Print Edition
August 2010 
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Hedge Fund Litigation |
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Claire Spencer, July 2009 |
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Politicians, regulators and the media have all charged hedge funds with playing an instrumental role in precipitating the financial crisis. While this role has possibly been overstated, the damage has been done, and today, hedge fund litigation is on the rise, driven by investors pressured by a need for acceptable returns and scarred by falling valuations. This has severe implications for hedge fund managers and other participants in the hedge fund structure. As such, those that have been lucky enough to escape litigation up until now are, or should be, focused on ensuring that their fund documentation and marketing materials are beyond reproach.
Investors fight back
Hedge funds have been feeling the effects of the financial crisis for some time now, but the knock-on effect on litigation was not instantaneous. “Many funds staved off litigation in the first 12-18 months of this downturn, through a combination of stop-gap strategies ranging from suspension of redemptions to informal restructurings,” recalls Jeremy Walton, a partner at Appleby.
“By the turn of this year, it was becoming clear which funds would or could recover; for the others, their creditors and investors lost patience or otherwise concluded that there was no further scope for a consensual workout, and so initiated legal proceedings,” he says. Indeed, it can be said that litigation first began to increase dramatically when Lehman Brothers collapsed in Q4 2008. This rise occurred for a number of reasons, but is mainly due to the decline in asset prices the world over. This caused a sharp increase in the number of redemptions and market calls by panicky investors, and ultimately exposed a number of long-standing frauds – notably Bernard Madoff’s $65bn Ponzi scheme.
And when fraud is exposed, litigation inevitably ensues. “It generally takes an investment loss to expose wrongdoing on the part of the investment adviser, so in an environment such as this, you naturally are going to see lots of investor driven litigation,” says Douglas Hirsch, a partner at Sadis & Goldberg LLP. “In addition, due to past failures to detect fraud such as Madoff, the regulators are aggressively examining regulated entities, and broadly construing regulations and their mandate. Such action by regulators often leads to enforcement proceedings against the adviser, which also spurs investor lawsuits,” he adds. This much is clear – the SEC itself has said that the number of Ponzi schemes uncovered during 2008 and 2009 has remained consistent. As such, it is the heightened profile of such schemes that has increased the likelihood of investors enforcing their rights in court.
Indeed, it should come as no surprise that much of the current fund litigation is driven by investors. Other traditional constituents of the hedge fund structure – such as banking creditors, leverage counterparties and margin providers – have been better able to avoid litigation because they are in a different bargaining position. For them, the priority is often to maintain their business relationships, and chasing highly-publicised litigation is not conducive to that goal. In addition, they tend to have self-help remedies built into their contracts. Investors do not have that luxury. Most of them are fund-of-funds and pension funds, both of which are under constant pressure in terms of their own performance returns. As a result, many have been forced into taking legal action in order to comply with the fiduciary duties owed to their own investors.
Consequently, investor-driven litigation is likely to increase in the near term. The filings tend to be directed at fund service providers, such as independent directors, administrators and auditors, and will usually focus on disclosure, valuation and marketing representation issues. This highlights the importance of well-drafted offering documents and marketing materials, says Mr Hirsch. “These documents generally play a large role in the outcome of a case, and while the adviser may have intended the documents to provide various protections for the adviser through exculpation clauses, indemnity clauses and risk disclosure, poorly drafted documents can have the opposite effect. Indeed, they can create exposure by failing to accurately describe the investment strategy, failing to make accurate or complete risk disclosures, failing to make accurate or complete conflict of interest disclosures, and failing to properly disclose the use of soft dollars,” he warns. Of course, by the time it gets to litigation, it is too late to address those shortcomings.
A patchy response
In the event that hedge fund managers are accused of fraud, or general mismanagement causing significant losses, the ensuing controversy often brings the business of the fund to an end. In such cases, investors may seek a court-appointed independent liquidator to wind up the fund, as well as to bring compensation claims on behalf of the investors, explains Mr Walton. “However, in a typical master-feeder structure any cash assets are usually held by the master fund, whose primary stakeholders will be banks and leverage providers: they may have significant creditor claims with priority over shareholders – assuming such claims are not satisfied by contractual self-help remedies – and their views may conflict with investors. The liquidator may struggle to obtain funding for litigation claims on behalf of feeder fund investors, who may be reluctant to throw good money after bad.” He adds that the market for third-party litigation funding is quite small, and the terms are quite onerous. Undoubtedly though, options will improve as more competitors enter this market.
This is quite likely, given the rise in investor-driven litigation. And clearly, investors could really benefit from the trend, which has the potential to reveal the true nature of hedge fund investment. “Litigation will demonstrate the extent to which investors have rights and remedies available to protect their interests, and more importantly their limits,” explains Mr Walton. “Some investors will therefore lobby for increased protection in terms of enforcement action by regulators.” Using the Cayman Islands as an example, he suggests that such protection may include the creation of “an equivalent to the Official Receiver in the UK for appointments in the public interest, where there are no assets with which to pay for a private sector appointee to liquidate the fund.”
While these matters continue to unfold, hedge fund managers are left to adjust to an unfamiliar, litigious landscape.
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