What Can You Do When Your Hedge Fund Investment Goes Bad?

A Presentation and Discussion Hosted by IIEF New York City, Wednesday, October 10, 2012

Keynote Speaker: Simon Lack, Author of The Hedge Fund Mirage

Discussion Moderator: Allan Bell Chair of the Trusts and Estates Practice Group at Sills Cummis & Gross P.C.

Keynote Presentation: Simon Lack

(click here to view the slides from Mr. Lack’s presentation.)

Simon Lack’s book, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to be True, created quite a stir when it was published in January 2012. He was accused by some of bias and faulty math, and lauded by others for revealing that the emperor was wearing no clothes. In his book, and in his keynote address at this IIEF Roundtable, he made the case for why, “If all the money that’s ever been invested in hedge funds had been put in Treasury Bills instead, the results would have been twice as good.” Lack’s analysis of hedge fund returns between 1998 and 2011 revealed that, while hedge funds did very well relative to the market in the late 1990s, they did significantly worse than a traditional 60% equities/40% bond portfolio after 2003. And in 2008, hedge fund losses wiped out all of their historical profits. Meanwhile, the fees earned by hedge fund managers grew substantially in proportion to real investor profits. To explain the downward trajectory, Lack asserts that hedge funds were better when they were smaller. In the early hedge fund days, they tended to be nimble and run by creative, intensely focused managers. The time to get into hedge funds was back when few people were doing it. After early big gains, everyone rushed into hedge funds, and performance plummeted.

Lack focused on four main reasons why hedge funds are no longer a good bet: Fees: Hedge fund managers are doubly paid, earning both a standard fund management fee and performance fees that can be extremely high. These fees have eaten away real investor profits. One of Lack’s slides shows that, between 1998 and 2011, real investor profits were down $80 billion; in the same time period, hedge fund managers earned $413 billion in fees.

-More-

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Simon Lack Keynote Address —Continued

Lack of Transparency: Hedge funds are subject to less transparency than other major investment vehicles, including public equities and debt, private equity and real estate. Traditional assets are largely handled through separately managed accounts. Clients retain complete ownership of their capital as well as the ability to observe precisely how it’s invested. The co-mingled, open-ended fund structure so common in hedge funds limits transparency. Size: Lack asserts that hedge funds are over-capitalized. And big hedge fund managers today are not as nimble or as talented as smaller managers who launched the hedge fund concept in the 1990s. Lack of Investor Protections: Most U.S. hedge funds are incorporated as limited partnerships in Delaware. As pointed out in one of the Roundtable workbook articles written by Jay Eisenhofer, under Delaware law, general partners are legally permitted to void the fiduciary duties they owe to investors. They can also disclaim all liability when they take action in reliance on the opinion of an investment banker. Mr. Lack stopped short of arguing that investors should avoid hedge funds altogether. He urged investors to look for smaller, more nimble managers and demand transparency. And he cautioned against expecting magical returns. He notes that many of today’s investors are betting on a record year for hedge funds every year, despite the fact that they fail to deliver on that promise. Investor expectations of a 7% return have only been realized once – in 2009. 2002 was the last year that hedge funds outperformed returns on a traditional 60/40 portfolio. The lack of consistent performance among hedge fund managers is another concern. High-performing man-agers rarely stay that way; of funds in the top 40% of performers in any one year, only 7% are able to stay on top every year. The other 93% spend some time in the bottom 60%. This absence of return persistence makes manager selection especially challenging. He argued against “diversified” hedge funds and in favor of narrowly focused strategies. “A hedge fund is not trying to match the market. Manager selection is everything.” Lack asserts that the hedge fund industry offers a bad combination: investors who are helplessly momen-tum driven, and a set of investments that is utterly mean reverting. “This is never going to end well. Investors are always going to be going in at the wrong time because no one wants to invest in out-of-favor hedge funds.”

Mr. Lack’s introductory remarks were followed by a Q&A discussion with the participants (Page 3)

and a Roundtable Discussion (Page 7).

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Q&A with Simon Lack Fund Counsel: There’s not necessarily a correlation between investors’ rights and managers’ rights; side letters are becoming less in favor than in the past. Corporate governance is in the process of changing; we’re working on new models to enhance corporate governance and create greater parity between investors and managers. Simon Lack: Let me posit a provocative idea here – that a diversified portfolio of hedge funds is the dumbest idea in finance. The whole point of the Capital Asset Pricing Model is that idiosyncratic risk doesn't get rewarded, and that's why the efficient frontier generally has you investing in a diverse basket of securities. Diversification is designed to systematically get you the market return. But if you're a hedge fund investor, you want to get as far away from the market return as you can. If you are truly skilled at selecting managers, the intelligent way to invest is to have a very small number of hedge funds in your portfolio and a total of 2-3% invested in hedge funds. I know that doesn't solve the problem for the pension fund with a 7 or 8% return target. Chief Investment Officer: Simon, some of the examples and illustrations you cite could be improved upon if you considered leverage as part of the adjustments you make for size and return. Simon Lack: I think you're right; I just don't know how to get the data in a way that would make sense across the whole industry. It's hard to get data on leverage; you have to get to the individual fund level to get that information. And leverage is only one measure of risk, particularly as the derivatives industry has grown. You can have no apparent leverage and lots of economic leverage, depending on what derivatives you're using. Chief Investment Officer: Your point is well taken with regard to fees versus total returns. The market was slack for a decade, and only a very few managers beat the market over that same period.

Simon Lack: People say to me that mutual funds are bad as well. That's not an argument for hedge funds; it just says we all suck. I think with hedge funds it's a bigger sin, because mutual fund managers have to stay fully invested. If you were a tech manager in the late 90s, assets flowed in and then you got clobbered. Your IRR may have been really low because you had maximum assets and the market was falling – but your job was to stay fully invested. The hedge fund industry grew up as a way to generate absolute returns – to make you money, not every day or every month, but over a cycle. So that's why I thought it was fair to ask if they’ve actually done that. The answer is clearly “no.” Investment Industry Regulatory Advocate: Every kid who comes through our program has visions of becoming a hedge fund manager and driving a Ferrari in two years. Large institutions are still pouring money into alternatives – a lot of it into the hedge fund space in pursuit of returns. Assets under management are up to pre-crisis levels, and fund formation seems to be on the upswing again. I'm not quite sure where the disconnect is here – why people keep pursuing this.

“The whole infrastructure of the investment industry is designed to channel assets

into hedge funds.“ Simon Lack: I think the most likely outcome is that assets will continue to flow in and returns will continue to be really bad – very low single digits – at great expense. The whole industry is designed to move assets into hedge funds, and all the people in the industry are pro hedge funds, including consultants recommending allocations, capital introduction people at the prime brokerages, fund of funds analysts and hedge fund specialists at big institutions. The career costs of switching direction are very high. If you're a hedge fund analyst at a big institution, it’s not so easy to become a private equity guy; it takes years to develop the expertise and the contacts. There’s just enough of a positive story that it still looks compelling, but eventually, enough years of poor returns will force a change.

“Let me posit a provocative idea here – that a diversified portfolio of hedge funds is the dumbest idea in finance.”

- Simon Lack

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Q&A with Simon Lack Continued: Simon Lack: Chris Vogt, formerly with Allstate Insurance, was one of the first to invest in hedge funds. In an interview recently with Reuters, he said that this is a make or break year for hedge funds, because the past five years have all been bad. When you put the five year returns into the mean variance optimizer, hedge funds will start to look a lot less attractive. Institutional investors are patient but I would bet that they'll be disappointed. The math is not going to work. Fund Counsel: There's a lot of conjecture behind the scenes that there will be a compression of manager fees, so I'm suggesting that we're in a dynamic marketplace. Certain managers are closing down because they can't handle the volatility of the markets, and many people blame government interference in the markets. There’s no relying on fundamental analysis. Simon Lack: There are a lot of really intelligent people running hedge funds. My book was not written for hedge fund managers; it’s investors who need help. The smartest people will probably always run hedge funds because that’s where you can make the most money, and they will evolve and adapt. I certainly don’t expect the industry will go away, but in its present structure, I believe we’ll continue to get disappointing results.

“Is there not value in having hedge funds as a diversifying asset in a portfolio?”

Alternative Investments Manager: You mentioned return correlation, but you didn’t talk about the downside protection hedge funds offer in portfolio construction. If you look at that negative period of 2008 and 2009, where they outperformed, is there not value in having hedge funds as a diversifying asset in a portfolio? Simon Lack: In our interviews with people before 2008, one of our common questions included: “What will a bad run look like? How much can you afford to lose?

“Prior to 2008, any hedge fund money manager would have said that to be down 12 -15% would be

an absolute worst-case.“

And so I was surprised after 2008 that hedge fund investors were not even more upset, because I believe being down 23% is a disaster for strategies that are supposed to hedge. But hedge funds blew up as well and investors justified their 23% hedge fund losses by saying that their stock portfolios were down 35%. So why didn’t hedge funds do what they were designed to do? I believe it’s because the hedge fund industry is six times the size it used to be; they don't provide that much diversification. Alternative Investments Manager: You suggest concentrating on a very small number of hedge fund managers, but that's totally counterintuitive to most of us. If you have just 2 or 3 managers, when one blows up it defeats the purpose of having them in the first place. Simon Lack: I'm not suggesting that you should have 20% in hedge funds. If you're only going to have two or three managers, be sure to have only 1-2% invested in hedge funds. Go elsewhere; in fact, you can do a lot with stocks and bonds. For the past 10 years, a traditional 60/40 portfolio did better than the hedge funds; looking at that, it’s questionable whether hedge funds have any place in the portfolio. I'm taking the Capital Asset Pricing Model and applying it to hedge funds, recognizing that the hedge fund risk premium is negative. When you put that into the CAPM, it produces a total totally different result than if you assume that hedge funds have a positive risk premium. For institutional investors with long-life liabilities, hedge funds are not going to do it for them. The math just won't work. There’s a big concern about all of the public pension money going into the hedge funds. The hedge fund industry can’t make money with $2 trillion; why will it make money with $2.5 or $3 trillion?

“For the past 10 years, a traditional 60/40 portfolio did better than the hedge funds; looking at that, it’s questionable whether hedge funds have any

place in the portfolio.” - Simon Lack

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Q&A with Simon Lack Continued: Wealth Advisor: As someone who was in the hedge fund business for a long time, I completely agree with you, but now I work with high net worth clients. I'm curious to know if you’ve tax-effected your numbers. If we assume that the bonds in a 60/40 portfolio are municipal bonds, and we assume a very inefficient tax structure for most hedge funds, am I correct that the numbers would be even worse? Simon Lack: Yes, they would be much worse. And hedge funds do a lousy job in generating ordinary income. Clearly for taxable investors, hedge funds are highly tax inefficient. I was once a taxable investor in an incubator fund and recognized how bad that was; the only mitigating feature was that I didn't have to pay the fees that we charged other clients, because I ran the fund. Restructuring Counsel: Across the life of funds, from performance reporting to the redemption process to litigation, we see issues around valuation. I wonder if you have an industry-wide prescription for those valuation problems, things that investors should be looking at to safeguard their interests.

“I think the open-ended fund structure that's prevalent in the hedge fund industry is dis-advantageous to many investors.”

Simon Lack: The fact is that there's no mid-market; there’s a bid and an offer. You have fund documents that assume a Net Asset Value based on mid-market value - and it's a hypothetical concept. In reality, any portfolio has a high NAV if you need to buy securities, and a bit lower NAV if you need to sell securities for money coming out. I’ll give you an example. We invested $25 million of seed capital in an equity market-neutral fund in San Francisco that runs 3 to 1 leverage in a quantitative strategy. I had daily transparency as a non-negotiable requirement.

On the first day, the P&L was down 35 basis points and I was told that was due to market impact costs. The month goes by and the fund is up a little bit. Another month goes by and another $25 million comes in from another investor. We’re down 17 basis points on the first day, because the second $25 million is now invested with the same market impact costs, but the costs are spread across twice the money. In fact, as money comes into a fund that is growing, there are market impact costs incurred to employ new capital. Hedge fund managers totally understand this, but most investors don't; hedge fund managers have no reason to explain this to clients. It's the same thing in reverse when money comes out. If you're in a hedge fund where assets are declining and monies are coming out, you also pay part of the fees and expenses of the assets being sold to pay out cash to the departing investor.

“There’s an inequitable allocation of costs.” So I suggested we should change this and charge an entry and exit fee for new money, and that fee should be our estimate of the market impact costs of money coming in. I suggested that the fee should go to the fund, not the manager, and be used to defray the cost of new money coming in and going out. This doesn't change the economics overall; it just makes sure that the costs are equitably allocated. The company did a second fund with this entry and exit fee and they had a hell of a time convincing investors that it wasn't just another fee. The open-ended fund structure really should only exist for strategies that are in liquid securities such as government bonds and large cap U.S. equities, where the market impact costs of money coming in and going out are minimal. Every hedge fund, in my opinion, should actually be a closed-end fund where investors get in and out based on whatever the prevailing discount is. The problem with that is that closed-end funds generally trade at a discount, and it's a very small, inefficient market in the U.S. They trade at a discount for a reason, because of the value of that liquidity.

“If we assume that the bonds in a 60/40 portfolio are municipal bonds, and we assume a very inefficient tax structure for most hedge funds, am I correct that

the numbers would be even worse?” - Wealth Advisor

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Q&A with Simon Lack Continued: Simon Lack: Here’s another example. We invested in a convertible arbitrage fund called Acuity. We had the right to take money out intra-month, based on what the NAV was. I benefited from daily transparency. We had our own internal risk management rule; if we were down more than 10%, we had to take some of the money out. We saw the daily results go down the gutter and wanted to take half our money out. All of a sudden, Acuity’s results accelerated down. Knowing that they were going to be giving us back our money, they valued the portfolio using the mid-market of convertible bonds - thereby depressing the NAV. This is all legal; it’s all within the discretion of the manager. I was really angry and said, “You guys are ripping me off; you should be consistent.” There's no real consensus on this issue. Some people would say that if they have to sell bonds to give you your money, of course they should value the portfolio on the bid side because that's where they have to sell the bonds. If money’s coming in, they should use the offer side because they have to buy bonds to invest that new money. In our case, Acuity already had cash, so they really did rip us off. They just gave us the cash they already had, didn't sell any bonds and valued our portfolio on the bid side – so all the remaining investors benefited from getting someone out at a bad price.

“Hedge fund investors should demand transparency.”

I would never have known this if I didn't have complete transparency. I sat with a trader on the convertible bond desk at J.P. Morgan to figure it out. Most investors don't have this level of insight, which is one of the reasons why hedge fund investors should demand transparency. There is a lot wrong with the current open-ended fund structure. An open-ended fund is great for the manager, because you set up one fund and create the illusion of a discrete NAV where everything can get done with no friction.

“Investors delude themselves into thinking that they really have 30-day liquidity.”

If they understood more, they would ask for transparency. But they don't even know to ask for it, because if you haven't actually traded and incurred market transaction costs, it’s not a normal thing to think about. Insolvency Administrator: Beyond transparency, did you draw some conclusions about corporate governance?

“I think investors have very weak rights, and it's very hard for investors to act in concert – or even

get a list of other clients from the manager.“ Simon Lack: Investors will claim that they read the small print and the LPA, but you really pay attention to it only when things go wrong. I think investors have very weak rights, and it's very hard for investors to act in concert – or even get a list of other clients from the manager. In a public company, you can have a proxy fight where everyone has all the same information. But in a hedge fund, you can’t require the manager to communicate information that you'd like to share with other investors in the fund. Prior to ‘08, few people really thought that governance rights would be that important. But in recent years, I’ve been quite shocked. One manager we had took a portfolio that had been suspended for two years and sold it to a private equity group at a third off the NAV that he had presented to us. The investors never had the opportunity to say, “Before you sell that portfolio, can we at least consider firing you and finding someone else to manage the portfolio?” This illustrated for me how much control the managers have.

The program continued with a Roundtable Discussion (Beginning on Page 7)

“Investors will claim that they read the small print and the LPA, but you really pay attention to it only when things go wrong.”

- Simon Lack

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Roundtable Discussion: Moderator Allan Bell announced that Chatham House rules would be followed to encourage frank and open dialogue. Only the keynote speaker’s and moderator’s comments are attributed by name in this discussion summary. Roundtable topics:

Fiduciary Standards Governing Hedge Funds

How To Get Out Of A Zombie Hedge Fund

Clawbacks: The Law Post–Madoff

Insider Trading And Hedge Funds

Valuation Issues: Can You Trust Your NAV

Fiduciary Standards Governing Hedge Funds Investors’ Counsel: This issue has gotten a lot of attention recently, both in the Delaware courts and in some offshore jurisdictions – including the Cayman Islands and the BVIs. Hedge funds, as everyone knows, are a completely different entity than traditional equities; they’re either governed by a foreign law, or by Delaware LLP or LLC law. The differences between a corporate structure and the typical operations of a hedge fund have a significant impact on the rights of investors and managers. Delaware's LLC program essentially allows all the rights to be contract based, whereas the corporate structure imposes fiduciary duties. The default rule under Delaware law is that a hedge fund manager has all the fiduciary duties that a director of a corporation has, but Delaware law allows you to eliminate or restrict those fiduciary duties by contract. As the industry has grown, managers and the people who create hedge funds have become increasingly adept at drafting clauses and restrictions on shareholders’ rights to eliminate their fiduciary duties. Let’s take Simon’s example about a manager who sold the portfolio at a dramatic discount without consulting the investors.

Under typical fiduciary duty law, there would be significant recourse, depending on how the sale was done. But if the LLC agreement was drafted in favor of the manager, the investors are stuck. With offshore funds, investors’ rights are essentially limited to seeking a wind-up or liquidation of the fund under Cayman or BVI law, and it's often harder to do that in the BVIs than in the Cayman Islands. How much do hedge fund investors actually pay attention to the LLC agreement and the underlying laws? Do they fully understand the limitations on their liability and responsibility – and the differences between the remedies and rights available in an equity investment versus the rights available in a hedge fund context? Investors could positively impact their investments by choosing more responsible LLC organizations - rather than ones that essentially create a black box with no remedies.

“After the convulsion of 2008, I thought we'd see a big shift in LLP terms

protecting investors, but that hasn't occurred.” Family Office Advisor: I do strategy work with families and wealth management firms, am chairman of a major American not-for-profit and I served in a state legislature. After the convulsion of 2008, I thought we'd see a big shift in LLP terms protecting investors, but that hasn't occurred. I even thought there would be a populist movement in the legislatures, but that hasn’t happened either. Hedge funds still seem to control the game. Investors’ Counsel: I think that’s because the person writing the documents wants maximum flexibility. It's a race to the bottom, just as it was in corporate law back in the 80s and 90s. Family Office Advisor: But Simon was able to get transparency with the San Francisco fund in which he invested $25 million.

“The differences between a corporate structure and the typical operations of a hedge fund have a significant impact on the rights of investors and managers.”

- Investors’ Counsel

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Simon Lack: That's because we were a seed investor and transparency was non-negotiable. I think the reason why LPs haven’t gotten better terms is that looking at the documents is the last thing investors do – and hedge funds are not easily substitutable. Once you've selected a hedge fund and done all the investment analysis and research, then you review the offering documents and terms. It would be unlikely for an investor to say, “We like everything about you, but we don't like the liquidity terms. If you won't give us those terms, we’ll go with another hedge fund.” Maybe investors should start out by saying, “Here are the basic terms on which we invest; if you don't like them, we won't do any due diligence on you.” Investors are not doing that. Fund Counsel: At the SEC, I used to prosecute money managers. I started a law firm and we represent over 800 funds as well as investors. An important shift has occurred in the last five years: over 90% of the assets in the alternative space are going to managers with $5 billion or greater in assets. Last December, I worked on a $500 million allocation from a state government going into one manager. There are a limited number of managers large enough to take an investment of that size, so the big investors will invest regardless of what the terms are. There's a large swath of managers with whom they probably could negotiate much more friendly terms, but they’re not suitable investments by virtue of their size. On the other hand, smaller investors with $15-25 million are too small to have negotiating power. Family Office Advisor: You’re on to a big theme in my world of family offices. While large families with $1 billion to invest might take a unit and invest it into an LP, it’s still a small amount to some of these funds. There are no standards for due diligence at the family office level. In fact, in contrast to what you would think would be a movement toward standardization, there is no real community emergence of standards in the family office world. There is actually a movement in the opposite direction.

“Investors may pay the fees but hedge funds are the real clients.”

Simon Lack: Here's a true story. A very large hedge fund was meeting with a big U.S. pension fund. The chief risk officer of the hedge fund was presenting and the investor said, “We've been invested with you for two years, have placed $500 million with you, and I don't think you know my name.” The chief risk officer paused, left the room, came back in and said, “I've been in this business 30 years, and no one's ever talked to me like that. You're going to apologize to me right now.” The pension fund is still a client! That's why I went into the seeding business. In the 90s, I invested in big hedge funds as part of a proprietary portfolio. You have to put your kneepads on to become a client and I didn't want that. I wanted to invest where I had a strong hand to negotiate. Don’t invest in a market where you have such a weak negotiating position; there’s a lot better things to do with your life.

“When you buy a TV set, you don’t read the fine print and say, ‘I don't like the way Panasonic limits

its legal liability, so I won’t buy a Panasonic.’ ” Institutional Investors’ Counsel: Unfortunately, it seems that investors deal with their hedge fund investments in the same way. And that's why we need the protection of legislative rules, because investors are not going to do it for themselves. There need to be limits on how far funds can go into abridging these rights. Fund Counsel: But isn’t that a slippery slope? We unfortunately live in a world where people don't take responsibility for their own decisions, and sadly Dodd-Frank is going to make that worse. Investors expect registration will be a cure-all for fraud, and it's not. You need to know what you're getting into and be willing to walk away from the deal.

“An important shift has occurred in the last five years: over 90% of the assets in the alternative space are going to managers with

$5 billion or greater in assets. ” - Fund Counsel

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Institutional Investors’ Counsel: Experience has shown that investors are not going to adequately protect themselves. You have to have a default rule; the question is whether it will be more protective or less protective of investors. Fund Counsel: There are rules in place; there are anti-fraud provisions. Investors’ Counsel: There are some basic ground rules that apply in normal business organizations that don’t have to apply in the LLP context. For example, I had a case several years ago in which the fund manager transferred assets to the general partner. Under the LLC agreement, they waived the manager’s fiduciary duties and they argued that they also waived fiduciary duties to the general partner. And as a result, they argued, the asset transfer didn't have to be on fair terms to the fund or to the investors. We were able to argue that the agreement wasn't carefully drafted enough, and they wound up settling. Fairness should be a basic ground rule. But under the statutes now, you are allowed to eliminate even the most basic requirements for fairness. Fund Counsel: One of the very basics of Delaware Law is to allow two people to negotiate whatever terms of whatever the arrangement is. The alternative investment industry has become a much more sophisticated marketplace, the stakes have gotten higher and investors need to gear up.

“What I see with family offices, is that the family often made its money by keeping costs under

control. They fixate too much on that issue and commoditize some of the services they receive.”

Investors’ Counsel: Delaware Law is based on the premise that people can negotiate, but as Simon just pointed out, you don't negotiate with hedge funds.

Fund Counsel: I’d rather the government get involved in educating investors. In the alternative space, accredited investors make up just 8% of the entire population. Given that we’re in an environment where government seems to be growing, not shrinking, it’s a concern for me to have government intervene further.

“The law has evolved to be friendlier to hedge funds than to corporations in similar situations,

and less friendly to an investor than to a shareholder in a public company.”

Institutional Investors’ Counsel: I agree that there's no need for government to be more involved than it already is. I’m talking about the opposite of government intervention; I’m talking about rules that should govern private disputes between investors and the hedge funds. The law has evolved to be friendlier to hedge funds than to corporations in similar situations, and less friendly to an investor than to a shareholder in a public company. Will the rules be similar to the rules that govern a dispute between an investor and a public company, or will they be different? Fund Counsel: While conceptually I'm not opposed to new rules, I'm concerned that there have been too many laws imposed, too many changes, and the financial services industry is devastated. The cost of staying compliant is astronomical. I think it's a really bad time in history to add or modify the laws already on the books. I’d prefer to know what we currently have and pull back from some of what Congress has done. While their intentions were good, they don't realize the impact of their actions.

“I’m also concerned that there's incongruence among state laws and

between federal and state law.”

“Fairness should be a basic ground rule. But under the statutes now, you are allowed to eliminate even the most basic requirements for fairness.”

- Investors’ Counsel

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Zombie Hedge Funds: What Are They And How Do You Get Out of One?

Restructuring Counsel: A zombie hedge fund is a colorful term for a fund in which investors are essentially locked up for long periods. As we all know, fund managers can suspend redemptions, throw up gates, cease valuing the assets and essentially lock the fund down when market conditions or a wave of redemptions make it unfeasible and unwise to liquidate the fund immediately. It seems in everyone's interest for the fund to go into a period of suspension while the market turns around, the managers are able to evaluate the assets and liquidate them in a more orderly fashion. However, these suspension periods, which may have been anticipated to be a year or two at most, have become 3, 4, 5 years and sometimes longer, while the manager continues to collect fees on the assets. To get out of the fund, the investor can put some pressure on the manager to actively liquidate the fund and make distributions. And sometimes the fund manager is approached by a group of investors and given the opportunity to step out with some sort of compensation arrangement so that a new manager can take over and begin to liquidate the fund. But absent those consensual arrangements, what's an investor to do?

“When you look at the documents, you see that the fund manager really is protected and the

investor has no wedge.” In those cases, investors have to look to the courts for relief. This hasn't occurred so much in the U.S., but it’s been an offshore phenomenon. One of the legal theories is that when a fund goes into deep suspension and stops taking on new investors or making distributions, its underlying purpose - its “substratum” - has ceased to exist. It's appropriate to liquidate the fund and make distributions because the business as it was initially conceived has terminated.

An investor who's been the victim of this extended suspension has to petition the court to wind up the fund. This theory has had some success, particularly in the Caymans. In other offshore jurisdictions, the courts have ruled that as long as the fund manager has the right to suspend the fund, and as long as there's the possibility of a turnaround in the future, then there has been no abuse of discretion and no ultra vires activity on the part of the manager – and thus no basis for winding it up. Insolvency Administrator: One of the leading judges in the Caymans, if he sees a fund in suspension with no new investment and no new funds being sought, will say the substratum is gone and will grant a winding up of that particular structure. However, there are signs that this view may move closer to the BVI attitude that if the articles allow a suspension, then it probably isn't a removal of substratum.

“It's easy to do nothing, and a whole class of zombie funds has been created.”

Why more investors haven’t moved to petition for fund windups in the Caymans is open to debate. Part of it may be uncertainty about how much value will actually be unlocked in the process. If the loss statements are inaccurate, you could end up spending a considerable amount of client money winding up the structure only to recover very little at the end of the day. Another reason may be that investors don't want to have to report a huge loss once they commence the liquidation process. Going back to the topic of corporate governance and the importance of a properly constituted Board of Directors. I see the companies that go into liquidation, not the many good funds. But in the examples I see, there’s a feeling that being a director of a hedge fund is different from being a director of some other sort of corporate entity, that you don't have the same responsibilities. A typical fund has an executive director/investment manager who is based in the U.S., and a couple of independent directors based in the Caymans.

“A leading judge in the Caymans, if he sees a fund in suspension with no new investment or new funds being sought, will say the substratum is gone and will

grant a winding up of that particular structure. ” - Insolvency Administrator

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“They expect the Board of Directors to be truly independent and to act in the interest

of all the members, and frankly that doesn't seem to happen very often.”

Insolvency Administrator (continued): The two independent directors take their leadership from the executive director, who is continuing to draw his 2% per annum for doing nothing. At the point of investment, investors are not thinking about exit options and down-side potential. They don't realize the full indemnification of all the professional service providers, what the valuation process, or what will happen if the fund gets to this zombie state. They expect the Board of Directors to be truly independent and to act in the interest of all the members, and frankly that doesn't seem to happen very often. Fund Counsel: There is an interesting case in the Caymans waiting for appeal, Weavering, which dealt specifically with the issue of directors’ duties. Weavering was pretty blatant; they were fabricating journal entries. But where is the fiduciary responsibility when you move into grayer territory? Insolvency Administrator: I agree that Weavering is different from other cases I’ve seen where the directors were going through the motions and not really fulfilling their director’s duties. How appropriate is it to make it easy for everyone to get full indemnification? If there is wide indemnification and you can't show willful neglect or gross negligence, then these guys will get away with not doing their job properly.

“Investment managers want to keep fees down and are often penny wise, pound foolish.”

Hedge Fund Due Diligence Director: They don’t want to invest in due diligence of fund governance. They don’t want to pay $20-30K each for independent directors to actually do a proper job; they only want to pay $6-7,000.

Clawbacks: The Law Post–Madoff

Moderator Bell: Before Madoff, I don’t remember ever hearing the term “clawback;” now I hear it in so many contexts. Restructuring Counsel: Like the term “zombie fund,” “clawback” is a colorful term for the power of the bankruptcy or insolvency trustee to recover transfers from the entity to certain classes of transferees prior to the filing of the bankruptcy petition. The two basic clawback provisions in the bankruptcy code relate to either fraudulent transfers or preferences. A preference payment is any payment that went out to a party in a very short period of time before the bankruptcy filing – 90 days for an unaffiliated transferee and a year for insiders. Even though the payments were properly payable to those parties, they can be clawed back to the estate so that all creditors can be paid fairly.

“Fraudulent conveyance is a bit trickier. Transfers can be called constructively fraudulent if they

were made to a transferee without any reasonably equivalent value coming back.”

There doesn't have to be intent to defraud or any kind of nefarious activity; if the entity makes a transfer and got nothing back in return, it’s a constructively fraudulent transfer. If there's any intent to defraud the creditor, hinder payment to other creditors, or engage in other fraudulent activities, that's an actual fraudulent transfer. Under the bankruptcy code, you can look back two years to claw back actual fraudulent transfers. What happened in the Madoff case and what will happen in the MF Global case is really very different from what has been happening all along in bankruptcy cases. What has so inflamed the public about clawbacks, post-Madoff, is the practice of trustees clawing back fictitious profits.

“There’s a feeling that being a director of a hedge fund is different from being a director of some other sort of corporate entity, that you don't have the same

responsibilities.” - Insolvency Administrator

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Restructuring Counsel: Investors took money out of Madoff (and other funds) believing it to be their profit, the increased value of their investment. Years later, the trustee came back after them, usually under an extended look-back period under state law, instead of under the more limited look-back periods under federal statutes. Investors thought, “I’ve already lost the value of my investment, and now I have to give back the little I thought I had made, which turns out to be fictitious. What’s the justification for this?” The justification is that no one should benefit to a greater extent than others. And everyone needs to share the pain. Investors are often incensed, but the law is pretty clear that the trustees are empowered to do that.

“It's difficult to explain to a lay person that an innocent investor, a bystander, can be subject to

clawback.” - Moderator Bell Investors’ Counsel: Under the U.S. bankruptcy code, or the Cayman Islands code, is there any ability to claw back management fees paid during the period when the fund has lost some substratum? Insolvency Administrator: I'm not aware of that having arisen in the Caymans, although we have a case where we’re considering doing exactly that. Restructuring Counsel: The theory would be that the manager hasn’t done anything, that there's not a reasonably equivalent value coming back. I'm not aware of any cases where a trustee has argued that, but I think the manager would have a pretty good defense. “I showed up for work every day, I did my job and did what I was supposed to do.” The courts would need to look beyond that and say, “Sitting in the chair is not the issue; you need to do a lot more.” Insolvency Administrator: But if the management fees are based on the NAV declared by the investment manager, where do you go next? Participant: You say that the NAV is wrong!

Insider Trading And Hedge Funds

Restructuring Counsel: In recent years, there has been a seeming increase in insider trading convictions, confessions and indictments involving hedge fund managers. The cases I'm aware of involve expert networks – consultants that managers use to give them information on an industry, in pursuit of an investment edge. The initial thought was that these experts would help explain esoteric terms and help managers get a better sense of an industry as a whole. But there's a fine line between that and giving material, nonpublic information that the manager can then trade on. Fund Counsel: At the SEC, I used to be in a group focused on prosecuting asset managers. This small group was disbanded shortly after I left, but for the past five years they have been rebuilding this expertise within the SEC. There are some very blatant cases that we all agree are wrong. And then there are potential cases or threats of cases that aren't so blatantly wrong. Take Mr. Jones, one of the first managers running a hedge fund. To get an edge, he would send his employees to the SEC's offices and courthouses to read the cases as soon as they came out. So sometimes, it's not so clear where the line actually is.

“If Steve Cohen is ever prosecuted for insider trading, I’m concerned that it will have a

materially detrimental effect on the industry as a whole.“

It may create a perception that managers who continually outperform, who are continually in that Tier 1 that Simon talks about, got there through illegal means. Most of our clients, when they're working with expert networks, ask us to draft language requiring the expert to state that they're not in possession of material nonpublic information. They don’t want to be tainted. As an investor, it's something you have to be sensitive to, because you don't want your assets frozen in a fund due to allegations of insider trading.

“What has so inflamed the public about clawbacks, post-Madoff, is the practice of trustees clawing back fictitious profits.“

- Restructuring Counsel

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Restructuring Counsel: Another danger is that the industry consultant, who’s getting paid far more handsomely per hour than they might normally, and is flattered by having investors ask questions about their industry, can unwittingly provide material information. Fund Counsel: I represented a witness to a case that may have just settled. The witness had called the company to ask some very basic questions, and the person he spoke to shared information that the witness didn't realize was material, nonpublic information. He shared the information with his portfolio manager, and all of a sudden it's an insider trading case. Restructuring Counsel. My sense is that enforcement is greater than it's been in the recent past. We have some notorious cases, because the industry is doing whatever it can to get a little edge.

Can The NAV Be Trusted?

Restructuring Counsel: If you could come up with predictable methodologies to value assets, everything from performance reporting, to redemption processing, to suspension issues, to liquidation issues, would be significantly resolved. You wouldn't have all the litigation, which in many cases comes down to valuation. Fund Counsel: My impression dealing with managers invested in liquid portfolios is that, while there might be some disagreement as to valuation, it's a very limited range of issues. It's harder when you get to more esoteric assets. Over the last four years, we’ve seen a larger number of new products that seemingly intend to avoid correlation to the traditional indices; they’re investing in other asset classes to avoid clarity of valuation. Oftentimes we've had managers fight with valuation committees of independent firms to lower the valuation of some of their instruments, so it cuts both ways. I would suggest that investors should look at managers’ expenses; that's an untapped area of risk.

Hedge Fund Due Diligence Director: Most fund documents say that the manager values the assets, not the administrator. Level III securities are the hardest to value, and the administrator doesn’t want to take responsibility for that. I used to work for a valuation company. The valuation company would be paid to come in and give a range of values of Level III security. At the end of the day, the investor has to decide if things are going to change in their documents; the manager’s not going to change. Fund Counsel: Getting back to negotiations, let's say you go to invest in a fund and you have a concern about valuation methodology, operating costs or expenses. To make those changes on your behalf would require consent in most cases by all investors, so that’s a practical limitation.

“If someone is routinely changing vendors, there’s usually an inherent problem with how they're running their operations.”

When we’re looking at valuation issues, one of the key factors I look at is whether there’s been a change of vendors over time. Institutional Investors’ Counsel: Do you ever see fees structured differently for illiquid investments where the managers get paid when the investments are exited? Fund Counsel: You can create side pocket methodology to put illiquid assets into a fund, and other funds sometimes have elongated redemption provisions and fee payments. But a lot of times, these documents are not written well.

Moderator Allan Bell thanked the participants and Mr. Lack for their contributions to a lively discussion. The Workbook readings, including Simon Lack’s slide

presentation, are available to IIEF members in the Members Only section of the IIEF website.

“If you could come up with predictable methodologies to value assets, every-thing…. would be significantly resolved. You wouldn't have all the litigation,

which in many cases comes down to valuation.” - Restructuring Counsel