Hedge funds typically too smart to be victims of financial crime, says US lawyer
Hedge funds might capture news headlines when they lose money as a result of financial crimes and misdemeanours, but pensions are stung more often partly due to their more regular investing patterns, according to a securities litigation lawyer at US firm Labaton Sucharow.
Dominic Auld said hedge funds are typically too adept at not buying high and selling lower – which would provide the key ingredient of realised losses needed to bring litigation to court – to have a basis for court action.
“To have a case you have to have bought at the peak and sold at a trough, and hedge funds are pretty good at avoiding that.”He said that pensions “get burnt more often, because they are active. The classic client in a case in the US would be a large pension fund, taking in $3bn to $4bn of beneficiary contributions with which they have to buy securities”.
Partly because pensions receive regular inflows from members, it is more likely scheme managers will be forced to buy higher then sell lower.
When the sale occurs after an irregularity has been uncovered and the price has fallen, the pension may have grounds to sue, Auld said.
He added another reason hedge funds surface less in courtroom as plaintiffs is that they are generally less public than pension plans.
“Hedge funds historically have tended to be very transparency-averse, because as soon as their alpha is public, it becomes beta. If you litigate, your strategy becomes public.
“But for pensions it is different, they may be strategic investors but they are also quite public, especially for quasi-government mandates where they have to put out reports.”
He said there was “no clear fiduciary duty” on pension trustees to litigate when wrongdoing relating to one of their investments was uncovered, “but if they leave money on the table in settled cases then they are probably butting up against the fiduciary risk area. If all a pension plan must do to get the money is to fill out a form, then clearly they have a duty to get the money that is theirs.”
Labaton Sucharow is counsel mainly to institutional investors, and primarily in North America, although Auld said its European client base was growing.
Auld said more cases around the credit crunch, and related financial securities, did not come to court partly because the legwork to identify valid cases was often laborious and time-consuming; some pensions preferred to write off their losses; some cases were struck out as invalid; and many cases would settle before coming to trial.
All the different ingredients that made up the sub-prime stew were involved. There was a flood of litigation aimed at managers, financial services companies and their ilk. A flood came out about financial services companies being unclear, or deliberately concealing exposure to sub-prime debt.
Auld said: “It is tough as a pension spending resources trying to chase money, when the pension can realistically write off their loss. It is a lot of work to see if a hedge or mutual fund, or asset manager has the kind of exposure to MBS that may result in a recovery, and remember, some of the tranches [of structured credit products] were so narrow they get sold to just one entity.”
He added class actions, encompassing everyone affected by the one event, were often difficult to bring in cases of mortgage-backed securities, “because in many cases you could see individual reliance on a salesperson, who had to knock on your door and sell the security to you.
“Most of the cases were launched in 2008, but there is a finite amount of RMBS securities, only a certain number that could be litigated, and a tremendous amount of work. The cases are almost certain to settle, so there will not be a lot of applicable law.”
He added many pensions were precluded by their own guidelines from investing in the complex credit structures that collapsed during the crunch.
One area of litigation that remains live, and is producing verdicts, is Bernard Madoff’s fraud of the whole spectrum of investors, posing as a hedge fund manager.
By late July, Irving Picard, a US lawyer acting on behalf of those defrauded by Madoff, had retrieved nearly half the $17.3bn principal they lost in the Ponzi scheme.
Auld says: “The problem for Picard is he cannot just go after the big fish, he has to go after the ‘old ladies’, too. His defence would be he cannot pick and choose, but still it’s a difficult thing to have to do.”
He adds the issue of third-party liability for involvement will be “where you will hang liability in the case of Madoff. It is difficult because of the structure by which the feeder funds went to Madoff was typically offshore vehicles.”
Recently a ruling in a British Virgin Islands court found the Fairfield Sentry feeder fund into Madoff’s pyramid scheme could not recoup redemptions they had honoured before Madoff was caught.
Liquidators of some funds have sought to recoup withdrawals that effectively, they claim, comprise ‘ill-gotten gains’ unjustly enriching clients, but the BVI ruling stated redeemers from Fairfield Sentry up to six years before Madoff’s arrest could not be compelled to return withdrawals.
While the matter of Madoff rumbles on, Auld said another area of growing interest this year has been work custodial banks had done for pension funds.
“Some custodial banks might have taken an extra percentage on FX clearing they did for [pension clients],” Auld said.
“It is an ongoing matter, but it behoves the average investor to take note. There may be cases on FX where the banks took an extra bit of money, which in aggregate ends up being a lot. If you have custody banks clearing FX for you, you had better make sure they’re doing a good rate for you.
“If a pension is relying on a custodian clearing for 20 years based on the contract they came up with they began the relationship, chances are the contract could be quite old. Make sure there is a contract governing the service they provide.”
Auld said his industry is “certainly not a dying one, greed is fairly ingrained in the market, people are greatly egotistical and things go wrong.
“But in terms of pensions suing their asset managers, they recognise it is about a long term relationship with a manager. Do they want to spend the money and time building up a new relationship? It almost always causes more problems and is a short-term solution for anger.
“The best advice I can give is, in situations not involving clear-cut fraud, ‘stay out of court’. I am not the only lawyer that preaches plain common sense.”