Hedge Your Bets

The threat of litigation is looming over the industry

Originally published in the November/December 2009 issue

The much maligned SEC, which last month was on the receiving end of two law suits from former Madoff investors, is said to be bracing itself for what may be the tip of a litigation iceberg. Disgruntled hedge fund investors are both angry and furious, demanding to know why the SEC, despite repeated warnings, failed to step in when it had the chance.

What many market analysts are now asking is what the ripple effect of this litigation will be, both for regulatory compliance and hedge fund managers alike. In a post Madoff world, what should hedge fund managers be looking to do in order to mitigate their own risks? What is the market landscape like for hedge fund managers in the US compared to the UK? Will this newly found zeal for regulatory and best market practice lead to a different kind of corporate culture within hedge funds?

Suddenly it seems everyone from tabloid editors to Senate committee leaders and government heads is looking to lay the blame on hedge funds for the world’s recent economic ills. Irrespective of the correctness of this, the perception is real, and so too are the ramifications for an increase in litigation against both hedge fund managers and those associated with the industry.

What is a relatively new development is the willingness and appetite of fund investors to file litigation directly against the hedge funds and those who manage them. Why is that happening now? One answer may be that the composition of individual fund investors has changed.

Hedge funds have historically been the preserve of institutional investors. As such they were in a different bargaining position to the more mainstream market investors, many of whom were themselves subject to the demands of performance returns from the funds and pension funders who had provided the admission fee to the party.

As a result, many of these investors have had to file lawsuits in order to satisfy their own fiduciary duties owed to their investors. If you then add the recent exposure of many long standing alleged fraudulent schemes within the market, it is a volatile mix. Whenever fraud is alleged and exposed, litigation is invariably its handmaiden. It is a two fold cause and effect. Investment loss on the part of the investment advisor often now leads to an allegation of mismanagement and negligence. That in turn leads to litigation by the investors. Equally, in the post Madoff world of increased regulatory involvement, regulators issuing enforcement proceedings against advisers and fund managers alike are often the catalysts for further law suits by disgruntled investors.

Cynically of course, what better way for an under-performing fund of funds or pension fund investor to mitigate his own position than by bringing the deep pockets of hedge fund directors and officers, and errors and omissions insurance policies into play? In the US, a plaintiff bar ever in search of its next pay day may well have hit pay-dirt!

The growth of investor action groups against hedge funds, coupled with such an aggressive plaintiff bar, is a prospect which fills both the US and Lloyds Insurance markets with alarm. It is not without precedent: the savings and loan collapse of the 1980s still haunts both underwriters and claim managers.

Notwithstanding this, at present there is a very noticeable difference in the litigation landscape in the UK compared to the US. It may well be the calm before the storm, but for now the bulk of lawsuits filed against hedge funds and associated parties have been domiciled in the US.

The most recent high profile suit is against the US insurer AIG for allegedly merging its stocks, bond, and insurance company funds into a form of internal hedge fund, which the suit alleges was unregulated. In the US, where the hedge fund industry is larger and more mature than in the UK, law suits filed have mostly followed a pattern of alleged negligence and fraud against both the funds and fund managers. However there has also been a growing trend in actions being filed against fund service providers, such as the investment banks and fund administrators themselves.

Typically the types of claims made against hedge funds, investment advisers and also directors and members may include:

• misrepresentations made in the PPM, or private placement memorandum;
• failure to supervise the investment advisor;
• failing to perform adequate due diligence in evaluating potential investments;
• investing assets or using strategies not mentioned in the PPM;
• excessive fees (watch this space, the Supreme Court is currently hearing what may yet be the landmark case on what constitutes excessive fees – Jones versus Harris Associates); and
• claims made by the SEC alleging violations of regulations or statutes.

The jugular in many of these actions is the quality and accuracy of the original offering documents at issue. This of itself raises the question: what risk management can be taken by hedge fund managers keen to avoid being caught in the cross hairs of investor-driven litigation or arbitration?

Without doubt, regulatory bodies in the US and Europe view hedge funds as constituting a systematic risk. The political and economic pressure to increase regulatory scrutiny of the market and its players will only increase. How funds operate and conduct business will be carefully watched under the regulatory microscope, and with it the weight of compliance pressure upon fund managers and advisers.

How is all of this likely to affect the management culture of hedge funds? Although William Shakespeare once wrote that the first thing we should do is to kill all the lawyers, they may well be seen more often and with greater profile within hedge fund management.

Traditionally hedge funds have operated with few using in-house counsel. This may well change, as funds and managers wrestle to comply with newly mandated self-governance or government regulations. This will put the spotlight back on to both funds’ and managers’ compliance and ultimate performance.

The risks which funds are now facing in a changed landscape of litigious investors, means more attention being paid to the detail of business and what were traditionally back office and support functions.

It is no coincidence that many, if not all, of the hedge fund law suits feature to varying degrees the representations and statements contained in poorly or vaguely worded marketing and offering documents. Critically this is a key area to focus on for all who are involved in the drafting and dissemination process of such documents. A well defined offering document should aim to be transparent and cover the following clearly:

• adequate and clear description of the investment strategy;
• accurate and complete risk disclosure;
• accurate and complete conflict of interest disclosure; and
• proper disclosure of the extent and use of soft dollars.

An important support function for hedge fund managers should be a well focused placement or wordings staff, who would review and ensure the accuracy and compliance of offering documents and marketing materials. This is a function which would take on a similar role to that of a wordings technician or contracts specialist in a broking house or insurance/reinsurance company.

What is very clear from the litigation suits filed to date against funds and managers, has been the critical reliance placed upon the veracity and accuracy of both the marketing and offering documentation.

Good risk management and assessment is, as ever, paramount and the more successful funds are those who understand this and have put it to work.

The role of adequate insurance provision is also a core part of the future culture. The risk manager who understands what the benefit and advantage of the right cover in place for the hedge fund will certainly be thanked by his colleagues in the event of a claim. It is a case of understanding what is achievable and what is not; and managing expectations accordingly.

This is not to suggest that a well placed risk cover is a panacea to all and any ills suffered as a result of a law suit. But the right coverage and limits in place can help.

What errors and omissions insurance and directors and officers liability insurance will not cover are limits in amount equal to potential investor losses. What such cover should be providing are limits to defend in full the defence cost incurred in fighting an investor action, and even possibly enough for an offer of claim settlement.

Whatever the correctness (or not) of the public and political calls about the role which hedge funds are alleged to have played in recent economic events, the die has to a large extent been cast.

A change is coming to the way that hedge funds have traditionally undertaken their business. It is clear that there is going to be a greater regulatory role played by the authorities in the US and Europe, and the market will move forward against a backdrop of increased investor group litigation and regulation. How that will affect the market and the industry as a whole, only time will tell. What is certain, is that these funds, professionals and advisers that will be best equipped to weather the storm will be those that pay the greatest attention to the details of doing business, such as having a professional support staff structure and an understanding of how key risk management components will interact and compliment the overall business of the fund.

For many funds and advisers, it may really be time now to hedge your bets.


Andrew Banfill is managing partner of the New York office of law firm Miller Rosenfalck