Herrick, Feinstein LLP
December 2008
Authors: Richard M. Morris, Irwin A. Kishner
Recent financial frauds are raising questions about the role and potential liability of fiduciaries that have invested in fraudulent enterprises. Those who control hedge funds, private equity funds or other investment vehicles, including investment advisers and ERISA trustees, should take steps to evaluate their exposure to liability and determine if their policies and procedures require improvement. Investors will scrutinize a fiduciary's initial investment decision, the monitoring of the investment and their reaction to a financial fraud. All fiduciaries, whether or not a victim of a fraudulent enterprise, should keep some key points in mind to help avoid or minimize their liability.
Why Fraud is So Hard to Detect
Even vigilant fiduciaries can become victims of fraud. Perpetrators are becoming more sophisticated in concealing their illegal activities and creating the illusion of profitability and effective management systems and controls. Certain scenarios make it easier for fraud to occur. Some facts to consider:
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Powerful executives often diminish effective administrative controls, including proper segregation of duties;
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Third parties or fellow executives can conceal fraud through conspiracy, facilitation or negligence;
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Sophisticated fraudulent schemes diminish the effectiveness of customary due diligence procedures, including background checks and document reviews; and
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Sophisticated independent auditors may also become victims of fraud.
In general, a fiduciary is liable for directing an investment in a fraudulent enterprise if it breached its duty of care or if its conduct violated ERISA or securities laws, such as providing inadequate or misleading disclosures. Whether a fiduciary satisfied its duty of care or other legal obligations will depend on the specific facts, such as what information you obtained, the quality of your analysis, the extent of your reliance on professionals and the care and frequency you used in monitoring the investment performance. For example, fiduciaries that have access to additional information through co-investment structures or participation on advisory boards or committees could be held to a higher standard.
No Guarantees, But Act Fast
Fiduciaries do not guaranty that fraud or other unlawful acts by others will not occur and the fact that something went wrong, even materially wrong, does not necessarily mean that the fiduciaries are liable. But that won't stop victims of fraud from suing them. So if you have acted as a fiduciary and are a victim of a fraudulent enterprise, you should waste no time in taking these steps:
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Determine your equity and credit exposure to the fraudulent enterprise;
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Develop an appropriate communications plan, including your plan of action to mitigate losses and make appropriate disclosures to investors;
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Review and summarize the procedures employed in evaluating and monitoring the investment, including the analysis performed on reports from the investment entities, their auditors, and other information, opinions, reports or statements by your professionals and experts and the care you used in selecting them. This includes the information you received from management discussions, annual investor meetings or through your designee on a limited partners' advisory board.
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Consult with counsel and other professionals to mitigate the losses quickly and prudently.
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It may be appropriate to limit redemptions (that is, close the gates) or terminate the fund, all in the context of your fiduciary obligations. You should also quickly assess individual liabilities under "clawback" guarantees and similar provisions and take appropriate measures to identify, and communicate with, the individuals that must fund these "clawback" obligations.
Enhancing Best Practices
Procedures will no doubt continue to improve as fiduciaries analyze past frauds and identify what could have and should have been done to detect them. Reliance on any one procedure or process or merely "piggybacking" on the diligence of others will likely be insufficient. Massive frauds have been perpetrated by large SEC reporting firms with sophisticated executive staff and external auditors. Your procedures should be overlapping and redundant, and be designed to detect red flags such as:
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Lack of complete documentation;
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Lack of participation by third party professionals, such as attorneys and auditors;
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Absence of capital investment and adequate professional staff; and
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Absence of timely and regular financial and operational reports.
Of course, as procedures develop, so will the audacity and sophistication of perpetrators of fraud. Be sure to regularly review and improve your current procedures and processes.
For information on this and other matters, please contact:
Rick Morris at 212.592.1432 and rmorris@herrick.com
Irwin Kishner at 212.592.1435 and ikishner@herrick.com
Copyright © 2008 Herrick, Feinstein LLP.
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