Monday, April 02, 2007

A New Era in Hedge Fund Litigation?

Photo Sharing and Video Hosting at Photobucket When the giant hedge fund Amaranth imploded in late September 2006 in the largest hedge fund failure ever, it made the front page of the Wall Street Journal (here, subscription required). Amaranth lost more than $6 billion after the natural gas bet of one of its traders, Brian Hunter, took a severely wrong turn. Investors understandably were upset, but Amaranth nevertheless reportedly appealed to investors to agree not to sue the firm in exchange for a speedier liquidation (here).

The possibility that the fund might evade litigation costs disappeared on March 29, 2007, when one of the fund investors, the San Diego County Employees Retirement Association (SDCERA) filed a lawsuit in federal court in Manhattan against Amaranth Advisors (the fund’s management company), three of its officers, and Hunter, the fund’s former natural gas trader. A copy of the Complaint can be found here. SDCERA’s press release about the lawsuit can be found here.

The Complaint alleges that on September 1, 2005, SDCERA invested $175 million in Amaranth, but that as a result of the fund’s September 2006 collapse, the fund lost over $6 billion and SDCERA lost more than $150 million. The Complaint alleges that the advisory company and its principals induced SDCERA to invest in the fund based on a series of allegedly false statements to SDCERA and its representatives, as well as a series of allegedly false statements in the fund’s private placement memorandum and amended private placement memorandum. Specifically, SDCERA alleges that the advisory company and its principals misled SDCERA by representing in face to face meetings and in documents that the fund was “a multi-strategy hedge fund” that invested in six different market sectors and used sophisticated risk management controls. The Complaint further alleges that, in contrast to those representations, the fund “was being run, either intentionally or negligently, as a defacto single-strategy natural gas fund, placing billions of dollars at risk in highly volatile markets and with no exit strategy.”

SDCERA further alleges that having induced SDCERA to invest, the advisory company and its principals made a number of statements, to fund investors in general and to SDCERA and its representatives in particular, that misrepresented the extent of the fund's natural gas investment, the extent of its capital commitment to its natural gas investments, and the extent of the advisory company’s risk management controls. SDCERA also alleges that the advisory company and its principals timed their disclosures to avoid periodic withdrawal windows, in effect trapping SDCERA in the fund as it was melting down, and at the same time providing misleading reassurance that minimized the fund’s natural gas exposure.

SDCERA seeks recovery from the advisory company and its principals for alleged violations of Section 10(b) of the Securities and Exchange Act of 1934; common law fraud; gross negligence; breach of fiduciary duty; and vicarious liability. SDCERA also seeks recovery from the advisory company for breach of contract and from Hunter for gross negligence.

SDCERA’s attempt to increase its recovery through litigation represents an interesting gamble. The lawsuit potentially could have exactly the opposite of the intended effect. As the March 31, 2007 Wall Street Journal article discussing the lawsuit (here, subscription required) noted, “the funds… to defend the case would have to come out of the limited assets still remaining” because the hedge fund’s structure “provides that investors effectively indemnify the management company … in the event of lawsuits.”

By the same token, SDCERA’s lawsuit is not a class action; if SDCERA manages to overcome the circularity of the indemnification provision in the management agreement, and manages further to increase the amount of its recovery, it will either be: decreasing other investors’ recoveries; exacting some kind of payment from the individuals’ own assets; or perhaps even extracting some form of insurance recovery. These possibilities will compel the other fund investors to consider whether they too should pursue their own lawsuits, and risk possibly even further reducing the overall recoveries, or forbear, and lose the chance to augment their own recoveries – or even watch their recoveries diminish to the benefit of the more litigious fellow investors.

Of course, it remains to be seen whether SDCERA’s litigation strategy will succeed or backfire. The larger significance from SDCERA’s lawsuit may be in its potential implications for other hedge fund advisory companies and their principals. There have of course been other investor lawsuits brought against hedge funds in the past, but none as high profile as this lawsuit following Amaranth’s collapse. The prospect of large institutional investors suing hedge fund advisory firms and their principals when the hedge fund’s investment strategy goes awry potentially presents a significant layer of risk to the hedge fund management equation. It also make the various insurance solutions available in this sector a much more urgent consideration for hedge fund advisory firms and their principals.

In the meantime, Brian Hunter, the erstwhile trader whose strategy triggered the largest hedge fund failure in history, has formed a new commodities trading firm, and is seeking to raise hundreds of millions of dollars from investors in Europe and the Middle East. According to a March 23, 2007 Wall Street Journal article (here, subscription required), the new fund proposes to charge investors 2% of its assets and 20% of profit; in addition, each manager gets to keep his own 20% profit fee and as much as half of the 2% annual fee. Those who may wonder which investors would possibly consider investing in Hunter's new fund will recall the old adage about who is born every minute.

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