Failure to spot fraud or red flags in Form PF could lead to litigation against institutional investors
Complete disclosure of Form PF could theoretically lead to litigation against investors if they fail to spot a red flag or fraud at an underlying hedge fund.
Some funds of funds and other institutional investors are demanding access to un-redacted versions of Form PF as part of their operational due diligence processes into hedge funds. While access to the information contained in Form PF may help those investors gather additional insights, review of the full form may present liability concerns.
“Theoretically a fund of funds could face legal action from their underlying investors if they fail to spot a fraud or red flag in the Form PF. You can see this in the legacy of the Bernard Madoff scandal in which various feeder funds were sued for alleged negligence from their due diligence on underlying investments with Madoff. However, the question that remains is what data contained in Form PF could be viewed, in hindsight, as having presented indicia of fraudulent conduct or so called red-flags,” said Jeffrey Lehtman, partner at Allen & Overy in Washington DC.
Numerous managers are offering their investors redacted or “investor friendly” versions of Form PF while some are allowing investors to conduct on-site reviews of the unedited copy. This in itself presents a problem because any on-site review by investors of Form PF is likely to be hindered by time constraints. Failure to spot a red-flag under such circumstances could potentially be used against the investor.
“If any underlying client of an institutional investor can prove that the institutional investor either ignored red flags or should have spotted red flags, then that institutional investor may be open to litigation. Any potential litigation claim would necessarily be focused on the entirety of the due diligence process and would allege, based on all of the surrounding circumstances, that the process itself was insufficiently robust. If a fund of funds had full access to a Form PF which arguably provided indicia of fraud, then the fact of that review would be an important piece of the litigation puzzle," he added.
Another lawyer, who did not want to be named, agreed, stating negligence would have to be proven at the fund of funds and that litigation would be determined on a case-by-case basis.
Most operational due diligence personnel have said they will not devote huge swathes of time to over-analysing unedited versions of Form PF. Eric Lazear, head of operational due diligence at FQS Capital Partners in London, said un-redacted copies of Form PF would not have much added value, while reviewing DDQs and interviewing hedge fund staff was a more constructive use of time during on-site visits.