Recent legal action has highlighted the importance of due diligence in running and administering hedge funds. Nicholas Pratt examines the likely impact on current practice.
Prosecutions for fraudulent or failed hedge fund managers have occured recently with an almost reliable regularity. In fact just during the week of writing this article, there was a rich blend of cases – from the relative unsophisticated fraud of William Shternfeld, who was sentenced to five years in prison in New York for conspiring to cheat investors with a fake hedge fund, to the more traditional market manipulation of genuine hedge fund manager, Joseph Skowron, who was also sentenced to five years in a New York prison for insider trading.
A far more severe sentence was reserved for Philip Baker, a former managing director of Chicago-based hedge fund Lake Shore Asset Management, which collapsed in 2007 after fleecing investors of more than $150 million (€112.5 million) in a securities fraud involving the trading of commodities futures. Baker received 20 years and was ordered to pay restitution of more than $150 million.
The case of most interest to the hedge fund industry though has been running from some time and involves UK manager Weavering Capital and its flagship Cayman-based macro fixed income fund. Weavering was founded in London in 1999 but collapsed ten years later after it was discovered that $637 million of the $639 million macro fixed income fund was contained in a single swaps transaction with a counterparty controlled by Weavering’s founder and chief executive officer Magnus Peterson.
Dereliction of duty
Peterson was subsequently arrested on suspicion of securities fraud, although the UK’s Serious Fraud Office decided to drop the charges in September 2011, a decision greeted with dismay by the fund’s liquidators, creditors and investors. A civil case against Peterson, brought by the liquidator, is currently ongoing. Highlights so far include the allegation that Peterson significantly overstated various investments in order to bolster the balance sheet in the wake of the Lehmans default. This included valuing a £50 (€58) investment in a music and video company, MVM, at $37.25 million. Peterson alleged that the company was on the verge of an agreement with Nokia, however this never materialised.
While Magnus Peterson’s civil case continues, a Cayman Islands court has already declared its verdict on the fund’s two directors. In August 2011, Stefan Peterson and Hans Ekstrom were fined $111 million each by a Cayman Islands court for “wilful neglect” and “default of duties”. The judge highlighted various instances such as the failure to notify investors of various side-letters and the inclusion of new investors, despite agreements, signing off board meetings that did not happen and failing to raise any concerns about the impact that the Lehmans bankruptcy would have on the fund.
“The way in which these directors behaved during the most serious financial crisis is, in my judgment, the most compelling evidence that they never intended to perform their duties as directors,” read Justice Jones’s judgement. “The defendants did nothing and carried on doing nothing for almost six years.”
The two directors were, respectively, the fund founder’s brother and stepfather. Appointing family members as board directors is not a criminal act in itself, however Justice Jones did suggest that the family ties were significant factors in the dereliction of directors’ duties.
He was left the impression of board meetings were where “an elderly gentleman (Ekstrom) was sitting at home chatting to his two stepsons in a congratulatory way about Magnus Peterson’s apparently successful investment fund business”.
“The judgment in the Weavering case did not set out anything new but it was very high profile and the size of the damages was considerable,” says Deborah Poole, partner in the global hedge fund and private equity groups at UK law firm Walkers. “Also the decision gave some judicial guidance as to how a fund’s directors should interact with their service providers. The Weavering case has really acted as a wake-up call for those directors that had not considered the need for corporate governance.”
The Weavering case also has implications for the relationship between a hedge fund’s directors and its service providers, notably the administrators. In July 2011, Weavering launched a claim against its Dublin-based administrator PNC Global Investment Servicing (formerly PFPC International) for €380 million in damages, alleging breach of contract, gross negligence, misrepresentation and mis-statement in the provision of services. In essence, the Weavering board is alleging that PNC failed to notify it of any breaches of investment restrictions but PNC was never engaged to monitor compliance with the investment guidelines, as is made clear in the original judgment of Justice Jones. The case between PNC Global (now owned by BNY Mellon) and Weavering is ongoing and PNC has said the case is without merit and has promised to defend itself vigorously.
For service providers, the implications of the Weavering case are likely to lead to greater involvement with the board during a fund’s launch, says Poole. “There will be more questions carried out by the administrators, the reporting, the monitoring, the questions and the interaction with the board.”
According to Vernon Barback, president and chief operating officer at fund administrator GlobeOp, there has been a 30% increase in due diligence meetings with investors and a significant increase in the sophistication and the number of questions asked. “The judgment in the Weavering case and the scale of the damages will focus the attention of directors,” says Barback. “We are already seeing fund boards meet more regularly and they are asking us to attend and asking more questions about what we do.”
Consequently the administrator needs to have robust data management systems and, above all, to make sure there is clarity about what services are being provided and what services are not being provided, says Barback. “It is important that investors read the private placement and valuation policy memorandums to be clear about the administrators’ role in valuation issues.”
Although there are special circumstances involved with the Weavering/PNC case, it is indicative of a recent rise in investor-based litigation caused by the global recession, says Robert Foote, partner at BVI-based law firm Ogier. When returns start to fall, investors rush to redeem their funds, creating a run on the fund. At best, managers have to amend their redemption process but in other cases, any fraudulent funds that had been able to remain undetected during the days of high returns and unquestioning investors are suddenly exposed when assets are redeemed en masse.
Consequently, says Foote, the funds industry must now pay more attention to the documentation used to set out a fund’s terms and conditions. “The funds industry went through a period of quickly getting funds up and running and printing all the necessary documentation and it worked. The effect of the global recession has been to stress test these documents and make funds think carefully about how they draft their memorandums of agreement, particularly in relation to the redemption process.”
For others the increasing focus on due diligence is largely due to the fact that the market is so flat and there is little differentiation between managers. “If fees are consistent and performance is limited, then due diligence is the one thing left for investors to focus on in terms of assessing managers,” says Chris Kaye, chief executive of Co-Comply, a UK-based provider of compliance technology.
“It is reassuring that directors are paying more attention to governance but it is more work,” says Barback. This does raise questions about the cost of greater due diligence and who will be left to pay for it.
“The investors are the ultimate clients and, in essence, they pay everyone’s bill. As the requirements for due diligence increase from investors, directors and regulators, it does require more administration sector work, more investment in technology and better management of data – all of which costs money. This will ultimately be paid by investors but whether that cost gets shared along the way is open to interpretation.”
There is also the question of just how far the administrator’s role should go in terms of overseeing corporate governance. Some will argue that such a responsibility impinges on their independence and an alternative third-party should be appointed. Other administrators may feel that filling this role is a necessity in today’s competitive market and part of providing a value-added service.
In these instances, says Walker’s Poole, administrators are likely to want more influence in the composition of the board. “If the directors are inexperienced, they will cost more money in terms of hand-holding. And maybe administrators will refuse to take certain instructions if they are not happy with the composition of the board,” says Poole. “Up to now, there has been very little due diligence around the composition of the board. But getting involved in that area could introduce administrators to a whole new area of liability should things go wrong as we have seen in the Weavering case.”
©2011 funds europe