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Hedge Funds on the Ledge
London & Bermuda Newsletter
As the size of its assets under management plummets from $2 trillion to $1.4 trillion, the traditionally litigation-shy hedge fund industry has seen a sharp increase in litigation activity. A number of recent decisions of the Bermuda and Cayman Islands courts illustrate the issues that are being thrown up in these extraordinary times. For those insuring directors of hedge funds (including “independent” directors, often lawyers with off-shore law firms) as well as those insuring the managers, administrators and auditors of hedge funds, the exposures have never been higher.
There are four main issues that appear to arise in relation to distressed hedge funds. The first concern disputes over the control of hedge funds as their value spirals downwards and competing liquidation strategies emerge. The second concerns conflicts of interest between earlier redeeming investors and later redeemers, with those “left holding the bag” (very often the founders of the fund) looking to preserve value at the expense of exiting investors. The third involves difficulties in valuing a fund’s net asset value (“NAV”) in times of extreme volatility and limited liquidity. The fourth, and most notorious, arises from the discovery of frauds, as in the case of the funds operated by Bernard Madoff.
A recent decision of the Grand Court of the Cayman Islands - In the Matter of Bear Stearns High Grade Structured Credit Strategies (Overseas) Ltd (In Liquidation, 13 March 2008) - involved an attempt by voting shareholders to frustrate investors’ efforts to remove the hedge fund’s directors and replace them with directors of their choosing to investigate massive losses incurred by the fund. The court ultimately appointed liquidators nominated by the investors and described the actions of the voting shareholders (including representatives of a prominent Cayman law firm) as “clandestine” and “highly suspicious”.
In another Cayman decision, the Court of Appeal considered an application by redeeming investors to present a petition to wind up a hedge fund and to challenge the fund manager’s decision to suspend redemptions: In the Matter of Strategic Turnaround Master Partnership Ltd, 12 December 2008. The Court of Appeal found that the redeeming investors became creditors of the fund as at the date of redemption notwithstanding that the redemption value had yet to be quantified and ruled the court had jurisdiction to consider whether a fund’s power to suspend redemptions or the payment of redemptions had been exercised properly.
The Bermuda Supreme Court recently addressed two issues relevant to hedge funds that lost billions of dollars as a result of the Madoff fraud. In the Matter of Stewardship Credit Arbitrage Fund Ltd (27 November 2008) examined circumstances in which it was appropriate to redeem investors “in-kind” (i.e. by giving them title to underlying investments) and to reassess NAV retrospectively.
As to in-kind payments, the court ruled that these were permissible, but found the company’s purported in-kind payments were ineffective and did not have value equal to the relevant redemption price.
In the Stewardship case, the fund manager had attempted to re-value the NAV based on the discovery, in October 2008, of a wide-spread frauds allegedly committed by the Chicago-based Petters hedge fund in which the Stewardship fund was an investor. The court concluded that there was no basis for re-calculating NAV, referring to the company’s bye-law that a NAV given “in good faith … shall be binding on all parties”. Moreover, the court rejected the argument that the payment was based on a “mistake of fact” – namely, lack of knowledge of the Petters fraud. Given indications that remaining investors in the Madoff funds may seek to recover losses from investors who previously redeemed (based on a theory that such investors received the proceeds of a fraud), the Stewardship decision will provide guidance as to how such claims may be resolved in Commonwealth jurisdictions.
In the Matter of Bear Stearns High Grade Structured Credit Strategies (Overseas) Ltd (In Liquidation), 13 March 2008
In the Matter of Strategic Turnaround Master Partnership Ltd, 12 December 2008
In the Matter of Stewardship Credit Arbitrage Fund Ltd, 27 November 2008
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