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Court Rules Against Hedge Fund in Side Letter Case

March 4, 2009

Hartford, CT - A ruling against a hedge fund by the U.S. District Court for the District of Connecticut on February 18, 2009 highlights the potential problems with side letters which are increasingly used by hedge funds to satisfy the demands of large investors who want modifications to standard partnership agreements. As reported by the law firm Bingham McCutchen LLP in their Alert newsletter, in Umbach v. Carrington Investment Partners (US), LP the investor, Joseph Umbach, allegedly only agreed to invest in the fund after the GP verbally agreed to waive the one-year lock-up period. The parties then executed a side letter on May 27, 2005 confirming the verbal agreement. In July 2007, Umbach requested the redemption of his entire investment, as of September 30, 2007. On August 30, 2007, however, it is alleged that the GP proposed and obtained approval from a majority of the investors a new one-year lock-up period applicable to all investors, and at the same time rescinding any pending redemption requests. Umbach sued the fund and the GP for securities fraud, common law fraud, negligent representation, breach of fiduciary duty, breach of contract and a declaratory judgment in connection with the fund's refusal to permit him to withdraw his investment.

The court denied the fund's motion to dismiss the claims and found that the defendants may have made misstatements in failing to disclose that the fund could amend its partnership agreement to impose a new lock-up period which would restrict future withdrawals. The court also found that the side letter was ambiguous as to whether the waiver of the one-year lock-up meant only the lock-up period in the partnership agreement, or any future lock-ups that might be imposed by amendment.

In their analysis of the case, the Bingham attorneys found that while the decision is not binding on other courts, it suggests, "(a) a court may admit evidence of oral understandings to interpret the terms of an executed side letter where the investor alleges he or she was misled by the manager; (b) short-form side letters may give rise to claims for failure to disclose the continuing operation of the partnership agreement as it may impact the terms of the side letter; and (c) funds engaging in side letters with investors must take extraordinary care to clearly and unequivocally document the terms of the side agreement, including affirmative representations by the investor that there are no other terms of the agreement apart from those contained in the letter."

As a result of these and other claims involving side letters, E&O/D&O underwriters are now asking for information about client side letters for both new accounts and renewal of existing policies.

Hedge Fund Insurance, a division of Frenkel & Co., Inc., sells Errors & Omissions and Directors & Officers Insurance policies that provide coverage for defense costs and any judgment or settlement arising out of a claim alleging covered wrongful acts - as well as fraud protection for hedge funds and hedge fund investors. Call Mike Feinstein at (212) 488-0270 for more information on E&O/D&O and fraud protection.

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