Hedge fund managers count cost of Madoff fraud
Saturday, 20 December 2008
Jon Gerty
As funds of funds line up to reveal significant exposures to the alleged fraudulent activities at Bernard L Madoff Investments Securities and Petters Company, anxious investors are understandably looking for someone to blame.
Exposure to the recent frauds has already resulted in the suspension of redemptions and even winding-up of one or more funds. Faced with few alternatives, aggrieved investors with complaints about due diligence and diversification may think the fund manager should be held to account.
Recourse against the manager, however, is not the quick-fix solution. Investors will face difficulties bringing an action against a manager.
Typically, the fund will be incorporated as an open-ended offshore company, the investors will be shareholders and the fund manager will be incorporated in the UK as a limited liability partnership or company and will be appointed under an investment management agreement.
Investors as shareholders will have no direct contractual relationship with the fund's manager and so will struggle to demonstrate a claim in contract. The fund itself may have a claim and would have no difficulties in establishing a contractual relationship with the manager.
However, an investor will have to rely on the directors of the fund taking action against the manager. It is not uncommon for the directors of a fund to be affiliated to the fund's manager. This may mean the directors are less enthusiastic about bringing a claim.
In any event, there will often be terms in the investment management agreement that excludes or restricts the manager's liability for losses unless there was dishonesty, gross negligence or willful default.
For an investor in a fund where the directors are not taking action, there is little that can be done unless the investor can demonstrate a breach of fiduciary duty against the directors for their inaction. A shareholder in a fund might also seek to enforce a right vested in the fund. It can only do this (if at all) through a "derivative claim" brought by the shareholder in its own name, but on behalf of the fund.
The general rule in English law is that where a wrong (whether a breach of contract or a tort) is done to a company, only the company may sue for the damage caused to it. A shareholder has limited rights to bring a derivative action on behalf of the company.
If the fund is located offshore, a derivative action will succeed depending on the offshore jurisdiction in which the fund is incorporated. Often, the laws of such jurisdictions are even more restrictive than English law in permitting a derivative shareholder claim to be brought.
In the absence of a contract, in English law it will also be difficult for a third party investor to bring a claim of negligence against the manager. The investor will need to establish that the manager owes them a duty of care that will generally require an "assumption of responsibility" by the manager to the investor. The relationship is characterised by the law as one of "proximity" and it must be fair, just and reasonable for the law to impose a duty on one party for the benefit of another.
Whether a duty of care exists will depend on the facts in each case. Critical factors will be the nature of the relationships between the parties, the manner and purpose for which any information, advice or other services was provided and the availability of other means of redress.
If a manager has a significant role in promoting the fund or introducing it to investors and has frequent contact with investors during the life of the fund, this may help to establish an assumption of responsibility and a duty of care. However, much will depend on the specific circumstances and the nature of any representations made by the manager.
Another obstacle to bringing a claim is that the investor will have to establish that the manager is in some way at fault. The terms of the investment management agreement between the fund and the manager will be pivotal in determining the scope of the manager's responsibilities and duties for the purposes of such a claim. Under English law any disclaimers or liability exclusion clauses in the agreement could cut down the scope of the duty of care in negligence owed to the investor.
Whatever the precise scope, however, questions must be asked of fund-of-fund managers who are paid for expertise in fund selection and due diligence who have significant exposure to investment managers or companies such as Bernard L Madoff Investments Securities and Petters Company when red flags were raised.
Even if an investor can establish a claim against the manager (which will be costly, time consuming and by no means certain), the ability of the investor to recover damages may be limited because the manager is a limited liability partnership or company.
As a result of the Madoff fraud, many investors will naturally feel aggrieved and will look to blame fund managers.
While it may not be a defence for managers who have failed to undertake adequate due diligence to point the finger at regulators, it is clear that the typical structure of offshore funds of funds for investments made by sophisticated investors militates against legal recourse against the manager. The exception is where it can be shown there was a clear assumption of responsibility by the manager.
— Hedge Fund Review
As funds of funds line up to reveal significant exposures to the alleged fraudulent activities at Bernard L Madoff Investments Securities and Petters Company, anxious investors are understandably looking for someone to blame.
Exposure to the recent frauds has already resulted in the suspension of redemptions and even winding-up of one or more funds. Faced with few alternatives, aggrieved investors with complaints about due diligence and diversification may think the fund manager should be held to account.
Recourse against the manager, however, is not the quick-fix solution. Investors will face difficulties bringing an action against a manager.
Typically, the fund will be incorporated as an open-ended offshore company, the investors will be shareholders and the fund manager will be incorporated in the UK as a limited liability partnership or company and will be appointed under an investment management agreement.
Investors as shareholders will have no direct contractual relationship with the fund's manager and so will struggle to demonstrate a claim in contract. The fund itself may have a claim and would have no difficulties in establishing a contractual relationship with the manager.
However, an investor will have to rely on the directors of the fund taking action against the manager. It is not uncommon for the directors of a fund to be affiliated to the fund's manager. This may mean the directors are less enthusiastic about bringing a claim.
In any event, there will often be terms in the investment management agreement that excludes or restricts the manager's liability for losses unless there was dishonesty, gross negligence or willful default.
For an investor in a fund where the directors are not taking action, there is little that can be done unless the investor can demonstrate a breach of fiduciary duty against the directors for their inaction. A shareholder in a fund might also seek to enforce a right vested in the fund. It can only do this (if at all) through a "derivative claim" brought by the shareholder in its own name, but on behalf of the fund.
The general rule in English law is that where a wrong (whether a breach of contract or a tort) is done to a company, only the company may sue for the damage caused to it. A shareholder has limited rights to bring a derivative action on behalf of the company.
If the fund is located offshore, a derivative action will succeed depending on the offshore jurisdiction in which the fund is incorporated. Often, the laws of such jurisdictions are even more restrictive than English law in permitting a derivative shareholder claim to be brought.
In the absence of a contract, in English law it will also be difficult for a third party investor to bring a claim of negligence against the manager. The investor will need to establish that the manager owes them a duty of care that will generally require an "assumption of responsibility" by the manager to the investor. The relationship is characterised by the law as one of "proximity" and it must be fair, just and reasonable for the law to impose a duty on one party for the benefit of another.
Whether a duty of care exists will depend on the facts in each case. Critical factors will be the nature of the relationships between the parties, the manner and purpose for which any information, advice or other services was provided and the availability of other means of redress.
If a manager has a significant role in promoting the fund or introducing it to investors and has frequent contact with investors during the life of the fund, this may help to establish an assumption of responsibility and a duty of care. However, much will depend on the specific circumstances and the nature of any representations made by the manager.
Another obstacle to bringing a claim is that the investor will have to establish that the manager is in some way at fault. The terms of the investment management agreement between the fund and the manager will be pivotal in determining the scope of the manager's responsibilities and duties for the purposes of such a claim. Under English law any disclaimers or liability exclusion clauses in the agreement could cut down the scope of the duty of care in negligence owed to the investor.
Whatever the precise scope, however, questions must be asked of fund-of-fund managers who are paid for expertise in fund selection and due diligence who have significant exposure to investment managers or companies such as Bernard L Madoff Investments Securities and Petters Company when red flags were raised.
Even if an investor can establish a claim against the manager (which will be costly, time consuming and by no means certain), the ability of the investor to recover damages may be limited because the manager is a limited liability partnership or company.
As a result of the Madoff fraud, many investors will naturally feel aggrieved and will look to blame fund managers.
While it may not be a defence for managers who have failed to undertake adequate due diligence to point the finger at regulators, it is clear that the typical structure of offshore funds of funds for investments made by sophisticated investors militates against legal recourse against the manager. The exception is where it can be shown there was a clear assumption of responsibility by the manager.
— Hedge Fund Review