from BEA for a BE-11 survey but believes to qualify for an exemption from reporting.  Those fund managers who have never filed Form BE-11 with BEA and believe that they qualify as a “U.S. reporter” subject to the BEA reporting regime should contact their legal counsel for advice on how to proceed in order to avoid penalties and other enforcement actions on the part of the Commerce Department and/or the SEC.

In the past months, Form BE-11 and other BEA annual surveys have been highlighted to many fund managers, both registered under the 1940 Advisers Act and exempt, as a result of informal notification that the Department of Commerce may begin to enforce penalties against persons failing to make these filings.  It has been reported that so far BEA’s intent has not been punitive in that it is only asking U.S. reporters to file going forward and is not requiring them to file forms for prior years.  The foreign affiliates’ data collected is used by the U.S. government to monitor, among other matters, exports/imports and employment abroad by U.S. persons and is given limited confidential treatment (solely for statistical and analytical purposes).  However, BEA is legally empowered to impose fines and other penalties.  Moreover, with the increased interest in regulation of the alternative investments industry and expanded information sharing among federal agencies, compliance with BEA’s filing requirements should become a prerogative for all U.S. fund managers who fall into the definition of a U.S. reporter under the law.

Frenkel Sukhman LLP has been assisting its fund and other clients with filing BE-11 and other BEA surveys and reports and would be pleased to assist you with your BEA filing obligations, if any.

New Reporting Requirements for Newly-Registered and Exempt Investment Advisers

As a result of the implementation of new registration requirements adopted by the U.S. Securities and Exchange Commission (SEC) implementing certain provisions of The Private Fund Investment Advisers Registration Act of 2010 (“Title IV”) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”), some 3,000 advisers were required to register with the SEC in early 2012.  Those of these newly registered investment advisers are now subject to a wide range of reporting obligations, including on Form PF, the rules (the “Rules”) for which were newly adopted by the SEC in late 2011 to help monitor systemic risk in the U.S. financial system.  The Rules, however, apply not only to those financial institutions that are “too big to fail” but also to much smaller private fund advisors which have never been subject to SEC registration or this level of regulatory oversight and which now have to provide much greater disclosure to the regulators.  Moreover, the new private fund adviser exemption under the Rules, while exempting some advisers from registration with the SEC (often at the cost of state registration), no longer completely frees such exempt advisers, regardless of the size of their AUM, from reporting requirements, preventing them from “flying under the radar” as far as public disclosure of their investment operations is concerned.

The key innovation and, for many, a serious hurdle, in the new reporting requirements for all SEC-registered investment advisers is Form PF.  With respect to newly registered advisers, many of which managed relatively small funds, in particular, the Rules will require so-called “smaller” investment advisers (managing between $150 million and $1.5 billion in AUM) to report extensive information to the SEC on Form PF about the private funds they advise.  Form PF is designed to supplement Form ADV, which was also revised in 2011 to include substantial information about private funds advised by reporting advisers.  Although Form PF has been significantly streamlined from the original version as it appeared in the SEC Proposing Release,  it continues to represent an arduous task for smaller advisers without organizational resources to manage the new reporting process.

The information requested on Form PF is quite detailed and extensive and may require advisers to alter their compliance policies and procedures and, possibly, even to revise their recordkeeping systems.  It calls for disclosure about the management company, the assets under management and fund performance.  As adopted, however, Form PF generally permits advisers to rely on existing systems to provide information, a notable difference compared to the requirements proposed earlier.  In particular, Form PF removed the proposed requirement that submitting officials of the adviser certify, under penalty of perjury, the information contained therein.  An adviser is not required to update information that was provided in good faith at the time of submitting Form PF even if such information was subsequently revised for recordkeeping, risk management, or investor reporting purposes.  Although reporting advisers may only have to submit Form PF to the SEC on a quarterly or annual basis, much of the required information may need to be gathered monthly.

Smaller advisers are only required to complete Section 1 of Form PF, which calls for the provision of general identifying information, assets under management, size, leverage and performance information for each private fund and also basic information on hedge funds. Advisers must also provide information about related persons and their large trader identification numbers. With respect to each private fund, advisers must provide gross and net assets, derivative positions, borrowings, concentration of equity holders, investments in private funds and parallel managed accounts, performance information (with the same frequency with which the advisers already calculate performance), beneficial ownership, assets and liabilities, investment strategies (including use of high-frequency strategies) and counterparty exposures.  Although information submitted on Form PF is nonpublic and not subject to Freedom of Information Act requests, it is not completely confidential.  The SEC may use the information in enforcement actions and it may be accessed by various federal departments and agencies.

Advisers potentially subject to Form PF reporting have some time to review their structures and determine their status and subsequent reporting requirements (advisers to smaller funds with less than $1.5 billion in assets will make the first Form PF filings on April 30, 2013 assuming calendar fiscal year).  Nonetheless, because of the substantial reporting requirements, advisers should begin reviewing Form PF now to ensure that their internal systems are appropriately designed to capture necessary information before their applicable deadline looms close.  The advisers solely to private funds with less than $150 million in AUM, venture capital funds and family offices, among others, will not be required to file Form PF, provided that such advisers satisfy the definitional requirements under the Rules.  

Advisers to funds that qualify as venture capital funds under the definition contained in Rule 203(I)-1, and are therefore excluded from the definition of “investment adviser,” do not have any obligations to file Form PF.  Qualifying for this exemption has been made somewhat easier in the Rules as compared with the original SEC proposal largely due to the use of a 20% basket for non-qualifying investments and abandoned requirement for management involvement in portfolio companies.  Still, venture capital fund advisers would need to determine whether the funds they manage meet the new requirements under the Rules or under the grandfathering provisions of the Rules.  Similarly, advisers that qualify as “family offices” under Section 202(a)(11)(G) and the recently adopted Rule 202(a)(11)(G)-1 do not have any obligations with respect to Form PF.  Although not every “family office” would automatically qualify under this rule, advisers should carefully consider its requirements and, if necessary, take steps to alter their structure or operations to qualify for the Section 202(a)(11)(G) exception or for other Section 202(a)(11) exceptions in order to avoid Form PF filing obligations.  Foreign SEC-registered advisers with minimal U.S. assets under management may be able to reorganize those U.S. assets into a separate fund that is offered only to U.S. investors, which could avoid Form PF filing requirements (if it has less than $150 million of U.S. assets under management) regardless of the total AUM of such advisers.

It should be noted that, apart from Form PF, the SEC has imposed certain reporting requirements applicable even to the investment advisers exempt from registration under the Rules, such as those advisers with less than $25 million in AUM.  For example, exempt advisers, must comply with the reporting requirements by filing reports with the SEC through completing specific items on Part IA of Form ADV (but not Part II) and filing amendments to Form ADV.   These reports are publicly available on the SEC website.  The value of assets under management is to be calculated by reference to Form ADV and is generally equal to the fair market value of the assets of the qualifying private funds, plus the amount of uncalled capital commitments.  In a change from the quarterly calculation originally proposed, advisers are required to determine the value of assets that they manage on an annual basis.  Recordkeeping obligations of exempt investment advisers are yet to be specifically addressed by the SEC.

“Gardening Leave” Should Not Involve Lunching or Other Social Activities with Your Former Colleagues

While the term “gardening leave” or “garden leave” is thought to be an English import to the New World, some U.S. fund managers and other financial institutions have been using gardening leave provisions in their employment agreements in all but a name.  Under a “gardening leave” clause the employee is required to give the employer a certain notice prior to departure from the firm following which the employee is placed on a salaried leave of absence and is forbidden to work for competitors and to engage in certain other activities.  The name for this contractual device originates in the idea that the employee is paid to stay at home and tend to a garden rather than engage in a conduct the employer might find objectionable.  One basic distinction between gardening leave provisions and restrictive covenants following separation is that the terminated employee (whether by his or her own volition or by the employer) technically remains in an employment status during the period of the leave and continues to be compensated as before but is subject to greatly reduced (if not completely eliminated) job duties and lack of access to the employer’s offices, facilities, and personnel.

A case involving just this kind of clause is currently pending before the London High Court.  The employee in that case is Fahim Imam-Sadeque, the former head of sales for the UK, Middle East and Australia for BlueBay Asset Management, one of Europe’s largest specialist managers of fixed-income credit and alternative products, managing assets of more than £24billion.  Mr. Imam-Sadeque reportedly left the firm in December 2011 after having signed an agreement that was said to contain a gardening leave for a period of six months from the date he gave notice in July 2011 after he had accepted an offer to join a competitor, Goldbridge Capital Partners, as head of sales and marketing from January 2012.  As a reward for staying home in his English garden, during the term of the leave he was entitled to continued salary and to other compensation, including fund shares worth £1.7million.  While he continued to be a BlueBay employee, he was subject to a range of the common restrictive covenants, such as non-competition, non-solicitation and non-poaching.  It is the latter restriction that Mr. Imam-Sadeque reportedly violated in the course of having lunch with a current BlueBay employee, Damian Nixon, whom he sought out in a number of emails.

While we do not know what actually transpired during this December lunch, BlueBay clearly interpreted it as more than an exchange of season’s greetings and refused to turn over the accrued compensation, including deferred fund shares to Mr. Imam-Sadeque, claiming a breach  of the anti-poaching provisions of his contract.  BlueBay also claimed Mr. Imam-Sadeque had allowed Goldbridge to issue inaccurate and misleading references to himself and other BlueBay staff, with Goldbridge saying he no longer worked for BlueBay when he did so.  Not surprisingly, Mr. Imam-Sadeque has brought suit against BlueBay claiming that he did nothing wrong by having lunch with Mr. Nixon, and that BlueBay is wrongfully withholding his deferred compensation.

The lesson of this pending case, regardless of its outcome, which is more likely than not will turn on the employer’s ability to secure Mr. Nixon’s (its current employee) cooperation as a witness, is that gardening leaves serve a useful purpose for both the employer and the employee but should not be abused by either.  Employers can obtain a stronger legal protection by way of restrictive covenants when they continue paying the departing employee and in exchange get the privilege of counting him or her as a current (if not active) employee during the term of the leave because most legal challenges to the validity and enforceability of such restrictive covenants lose their potency precisely due to continued consideration being paid by the employer and the unambiguous employment status of the departing employee.  Furthermore, gardening leaves can offer greater protection against misappropriation of the employer’s confidential information and trade secrets because employees on leave are effectively kept away from the most current information, being denied access to the employer’s offices, files or networks as well as its employees, suppliers, customers, investors, and other counter-parties and as current employees are generally subject to greater control by the employer than former employees.  Employees also benefit by having a paid leave with full insurance coverage and often other benefits once they serve a termination notice on their employer before they completely sever the ties with the old employer and get to start with a new employer (or a new career in gardening or elsewhere).

However, once either party overreaches, the bargain of certainty and predictability is lost, and the courts are liable to step in with their own vision of what is just and fair in a given fact pattern.  U.K. courts have generally enforced gardening leave provisions with both injunctions against prohibited employee conduct and by upholding the employer’s right to withhold contractual compensation in the event of a material breach by the employee.  A typical U.K. Service Agreement for investment fund professionals and managers uses a fairly broad language for its anti-poaching clause of the garden leave provisions, such as:

“The Employee covenants with the Company that the Employee will not directly or indirectly on Employee’s own account or on behalf of or in conjunction with any person for a period of __ months after the Termination Date induce or attempt to induce any employee to whom this paragraph applies to leave the employment of the Company (whether or not this would be a breach of contract by such employee).”

It may also be possible to use more specific language prohibiting any contact by the employee who gave termination notice with any of the employer’s employees, directors, officers, investors, customers, suppliers, and service providers, re-defining the employee’s duties and obligations and so on.  It is unknown at this point whether the BlueBay employment agreement in question contained such language, but conceivably even the less-specific language reproduced above may subject the former employee to liability when sufficient evidence is introduced as to his or her attempts to poach the company’s employees or to violate the no-contact provisions of the contract.  What is clear is that any employee who voluntarily signs a contract with such provisions should steer clear of the employer’s business and employees until the gardening leave is over to protect his or her entitlement to deferred compensation and to avoid litigation.

In the U.S., gardening leave clauses are used more rarely than in the U.K. and almost exclusively with executive management and professional positions, including those in the financial services industry.  They are sometimes called “sitting out” clauses.  As in the U.K., courts in the U.S. generally find them valid and enforceable because the continued compensation dispenses with the challenge based on the lack of a “safety net” for the employee and gardening leave provisions are therefore a safer bet for the employer than pure post-separation restrictive covenants where no additional compensation is paid to the severed employee.  However, the reasonableness test still applies, and the period of the leave as well as the need for and the scope of the employer’s protection may still be scrutinized by a court.  U.S. employers rarely go beyond the 6 months term, and 2-3 months terms are more typical.  In addition, a number of cases raise special concerns with the availability of specific performance to enforce the garden leave which provides for some limited services to be continued to be performed for the benefit of the former employer during the transitional period (as opposed to an injunction against an employee who accepts an employment offer from a competitor and attempts to commence new employment during the period of the garden leave) as an involuntary servitude.  Money damages (including a setoff of deferred compensation) are much less controversial as a legal remedy and should serve as sufficient deterrent against potential violations on the part of competitors and former employees alike.  New York courts consistently rejected plaintiffs’ arguments that the employment exclusion effect of properly drafted garden leaves may make it difficult to resume work due to lost skills.  In addition, the scale of compensation typically granted hedge fund and private equity fund executives makes it very difficult for the executives in between jobs to get the sympathy of a judge or a jury in the absence of a truly despicable conduct on the part of the employer.

It should be remembered that there has been limited guidance from U.S. courts on the pure U.K.-style gardening leave provisions, and U.S. employers should exercise caution in including such provisions into U.S. employment or separation agreements and seek advice of U.S. counsel on their effect under local state law.  We have been involved in preparation, negotiation and litigation of such agreements on behalf of both hedge and private equity fund employers and their employees and would be pleased to assist you with your legal needs in this area.

Avoid the Urge to Overreach in Restrictive Covenants in Employment Agreements

A recent (September 2011) New York case, Novus Partners v. Vainchenker, illustrates the difficulty of enforcing overly broad restrictive covenants in the employment context relevant to hedge funds and other private fund entities.  In this case, an employee of a hedge fund research company left to work for a competitor and was promptly accused by his former employer of violating confidentiality, non-competition and non-solicitation clauses of his employment agreement among other claims.  After suing both the ex-employee and his new employer (who was sent a notice apprising it of its new employee’s breach of contract), the plaintiff was faced with a challenge from the defendants by way of a motion to dismiss that attacked the legal sufficiency of the agreements signed by the ex-employee.

As we all know, employers like to protect themselves against this very situation with what they view as “iron-clad” contractual provisions that they offer to employees as part of their employment package and that employees (short of very few executive-level employees) tend not to negotiate.  Which is all well and good.  We certainly encourage our employer clients to arm themselves with the appropriately-drafted restrictive covenants at every stage of interaction with employees, independent contractors and service providers (normally when they enter into employment or service agreements and, upon termination, in separation or termination agreements).  However, care must be taken not to have our defensive instincts get the better of us.  New York courts, as well as courts in other states, scrutinize restrictive covenants when they are being used against former employees and may refuse to enforce them when they are seen as overly broad, unreasonable or (probably rare in the investment fund industry given the scale of typical compensation packages) unconscionable.  

Failure to follow the basic principles may make it more difficult (read expensive) to enforce these covenants or may make them completely unenforceable.  In fact, the latter is what happened in this case, where on a motion to dismiss the plaintiff (former employer) was ordered to re-plead one of its claims for the sin of seeking to enforce an overly broad non-solicitation clause related to the employer’s clients. 

So the lessons of this case for the investment fund industry employers can be summed up as follows:

  1. Geographic limitations not crucial in the context of investment management industry.   These are not terribly relevant for the alternative investments industry, which is spread widely across the major financial centers of the globe.    Most of the successful challenges to these have to do with the duration (the 1 year term here was not viewed by this court as excessive) and with the scope (apparently the nature of the hedge fund research services offered by the former employer here was sufficiently specialized not to cause offence).
  2. Scope of non-solicitation limited to clients directly known to ex-employee.  With respect to the language of the non-solicitation clause the judge held that the clause must be limited to those clients of the former employer with whom the defendant ex-employee had some contact in his prior job.  While we do not advise to limit non-solicitation clauses so that they only prohibit solicitation of those clients with whom the employee has had a business relationship in every instance, the given employee’s direct exposure to the employer’s clients and the nature of the client list should be consider.  In this case, the judge noted that the ex-employee never had much of an exposure to many of his former employer’s clients.  The judge also stated that the restriction as drafted would effectively prevent the ex-employee from soliciting any of the hedge funds for the fear of unwittingly violating this clause.  On the other hand, the court found the defendant ex-employee’s effort to induce another employee of the plaintiff employer to leave and go work at his new employer a clear violation of the non-solicitation clause. 
  3. Broad confidentiality language subject to scrutiny.  While the benefit of a well-drafted confidentiality clause is clear in this context the plaintiff employer did face a challenge from the ex-employee (and the court) related to the over-broad language of the NDA in question.  This issue comes up quite often in our practice when we try to convince our (employer) clients to be reasonable when it comes to the scope of what constitutes confidential information to be protected against disclosure and/or misuse by their employees.  The simple reason for being cautious here is that when it comes to matching facts of the case to the contractual obligation you don’t want to be arguing that just because everything you deem confidential deserves to be protected b.  For example, while the judge here allowed the claim based on the confidentiality clause to proceed, the court spoke derisively of the extent of protection afforded to client lists when a business’s customers can be easily determined.  Proprietary software, on the other hand, was easily classifiable as a trade secret and deserving of legal protection.    

The reason for the additional scrutiny given to these restrictive covenants is that in ruling on these claims a variety of equitable considerations come into play.   The key to a smooth and cost-efficient enforcement lies in customizing these clauses to the specific circumstances of each employer’s business and each employee’s position.  Using a balanced approach in drafting restrictive covenants serves to deprive former employees of the ability to challenge their validity as a tactic to delaying or avoiding enforcement.  This is one situation where employers should not be using “one size fits all” standard form agreements.  As counsel to both employers and employees in the private fund industry we regularly negotiate restrictive covenants in the employment context and review them for potential employers considering a hire subject to these restrictions.  After all, given the entrepreneurial spirit in this industry, employees of the yesteryear often become future employers and so the cycle of relying on the enforceability of restrictive covenants to protect one’s business continues.

Counterparty Risk Returns with MF Global, Jefferies

The ghosts of Lehman Brothers and Bear Stearns returned late in this year in the guise of MF Global’s bankruptcy filing and a precipitous drop in Jefferies’ stock prices.  While these two may turn out to have little in common, from the perspective of investment fund managers to whom these institutions serve as prime brokers or custodians and, to a lesser extent, clearing brokers, the message is clear.  The risk of having your funds’ assets tied up for prolonged periods of time in a bankruptcy or some other insolvency process is quite real (as is a possible risk of loss of such assets to the extent they have become the subject of third parties’ security claims or simply have been misappropriated by your counterparty).  

Hedge funds have been on notice at least since 2008 that the text of the prime brokerage agreements they enter into can have momentous significance when things begin to go very wrong with their prime brokers (whether because they get caught up in a tidal wave of a financial crisis or for more localized reasons of financial mismanagement).  The failure of MF Global, in particular, has highlighted loopholes in the Australian regulatory system which allowed it to use client funds to hedge its own positions with full consent of the Australian regulator.  Whereas in the United Kingdom, we understand it is illegal to use clients’ money for any of the provider’s own activities, including hedging, the Australian OTC derivatives rules prevent brokers from using client funds to trade on their own account but allow trades with clients’ funds to hedge positions.  This includes margining, guaranteeing, securing, transferring, adjusting or settling dealings in derivatives by the licensee, including hedging positions taken by other clients.  As a result, the Australian government may be unable to take action if investors’ funds have been pooled together by MF Global and used for hedging purposes. 

Some of the same lessons of the Lehman bankruptcy apply today.  We advise our fund clients to negotiate their prime brokerage agreements carefully, especially with respect to the prime broker’s re-hypothecation rights and rights to transfer client assets to affiliates and sub-contractors.  Prime broker’s recourse against funds’ assets should be limited (preferably to those assets posted as collateral against loans in margin accounts) rather than left as blanket authority.  What has now emerged from the MF Global scandal underscores the necessity to restrict the powers of prime brokers to make use of the clients’ collateral as much as possible in order to prevent funds’ assets from being used in the prime broker’s own proprietary transactions and from being transferred out of the U.S. jurisdiction. 

Some of our clients have conducted a review of the insolvency laws in the major jurisdictions where their prime brokers are located to understand better the legal treatment of the funds’ assets in the event of the prime broker’s bankruptcy and to adjust the mix of their assets held by prime brokers accordingly.  The counterparty’s insolvency risk can also be managed through master netting arrangements to reduce the clients’ exposure although their enforceability varies from one jurisdiction to another.  In some situations, it may be prudent to request a special, segregated treatment of the client’s assets by having them held by a third party custodian and/or to request registration of the client’s securities in the fund’s name rather than in “street” name, though counterparties are reluctant to agree to such arrangement. 

We also advise our clients to negotiate the “boilerplate” clauses with vigilance to the extent they relate to the issues we highlighted above, including in the assignment clauses where we insist that any such assignments be limited to the prime broker’s affiliates that are licensed U.S. broker/dealers.  Once the funds leave the U.S., foreign laws and regulations make their well-being in the hands of foreign affiliates of the U.S. prime broker somewhat uncertain, as this latest case with MF Global amply demonstrates.  The protections of the U.S. regulatory regime do not normally extend to non-U.S. affiliates of U.S. prime brokers, and such entities are often utilized for margin or securities lending and as custodians outside of the U.S.

We realize that in the last few years the prime brokerage industry has become the game of a few, largest (though not necessarily strongest) financial institutions who resist vehemently any changes to their form agreements (which, incidentally, underwent few changes since 2008 to reflect the new realities of the marketplace).  Prudent risk management practices dictate that fund managers as fiduciaries avoid selecting weaker prime brokers, and so their business has been flowing to the few strongest banks with the healthiest balance sheets and reserves, resulting in the ever-growing obstinacy on their part to negotiate terms of their prime brokerage agreements characteristic of any oligopoly. 

However, it is incumbent on the fund manager to request reasonable assurances with respect to their managed assets when negotiating with these banks because any bank, no matter how big and strong today, may end up insolvent tomorrow.  In fact, accepting their standard forms without negotiation is not, in our opinion, the best practice to follow for investment managers.  And, to the extent a fund manager elects to deal with those smaller banks and brokers that lack market power, it ought to extract even greater legal protection for its investors’ assets from such counterparties to compensate for the higher risk of insolvency.  Gone are the days when default, cross-default and cross-acceleration provisions are thought to apply only to clients of banks.  Today, it is vital that as many of those be made mutual as possible.  Finally, in anticipation of a bank or broker succumbing to a potential crisis it is useful to include prime broker’s cooperation clauses to help transition to a different bank and to move the funds’ assets promptly that would be triggered by the client’s request (based on some early warning sign) rather than waiting for the prime broker’s default to occur before taking action.

Needless to say, prime brokerage agreements are not the only ones where counterparty risk of the service provider has to be addressed through contractual protections.  Agreements for any custodial arrangement, fund administration, collateralized borrowing (where the funds’ assets are the subject of a security interest) and even certain trading activities (such as under the ISDA regime with respect to swaps and derivatives) should be scrutinized to provide for the adequate contractual mechanisms to minimize counterparty risk.  Further, counterparty risk in dealing with third parties as principals rather than service providers can be extraordinarily high in certain transactions, such as participation agreements, contracts for difference and repurchase agreements (more on these in our future blog postings).  The economic risk with respect to any single transaction, however, tends to be significantly smaller than in typical global prime brokerage and custodial relationships where most, if not all, of managed assets may be placed so these should naturally be the priority in getting counsel to review and to help negotiate the appropriate safeguards. 

As counsel to hedge funds and private equity funds, we have helped many of our clients achieve a greater sense of security with respect to the assets they manage in the hands of prime brokers, fund administrators and custodial agents and other service providers to the private investment fund industry.      

Beyond Confidentiality: the private equity bidders’ experience with Yahoo!

A lesson from the recently reported Yahoo! sale process: carefully review and negotiate your NDAs!  As Yahoo! illustrates, confidentiality agreements can reach well beyond mere confidentiality and can affect not only the process but the potential outcome of a sale.

Confidentiality agreements, as we all know, are the life blood of private equity and, generally, M&A transactions.  In a typical NDA, the recipient agrees to keep information confidential and to limit its use to the transaction under consideration.  However, not infrequently, the disclosing party will include additional restrictions on the recipient which go well beyond confidentiality.  Common examples include non-circumvention (e.g., with respect to a particular target or subject), non-solicitation of employees, and no contact with the acquisition target (or borrower, if the transaction involves debt) as well as its customers, suppliers, vendors, etc.

These restrictive provisions are designed to protect the legitimate business interests of the target company by preventing, for instance, damaging rumors and employee and customer defections.  They may also serve to protect the interests of the broker or introducing party with respect to a particular opportunity. Occasionally, however, the disclosing party may seek to include in the NDA a provision which is primarily designed to influence the sale process.  As has been widely reported, Yahoo! included just such a provision—no “cross talk” as it has been described—into the NDAs circulated to potential private equity bidders.  

As reported, this no cross-talk provision precludes the potential bidders from speaking to each other regarding the potential transaction (presumably, whether or not confidential information is disclosed in the course of such conversations).  What is Yahoo!’s possible motivation for including such a provision in the NDA?  It is, almost certainly, a business consideration – the desire to influence the bidding process and, indeed, the likely outcome of the sale.  Given Yahoo!’s market capitalization of $20 billion, if the bidders are not able to discuss potential co-investment agreements, it makes it much less likely that any private equity bidder would be able to make an offer for 100% of the equity.  Not surprisingly, many potential private equity bidders balked at this restriction.  The one private equity sponsor who has reportedly agreed to this restriction in the NDA is TPG Capital which, as reported, is specifically interested in a minority stake.

From our perspective, as buy-side counsel, we strongly encourage our private equity and hedge fund clients to review and negotiate all NDAs, whether in M&A, private equity, distressed debt, real estate or other contexts.  As this case amply illustrates, the restrictions contained in many confidentiality agreements go well beyond confidentiality and may significantly impact one’s ability to evaluate and consummate a potential transaction (and, indeed, influence what kind of transaction or bidder is likely to succeed).