Avoiding court proceedings
To date, hedge fund managers have survived the financial crisis with relatively little court action. Claims relating to the financial crisis have thus far been very much limited to major one off events, for example the collapse of Madoff’s $50 billion Ponzi scheme, the collapse of Lehman Brothers and the insolvency of hedge funds themselves (an event which almost naturally encourages litigation between liquidators and creditors). A number of reasons may be advanced as to why hedge fund managers appear to be so proficient at avoiding litigation.
With investors, hedge fund managers are very protective of their market reputation and this, to an extent, encourages the resolution of disputes at an early stage and behind closed doors. It is also noteworthy that hedge fund managers typically deal with high-value and sophisticated investors on the basis of widely drafted trading strategies with various legal disclaimers and risk disclosures in place. This restricts the ability for investors to bring claims for investment losses. Indeed, hedge funds’ investment objectives are typically drafted so that, absent fraud, it is extremely difficult for investors to substantiate claims. Also pertinent is the investor’s right to redeem, typically allowing it to leave a fund on demand with (most of) its investment.
There is also a noticeable dearth of court disputes between hedge fund managers and their trading counterparties. This is perhaps because public disputes are not conducive to trading counterparties maintaining a good reputation within the market, a reputation upon which they rely. Indeed, this is something a leading investment bank learnt to its cost in the midst of the credit crisis with its criticism of hedge funds who were short selling its stock (paradoxically these hedge funds were also its key clients and did not take kindly to the criticism). Hedge fund managers’ significant investment expertise may be a further barrier to it pursuing claims against trading counterparties for investment losses on the basis that, as sophisticated traders, they will be expected to understand the risk of such trading counterparties’ investment processes.
For these reasons, it is likely that hedge fund managers will largely continue to avoid public disputes with investors and counterparties. However, with a plethora of regulation due to be implemented over the next couple of years, and with a certain hardening of investors’ attitudes after a period in which many have lost very large sums of money, there are some very real challenges to the status quo.
Increased litigation risk
In the current climate, there is certainly an increased risk of disputes developing into court action, in particular with investors. The market is reporting increased investor dissatisfaction with a number of issues including the independence of fund directors, the performance of auditors and administrators and the adequacy of risk disclosures and valuation and marketing representations. These dissatisfactions are hardened when investment returns cease to impress.
It may be that these increased risks are not such that one can now expect a slew of litigation to commence over the next year or so. As discussed above, to date, well into the post-financial crisis era, such litigation has not been forthcoming. Further, investor dissatisfaction does not necessarily lead to formal and public disputes, as evidenced by the lack thereof following the imposition of redemption gates during the financial crisis, a move that was not always appreciated by investors. However, the environment has changed somewhat and one cannot predict with certainty how adversarial the next 18 months may be for hedge funds. Some leading practitioners note that US investors represent a larger proportion of recent allocations and there is more of a cultural tendency in the US to litigate when a dispute arises. In any event, the increased risk does underline the importance of well drafted marketing material, offering documents and contractual documentation.
Looking forward, a key legal risk to hedge fund managers is the FSA’s current willingness to be tougher on enforcement, particularly through the imposition of significant financial penalties. The more hands on approach being taken by the FSA is possibly intended to encourage a public perception that it is in control of the financial services industry. This naturally translates into an increased desire to make an example of firms and to pursue firms more vigorously for breaches of the FSA’s rules and regulations.
This approach was recently demonstrated by the FSA fining J.P. Morgan £33.32 million for not properly segregating client money while Goldman Sachs suffered a £17.5 million fine for not informing the FSA that it was being investigated by the SEC. These fines were imposed on the basis of breaches of principles and duties owed to the FSA; in Goldman’s case that all relevant information should be communicated to the FSA (Goldman’s had wrongly assumed that, as the SEC was investigating the issue in question, the FSA did not need to be informed). In the hedge fund sphere, earlier this year, two former directors of the failed hedge fund Mercurius Capital Management were fined £2.1 million for deceiving investors on the fund’s performance. The FSA has also recently been successful in pursuing investment firms for not complying with transaction reporting requirements. Not only are breaches more likely to be met with a more robust approach by the FSA, any such breach provides a potential avenue for investors to take action for loss (it being easier to establish a breach of duty).
On top of the existing regulation, a plethora of new regulation is due to come into force over the next couple of years. It is this, together with the FSA’s increased willingness to enforce such regulation more strictly, which forms the key legal risk currently facing hedge fund managers. Key regulatory changes include:
• MiFID II
Although still the subject of some debate, MiFID II looks set to introduce additional position limits, more stringent rules on contract design and increased concentration limits for client funds. There will also be additional reporting requirements for derivatives and requirements regarding governance standards, such as board composition. Of particular relevance to those firms who have dealings with private customers (such as UCITS), MiFID II allows such investors to sue directly for any loss caused by breach of MiFID II under s150 FSMA 2000 as a tortious claim.
• Market Abuse Directive (MAD)
The scope of MAD is to be extended and enforcement strengthened. The scope of ‘accepted market practices’ which do not constitute market abuse will be limited and the number of financial instruments to which MAD applies will increase to any financial instrument admitted to trading on a Regulated Market (whether or not it is actually being traded). There will also be an enhancement of regulators’ information gathering and investigation powers, an extension of suspicious transaction reporting obligations and increased sanctions thereto.
• Alternative Investment Fund Managers Directive (AIFMD)
The AIFMD will in effect regulate hedge fund managers’ ability to market to investors. The directive sets out some requirements for the appointment of depositaries to provide certain supervisory, custodian and safekeeping functions. There are also additional valuation, reporting, disclosure, remuneration and capital requirements.
It is important that hedge fund mangers get to grip with the forthcoming regulation before it is introduced and understand its impact on their businesses. This may not be simple as the regulation will come into force at different stages and,as currently drafted, there is a real possibility that the rules will overlap to some degree. Hedge fund managers need to train their staff adequately and ensure that sufficient controls and monitoring are in place to pre-empt and prevent, so far as possible, any breaches of reporting limits and other requirements set out within the regulations. As already alluded to, regulators seem keen to take a harder line following the financial crisis and there is a greater risk of financial penalties for any breaches.
It is not suggested that the hedge fund industry will be unable to maintain the status quo. However, it will have to head off some significant challenges in order to do so.
William Rodger and Craig Borthwick are in Simmons & Simmons LLP’s Hedge Fund Litigation Group