Can You Get a Refund From a Bad Hedge Fund?

April 26, 2013, 5:08 p.m. ET

Can You Get a Refund From a Bad Hedge Fund?

By JASON ZWEIG

Disgruntled hedge-fund investors might be able to make new use of an old technique to erase some of their losses. Earlier this month, David Blass, chief counsel of the division of trading and markets at the Securities and Exchange Commission, gave a speech before an investment-law group in which he warned that many “private funds”—hedge funds, private-equity portfolios and the like—might be breaking the law when they sell to investors. Mr. Blass’s message wasn’t entirely new. Unless they can meet a series of tests to be exempt, private-fund managers have long been required to register as broker-dealers if they solicit outside investors by selling interests in their funds. Registering compels them to follow SEC rules on how they sell their wares. But Mr. Blass’s speech also threw a fresh spotlight on the question of whether the hedge-fund industry has been following the law. And it reminded alert investors of an unusual—but rare and difficult—way to bail out of a rotten fund.

“Many private-fund managers know the rules of the road and have structured their sales practices in ways that are fine,” Mr. Blass told me this week. “Based on recent observations we’ve made, however, others may have been acting in ways that might cause them to have to register as a broker-dealer. That can have serious consequences.”

Often, these funds are sold to Main Street investors through salespeople who work for conventional brokerage firms.

But some private funds pay “transaction-based fees” (commissions, bonuses and other compensation based on new assets raised for the funds) to employees who aren’t registered as brokers with the SEC. That practice can be permissible if the sellers of the funds are exempt from SEC registration. If they aren’t, however, it can be illegal—and could enable investors to demand their money back.

How unusual is it for private funds to be marketed and sold by people who aren’t appropriately registered as broker-dealers? No one can put a number on it, but it’s distressingly common, say industry insiders.

“What you hear is, ‘We’re doing it because everybody’s doing it,’ and that’s true,” says Jay Gould, head of the investment-fund law practice at Pillsbury Winthrop Shaw Pittman in San Francisco. “But they’ve been doing it wrong for years and years.”

Adds Mr. Gould, “A lot of hedge-fund guys have been saying, ‘I don’t really care whether I paid people based on sales. It hasn’t been a focus of the regulators.'”

The head of a brokerage firm in New York tells me that in 2007 he tried to interest hedge-fund executives in a service that would have handled the red tape of registration for them, enabling the funds to operate legitimately as broker-dealers under the SEC’s rules.

He says the hedge-fund officials told him they didn’t need to register their salespeople and that he was “crazy” for suggesting they incur an unnecessary expense.

In his speech, Mr. Blass also reminded investors that the law gives them an unusual sort of put option.

If a private fund performs well, you can keep it and enjoy the gains. If, however, you lose money on it and the person who sold it to you wasn’t properly registered, then you might be able to exercise the right to get rid of the fund and get your money back—what lawyers call “rescission.”

“If you lose your tail on that fund, in most states you have the right to seek rescission plus interest,” says Heath Abshure, the Arkansas securities commissioner. “I’d expect these cases to become more common as you see losses in private funds.”

Rescission cases are heard as civil claims in state court, where you needn’t demonstrate that you were intentionally misled or materially damaged; you need only prove that the person who sold you the fund should have been registered but wasn’t.

Many executives in the hedge-fund business scoff at the idea that investors can get their money back this way. But “it’s an absolutely realistic scenario,” says Mr. Abshure, as long as investors can meet a few criteria.

First, your losses have to be large enough to justify pursuing a lawsuit. Don’t sell your interests in the fund; you can’t bring a rescission case unless you still own it.

Check that you invested within the past three years, or else the statute of limitations may have expired. Also consult your state securities regulator and the Financial Industry Regulatory Authority website brokercheck.finra.org to see whether the person who sold you the fund is registered as a broker-dealer. Your lawyer will need to double-check that the seller was required under SEC rules to be registered.

None of this means that investors in hedge funds and other private vehicles suddenly have the upper hand on the managers. But it never hurts to know how to push back.