The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

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By Topic: Style Drift

  • From Vol. 9 No.30 (Jul. 28, 2016)

    Hedge Fund Managers Must Ensure Portfolios and Valuation Comport With Investor Disclosures or Risk SEC Fraud Action

    The SEC recently commenced an enforcement action against a hedge fund manager, along with its founder and CEO, for misleading investors about the nature and value of the assets held by its funds. The respondents had promised investors that the funds they managed would purchase legal fee receivables from law firms in settled cases. However, the cease-and-desist order instituted by the SEC alleges that a substantial portion of investor money was actually used to purchase receivables from cases that were unsettled or where collection was subject to ongoing litigation risk. The respondents also allegedly manipulated the value of the receivables they purchased. This case highlights the need for hedge fund managers to ensure the investments held in their portfolios, as well as the valuation of those investments, are in line with disclosures made to investors. This article outlines the SEC’s allegations and the relief requested. For more on litigation funding, see “How Can Hedge Funds Mitigate the Risks of Investments in Litigation? An Interview with Kenneth A. Linzer” (Jun. 21, 2012); and “In Turbulent Markets, Hedge Fund Managers Turn to Litigation Funding for Absolute, Uncorrelated Returns” (Jun. 24, 2009).

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  • From Vol. 8 No.42 (Oct. 29, 2015)

    Explicit Disclosure of Changes in Hedge Fund Investment Strategy to Investors and Regulators Is Vital to Reduce Risk of Enforcement Action

    Federal securities laws are largely disclosure-based; absent any misconduct, a fund adviser that appropriately discloses and follows its investment strategy will not generally be liable to investors for losses sustained by the fund.  However, as evidenced by a recent SEC enforcement action, broad disclosures about permissible investments will not shield a manager that departs wholesale from a fund’s stated investment strategy.  The SEC recently settled charges that an investment adviser violated numerous antifraud and other provisions of the federal securities laws when it abruptly changed from its stated long distressed debt strategy to a net short position without appropriate disclosures.  This article summarizes the facts underlying the proceeding, the SEC’s specific charges and the sanctions imposed on the respondents.  For another recent enforcement action involving style drift, see “Appropriately Crafted Disclosure of Conflicts of Interest Can Mitigate the Likelihood of an Enforcement Action Against an Investment Adviser,” The Hedge Fund Law Report, Vol. 8, No. 40 (Oct. 15, 2015).  See also “To What Extent Is a Hedge Fund Bound, Legally and Practically, by Its Strategy as Stated in Its Governing Documents and at Marketing Meetings?,” The Hedge Fund Law Report, Vol. 2, No. 49 (Dec. 10, 2009).

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  • From Vol. 7 No.36 (Sep. 25, 2014)

    Hedge Fund Adviser Structured Portfolio Management Settles SEC Charges Relating to Improper Trade Allocations and Investor Disclosures

    Registered investment adviser Structured Portfolio Management, L.L.C. and two affiliated investment advisers have agreed to settle SEC charges stemming from allegedly inadequate compliance policies and procedures that resulted in improper trade allocations among the funds they advised and failure to disclose a change of strategy to fund investors.  For more on SPM, see “Dispute between Structured Portfolio Management and Jeffrey Kong Offers a Rare Glimpse into the Compensation Arrangements between a Top-Performing Hedge Fund Management Company and a Star Portfolio Manager,” The Hedge Fund Law Report, Vol. 4, No. 8 (Mar. 4, 2011).  “Cherry picking” of trades, and the conflicts of interest that arise when advisers allocate trades, have been ongoing focus areas for the SEC.  See, e.g., “SEC Charges Hedge Fund Manager and Its Founder with Securities and Investment Adviser Fraud Based on ‘Cherry Picking’ of Trades,” The Hedge Fund Law Report, Vol. 6, No. 1 (Jan. 3, 2013).

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  • From Vol. 7 No.7 (Feb. 21, 2014)

    Co-Investments Enable Hedge Fund Managers to Pursue Illiquid Opportunities While Avoiding Style Drift (Part One of Three)

    A co-investment offers an investor in a private fund or another investor the opportunity to participate in an investment to the extent that the fund (via its manager) elects not to pursue the entire investment.  Historically, co-investments have been the province of private equity funds, managers and investors.  However, as the range of hedge fund investment strategies has grown to incorporate less liquid approaches, the relevance and use of co-investments has grown as well.  For example, in its 2014 Hedge Fund Manager Survey, Aksia found that nearly one-third of surveyed managers currently offer co-investment opportunities to their investors, and another one-third were considering doing so or would consider doing so if there was sufficient investor demand.  See “Aksia’s 2014 Hedge Fund Manager Survey Reveals Manager Perspectives on Economic Conditions, Derivatives Trading, Counterparty Risk, Financing Trends, Capital Raising, Performance, Transparency and Fees,” The Hedge Fund Law Report, Vol. 7, No. 2 (Jan. 16, 2014).  This article is the first in a three-part series analyzing co-investments in the hedge fund context.  In particular, this article discusses five reasons why hedge fund managers offer co-investments; two reasons why investors may be interested in co-investments; the “market” for how co-investments are handled during the negotiation of initial fund investments; investment strategies that lend themselves to co-investments; and types of investors that are appropriate for co-investments.  Subsequent articles in the series will cover structuring of co-investments; common terms (including fees and liquidity); and regulatory and other risks.

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  • From Vol. 5 No.23 (Jun. 8, 2012)

    SEC Sanctions Quantek Asset Management and its Portfolio Manager for Misleading Investors About “Skin in the Game” and Related-Party Transactions

    Investments by hedge fund managers in their own funds and related party transactions (such as loans from a fund to a manager) exist at opposite sides of the incentive spectrum.  The former – so-called “skin in the game” – is typically thought to align the interests of investors and managers while the latter is seen as pitting the interests of investors and managers in direct conflict.  Investors want to know about both, for obviously different reasons.  A May 29, 2012 SEC Order Instituting Administrative and Cease-And-Desist Proceedings against Quantek Asset Management LLC (Quantek), Javier Guerra, Bulltick Capital Markets Holdings, LP (Bulltick) and Ralph Patino highlights these and other investor considerations.  This article summarizes the SEC’s factual and legal allegations against Quantek, Bulltick, Guerra and Patino, and the settlement among the parties.  The SEC’s action follows private actions against the same or similar parties.  See, e.g., “Fund of Hedge Funds Aris Multi-Strategy Fund Wins Arbitration Award against Underlying Manager Based on Allegations of Self-Dealing,” The Hedge Fund Law Report, Vol. 4, No. 39 (Nov. 3, 2011); “British Virgin Islands High Court of Justice Rules that Minority Shareholder in Feeder Hedge Fund that had Permanently Suspended Redemptions Was Not Entitled to Appointment of a Liquidator,” The Hedge Fund Law Report, Vol. 4, No. 9 (Mar. 11, 2011).

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  • From Vol. 5 No.22 (May 31, 2012)

    Investors Sue Hedge Fund Manager Harbinger Capital and Philip A. Falcone for Alleged Style Drift

    Hedge fund investors have certain fundamental expectations of hedge funds in which they invest, including that the hedge fund will invest assets in accordance with the investment strategies, guidelines and restrictions outlined in the fund offering documents.  In addition, the stated investment strategy informs investors as to whether the hedge fund manager has the requisite expertise to manage the fund, given its investment experience.  Also, investors often want to ensure that they have allocated their assets in accordance with their own asset allocation parameters.  As a result, when hedge fund managers deviate from these investment strategies, fund investors find themselves exposed to risks that they had not anticipated when performing due diligence on the fund and manager.  The SEC has increased regulatory scrutiny of funds to identify style drift and has brought enforcement actions premised on allegations of style drift.  See “Recent SEC Enforcement Action Provides a Dramatic Example of Style Drift in the Hedge Fund Context,” The Hedge Fund Law Report, Vol. 4, No. 43 (Dec. 1, 2011).  Investors have also initiated private legal action against fund managers for style drift, as demonstrated by a recent class action complaint brought against Harbinger Capital Partners LLC, Harbinger Holdings, LLC and Philip A. Falcone.  The allegations in the complaint generally arise out of investments by a Harbinger fund in LightSquared Inc.

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  • From Vol. 5 No.22 (May 31, 2012)

    Three Steps Hedge Fund Managers Can Take to Avoid Liability for Related Party Conflicts of Interest

    The interests of hedge fund investors and managers are not always in perfect alignment.  One of the principal conflicts with which investors are concerned is the investment of fund assets in companies in which the manager or one of its affiliates has a financial or other interest; consciously or unconsciously, such interests are thought to color the manager’s judgment.  For this reason, hedge fund investors and regulators expect managers to disclose (in hedge fund offering documents) all material facts necessary to understand the incentives informing a manager’s investment decision-making.  A recent SEC enforcement action demonstrates the agency’s commitment to identifying and interdicting undisclosed conflicts of this nature.  Specifically, the SEC’s action alleges that a registered fund manager invested fund assets in two high-risk private technology companies he founded without disclosing the attendant conflicts of interest to investors, and in contravention of fund offering documents which stated that he would invest fund assets primarily in publicly traded securities.  This article describes the factual allegations, causes of action and remedies sought by the SEC.  This article also provides three recommendations for hedge fund managers aiming to avoid enforcement activity for failing to disclose related party conflicts of interest.

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  • From Vol. 5 No.9 (Mar. 1, 2012)

    Hedge Fund Investor Accuses Paulson & Co. of Gross Negligence and Breach of Fiduciary Duty Stemming from Losses on Sino-Forest Investment

    Hugh F. Culverhouse, an investor in hedge fund Paulson Advantage Plus, L.P., has commenced a class action lawsuit against that fund’s general partners, Paulson & Co. Inc. and Paulson Advisers LLC.  Culverhouse alleges that those entities were grossly negligent in performing due diligence in connection with the fund’s investment in Sino-Forest Corporation, whose stock collapsed after an independent research firm cast serious doubt on the value of its assets and the viability of its business structure.  Culverhouse seeks monetary and punitive damages for alleged breach of fiduciary, gross negligence and unjust enrichment.  This article does two things.  First, it offers a comprehensive summary of the Complaint.  This summary, in turn, is useful because lawsuits by investors against hedge fund managers are rare, and particularly rare against a name as noteworthy as Paulson.  Disputes between investors and managers are almost always negotiated privately, but such negotiation occurs in the “shadow” of relevant law.  This article outlines what the relevant law may be.  Second, this article contains links to various governing documents of Paulson Advantage Plus, L.P., including the fund’s private offering memorandum, limited partnership agreement and subscription agreement.  Regardless of the merits of Culverhouse’s claim, Paulson remains a well-regarded name in the hedge fund industry.  According to LCH Investments NV, Paulson & Co. Inc. has earned its investors $22.6 billion since its founding in 1994.  Those kinds of earnings can – and have – purchased highly competent legal advice, which translates into workably crafted governing documents.  Accordingly, the governing documents of the Paulson fund are useful precedents for large or small hedge fund managers looking to assess the “market” for terms in such documents or best practices for drafting specific terms.  Thus, we provide links to the governing documents.  See also “Questions Hedge Fund Managers Need to Consider Prior to Making Investments in Chinese Companies,” The Hedge Fund Law Report, Vol. 4, No. 21 (Jun. 23, 2011).

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  • From Vol. 4 No.43 (Dec. 1, 2011)

    Recent SEC Enforcement Action Provides a Dramatic Example of Style Drift in the Hedge Fund Context

    Style drift generally refers to a situation in which a hedge fund manager tells investors he will do X and instead he does Y.  At its worst, style drift constitutes a classic “bait and switch.”  A manager promises a safe and sober investment strategy and does something wild and risky.  In its more innocuous forms, style drift is a matter of degree.  A recent SEC enforcement action illustrates style drift of the former, more egregious, type.  While bad facts make bad law, this enforcement action nonetheless illustrates rather starkly one of the ways in which a hedge fund manager may depart from its representations, and the importance of identifying a manager’s outside business activities.  Our article on the matter, accordingly, will help investors ask questions in ongoing due diligence to ascertain the consistency of a manager’s actual investments with its represented investment strategy.

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  • From Vol. 4 No.29 (Aug. 25, 2011)

    How Should Hedge Fund Managers Account for Organizational Expenses and Fund Loans, and What Role Should Such Accounting and Manager Solvency Play in Operational Due Diligence?

    A recent federal court judgment against the manager of hedge funds purporting to follow a socially responsible investment strategy yields a number of important lessons for hedge fund investors when conducting due diligence.  Among other things, the judgment highlights the relevance of the financial condition of the manager and its principals; how managers should account for organizational expenses; how managers should account for fund loans, if they are used at all; and the perils of guaranteed returns.  See “Twelve Operational Due Diligence Lessons from the SEC’s Recent Action against the Manager of a Commodities-Focused Hedge Fund,” The Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011).

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  • From Vol. 4 No.29 (Aug. 25, 2011)

    Failure to Follow Investment Guidelines, Manipulative Trading and Misleading Investors Leads British FSA to Impose Steep Civil Penalties and Ban Principals of Defunct Hedge Fund Manager Mercurius Capital from Securities Industry

    From July 2006 through January 2008, the manager of Cayman Islands hedge fund Mercurius International Fund Limited (Fund) repeatedly violated the Fund’s investment guidelines by over-concentrating investments in thinly-traded companies.  When the values of those investments began to drop, the Fund’s director and chief executive officer, Michiel Visser (Visser), and its chief financial and compliance officer, Oluwole Modupe Fagbulu (Fagbulu), engaged in market manipulation to inflate artificially the Fund’s net asset value (NAV), engaged in sham trades to increase NAV and conceal money borrowed at exorbitant rates and concealed all these machinations, and the Fund’s perilous financial position, from existing and prospective investors.  The Fund collapsed in January 2008 and is now in liquidation.  The British Financial Services Authority (FSA) charged Visser and Fagbulu with market manipulation and other violations of the Financial Services and Markets Act of 2000.  It banned the defendants from the securities industry and imposed steep financial penalties on them.  Visser and Fagbulu appealed to the Upper Tribunal of the British Tax and Chancery Chamber.  We summarize the Tribunal’s decision.

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  • From Vol. 4 No.11 (Apr. 1, 2011)

    Twelve Operational Due Diligence Lessons from the SEC’s Recent Action against the Manager of a Commodities-Focused Hedge Fund

    On March 15, 2011, the SEC filed a complaint the U.S. District Court for the Southern District of New York against Juno Mother Earth Asset Management, LLC (Juno) and its principals, Arturo Rodriguez and Eugenio Verzili.  The complaint alleges that Juno and its principals started selling interests in the Juno Mother Earth Resources Fund, Ltd. (Resources Fund) in late 2006, and by the middle of 2008, substantially all of the Resources Fund's investors had requested redemptions.  The SEC alleges that during the short life of the Resources Fund, Rodriguez and Verzili engaged in a range of bad acts, including misappropriation of fund assets, inappropriate loans from the fund to the management company, misrepresentations of strategy and assets under management and disclosure violations.  Assuming for purposes of analysis that the allegations in the complaint are true, the complaint illuminates a variety of pitfalls for institutional investors to avoid.  This article describes the factual and legal allegations in the complaint, then details twelve important lessons to be derived from the complaint.  Similar to other articles we have published extracting due diligence lessons from SEC complaints, the intent of this article is to serve as a tool for institutional investors or their agents that can be used directly in performing due diligence, or can be used to update a due diligence questionnaire.  Our hope in publishing this article (and others of its type) is that at least one of the twelve lessons that we extract from the complaint enables an investor to identify a due diligence issue that it otherwise would have missed.  We think that there is no better way to identify future hedge fund frauds than to understand the mechanics and lessons of past frauds.

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  • From Vol. 3 No.50 (Dec. 29, 2010)

    Ten Due Diligence Questions that Might Have Helped Uncover the Fraud Described in the SEC's Recent Administrative Proceeding against Subprime Automobile Loan Hedge Fund Manager and Its Principals

    On December 21, 2010, the SEC instituted and settled administrative proceedings against a San Francisco-based hedge fund management company and its principals.  A hedge fund managed by that company purported to invest almost exclusively in subprime auto loans, but in fact wound up "investing" largely in debt owed to the fund by entities controlled by principals of the management company and other hedge funds managed by the management company.  The SEC's Order in the matter is a study in conflicts of interest, strategy drift, material misstatements and omissions in offering documents and Form ADV and improper principal trades.  Working from the alleged facts of this matter, we derive ten due diligence questions that any investor should add to its questionnaire or incorporate into in-person meetings with managers.  Importantly, these are questions that should be asked periodically, not just prior to an initial investment.

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  • From Vol. 2 No.49 (Dec. 10, 2009)

    To What Extent Is a Hedge Fund Bound, Legally and Practically, by Its Strategy as Stated in Its Governing Documents and at Marketing Meetings?

    In the hedge fund context, strategy drift (also known as style drift) broadly may be defined as a material deviation from the investment strategy represented to an investor – in the fund’s governing documents as well as orally, for example, in marketing meetings – prior to and during the investor’s investment in the fund.  Implicit in this definition is the notion that a hedge fund investor purchases a product.  But there is a competing, often more apt, view of the hedge fund investment process which holds that sophisticated investors do not invest “in a fund,” but rather “with a manager.”  While this distinction may be more theoretical than practical – manager selection matters profoundly even for less customized products like hedge fund replication ETFs, and even the most gifted managers have to articulate the layout of their product waterfront with reasonable clarity – it has important legal and drafting implications.  Investors with a product-purchase view of hedge fund investing will demand more specificity in governing documents with respect to strategy, which will narrow manager discretion and expand the range of potential strategy drift claims.  On the other hand, investors with a manager-commitment view of hedge fund investing will, other things being equal, require less granularity on strategy, and may compensate with deeper and longer manager due diligence.  For this latter category of investors, once they have satisfied themselves as to the manager’s investment competence, talent bench, infrastructure quality, risk controls and related matters, they are apt to confer a wider discretion, and less inclined to bring strategy drift claims.  But even managers who have earned the full faith and credit of their investors cannot offer apples and deliver oranges.  Strategy drift claims tend to increase in frequency during and immediately following major market dislocations.  There are two reasons for this.  First, funds launched prior to such turbulence often do not include mechanisms adequate to deal with it, especially if the nature of the dislocation is relatively unprecedented.  For example, many hedge funds launched prior to 2007 lacked mechanisms to deal with the illiquidity of 2008 in a manner satisfactory to investors.  Second, managers – rightly and consistent with their fiduciary duties – want to stem losses or seize opportunities in times of dislocation.  When such defensive or offensive moves work, investors applaud.  (We have yet to find a strategy drift claim that follows a period of positive performance.)  But when such moves fail, strategy drift claims often follow.  In light of our current posture at what appears to be the tail end of a major market dislocation, this article focuses on strategy drift in the hedge fund context and in particular covers: two recent examples of strategy drift claims; what hedge fund “strategies” are and where they are stated; what strategy drift is and the types of legal claims it may give rise to; the relevance of materiality in assessing whether an alleged departure from a stated strategy may give rise to a legal claim; the legal consequences of strategy drift; and – probably most importantly – concrete steps that hedge fund managers can take to avoid allegations of strategy drift.  One of the more heartening takeaways from this article is that, under appropriate circumstances, a manager need not be a “hostage to its documents.”

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