Thursday, January 28, 2016

Claim for Feeder Fund's Losses Is Derivative, Not Direct

By Anne Sherry, J.D.

An investor in a feeder fund could only bring a derivative claim, not a direct claim, against the master fund's general partners. The Delaware Supreme Court held that the investor failed to meet both parts of the Tooley test, which determines whether a claim is direct or derivative based on who suffered the alleged harm and who would benefit from any recovery. The case will proceed before the Eleventh Circuit, which certified the question on the direct/derivative divide (Culverhouse v. Paulson & Co. Inc., January 26, 2016, Seitz, C.).

The Eleventh Circuit asked whether an investor in a feeder fund has standing to bring a direct claim against the master fund’s general partners for losses incurred by the feeder fund. In Anglo American Security Fund, L.P. v. S.R. Global International Fund, L.P. (Del. Ch. 2003), the chancery court held that claims brought by former limited partners of a hedge fund against the fund and its general partner and auditor were direct. Although the analysis in Anglo American appeared consistent with the analytical framework laid out six months later in Tooley v. Donaldson, Lufkin & Jenrette, Inc. (Del. Sup. Ct. 2004), the appeals court noted that the Southern District of New York doubts whether Anglo American remains good law after Tooley.

Anglo American distinguished. The supreme court did not clear up the debate over Anglo American's precedential value. Instead, it distinguished its facts from those of the feeder-fund case. The limited partners in Anglo American were direct investors who had a direct relationship with the investment fund and its manager. By contrast, the feeder fund investors chose not to invest directly with the master fund and had a legal relationship with the feeder fund alone.

Corporate form. The court would not disregard the separateness of the feeder and master funds simply because the feeder fund is a pass-through entity that does not issue transferrable shares. Ignoring the funds' respective governing agreements would upset the contractual expectations of the funds' investors and managers, as well as call into question the same type of agreements in the established feeder/master fund investment model.

Tooley. Applying the facts to the certification request, the court found that the investor failed to meet both parts of Tooley. Because the investor chose not to invest directly in the master fund, neither the alleged harm from the master fund's losses nor the benefit of any recovery would flow to the feeder fund's investors in the first instance.

The case is No. 349, 2015.

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