In Focus

April 30, 2007

edge funds continue to present investor protection concerns, for three reasons. First, in late March the SEC's Director of Enforcement, Linda Thomsen, stated that the SEC "continues to see too many examples of fraud…", and that these frauds "run the gamut" from outright theft to providing false information. More common is the scenario in which the hedge fund managers "get in over their heads when trading losses mount and try to cover their tracks with lies and deceit in order to keep the money coming in and stem mass redemptions."

Second, in late April the world learned that if a hedge fund manager earned less than $240 million in 2006, that manager failed to make the list of the top 25 earners! J. Bradford DeLong, an economist at UCal Berkeley, commented, "There is some question as to what the hell they are doing that is worth that kind of money….The answer is damned mysterious." Moreover, hedge fund managers have an incentive to take risks with their investors' money. That's because hedge fund manager compensation partly is based upon performance fees. In one fund managed by a top 25 earner, the fund reaps 44% of the profits, and of course, shares 0% (no penalty) of the losses.

Third, in January 2007, two executive recruiters, Mark Elzweig and Nancy Miller, alerted us to the fact that, "Due diligence departments, the first line of defense in risk assessment, are suffering a severe labor shortage." Quite simply, due diligence experts aren't paid enough - or more accurately, are paid far more on the sales and management side. The authors cite specific concerns regarding the 9,000 hedge funds that exist today, many of which will not exist ten years from now. Increasingly, lawyers (such as those at SNSFE) are called upon to fill the gap left by Wall Street in conducting pre-investment and post-investment due diligence of hedge fund (and other) investments.

These three factors - occurrences of fraud, manager incentives to take risk and lack of due diligence experts - all paint a bleak picture for the hedge fund investor. Worse, now that pension funds and endowments are jumping on the bandwagon to invest, hedge fund problems will impact the non-wealthy. Increased enforcement, sensible compensation arrangements and sufficient due diligence must occur to protect investors from hedge funds.

_______________________________________________________________________
James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.