Hedge Funds: The Legal Risks

Karen Donovan picks up on some interesting rhetoric from Brooklyn's very own US attorney Benton Campbell:

"Hedge fund investors, like investors in publicly traded corporations or mutual funds, are protected by the federal securities laws."

Hedge funds are often considered part of the unregulated financial wild west, and there's no secondary market in hedge-fund investments like there is in stocks or mutual funds: they're not securities, per se. But as Donovan says, Campbell here "has drawn a line in the sand".

What are the possible consequences? Well, the prosecution could collapse with a tour de force defense showing that Bear Stearns was very careful to restrict its funds' investor base to people who could afford to lose the money and who knew what they were letting themselves in for. That would strengthen the hedge fund world's general impunity.

Alternatively, the prosecution and defense could get bogged down in a technical debate over investment decisions. That would be reasonably good for the defense: "If it becomes a valuation case, the prosecutors lose," blogger and law professor Peter Henning tells Donovan. But it would still set the precedent that hedge fund managers risk criminal prosecution if they implode. That could send them offshore faster than any hike in income taxes.

Or the prosecution could stick to a simple fraud-and-lying case. That's probably the best-case scenario, no matter who wins, because the only precedent it really sets is that hedge fund managers shouldn't lie to their investors. Yes, the investors are sophisticated and can afford to lose their money. But that doesn't mean they can be defrauded.