When investors are upset about poor fund performance, illiquidity, insufficient, inaccurate or untimely disclosures, or inconsistent or unfair treatment, they can, and frequently do, reach out to their lawyers, the SEC [Securities and Exchange Commission] and Congress.
Smart Business asked Scott Meyers, a litigation partner and chair of the Litigation Practice Group at Levenfeld Pearlstein, LLC, about potential legal pitfalls for hedge fund managers and how to sidestep them.
How can poor performance turn into a legal liability for hedge fund managers?
Investors may blame the investment manager for failing to insulate them from a general market event or improperly managing the investments. Sustained subpar performance that causes many investors to attempt to exit the fund can trigger a liquidity crisis as the fund must then sell assets to generate cash for the redemptions. Not only can such a fire sale further downgrade the fund’s performance — as assets are sold at distressed prices — but also, the funds will frequently restrict or prohibit the investors’ ability to redeem their interests and exit the fund. This creates further investor dissatisfaction, often motivating them to take legal action to force the fund to return their money. Spending time and money defending lawsuits and managing investor problems can significantly distract fund managers and further erode fund performance. This ‘death spiral’ commonly results in the eventual liquidation of the hedge fund.
What legal problems can result from organizational documents?
There are three basic types of potential problems: (1) not doing what the documents require, (2) doing what the documents prohibit and (3) unreasonably exercising the discretion the documents allow. Most hedge fund organizational documents provide the managers with broad discretion, but there are always certain manager requirements, like providing periodic reporting to investors. Failure to take required actions or engaging in prohibited actions provides investors with an easy legal claim for breach of contract and/or breach of fiduciary duty. But the most common area of concern is the investment managers’ exercise of their discretion, which is limited by constraints in the fund documents and by applicable law. Because many of these contractual, statutory and common law limitations are unclear, a manager may believe he or she is following the terms of the organizational documents to the letter and acting with the best of intentions, but the investors may have a different perspective and seek to hold the manager accountable for perceived misconduct. This is particularly problematic when decisions have a disparate impact on different classes of investors.
What disputes can result from communication issues like misrepresentation and failure to disclose?
There are three common problems in this area: misrepresentations — telling a lie, omissions — failing to tell the whole truth and selective disclosure — disclosing material information to some but not all investors. The law generally requires investor communications to provide full, fair and accurate disclosure of all information that a reasonable investor would want to know to make an informed investment decision. Regarding selective disclosure, many state laws impose fiduciary obligations on investment managers so they cannot discriminate against or among the individual investors. Some hedge funds, however, expressly disclaim this duty in their operating documents and PPM [private placement memorandum].
How can hedge fund managers avoid these liability issues?
- Review the operating documents and
PPM, and update them to provide maximum discretion, broad indemnification
and comprehensive risk disclosures.
- Read and follow the operating agreements — do what's required and avoid
- Manage your investors’ expectations
— advise them of upcoming material
events, both good and bad, and avoid surprises.
- Address investors’ questions and concerns on a timely basis while avoiding
selective disclosure — monthly newsletters, telephone conferences and electronic
town-hall meetings can be very effective.
- Where possible, avoid suspending
redemptions and NAV [net asset value] calculations.
- Don’t keep unhappy investors in the
fund — try to accommodate redemption
and withdrawal requests to the extent possible without compromising the integrity of
- Be consistent with your accounting
and valuation methodology, and disclose
any material changes.
- Follow your documents and be consistent in exercising discretion.
- Avoid even the perception of impropriety.
- Don’t lie.
SCOTT MEYERS is a litigation partner and chair of the Litigation Practice Group at Levenfeld Pearlstein, LLC. Reach him at (312) 476-7576 or firstname.lastname@example.org.