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In The Deal NewsWeekly, Timothy E. Hoeffner and Caitlin M. Piccarello of Saul Ewing LLP outline four guidelines for hedge fund directors, officers, and service providers to protect against fraud.
The Securities and Exchange commission has a new message for hedge fund directors, officers and service providers: We are watching you. SEC Chairman Christopher Cox has warned that starting this year, hedge funds will face "the concentrated resources of a relentless SEC." Mark Schonfeld, director of the SEC in New York, has likewise emphasized that hedge funds are a "major area of concern" and will continue to be among "his office's enforcement priorities."
In addition, a perfect storm of hedge fund collapses and public outrage has brought a wave of civil lawsuits and criminal indictments. The result is that those affiliated with hedge funds can be subjected to substantial damage awards, enforcement proceedings and even criminal exposure.
For example, the collapse of the Philadelphia Alternative Asset Fund, or PAAF, resulted in the criminal indictment of the fund's investment adviser, Paul Eustace, and a flurry of lawsuits against the fund's service providers. The fund's clearing broker, Man Financial, settled claims against it for $75 million, agreed to pay $2 million in civil penalties and consented to an order with the Commodity Futures Trading Commission for failure to supervise and for violations of record-keeping provisions. UBS Fund Services (Cayman) Ltd., the fund's administrator, settled claims against it for $19 million. Similarly, a New York court ordered Bear, Stearns & Co. to pay $125 million resulting from its role as the clearing broker for the Manhattan Investment Fund Ltd. Michael Berger, the fund's former manager, has pleaded guilty to securities fraud. Fortunately, if you are doing business with a hedge fund, there are ways you can protect yourself. We have identified some of the most consistent sources of legal risk for hedge fund directors, officers and the professionals who serve them and offer some "best practices" you can follow. First, you should perform background checks on key personnel, particularly the lead trader and investment manager. In a number of cases, these individuals have had tainted histories that raise questions about their integrity. In addition, if you have reason to believe that a fund manager may be making misrepresentations, you are obligated to investigate. In the Manhattan Investment Fund case, when Bear Stearns executives questioned the profitability of the fund due to losses in the Bear Stearns accounts, the fund manager, Berger, explained that Bear Stearns was only one of many brokers being used by the fund and that the fund was profitable elsewhere. Berger refused to identify the other brokers, and Bear Stearns did not pursue the issue. The court held that Bear Stearns could not wear "blinders" and should have verified the information provided. Second, be careful not to simply repeat information to third parties provided to you by fund managers without vetting it. You can be held responsible for the information's accuracy. For example, Banc of America Securities LLC is currently fighting litigation because it simply passed on valuations to an auditor -- provided by a fund manager -- that turned out to be fraudulent. Third, hire brokerage firms, administrators and auditors with significant experience with hedge funds and the particular trading activity engaged in by the fund. These professionals are more likely to spot fraud and suspicious behavior, as well as lend credibility to the hedge fund. The PAAF fraud was made possible, in part, because the fund's administrator was unfamiliar with the reporting rules for certain commodities traded by the fund. Fourth, make sure you are protected in legal documents. Directors of a trading adviser or hedge fund should insist that the operating agreement limit directors' liability in the event the director is sued. Directors should also consider establishing the investment adviser and the hedge fund as independent entities with separate boards of directors. Doing so will enhance the argument that the directors and officers of each entity are independent and not responsible for the misconduct of individuals employed by the other entity. Now more than ever, directors, officers and service providers need to know how to protect themselves from fraud. With reasonable care and precautions, you can minimize your exposure to legal risks. If you suspect fraudulent conduct, seek counsel from an attorney familiar with hedge fund fraud cases. Timely and competent representation is crucial to prevent problems and to develop a record that the appropriate steps were taken. Timothy E. Hoeffner is the chair of the corporate governance practice and Caitlin M. Piccarello is a litigation associate with Saul Ewing LLP. Categories Deal Video
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