Tuesday, August 30, 2011

Hedge Fund Manager Owed Fiduciary Duty to Fund’s Seed Investor Says Delaware Chancellor

A hedge fund manager’s refusal to honor a withdrawal request and return the capital of the hedge fund’s seed investor at the end of a three-year lock-up period was a violation of the seeder agreement and a breach of contract, ruled the Delaware Chancery Court and, alternatively, a breach of the fund manager’s fiduciary duty. Thus, Chancellor Strine ordered a remedy requiring the immediate return to the seed investor of all of its capital and of an award of interest to compensate it for the delay.

When the seed investor sought to withdraw its entire investment in the fund, the hedge fund manager invoked a gate provision in the contract enabling the fund manager to restrict a withdrawal of capital if it would result in more than 20 percent of the total assets of the hedge fund being withdrawn in any six-month period. Because the hedge fund manager had never secured any other outside investor in the fund, the seed investor’s $40 million investment comprised over 99.9 percent of the fund’s invested capital. Rather, the gate was erected solely for the self-interested benefit of the hedge fund manager as manager, and not for the benefit of the fund’s investors.

The court found that the hedge fund manager was not contractually entitled to raise the gate provision. The partnership agreement is a general agreement that specifically contemplates agreements like the seeder agreement between the hedge fund manager and the seed investor. When pertinent principles of contract law are considered, the terms of the seeder agreement setting forth the conditions and time frame under which the seed investor could withdraw must be read as exclusive and as excluding any application of the gate provision, which would undercut the specifically negotiated withdrawal arrangements in the seeder agreement.

Alternatively, said the court, even if the gate provision was potentially applicable, it was a breach of fiduciary duty for the hedge fund manager to use the gate solely for a selfish reason. The only rational reason for the failure to take down the gate was to enable the manager to continue to receive management fees for as long as possible. The discretion granted to the hedge fund manager to determine whether to waive the gate provision is a fiduciary authority that must be used for the benefit of those whom the hedge fund is intended to benefit, reasoned the court, and not for the selfish interest of the manager. Because the decision to use the gate was a selfish one, inimical to the interests of the fund’s 99.9 percent investor, it was a breach of the duty of loyalty.

The Chancellor invoked a line of Delaware precedent establishing that a director, member, or officer of a corporate entity serving as the general partner of a limited partnership, like the hedge fund manager, who exercises control over the partnership’s property owes fiduciary duties directly to the partnership and its limited partners, the fund investors.

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