By Jonathan Sablone and Timothy W. Mungovan1, Nixon Peabody LLP

Reprinted from the International Investment & Securities Review 2007

Litigation, by its very nature, is backward looking. Trial counsel act as legal archeologists, attempting to determine what went wrong and when. Thus, litigation offers a unique opportunity to examine, with 20/20 hindsight, the issues and actions that led to failure. With this information, litigators can offer tangible steps and strategies to avoid a recurrence. In some respects, litigation can be analogised to the "black box" on an aircraft – the information is of no benefit to the current victims, but immensely valuable to avoid future disasters.

This model of litigation as a risk management tool has special application to hedge funds. Most hedge funds offer little transparency into their investment strategies or operations. In addition, there have been a number of high profile blow-ups and failures in the past few years and there is no reason to believe that trend will change.The lessons learned from hedge fund litigation, therefore, should be incorporated into any due diligence programme.

The Hotel California

The need for due diligence is amplified in the hedge fund context because hedge fund investing carries a special risk for investors. Hedge funds are like The Eagles’ mythical Hotel California, where you can check out anytime you’d like, but you can never leave. What do we mean by that? An investor may have withdrawn its investment from a fund before it failed, but that investor could still be vulnerable to certain claims, particularly if the hedge fund was involved in fraud.

This hedge fund redemption risk may be the single most contentious and uncertain area of hedge fund litigation. In several high profile litigation matters over the last few years, investors who had no knowledge of the fraud or wrong-doing have been targeted to repay some or all of their redemptions. The legal theories underlying these redemption actions are arcane and somewhat complex, but have the capacity to make a bad situation much worse for an innocent investor.

In the meantime, the best defence against redemption risk is to avoid fraudulent funds. While this is easier said than done, a well-designed due diligence programme can detect, and help an investor avoid, common problems that may trigger redemption risk.

In the company of strangers

People are often judged by the company that they keep. The same is true in the financial services industry. Although most hedge funds and alternative investment vehicles are relative newcomers to the financial services world, the professionals that support the industry, for example, the investment bankers, accountants, auditors, attorneys and brokerage houses, are not. Thus, just because a fund is unknown or new does not mean that its advisers, consultants and services professionals should be as well.

Investors should pay close attention to a fund’s service professionals. Who is the accountant, and are they independent? Precisely what services have they provided; an audit, an attestation, or something else?

Who is the legal counsel? Who formed the fund and does that firm still represent the fund? If not, why not?

Who is the fund’s prime broker and what is the relationship between the fund and the prime broker?

Who is the fund’s administrator?

Who calculates Net Asset Value? Is it done in-house, or by a third-party professional?

If the answer to any of these questions is "I do not know," or, perhaps worse, "I have never heard of that firm," warning flags should be raised immediately. Given the amount of capital that flows into even start-up funds, there is no excuse for a fund to hire unknown or sub-par professionals to service its needs and those of its investors. This is not the time or place for fund managers to employ illusory money-saving techniques or repay old college friends with professional engagements.

Criminals commit crimes

No regulation or law can ever completely deter fraudsters in the hedge fund world. Rather, hedge fund investors must shoulder the bulk of the responsibility for their own well-being. Investors, therefore, should "trust but verify".

The fact that a fund has apparently retained namebrand professional services firms should be the beginning of the inquiry, not the end. For example, investors should not simply take the fund at its word that it has hired a leading firm or firms. In a recent hedge fund fraud, the hedge fund adviser created a phony report from a well-regarded accounting firm and passed it off as authentic. Only later – after it was too late – did the truth come out.

The takeaway here is that investors should not simply accept the information provided by the fund. Investors must have direct communications with the professional services firms to confirm their engagement and the scope of their work on behalf of the fund.

An audit by any other name is not an audit

While it does mitigate some risk, the fact that a hedge fund has retained leading professional services firms is not a guarantee against fraud. Several of the biggest blow-ups in the past two years have occurred despite the fact that one or more leading professional services firms have been on the watch. Investors, therefore, should not be lulled into a false sense of security by the mere presence of reputable professional services firms.

Investors must understand precisely what those professional services firms are doing on behalf of the fund. For example, in a recent hedge fund fraud, investors were led to believe that the fund had undergone a GAAS audit. In fact, the professional services firm had issued a report pursuant to the AIMR Performance Presentation Standards, which is a far different inquiry than a GAAS audit.

Can I take it for a test drive?

It should come as no surprise that successful hedge fund managers are usually good sales people. They have used their sophistication, charm, knowledge, skill and experience to break through the "clutter" and woo investors into committing hundreds of millions of dollars. Investors, however, must look past these individual traits and objectively assess the operational structures that the manager has implemented.

First and foremost, investors (or their consultants) should visit the fund’s offices. It may sound trite, but simply looking around, speaking with employees and "kicking the tires" can yield hordes of useful information that would otherwise not get uncovered. During such a visit, investors should walk through the offices, speak with employees and witness the actual operations of the fund. See if employees other than the fund manager can answer legitimate questions within the employee’s purview. Are day-old pizza boxes and half-empty soda bottles cluttering desks? Is employee attendance erratic? If there are concerns or deficiencies, follow-up with more invasive due diligence before investing.

Second, investors must understand the management structure of the adviser. Are management responsibilities segregated among various individuals? Is there a management team separate and apart from the investment professionals? Who is the CFO and what role does he or she play? Are there written policies or procedures in place and are they followed?

Third, investors must consider whether the fund has implemented appropriate operations and risk controls. For example, in the largest, and most recent, example of a fund blowup, resulting in billions of dollars of losses for institutional investors, the trader responsible for the losses had set up his trading operation more than a thousand miles away from the fund’s headquarters. While the risks of this arrangement may be more imaginary than real, it may be an indication that the hedge fund is simply paying lip service to risk controls.

Fourth, investors should attempt to back-test a fund’s performance results. For example, investors should request a sampling of a fund’s trades for a set period and replicate those trades using available market data. Investors should be leery of a fund that balks at such a request on the grounds that the trading strategies are "proprietary".


The lessons are relatively simple, but not often followed: confirm the legitimacy of the materials provided by the fund; read them carefully; make sure you understand the nature of what is being presented; use sampling techniques to ensure that legitimate market activity can be replicated; follow-up with questions; inspect, first-hand, the fund’s operations; and, when in doubt, contact the fund and its professionals directly to clarify any remaining issues.

Of course, while litigation hindsight is 20/20, institutional investors operating in the real world understand that, in some instances, if they want to be allowed to participate in a fund (especially one that is over-subscribed), they will have to live with a certain level of opacity or lose the opportunity. We are not suggesting that every step described in this article is practical for every investment. The broader point is that such steps should be utilised whenever possible, and, if a fund will not allow such intensive due diligence, the investor needs to add that lack of transparency into the risk/return calculus.


1 Jonathan Sablone and Timothy W. Mungovan are partners at Nixon Peabody LLP and the co-chairs of the firm’s Investment Partnership Litigation team.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.