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.