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Federal Court Allows Investor’s Law Suit To Proceed Against Hedge Fund For Misrepresentations Concerning Redemption Rights

Mar.03.2009

In a recent decision, a federal court has recognized the right of a hedge fund investor to proceed with a lawsuit in connection with misrepresentations made in writing by the fund's manager and president concerning the investor's right to redeem its investment in the fund.

In Umbach v. Carrington Investment Partners, Inc., Judge Ellen Bree Burns of the United States District Court for the District of Connecticut rendered a decision, allowing an investor's federal and state law claims against a hedge fund and its general partner, president and manager to proceed. The case centered around the investor's $1,000,000 investments. At the time of the investments, the fund's limited partnership agreement contained a lock-up period, which provided that limited partners were not permitted to withdraw their investments for a 12 month period commencing from the date of their investment.

Prior to making its initial investment in the fund, the investor told the fund's manager and president that it would not invest in the fund unless the 12-month lock-up period was permanently waived. The fund's manager and president, whose compensation was based upon the amount of funds raised by the fund, told the investor over the phone that his investments would always be redeemable upon 30 days written notice. The fund's manager and president followed up that conversation with a side letter to the investor at the time of its initial investment in the fund, which waived the 12 month lock-up period for investments made by the investor.

Two years later, the investor gave 30 days notice of his intent to redeem all of his investments in the fund, effective September 30, 2007. Shortly before the September 30 redemption date, the fund amended its limited partnership agreement to rescind all pending redemptions requests and to impose a new 12 month lock-up period for all existing investments. The fund's manager claimed that this amendment was necessary to maintain the fund's existence based upon the downturn in the market.

The investor commenced an action asserting a federal securities law claim and state law claims for breach of fiduciary duty, fraud, negligent misrepresentation and breach of contract against the fund, its general partner and its manager and president. The investor claimed that the defendants failed to disclose that they would only honor the terms of the side letter agreement if the fund's limited partnership agreement was not amended in the future to include new lock-up provisions.

The defendants sought dismissal of the investor's federal securities law claim, asserting that the investor could not have reasonably relied upon any representations made by the fund's manager and president because of the integration clause contained in fund's offering memorandum and limited partnership agreement, which provided that the investor had not relied upon any representations other than those contained in those agreements.

The Court rejected this defense, holding that while under existing Second Circuit precedent, an integration clause may bar claims based upon oral representations made by a hedge fund's manager, such a defense was unavailable in this case. The court held that in this case, the investor "took measures to protect himself" and received a written side letter agreement provided by the fund's manager at the time of the investor's initial investment, which contained the defendants' misrepresentations.

The Court similarly rejected the defendants' assertion that the investor's federal securities law claim had failed to plead properly scienter, which requires a showing of the defendants' "intent to deceive, manipulate or defraud." The Court found that the investor had "presented strong circumstantial evidence of reckless conduct," which could satisfy the scienter requirement. This evidence consisted of: (i) the fact that the manager's compensation was linked to the amount of investments contained in the fund; (ii) the manager's conscious misrepresentation about the guarantee of the redemption right provided in the side letter when he knew that the investor would not have invested "if there was any chance his investment would be subject to a lock-up period;" and (iii) the defendants' attempts to lock-up the investor's money by amending the limited partnership agreement after the investor sought to withdraw his money from the fund.

The Court stated that although protecting the fund from a market downturn may have been a likely factor in the decision to amend the limited partnership agreement, that fact, standing alone, did not mean that the defendants had not committed securities fraud. As the Court noted, it is entirely plausible that the defendants did not need to act on the misrepresentations contained in the side letter for two years, when the investor sought to withdraw its money.

The Court also refused to dismiss the investor's state law claims for breach of fiduciary duty, fraud, negligent misrepresentations and breach of contract, relying principally upon its reasoning in refusing to dismiss the investor's federal securities law claim.

Conclusion

Hedge fund investors seeking to recoup their investments based upon the fund's misrepresentations are often turned away by the courts based upon the integration clause of the fund's offering memorandum and limited partnership agreement, which typically state that the investor has not relied upon any representations made by the fund or its manager prior to the investor's investment. Judge Burn's decision may provide an avenue of relief for those hedge fund investors who have been wrongly denied access to their funds based upon lock-up agreements which are inconsistent with prior written representations made by the fund or its manager.

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