Hedge funds seem to turn all conventional wisdom on it's head.  Hedge funds don't act like other shareholders -- they get seats on boards, push through reform, that kind of thing.  Now, investors in hedge funds don't act like regular investors, either.  The WSJ reports today that investors in Lipper Convertibles (the article calls it an investment partnership, so we'll assume it's an LP) are suing former investors.  Lipper Convertibles was flying high and making large distributions at one time, apparently due to some profit inflation by the portfolio manager in an attempt to attract new investors.  During this time of 40% profit inflation, some investors took their distributions and cashed out.  The ones that didn't, and the ones that invested during the inflationary time, are now suing the investors who cashed out, saying that the profits were "unjust enrichment."  (OK, so the investors in question are people like Sylvester Stallone, John Cusak, Ed Koch, and Henry Kravis' kids, but that's not the point.)

The point is whether there is any sort of theory of recovery here.  In corporate law, shareholders who sue the entity for 10b-5 causes of action or otherwise look to the entity for recovery, not the current shareholders, or even the anonymous shareholders who sold the overpriced shares to them.  This has led some to argue that private securities litigation is nothing but an intra-shareholder wealth transfer, which I've blogged about before.  These hedge fund investors have a leg up on shareholders in a publicly-held corporation, however:  they know the exiting investors.

Lipper Convertibles, of course, is not a corporation, and so the theory would be slightly different for a limited partnership.  (Other hedge funds named as examples in the article facing investor suits are LLCs.)  Generally, we don't look to limited partners, current or former, to disgorge prior distributions that were larger than otherwise available under the partnership agreement due to fraudulent bookkeeping on the part of an employee of the partnership.  (Is that right?  I think I may be convincing myself otherwise.)  The partnership agreement could have a clawback provision that would operate either upon discovery of an accounting error, such as this one, or upon some other happening.  I can imagine an investment partnership with illiquid assets such as real estate having provisions that allow partners to exit but be subject to an earnout provision or clawback over time.  However, the WSJ article does not mention any sort of partnership agreement provision.  These suits seem to be following some sort of theory based on fraud, unjust enrichment and fairness.

One of the suits mentioned involved a fund that was in bankruptcy, and the trustee is attempting to clawback distributions under the bankruptcy code.  That trustee may have a doctinal leg to stand on, but I'm not sure if the other cases do.  I would be happy to hear what others think.

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