In a guest comment authored by Jay Eisenhofer, co-managing director of the investor law firm Grant & Eisenhofer, revelations of bad behavior in the hedge fund industry are discussed.

Editor’s Note: Below is a comment authored by Jay Eisenhofer, co-managing director of investor law firm Grant & Eisenhofer, P.A. Views expressed are the author’s but this publication is grateful for the right to publish them. As always, reader responses are welcome.

When times were good, many hedge fund managers cultivated an image of Oz-like awe and invincibility. But recent revelations of bad behavior have left investors wary of those running the show.

It’s been a tough couple of years for institutional investors who placed their faith — and their cash — in the care of Philip Falcone, the founder of Harbinger Capital Management. While his hedge fund once reaped billions by betting against the US subprime mortgage market before the financial crisis, in recent years it has crashed to earth, thanks to Falcone’s gamble on a scheme to build a new wireless network, known as LightSquared, Inc., which filed for bankruptcy in May. From a peak of $26 billion in 2008, Harbinger Capital has dwindled to less than $3 billion, thanks to investment losses and withdrawals. 

It turns out the pain was far from over for Harbinger investors. In June, the Securities and Exchange Commission sued Falcone, charging that he had broken the law to support his lavish lifestyle (which includes a 27-room Manhattan townhouse and private jet) at his investors’ expense. Among the allegations: Falcone borrowed $113 million from one of Harbinger’s funds in 2009 to pay his personal taxes without disclosing the loan to clients, or seeking their approval, effectively using the fund as his personal piggybank. 

The SEC also charged that Falcone favored a few Wall Street institutions – including Goldman Sachs – above other investors and manipulated bond prices. “Today’s charges read like a final exam in a graduate course in how to operate a hedge fund unlawfully,” said Robert Khuzami, the SEC’s enforcement director, in a statement. “Clients and market participants alike were victimized.” 

The sad news is that Harbinger’s investors are not alone in feeling dismayed, deceived and disgusted by the hedge fund industry’s dark side. Even as they continue to pour money into these vehicles — some 7,000 hedge funds are now estimated to hold $2 trillion in assets — many institutional and high net worth investors have grown wary of fund managers’ endless promises and relentless hype, thanks to a parade of well-publicized scandals that shows no signs of slackening.

Revelations of widespread deceptive practices – including bait-and-switch investment tactics, conflicts of interests, and severely mispriced assets – coupled with news of fund collapses and bankruptcies, and topped off by several years of sub-par investment returns, have left many hedge fund investors feeling sour and ripped off. Unlike the wave of recent insider-trading cases, like the one which sent Galleon Financial founder Raj Rajaratnam to prison earlier this year, the latest cases depict managers preying on their own investors. 

Though the allegations against Falcone were outrageous, they are hardly unique. Consider: 

· The SEC found that managers of Miami-based Quantek Asset Management deceived investors about their own stake in the $1 billion fund and failed to disclose self-dealing loans it had made to one of its managers, as well as to the fund’s parent company. “Quantek’s investors deserved better than the misleading information they received in marketing materials, side letters, and other fund information,” the SEC said. It ordered the fund to pay investors $3 million, and temporarily barred two fund principals from working in the security industry. 

· In New York, investors filed a civil suit against Michael Balboa, manager of bankrupt Millennium Global Investments, claiming he had conspired to inflate valuations of emerging market debt by at least $80 million in marketing documents, in order to hide losses suffered in the 2008 meltdown and attract additional capital. Balboa faces a criminal complaint from US prosecutors and an SEC suit stemming from the same incident.

· In the UK, the Financial Services Authority fined Alberto Micalizzi, chief of Dynamic Decisions Capital Management $3 million for lying to investors in order to conceal the true value of the company’s master fund, which lost 85 per cent of its value — $400 million — during the last quarter of 2008. The FSA said Micalizzi continued to court new investors in the period leading up to the funds collapse in 2009. “Micalizzi’s conduct fell woefully short of the standards that investors should expect and behavior like this has no place in the financial services industry,” said an FSA official.

These developments come as more funds are struggling to deliver superior financial returns in the face of an increasingly volatile world economy. 

Some well-known names have racked up significant losses. JAT Capital, the investment vehicle of New York-based fund manager John Thaler, was down nearly 20 per cent in the first half of 2012. Shares of Man Group, the world’s largest publicly listed hedge fund, were down over 60 per cent over a 12-month period. According to Hedge Fund Research, 775 funds were liquidated last year, the most since 2009. Meanwhile, it’s estimated that some $50-$60 billions of investors’ money remains locked up in illiquid “zombie” hedge funds that suspended redemptions in the darkest days of the 2008 meltdown.

The average hedge fund might not be such a smart choice for institutional and affluent investors after all. The typical investor would have done better over the last five years in a Vanguard index fund. Bloomberg’s hedge fund index, which tracks 2,697 funds, declined 2.2 per cent annually since 2007; by comparison, the Vanguard Balanced Index Fund, based on a conservative portfolio allocation of 60/40 stocks and bonds, gained 3.5 per cent over the same period. 

So, what can be done to restore hedge funds’ luster and reputation? While there’s no simple solution, here are a couple of places to start. 

First, strengthen the laws under which most funds operate so that their fiduciary duties are explicit, transparent and publicly recognized. Remarkably, that is not the case at present. Most US hedge funds are incorporated as limited partnerships in Delaware. Under Delaware’s Revised Uniform Limited Partnership Act which took effect in 2004, general partners are legally permitted to void the fiduciary duties they owe to 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 marketing their ability to draft general partner agreements that leave 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. They make no sense in the context of a $2 trillion industry. Hedge fund investors deserve the same fiduciary protections as investors in Exxon Mobil, Wal-Mart, IBM and General Electric.

Many funds have a built-in litigation “poison pill” in their agreements, whereby legal fees stemming from investor lawsuits is stipulated to come from the fund's assets, rather than management fees. Investors should seek to change partnership agreements so that their own assets are not at risk in the event of a dispute with those running the funds. 

Next, hedge fund directors must be given the independence to force managers to live up to their obligations. Presently, many directors are little more than rubber stamps. The Financial Times reported that a survey of hedge funds domiciled in the Cayman Islands found that nearly a third of 2,315 funds reviewed possessed no outside directors; some “professional” directors sit on the boards of more than 100 funds simultaneously (the top three each sit on the boards of more than 500 funds). Some directors were said to have never even met the fund managers they supposedly oversee. There is no way such lap-dog directors can enforce their fiduciary obligations to investors. 

Courts should also make it easier for investors to claw back their money from hedge funds that are no longer financially viable. Recent offshore case law recognizes an investor’s right to seek a “just and equitable” windup of a fund when it has gone into lockup mode and ceased to take in new subscriptions or make redemptions.

Earlier this year, the Cayman Grand Court ordered the liquidation of the Heriot African Trade Finance Fund, which had suspended all redemptions since 2009, after its underlying investments defaulted. Investors had initiated proceedings to liquidate the fund, asserting that it had lost its “substratum” and was no longer viable. (Under UK law, “loss of substratum” refers to a situation in which a business can no longer carry out its intended operations or services in accordance with its governing documents.)

The court agreed, stating that: “It is impossible for the fund to carry on its original businesses in the sense that it will not make any new investments or enter into any new trade finance transaction.” It required the fund to be wound up in a “just and equitable” manner. Since such a high percentage of hedge funds are domiciled in the Caymans, the Aris rulings represent significant pro-investor case law. 

When times were good and many hedge funds were able to routinely deliver market-beating returns, some fund managers cultivated an aura of Oz-like invincibility. As long as the profits kept rolling in, many investors were willing to go along. Recent revelations prove that not only are fund managers fallible, they are sometimes prone to schemes and shenanigans that trample the interests of their constituents. Investors should not be afraid of challenging fund executives and boards to live up to their legal obligations. If necessary, they must embrace a strategy of pursuing litigation and activism when fund managers have behaved badly.