Recently, the U.S. District Court for the Western District of Washington came down with a ruling primarily addressing two issues for hedge fund managers: (1) providing investors with timely annual reports and financial statements and (2) delayed redemptions that could bar the management company from charging management fees (see Seattle City Employees’ Retirement System v. Epsilon Global Active Value Fund II, L.P. ). Although the decision is not binding authority in any jurisdiction, it sheds light on how the redemption provisions in a fund’s offering documents fund’s offering documents can affect the management company’s right to continue charging those fees when a redemption is suspended or delayed.
Case Background & Remedy Sought
On March 15, 2010, Seattle City Employees’ Retirement System (“SCERS”), an investor of Epsilon Global Active Value Fund II, L.P. (“Epsilon”), filed suit against the Epsilon, the general partner, the investment manager, and officers of the fund for failing to provide a 2008 annual report and audited financial statement to its investors. When SCERS inquired about the required disclosures and did not receive a satisfactory response from the fund, it decided to request a redemption of its investment on January 28, 2010. About a week later, on February 4, 2010, an Epsilon officer temporarily suspended the redemption of shares in a letter issued to the investors. The letter stated that the funds had not received their audited financial statement for 2008 because an SEC investigation of one of the funds was pending.
Ultimately, SCERS sought a preliminary injunction to:
- to disclose the name/address of undisclosed investors, to disclose the name/address of Epsilon’s directors and officers, and
- to present documents showing investments into the master fund and the specific fund pending SEC investigation,and
- bar Epsilon from collecting management fees,
The court found that although SCERS would likely succeed on the merits of its claim–that Epsilon breached its agreement to produce an annual report and audited financial statement–the court had no power to cure that breach because Epsilon’s auditors had not completed the report and the court could not compel the production of a non-existent report. In addition, SCERS was not entitled to the disclosures that it requested. Neither the offering documents nor the governing substantive law gives SCERS the right to those documents.
With respect to the management fees, the court found that SCERS was unlikely to succeed on the merits. The court reviewed the redemption provisions in the fund’s offering documents. The offering documents grant Epsilon two separate authorities–the power to suspend redemptions and the power to delay redemptions (two very common provisions). The documents provided that the fund shall not charge management fees when the fund delays redemptions, but the documents did not provide that the fund would not charge fees if there was a suspension of redemptions. The court found that the language Epsilon used in its February 4, 2010 letter to the investors indicated a suspension of redemptions, not a delay. Therefore, the court could not bar Epsilon from charging management fees.
The court concluded by indicating that SCERS failed to meet the remaining elements required for a preliminary injunction. In terms of the requested disclosures, SCERS failed to describe what harm would result if it did not receive them. The court denied SCERS’ motion for a preliminary injunction and with no remaining causes of action, the suit was resolved.
First, manager should always be aware of the possibility of litigation when redemptions are delayed or suspended and should plan accordingly. Although the facts we have about this case are limited to what was included in the opinion, it seems like there may have also been ways that the fund managers could have communicated with the investors to avoid litigation. Another important aspect to this case is drafting of the offering documents – managers should address the issue of management fees on delayed or suspended redemptions. In this case, the documents were drafted (perhaps unintentionally) in a way that favored the manager.
Cole-Frieman & Mallon LLP provides comprehensive regulatory support and hedge fund formation services. Bart Mallon, Esq. can be reached directly at 415-868-5345.