Funds Gone Wild
The spectacular losses in investment values suffered by Amaranth Advisors recently is just the latest in a well publicised series of what the media like to refer to as “hedge fund collapses”. The International Monetary Fund says that global hedge fund assets under management grew 20% in 2005. The Hedge Fund Research of Chicago organisation, which tracks 6,000 funds, has found that 300 funds “collapsed” in the first half of 2006. It is not difficult to see that the impact of fund collapse, and the issues that arise out of such collapse, are going to be more and more relevant to more and more people. So what does happen after a fund collapses?
It all looks simple enough… maybe too simple ?!?
When people talk about “hedge fund collapse” what they mean is that the fund has lost investment value, often a very large percentage of it. A fund’s purpose in life is to take investors’ money, in return for issuing them shares in the fund, pool that money and use it to make investments, according to a stated investment policy, with a view to increasing the value of the original investment.
When things go horribly wrong what the fund ends up with is assets which are worth substantially less than the investors money with which it started out. At this point, unsurprisingly, shareholders will start to request redemption of their shares in the fund in order to cut their losses. As a result of this the fund will have a liquidity crisis as it will be unable to keep up with the demand for redemptions and so redemptions will be suspended.
Assuming there is not interference from regulators, the troubled fund has two options. It can attempt the, usually, very hard job of persuading the investors to have faith and stick with their investment and allow the fund’s investment managers, who probably got the fund in this position in the first place, to try to trade out of its difficulties. If the fund does persuade its investors to retain their investment then new agreements will be entered into between the fund and the shareholders and these will govern what happens next.
The alternative is for the fund to wind itself up by realising its assets and paying the shareholders their pro rata share of those assets, after payment of creditors. However, it is unlikely that the fund is technically insolvent. The fund may well owe money for contractual fee obligations to the investment manager, administrator, auditors and directors and maybe some banks and brokers. However, it is likely that the amount of assets it has left will exceed any sums due to them. As the investors are shareholders they only have an entitlement to share in any surplus assets of the fund but do not count as creditors of the fund.
Despite the lack of insolvency, many funds will decide to appoint a receiver or liquidator. The practical reality of most funds is that the investment managers run the show so if they have headed for the hills, or the investors no longer have any faith in them, then somebody else will have to step into the breach. Most directors of funds are professional directors who are not usually involved in the day to day running of the hedge fund in any detail, having contracted with the investment manager to do that. They may be reluctant to take on that role as a result of the investment manager having ceased to function.
At first glance winding up the fund looks to simply involve realising the assets, which exceed any fees liability to the fund’s service providers so it can just pay them and share out the remaining assets to the Shareholders. Naturally it is not that easy.
The Blame Game
What usually follows hot on the heels of an announcement of a fund having significant investment losses is that the investors start looking for who is to blame for those losses and trying to pin legal liability on someone. Obvious targets are the investment manager, and the auditors. Quite frequently the directors and administrators will also get dragged into the fray as well.
Generally speaking if the investment losses are simply due to bad investment decisions then the usual documents provided to investors when they purchased shares in the fund will make it clear bad investment decisions are simply a risk an investor has to take. However, investors find this hard to accept and will look at whether the investment managers were following the stated investment policy at the time the bad investment decisions were made and if there was any fraud, usually on the part of the investment manager.
As a result it is common to see litigation being commenced by investors against a funds’s investment managers, auditors etc. This litigation by the investors will almost certainly trigger claims from the defendants against the fund based on contractual indemnities that were given by the fund to them. The indemnities will vary from contract to contract but the common factor is that they are usually designed to cover the indemnified whenever they are sued by a third party, as a result of their involvement with the fund, in a situation where they are found not to have been at fault.
An indemnity claim is a creditor’s claim and must be resolved and, if appropriate, paid prior to the fund being able to make any distributions to shareholders. As the right to be indemnified may not be exhausted until all possible claims have been brought, or the time in which such claims could be brought has expired, it is possible that the rights of those indemnified by the fund will prevent any distribution to shareholders for years. This is the “indemnity trap”.
Of course, it is also possible that the funds themselves may have claims against those responsible for the losses suffered. Indemnities are usually drafted so as not to provide cover for the indemnified in regard to losses suffered by the fund, or at least not when the losses have been suffered as a result of fraud or other types of wilful misconduct. However, it is possible that the terms of the indemnities mean that litigation by the fund is pointless as any damages that an indemnified defendant is ordered to pay to the fund will just be offset by the right to indemnity of that defendant from the fund.
Where does it all end?
At some point in an investors’ probably fairly dim and distant future, a proportion of the amount of money that they originally invested in the fund will be returned to them. It would be a lucky investor, indeed, who got a full return on their investment. Even if it is possible to clearly pin liability on somebody for the losses and avoid the “indemnity trap” the reality is that recovery of the, usually, large sums involved, in even a moderate sized fund collapse, is just not possible as the people who are liable simply don’t have that kind of money.
Generally speaking, it is likely to take years before those in charge of the collapsed fund feel like they are in a position to fully assess the extent of the creditor’s claims, including the indemnity claims, make payments due to creditors, finalise any litigation claims and distribute money to investors.
Whilst litigation against the people who are perceived to be responsible for losses that a fund has suffered is a knee jerk reaction, careful consideration needs to be given as to whether the costs and delay that will be caused by litigation is worth the potential benefits. By far the biggest fly in the asset distribution ointment is the “indemnity trap” and its existence is always going to significantly complicate and delay the winding up of a fund and hence the return of any of an investor’s money. It might be that the best approach for an investor when involved in the winding up of a fund is for everyone to be persuaded to file the experience under “stuff happens” and not seek to play the blame game if they want to see any of their money back at all soon.
Laura Hatfield is head of the Litigation Department at Cayman Islands law firm Solomon Harris. Click here to email Laura.