Hedge Defence

Legal liability and risk management for hedge funds

Originally published in the November 2007 issue

Mark Hastings discusses important legal liability and risk management issues for UK hedge fund managers and explores ways in which funds can take preventative measures to avoid damaging and protracted legal disputes.

It is no surprise that the recent rapid expansion of the UK hedge fund industry has led to disputes. Asset rich defendants will always attract claims. Such disputes have to be managed and resolved whether by negotiation, mediation, arbitration or, occasionally, litigation. Often their management will have to be with an eye to future possible claims, or other broader reputational or industry wide concerns. Three of the most common areas in which disputes have surfaced in recent years are:

  1. Claims by former traders for unpaid bonuses or deferred compensation;
  2. Disputes concerning misappropriation of software; and
  3. FSA Investigations and (occasionally) enforcement proceedings.

I concentrate on these three areas, but there are many more in which claims are made: for example, claims by investors, claims against advisers for negligence, for fraud, conflict of interest, legal uncertainty in relation to credit derivatives, mis-selling and misrepresentation, to name but a few.

Claims by former traders for unpaid bonuses

There have been a number of these high profile claims in recent years. Last year, Vega Asset Management was sued by a former trader for the alleged non-payment of deferred compensation. The trader, amid much publicity, commenced proceedings against Vega in the High Court in London. My firm’s HedgeDefence team acted for Vega in those proceedings. The parties have since entered into a settlement agreement. Although the full details are confidential, the trader withdrew his claim against Vega. Vega made no payment or admission of liability.

This case shows the importance of ensuring that appropriate risk management measures are put in place early. Agreements with traders should be reviewed in order to avoid disputes later on. The cost of such a review by lawyers familiar with the sector and the legal issues is negligible compared to the costs of defending proceedings in the High Court. They also show the potential for unwelcome publicity for hedge funds. Claimants sometimes leak details of their claims to the press to force a settlement. Even if they do not, the press will often get hold of details just by searching the public register of claims lodged with the High Court. On payment of a small fee they can even obtain copies of the pleadings which will contain the details of the claim/defence. Where necessary, lawyers can work with communications professionals to manage the wider market implications of a dispute.

Finally, if a dispute cannot be settled early and a fund is faced with an aggressive claimant intent on bringing a claim, it should seek legal advice from those with experience in the specialist area of hedge fund litigation.

Misappropriation of software

Sometimes, hedge funds will need to take action to defend their legitimate business interests, such as the intellectual property in their software.

Last year, we acted for a fund against a former trader where he was found to have copied vast quantities of electronic documents from the fund’s servers shortly before leaving to start up his own rival fund.

Clearly, this is an area where prevention is far better than cure. Given that many funds are built on their market modelling applications, it is surprising how many do not have software security protection. Funds can make a start with tightly drafted clauses in employee contracts preventing them from making any unauthorised use of the fund’s intellectual property after they cease to work for the fund. Funds should also keep their IT security under close review. Specialist organisations such as Kroll Ontrack can help with this.

FSA enforcement

It is well known that the hedge fund industry in the US has come under close scrutiny by the regulators. The Securities and Exchange Commission has launched an investigation into Amaranth Advisors, a US hedge fund which lost $6 billion on natural gas trade last year. The Federal Bureau of Investigations has warned that the $1700 billion industry is expanding too fast and small savers are being lured into risky investments. Even the US Federal Reserve has hinted at a crackdown, expressing concern that an ever greater share of the financial system goes beyond the oversight of regulators.

In the UK too the FSA has hedge funds in its sights. As the FSA’s engagement with the industry increases there will be more compliance/regulatory enforcement issues for the industry to deal with.

Commenting last year on fines of £750,000 for market abuse and breaching FSA principles imposed on both GLG Partners LP and Philip Jabre (its former managing director), Margaret Cole, the FSA’s Director of Enforcement, said that “firms are accountable for the behaviour of their employees, particularly if they are at a senior level.”

If and when hedge fund managers come across an issue that may be of interest to the FSA, they will need help from specialist legal advisers. Difficult issues could include:

  1. preservation of documents and consideration of privilege issues, including whether to suspend normal document destruction policies;
  2. how best to manage large volumes of electronic documentation;
  3. identifying and protecting sensitive material not relevant to any subsequent investigation;
  4. analysing Data Protection Act issues; and
  5. notification to the FSA and (if appropriate) agreeing a timetable for an investigation. The FSA has said that it considers co-operation and prompt and effective remedial action to be paramount.

Issues of privilege are hugely important. As soon as a hedge fund becomes aware of an issue which may be of interest to the FSA, or finds itself under investigation without warning, it should obtain advice as to how to manage the ongoing creation of documentation.

In the REO v Aberdeen Asset Managers and UBS case, information provided to the FSA pursuant to an investigation was later used by a third party litigant against Aberdeen and UBS. Great care needs to be taken with a view to the future use of documents which have become public during an investigation.

The current credit squeeze will certainly lead to further disputes. Where asset growth is affected claims will emerge. A variety of strategies will be available to defendants. Some situations can be defused and a damaging dispute avoided altogether. Others will require a hedge fund to act quickly and decisively to defend its business interests. Advisers experienced in dealing with such disputes will be able to identify likely and possible outcomes, manage the process and help with decision making.



Mark Hastings is a Managing Associate in the Contentious Group at Addleshaw Goddard, specialising in the Hedge Fund Sector. Addleshaw Goddard’s HedgeLegal team of hedge fund lawyers provides a portfolio of legal services specifically for the hedge fund industry, including advising on LLP structures; mergers and acquisitions; employment issues; tax; restructuring; FSA; real estate; and dealing with claims, complaints and investigations.