Katten Hosts Program on Infected Hedge Funds
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The The definitive source of Hedge Fund actionable intelligence on LAW REPORT hedge fund law and regulation www.hflawreport.com Volume 3, Number 12 March 25, 2010 Insider Trading Katten Muchin Rosenman Hosts Program on “Infected Hedge Funds” Highlighting Rights and Remedies of Investors in Hedge Funds Whose Managers are Accused of Insider Trading or of Operating Ponzi Schemes By Jennifer Banzaca The discovery, duration and depth of Ponzi schemes and fund managers can take to prevent accusations of insider insider trading rings uncovered during the last two years trading or running a Ponzi scheme. This article describes in have altered, to a degree, the assumptions of institutional detail the most relevant topics discussed and points made at investors. While investors do not presume that every the Katten seminar. hedge fund manager is engaged in illicit activity, they have expanded their due diligence checklists to include questions Ponzi Scheme Risks, Rights and Remedies intended to identify and avoid bad actors. Investors Anthony Paccione, Partner and Co-Chair of the Litigation also realized that due diligence can never be perfect, and and Dispute Resolution Practice in Katten’s New York office, accordingly, have refocused on the legal rights and remedies explained that your risks, rights and remedies as an investor available to parties invested with managers that are or are in a hedge fund whose manager is accused of running a Ponzi alleged to be operating Ponzi schemes or engaged in insider scheme will depend largely on whether you invested directly trading. See “Hedge Funds in the Crosshairs: The Law of in the fund or indirectly through a feeder fund. Insider Trading in an Active Enforcement Environment,” The Hedge Fund Law Report, Vol. 3, No. 7 (Feb. 17, 2010). Direct Investors In recognition of these abiding concerns among institutional Direct investors have advantages such as affirmative claims investors, and the concomitant interest among hedge for recovery. Direct investors may be able to file insurance fund managers in demonstrating their commitment to claims with the Securities Investor Protection Corporation, compliance, law firm Katten Muchin Rosenman LLP hosted the entity that administers SIPA. Claims can sometimes a seminar on March 16, 2010 titled “Infected Hedge Funds: be made directly against the investment manager and, Rights and Remedies.” The Katten Partners that served as possibly, against secondary actors that may have aided and panelists discussed various relevant topics, including the abetted the scheme, such as accountants and advisers. On categories of claims and defenses available to investors in SIPA procedure, see “Can the Madoff Trustee Recover hedge funds whose managers are accused of Ponzi scheme Disbursements of Fictitious Investment Returns Made to operation or insider trading; differences in remedies available ‘Remote’ Transferees?,” The Hedge Fund Law Report, Vol. 2, to direct and indirect investors; the SEC’s new enforcement No. 21 (May 27, 2009). initiatives and cooperation measures (including cooperation agreements, deferred prosecution agreements and non- “As a direct investor, you may have claims against the prosecution agreements); and prophylactic measures hedge investment manager of a Ponzi scheme directly, although ©2010 The Hedge Fund Law Report. All rights reserved. The The definitive source of Hedge Fund actionable intelligence on LAW REPORT hedge fund law and regulation www.hflawreport.com Volume 3, Number 12 March 25, 2010 those claims may not be worth much at all, particularly since well as the same group of secondary actors targeted in claims the investment manager is likely out of business and facing filed by direct investors, are also subject to claims by indirect regulatory and/or criminal charges,” Paccione said. “You investors. The types of claims seen in these cases generally perhaps could have claims against secondary actors, the include securities and common law fraud claims, claims of alleged aiders and abettors of the Ponzi scheme – typically misrepresentation of material facts, breach of fiduciary duty these can be bankers or accountants or advisers.” claims, negligence and gross negligence claims. The types of claims asserted against secondary actors tend to Indemnification and Exculpation Clauses include negligence and allege in substance that the third party However, in filing claims against feeder funds, investors would aided and abetted the fraud or perhaps aided and abetted the likely have to overcome the exculpation clauses in offering investment manager’s breach of fiduciary duty. “Of course, documents of the feeder funds. Hedge fund documents the defenses available to secondary actors in these scenarios typically provide that the general partner or investment are very substantial,” Paccione said. “You have to prove, manager will be indemnified and exculpated by the fund especially on the aiding and abetting side, actual knowledge of to the extent permissible under applicable law, provided the wrongdoing.” that their actions do not constitute gross negligence, willful Indirect Investors malfeasance or misconduct, fraud, bad faith or dishonesty. In the case of indirect investors caught up in a Ponzi scheme, Clawbacks claims can also be filed against feeder funds or fund of funds managers, and would likely include breach of fiduciary duty In general, clawbacks are actions by the trustee to recover or misrepresentation based on failure to perform the level profits paid out to (and in some cases principal invested by) of pre-investment due diligence and ongoing investment investors within a certain period prior to the filing of the SIPA monitoring promised in marketing materials. or bankruptcy proceeding, for distribution to other investors. “Indirect investors have a litigation advantage in that they There are two types of clawback claims: preference claims and have the ability to assert claims not just against the Ponzi fraudulent conveyance claims. scheme or its investment manager but, assuming you made your investment through a feeder fund, you now have a Preference claims seek to avoid payments made by the different class of potential defendants from which you may bankrupt entity within the 90 days prior to its bankruptcy seek recovery in litigation,” Paccione stated. “In other words filing. Investors involved in a preference claim have limited you could sue the feeder fund and, more appropriately, its defenses, such as the “ordinary course” defense – which, under investment manager.” Section 547(c)(2) of the Bankruptcy Code provides a creditor (or investor) with a defense to a preference complaint if the The feeder fund, the investment manager and its advisers, as creditor (or investor) could prove that the payment was (a) ©2010 The Hedge Fund Law Report. All rights reserved. The The definitive source of Hedge Fund actionable intelligence on LAW REPORT hedge fund law and regulation www.hflawreport.com Volume 3, Number 12 March 25, 2010 for a debt incurred in the ordinary course of business between Themselves in an Unusual Dual Role – As Potential Lawsuit the debtor and the creditor; (b) made in the ordinary course Plaintiffs or SIPA Claimants, but also as Potential Clawback of business between the debtor and the creditor; and (c) made Defendants,” The Hedge Fund Law Report, Vol. 2, No. 9 according to ordinary business terms in the relevant industry. (Mar. 4, 2009). For more on the Bayou case, see “Bayou There is also a defense provided under Section 546(e) of the Creditors Sue Goldman Prime Brokerage Unit to Avoid Bankruptcy Code that says that money received in connection Allegedly Fraudulent Transfers,” The Hedge Fund Law with a settlement of a trade is generally excepted from a Report, Vol. 1, No. 13 (May 30, 2008). preference clawback claim. Insider Trading Risks, Remedies and Rights Fraudulent conveyance claims concern the illegal transfer of Investors in hedge funds whose managers are embroiled property with the intent to commit fraud. Investors have in insider trading allegations are concerned about whether been subject to such claims in connection with other Ponzi money withdrawn from the funds may be subject to schemes, such as the scheme involving Bayou Group LLC. fraudulent conveyance or preference claims of the sort In December 2008, the federal bankruptcy court overseeing generally brought in the wake of a Ponzi scheme. the Bayou case ruled that investors who had redeemed their investments from Bayou, sometimes years before Bayou’s Katten Partner Scott Resnik stated, “If you find yourself in fraud was detected, had to give back profits, and even a fund where the manager is charged with insider trading, some of their initial investments, to help offset losses by my first piece of advice is to get your money out. From other investors ensnared in the scheme. “The fraudulent a legal standpoint, there is a danger to your money if it’s conveyance aspect of these clawback claims is something invested with someone who is indicted, under investigation that I think is interesting,” Paccione said. “You need to or charged with insider trading. The government can move understand two things about fraudulent conveyance: first, in to seize accounts. However, from a practical standpoint, order to be deemed an intentional fraudulent conveyance, if you look at recent insider trading cases, the government you would have to receive a transfer that was made with an has demonstrated generally a low to de minimis interest in actual intent to defraud creditors.