Hedge Funds Need More Accountability
by Jay Eisenhofer
Co-founder and managing director of the law firm Grant & Eisenhofer
In the past few years, hedge funds have moved into the mainstream of the U.S. economy. Once restricted to a small number of super-wealthy “sophisticated investors,” they now receive hundreds of billions of dollars from public and private pension plans acting as fiduciaries for school teachers, truck drivers, construction workers, first responders and others whom we have lately come to call “the 99 percent,” who share little in common with fund managers stocking the Forbes 400 list. Surfing upon this incoming tide of money, some individual funds now manage enough assets to exert significant influence in the markets.
But the widespread acceptance of hedge funds among institutional investors has not been matched by commensurate improvements in their level of transparency, accountability and corporate governance. In recent months, we’ve witnessed the dismal result: a parade of inside-trading scandals evoking the fraud-riddled implosions of Worldcom, Tyco, Enron and Global Crossing that rocked corporate America a decade ago. It’s time for hedge funds to be brought into the 21st century and reflect their new broader role and fiduciary responsibilities. This means the legal regime that sets the rules for hedge funds must change.
Without question, the profile of the average hedge fund investor has changed in the past few years. Battered by the financial crisis that erased billions of dollars in stock market value just a few years before the first baby boomers were scheduled to retire, many pension funds started investing with hedge funds in the hope of making up lost ground by taking advantage of their customized, often quant-driven investing strategies and promises of “absolute returns” regardless of the markets’ direction.
Consequently, hedge funds — which now number more than 7,000 and manage some $2 trillion in assets — increasingly are dealing with fiduciaries managing other people’s money, rather than investing for their own account or on behalf of wealthy individuals. Cliffwater, a consulting firm that tracks the industry, reported that more than half of the 96 state pension plans it surveyed had invested a total of $63 billion with hedge funds by the end of fiscal 2010 — more than double the amount invested only four years previously. The California Public Employees’ Retirement System, the country’s largest public pension fund, had a reported $5.2 billion invested in hedge funds by the end of last year.
Corporate pension plans, which control $1 trillion in assets, are also following suit. Hedge fund investing has been democratized, albeit indirectly.
Last year the hedge fund industry recorded one of its best years ever. Institutional investors poured an estimated $40 billion of new cash into funds during the first 10 months of 2011, a 24% increase from the year before, according to Pensions & Investments; it was the second-highest amount recorded since P&I started tracking hedge funds inflows in 2004. And that figure represents only deals that were publicly announced; many institutional investors prefer no publicity when striking a deal to invest in a fund (P&I, Nov. 14).
Commanding enormous pools of capital, hedge funds have amassed significant economic clout. Combined, the top 10 U.S. hedge funds control financial assets valued at $325.5 billion, according to Bloomberg. The country’s top hedge fund, Westport, Conn.-based Bridgewater Associates, controls assets of $120 billion.
And yet it is increasingly clear there is a serious ethics lapse hitting a portion of the hedge fund sector. In the past two years, there have been nearly 60 convictions or guilty pleas by hedge fund executives and consultants. Chief among them: Raj Rajaratnam, the billionaire manager of Galleon Group, who was sentenced last November to more than 11 years in prison and fined $10 million for masterminding a trading scheme that netted almost $54 million in illegal profits; the Securities and Exchange Commission ordered Mr. Rajaratnam to pay $93 million in a related civil case. Joseph Skowron III, former manager of FrontPoint Partners, was given a five-year sentence for conspiracy to commit securities fraud and obstruct an SEC investigation after he admitted trading on non-public information.
More revelations are certain. The SEC has disclosed that it is considering securities fraud charges against Harbinger Capital Partners and its manager, Philip Falcone, regarding allegations it gave preferential treatment to some blue-chip clients, including Goldman Sachs, at the expense of other investors. The SEC also is reportedly investigating SAC Capital Advisors, the $15 billion hedge fund run by Steven Cohen, after two of his former managers pleaded guilty to insider trading and agreed to cooperate with federal prosecutors. Diamondback Capital Management, which manages $2.5 billion in assets, was recently ordered to pay $9 million in fines and penalties stemming from a government investigation into its insider trading activities. And in late January, prominent hedge fund manager David Einhorn, head of Greenlight Capital, was hit with a fine of $11.2 million by British regulators for “market abuse” by dumping shares of leading U.K.-based pub operator Punch Taverns ahead of a stock offering.
Some institutional investors have begun to show their mettle. Three Louisiana public pension funds, fed up with their inability to redeem $100 million invested with New York-based hedge fund Fletcher Asset Management, recently filed a petition seeking to force a liquidation of Fletcher, which is under regulatory investigation for possible securities fraud. Stay tuned for more developments.
There’s no single fix to cleaning up the hedge fund industry. But here’s a good place to start: Strengthen the laws under which most funds operate so their fiduciary duties are explicit, irrevocable and publicly recognized. Remarkably, that is not the case at present. Most U.S. hedge funds are incorporated as limited partnerships in Delaware. Under Delaware’s Revised Uniform Limited Partnership Act, which took effect in 2004, a partnership’s general partners are legally permitted to void the fiduciary duties they owe to their limited partners — their investors. They can also disclaim all liability when they take action in reliance on the opinion of an investment banker. Considering how many instances there have been of bankers and third-party consultants covering up or facilitating wrongdoing, this provision is an invitation to fraud and abuse.
In fact, some law firms are now marketing their ability to draft general partner agreements that leave hedge fund limited partners unprotected and managers secure from accountability. Broad indemnification provisions are just one of a list of other one-sided protections being written into these agreements.
These types of limitations and agreements might make sense when a partnership is a small entity with a group of persons who know each other. They make no sense in the context of a $2 trillion industry with $120 billion behemoths. How would shareholders of Exxon Mobil, Wal-Mart or General Electric respond if their managements said they had no fiduciary obligation to their millions of investors? The uproar would rattle Wall Street to its foundation.
Pension fund and other fiduciary investors need to become more activist regarding their hedge fund holdings. They should add their voice to those calling for greater transparency among managers, refusing to accept one-sided provisions that restrict their limited partners. And they should call on lawmakers to provide a legal regime that protects minority investors who are, in fact, fiduciaries for the American majority.
Jay Eisenhofer is co-founder and managing director of the law firm Grant & Eisenhofer P.A. He has been counsel in more multi-hundred million dollar cases than any other securities litigator, including the $3.2 billion settlement in the Tyco case, the $895 million United Healthcare settlement, the $450 million settlement in the Global Crossing case, the historic $450 million pan-European settlement in the Shell case, as well as a $400 million settlement with Marsh & McLennan, a $303 million settlement with General Motors and a $300 million settlement with DaimlerChrysler. Mr. Eisenhofer was also the lead attorney in the seminal cases of American Federation of State, County & Municipal Employees, Employees Pension Plan v. American International Group, Inc., where the U.S. Court of Appeals required shareholder proxy access reversing years of SEC no-action letters, and Carmody v. Toll Brothers, wherein the Delaware Court of Chancery first ruled that so-called “dead-hand” poison pills violated Delaware law.
Mr. Eisenhofer has served as litigation counsel to many public and private institutional investors, including, among others, California Public Employees Retirement System, Colorado Public Employees Retirement Association, the Florida State Board of Administration, Louisiana State Employees Retirement System, the Teachers’ Retirement System of Louisiana, Ohio Public Employee Retirement Systems, State of Wisconsin Investment Board, American Federation of State, County & Municipal Employees, Service Employees International Union, Amalgamated Bank, Lens Investment Management, Inc. and Franklin Advisers, Inc.
This article was first published on the Harvard Law School Forum on Corporate Governance and Financial Regulation and is re-published with the author's permission.
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