When good hedge funds go bad

Law firm Maples and Calder thinks there is a misconception that hedge funds fail because there is something dark and rotten at their core, or some fraudulent malfeasance. Maples and Calder, a specialist in setting up offshore funds in the Cayman Islands, also tries to draw the distinction between 'honest and dishonest failure'. Its partners noticed that most funds disappear because they are just plain, old fashioned useless and get the markets wrong.

So what happens when your good hedge fund suddenly turns bad?

In a crisis, a hedge fund might seek to restructure with a view to continuing, perhaps involving a reduction in fees in return for a lock-up, a side pocket or a gate.

However, on redemption date an investor becomes a creditor of a fund and is allowed to petition as a creditor, unless a suspension is made. That status as creditor remains until payment is made. As a creditor, you have the right to be paid ahead of other creditors. At this point, unless a wind down outside of formal liquidation is entered into, a receiver or liquidator gets brought in and the directors of the fund move to one side.

"Investment fund directors have a light touch most of the time anyway. They get low remuneration, and after the funds are set up, a lot of their responsibilities are delegated," says John Trehey, an insolvency lawyer at Maples and Calder in Hong Kong. "They don't usually have experience in crisis management and the directors like it when liquidators take over as it takes the heat off them."

The Cayman Islands' legal system does not have a US-style Chapter 11 of British-style administration. It has its own system, understood by a handful of knowledgeable people in the form of 'big four' accounting firms, who would most likely be those chosen for appointment when your fund goes feral.

"A creditor has to seek a liquidation in the place where the assets are and where a liquidation order can bite," says Trehey. "It's not much use if a liquidator goes only to the Caymans waving his order as he isn't going to find assets there, and that's what the creditor wants. So, there have to be parallel proceedings."