The Hedge Fund Industry: an increasingly litigious environment

United Kingdom

Inherently secretive in nature and heavily dependant on the maintenance of a strong reputation for their survival, hedge funds have historically been relative strangers to the process of litigation.  A number of recent actions brought by and against hedge funds in the United States suggests that the position is changing. 

The heightened risk profile associated with the hedge fund industry as a whole coupled with the fact that the ability to demonstrate insurance cover is increasingly becoming a pre-requisite for institutional investors is likely to lead to a greater call for insurance protection by those potentially exposed to legal action. This will include:

  • the fund
  • the fund's investment manager
  • any other service providers retained by the fund/ manager

The bespoke cover available to such entities in the London market will include:

  • professional indemnity insurance
  • directors' and officers' liability insurance
  • crime insurance

The inevitable increase in demand signals a period of real opportunity for insurers offering these products in the London market. Thorough due diligence prior to inception will be vital and care should be taken from the outset to ensure that proposal forms/questionnaires ask the right questions. Similarly, policy wordings must be drafted with the unique characteristics of hedge funds in mind so as to meet the industry's needs whilst at the same time containing insurers' exposure - in the author's view it is only a matter of time before the incidence of hedge fund related claims starts to rise.

Inherently secretive in nature and heavily dependent on the maintenance of a strong reputation for their survival, hedge funds have historically been relative strangers to the process of litigation. A number of recent actions brought by and against hedge funds in the United States suggests that the position is changing. This article examines the confluence of factors that has given rise to the heightened risk profile of those that work within the industry and some of the consequences that flow from it.

In July 2006, Fairfax Financial Holdings Limited (the insurance and financial services holding company based in Toronto Canada) brought a legal action in the Superior Court of New Jersey against a number of prominent US based hedge funds including S.A.C. Capital Management (the $10billion hedge fund operated by Stephen Cohen), Exis Capital Management, Lone Pine Capital, Rocker Partners L.P. and Third Point LLC alleging stock market manipulation.

It is alleged that the Defendants, after having taken short positions in Fairfax Stock, “engaged in an organised effort to damage severely, if not destroy, Fairfax and affiliated companies by, amongst other things disseminating false misleading information concerning Fairfax to …its employees, executives, shareholders, bankers, regulators and rating agencies; disseminating false and misleading information to the markets and the public through purportedly independent analyst reports, statements to the press and wholesale manufacture of bogus accounting and business issues; engaging in a long-term campaign of personal harassment of employees, executives and shareholders of Fairfax including personal attacks delivered to executives’ clergy and family members; and attempting to instigate regulatory investigations of Fairfax by providing false and misleading information and documentation to the regulatory agencies”.  The resulting decline in Fairfax’s stock price brought with it substantial profits for those hedge funds that had short-sold Fairfax stock.  Needless to say, the allegations are being contested by the defendants.

Some of the specific examples of the dirty tricks allegedly employed by the defendants and cited in the lengthy complaint document filed by Fairfax are certainly eye catching. It is alleged that rumours were circulated that the CEO of Fairfax, Prem Watsa, had absconded with company funds and was being pursued by the Royal Canadian Mounted Police. Reference is made to the delivery of a package to Mr Watsa’s Pastor in Toronto which contained a note referring to the similarities between “ the massive money laundering schemes perpetuated by Mary Frankel (who was said to have perpetrated a massive fraud on the Catholic Church) and the massively convoluted paper shuffle created by Mr Watsa through his public vehicle Fairfax Financial Holdings Ltd”. The note concluded rather dramatically with the comment “Be aware Father, be sceptical and ask Mr Watsa to make confession..” and enclosed a 30 page document entitled “Marty Frankel: Sex, Greed and $200million fraud”. The allegations are being contested by the defendants.

Fairfax has claimed $6billion in damages. The alleged campaign of negative misinformation is said to have (amongst other things) “devastated the market reputation of Fairfax and its affiliated companies” and “caused Fairfax’ operating companies to suffer downgrades by the ratings agencies with concomitant decrease in business”. The “misinformation disseminated ..about Fairfax’s accounting and business practices devastated Fairfax’s reputation among and relationship with customers, agents, regulators and business partners critical to the success of Fairfax’ growth and survival. The same reputational damage caused Fairfax to seek financing for its operations and growth on far more expensive terms than would otherwise have been necessary”. It also sought injunctive relief barring the defendants from continuing to perpetrate the alleged scheme. The causes of action pleaded include racketeering, commercial disparagement, tortious interference with contractual relationships, tortious interference with prospective economic advantage and common law conspiracy. 

The Fairfax complaint also refers to the “enormous financial harm” inflicted on its investors “who collectively lost many billions of dollars to the defendants who reaped correspondingly enormous profits at the expense of those innocent investors”. Such comments raise the possibility of further proceedings being  brought against the hedge fund defendants by investors in Fairfax (if such an action is not already afoot).

A similar action was brought earlier this year by Biovail Corporation (an Ontario based pharmaceutical company) against a group of hedge funds (again including S.A.C Capital Management LLC) and others seeking $4.6 billion in damages. This in turn spawned a class action filed in March of this year by Biovail shareholders against S.A.C. Capital and others for loss resulting from the sale of Biovail shares at allegedly artificially depressed prices. This suit, based upon the facts set out in the Biovail complaint, alleges that the defendants “exploited advance access to material non public confidential information  that was shared with them (including for example information concerning certain FDA drug approval decisions, the timing of company product launches or business developments…The defendants traded on such material non public information by shorting stocks before the release of unfavourable information, reducing short positions or taking long positions before the release of positive information and executing various trading strategies surrounding the release of the anticipated information. For example…the defendants ..ghost wrote purportedly independent analyst reports which were then held before release until the defendants could take short and other trading positions based on the report’s expected impact upon release..”.

A third similar action was filed in October 2005 by Overstock.com (a Utah based online “closeout” retailer) against the hedge fund Rocker Partners L.P. (also a defendant in the Fairfax action), Gradient Analytics, Inc (stock research firm) and others.  Overstock alleged that the Defendants orchestrated a “wide scale predatory campaign of knowingly distributing false and covertly biased written reports about Overstock in order to disparage Overstock and enrich themselves”. 

Given the seemingly positive experience of Fairfax as a result of having brought proceedings, further similar legal actions may well follow. Fairfax have claimed that production of negative reports against the company ceased immediately following the filing of the lawsuit as did the allegedly threatening behaviour.  This has had a positive effect on the company’s share price and the arrest (on 13th November) of one of the named individual defendants, a Spyro Contogouris in connection with an unrelated matter, appears to have further improved their position. Fairfax shares are said to be up 50% in value since the lawsuit was filed in July.

The practice of short selling is also at the heart of two other US legal actions this time brought by hedge funds - The Electronic Trading Group, the Quark Fund LLC (the latter of which has since been withdrawn) against 11 prime brokers for naked short selling i.e. charging for stock lending services which services were never in fact provided.  The causes of action pleaded by the US Hedge Fund claimants include breach of fiduciary duty, conspiracy and unjust enrichment. 

The United States often provides a useful indicator of what is to come here in the UK and the increasingly litigious environment in which hedge funds and their associated entities now operate may be no exception. This development should come as no surprise.  The industry has experienced phenomenal growth over recent years with global assets under management now approaching £1.25 trillion as opposed to £200 million in 1998 (as per data released by Hedge Fund Research Inc).  In Europe alone, assets have increased 44% over the year June 2005 to June 2006 from $280 billion to $401 billion and London’s dominance in Europe continues with the city managing 79% of those total assets (EuroHedge).

This growth has been fuelled most recently by increasing investment on the part of institutional investors, a traditionally more litigious class of investor representing the interests of the working public anxious to retire in comfort. The Bank of New York recently predicted that two thirds of new money invested into hedge funds over the next four years would derive from institutional investors.  Hedge fund managers face potential exposure to actions for: negligence/breach of contract in failing to invest hedge fund assets in accordance with offering documents (although most well advised hedge funds afford themselves with the maximum degree of flexibility in this regard); negligent investment within stated investment parameters where for example losses result from over-exposure to one particular investment strategy or asset class, negligent execution of trades, misrepresentation with regard to the contents of offering documents and negligent valuation of fund assets.

The recent experience of Amaranth Advisors, a US Fund, is an example of what can happen in the current environment.  Amaranth lost around $6 billion in 2 weeks after investing a significant proportion of its assets and trades that were dependent on the continuing rise in natural gas prices.  The SEC is currently investigating and their findings will no doubt be eagerly awaited by some. A recent EDHEC study commented that whilst the Amaranth investment strategy was defensible, the size of its positions relative to its capital base was not.  This coupled with the significant losses sustained by investors (including institutions such as pension funds) is likely to mean that the possibility of legal action is being considered.

The greater number of hedge funds chasing a limited pool of opportunities has increased competition within the industry which heightens the chances of hedge funds pushing their luck to out-perform the competition with potentially disastrous consequences. Funds are also being forced to diversify into more opportunistic investment strategies (with the potential to provide enhanced returns) which themselves carry new risks. Examples include film finance, reinsurance sidecars and complex collateralised debt and loan obligation vehicles to name but a few. 

Increased competition may well bring with it increased failure rates as smaller funds struggle to compete with the larger more established funds which are inherently more attractive to institutional investors. This could result in heightened risk of overvaluation of assets as funds seek to mask losses/attract new investment in an attempt to make back monies lost. Equally, the continuing flow of capital into the industry may increase the risk of fraud.

Heightened regulatory scrutiny is the inevitable consequence of the increasing institutionalisation (and increasingly main stream nature) of hedge funds. The FSA currently monitors 31 (up from 25) of the larger hedge fund managers authorised under the FSMA through a dedicated supervisory team. These firms each manage more than $1 billion in assets and between them control around 50% of Europe’s hedge fund industry. The FSA has demonstrated that it is a regulator with teeth and is not afraid to use them. The heightened risk of regulatory investigations and action is a reality the industry will have to accept going forward.

This was illustrated by the FSA’s important victory in its action against GLG Partners LP (“GLG”). Pursuant to a final notice issued by the FSA in August of this year, GLG Partners LP and Philippe Jabre were both found to have committed market abuse under Section 118 of the FSMA and were each fined £750,000. Mr Jabre, on behalf of the GLG Market Neutral Fund which he managed for GLG, short sold ordinary shares in Sumitomo Mitsui Financial Group Inc (“Sumitomo”) to the value of $16 million ahead of an announcement of a new issue of convertible preference shares in Sumitomo notwithstanding the fact that he had previously been wall crossed and given advance confidential information on the prospective issue by Goldman Sachs who were pre-marketing the issue. In the case of Jabre, this was the largest ever fine imposed by the FSA on an individual. 

The FSA rejected GLG’s argument that as a matter of law, it could not be found liable for market abuse on the basis of vicarious liability or principles of attribution (having regard to Jabre’s seniority and status with GLG). The FSA also prevailed on the issue of its jurisdiction, rejecting the argument that the shares in question were not qualifying investments under the FSMA on the basis that the trades took place on the Tokyo Stock Market (i.e. not a prescribed market under Section 118 of FSMA). At the time of the trades in Tokyo, the same Sumitomo shares were traded on the London Stock Exchange which was a prescribed market and this was enough to establish FSA jurisdiction.  In the circumstances, further regulatory investigations can be expected in the future.

The heightened risk profile associated with the hedge fund industry as a whole is likely to lead to a greater call for insurance protection by those potentially exposed to legal action. This will include the fund, its investment manager (company), any service providers retained by the manager to ensure the smooth operation of the fund such as administrators and secretarial service providers and the directors and officers of each of these entities – all of whom could feasibly be named as defendants in any legal action.  The demand for such products will also be fuelled by the fact that the ability to demonstrate insurance cover is increasingly becoming a pre-requisite for institutional investors. Types of insurance cover available include professional indemnity insurance (covering loss arising from the provision of or failure to provide services as well as legal defence costs), directors and officers liability insurance (covering claims arising from alleged wrongful acts) and crime insurance (covering losses arising from employee and third party fraud).

In summary, the environment within which the hedge fund industry now operates is increasingly litigious in nature. This has significant implications for industry participants not least in the form of the management time and costs involved in investigating and defending civil or regulatory actions. Bespoke insurance cover is available within the London market and is increasingly likely to be viewed as a necessity rather than a luxury although by no means a substitute for strong risk management systems and controls.