Hedge Fund Fraud Lawyers — Bakhtiari & Harrison
Hedge fund fraud — common patterns
- Strategy misrepresentation: hedge fund managers frequently misrepresent their investment strategy — claiming to employ a conservative market-neutral approach while actually taking highly leveraged directional bets. When the actual strategy is revealed through losses, investors discover they were never invested in what they were sold.
- Performance fabrication: false or inflated performance records are one of the most common forms of hedge fund fraud. In Ponzi-style schemes, reported returns are fabricated entirely. In more subtle cases, cherry-picked performance periods, improper benchmarking, or inflated asset valuations create a misleading performance picture.
- Fee misrepresentation: hedge funds typically charge a management fee (1-2% of assets annually) plus a performance fee (20% of profits). Undisclosed additional fees, expenses charged to the fund, and side pocket arrangements that defer crystallization of losses can significantly increase the actual cost of hedge fund investment beyond what is represented.
- Liquidity misrepresentation: hedge funds frequently impose lock-up periods, redemption gates, and side pocket provisions that prevent investors from withdrawing capital when they need it. These restrictions are often not clearly communicated at the time of investment.
- Inadequate due diligence by selling broker: when a FINRA-registered broker recommends a hedge fund investment, the broker has an obligation to conduct adequate due diligence on the fund — verifying performance claims, understanding the actual strategy, and identifying red flags. Brokers who recommend hedge funds without adequate due diligence face liability for resulting losses.
Hedge Funds Have a History of Imploding
The bankruptcies of two Bear Stearns hedge funds, the High Grade Structured Credit Strategies Master Fund and the High Grade Structured Credit Strategies Enhanced Leverage Master Fund, demonstrates how dangerous hedge funds can be. It has been estimated that Wall Street took in at least $27 billion in revenues from selling and trading risky Mortgage Backed Securities (MBS) during the housing boom.
Hedge fund managers purchased questionable securities like Collateralized Mortgage Obligations (CMOs) and Collateralized Debt Obligations (CDOs) that contained large concentrations in subprime and Alt-A mortgages. Many of the CMOs were represented as investment grade, when in fact they were highly speculative investments that were designed to drive the Wall Street money machine.
The combination of risky strategies, large investments and lack of regulation have lead to catastrophic hedge fund disasters. The most visible was the failure of Long-Term Capital Management, a hedge fund whose founders included two Nobel laureates. Long-Term Capital Management turned a $4.8 billion into $125 billion prior to its failure in the summer of 1998. Long-Term Capital Management investors were virtually wiped out having lost 92% of their assets.
Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded. Hedge funds are flexible in their investment options and may use short selling, leverage, derivatives such as call options, put options, index options or futures to mitigate risk.
Hedge Funds Are Available in Different Varieties and Different Asset Classes With Different Risk Profiles
Not all hedge funds are the same. Investment returns, volatility and risk vary among the different hedge funds strategies. Some strategies, which are not correlated to equity markets, are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds. These defensive strategies mean that hedge funds may out perform benchmark indexes during down years.
A result of the lack of regulatory oversight means that hedge funds are approved and monitored almost exclusively by the brokerage firms or banks that sell them. As a result, hedge funds are particularly prone to sales practice abuse or fraudulent sales practices. The pre-sale due diligence done by the brokerage firm is critical.
The firm has a responsibility to ask the right questions and review pertinent documents to ensure that selling representations to the customer are consistent with the funds track record, management and investment philosophy. Brokerage firms also have a continuing duty to monitor hedge funds they recommend. Pre-sale and subsequent due diligence are conducted by the brokerage firm’s due diligence department personnel.
Hedge funds are sometimes sold with restrictions on an investor’s ability to liquidate their accounts. As a result of manager strategies some funds may impose lock up periods of one year.
Hedge funds charge costly incentive fees of approximately 20 percent. Incentive fees are split by the hedge fund manager and the brokerage firm selling the fund. A key reason for the high failure rate of hedge funds is the high-water-mark fee arrangement. If a fund loses investor money, it cannot collect its incentive fee until it regains the assets lost in the previous year and surpasses its previous high point.
This can lead to an exodus of talented mangers and staff who leave for other funds not subject to the high-water-mark problem. This can lead fund managers who are in the red at midyear to take extraordinary risks to get back above water. Given that brokerage firms solicit hedge funds as a investment vehicle to reduce or mitigate market risk, this type of situation is problematic.
Recovery paths for hedge fund investors
FINRA arbitration against the selling broker
When a hedge fund was recommended by a FINRA-registered broker or broker-dealer, the investor may have a FINRA arbitration claim against the selling broker for failure to conduct adequate due diligence, misrepresentation, unsuitable recommendation, or failure to supervise. These claims are against the broker-dealer — not the hedge fund itself — and can be pursued even if the hedge fund manager has fled or the fund has collapsed.
Court litigation against the fund manager
Claims against the hedge fund manager, feeder fund operator, or fund administrator are pursued in court rather than FINRA arbitration, since these parties are typically not FINRA members. Bakhtiari & Harrison handles parallel proceedings — FINRA arbitration against the selling broker and court litigation against the fund manager — where both are available.
Frequently asked questions — hedge funds
I am an accredited investor — does that affect my ability to bring a hedge fund fraud claim?
No. Accredited investor status means you were eligible to purchase the unregistered hedge fund interest — it does not waive your right to honest disclosure and suitable recommendations. A hedge fund that was misrepresented to an accredited investor is just as actionable as a misrepresentation to a retail investor. Bakhtiari & Harrison regularly represents accredited investors including high-net-worth individuals, entertainment professionals, and family offices in hedge fund fraud claims.
The hedge fund manager has been arrested — can I still recover my losses?
Possibly. Criminal proceedings against a hedge fund manager frequently run parallel to civil recovery options. The selling broker-dealer that recommended the fund may face independent liability for failure to conduct adequate due diligence, regardless of the manager’s criminal liability. SIPC may provide coverage in some circumstances. Bakhtiari & Harrison evaluates all available recovery paths in a free initial consultation.
My hedge fund imposed a gate and I cannot withdraw my money — what can I do?
A redemption gate — a restriction on withdrawals — may be permitted under the fund’s offering documents, or it may violate the terms under which the investment was sold to you. If the gate was not clearly disclosed at the time of investment, or if the fund’s financial condition has deteriorated due to mismanagement or fraud, you may have claims against the fund manager and the selling broker. Contact Bakhtiari & Harrison for a free evaluation.
For a full overview of the firm’s investment product failure practice, visit the Product Failure page.
Contact a hedge fund fraud lawyer — free consultation
Contact Bakhtiari & Harrison for a free, confidential consultation. Our FINRA attorneys evaluate every potential investor claim at no charge. Investor cases are handled on a contingency fee basis — no recovery, no fee.
Investor cases are handled on a contingency fee basis — no recovery, no fee.
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