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Turmoil in the capital markets and serial redemption requests have caused hedge fund investment advisers to close their gates and suspend redemption requests in order to protect the overall best interests of their investors. The only other meaningful alternative is liquidation. In these troubled markets, neither fully honoring redemption requests nor liquidation is an optimal option for the fund or its investors, especially when the assets consist of illiquid securities that are difficult to value.

Recently, a hedge fund scrambled to amend its limited partnership agreement because it faced liquidation if it honored all of its pending redemption requests, but a new case reveals that certain steps taken to protect a hedge fund may not be the most prudent course of action. If done carelessly, amendments to limited partnership agreements to avoid liquidation can result in fraud claims being brought against the fund.

Undue Pressure to Approve Amendments

In mid-February, the Honorable Ellen Bree Burns of the United States District Court for the District of Connecticut issued a ruling in Umbach v. Carrington Investment Partners permitting a hedge fund investor to pursue fraud claims against a hedge fund and its management related to amendments to the hedge fund’s limited partnership agreement that altered the way investors could redeem their interests in the hedge fund.

According to the court’s ruling, the hedge fund did three things that, when taken together, led the court to conclude that the plaintiff could proceed with his fraud-related claims. First, the hedge fund failed to follow written procedures for amendments to the agreement and instead proposed three different amendments in rapid succession. Second, before the final vote the hedge fund distributed three amendments that contained some materially different terms, and thereby provided less than the required 20 days between the distribution of the third amendment and the voting deadline. Third, the hedge fund circulated emails stating it had support for the amendments from other investors, thereby putting additional pressure on individual investors to accept the final amendment. In the eyes of Judge Burns, these facts provided the backdrop against which the plaintiff could proceed with his fraud-based case against the hedge fund’s management.

Cautionary Tale

Judge Burns did note that protecting the hedge fund from a market downturn was a legitimate interest, but the ruling sends a decidedly cautionary message. Hedge funds must be careful in how they seek to protect the fund in the current economic climate. Fund management should follow proper procedures if it seeks to amend the hedge fund’s partnership agreement. When amending a hedge fund’s agreement, management should communicate clearly with investors and refrain from actions which might be viewed as putting undue pressure on investors to approve an amendment. According to Judge Burns, even an e-mail that suggests there is strong support for the amendment could cause a problem if the statement is untrue or if management did not investigate the support for the amendment before sending the e-mail.

Nothing in the court’s ruling prevents hedge funds from passing an amendment regarding redemptions or relying on any other permissible means of protection. For example, hedge funds may still include clauses in their agreements giving the hedge fund discretion to deny redemption requests for certain reasons. Of course, this discretion—in light of the ruling in Umbach v. Carrington Investment Partners—must be exercised judiciously to avoid a lawsuit.

With the dislocation in the capital markets, liquidity issues, and the inability of funds to meet redemption requests, it has become commonplace for hedge fund investment advisers to close the gates of the fund and to suspend redemptions in order to satisfy their fiduciary duties to the funds’ entire investor base. But how they go about doing so, including in some cases rushing to amend their limited partnership agreements to avoid redemptions and/or liquidation, has created a number of issues, and is beginning to spawn litigation around the country.