Giving hedge fund investors more power

A derivative action is an action brought by a shareholder on behalf of the company when a wrong has been committed against the company. In the case of Foss v. Harbottle (1843), the court decided that the proper claimant in an action in respect of a wrong alleged to be done to a company is, prima facie, the company itself. However, there are several exceptions. In relation to hedge funds, the question is whether a shareholder who owns shares in a parent company to the subsidiary which has suffered a loss can bring an action on behalf of the subsidiary company because of the indirect loss suffered by the parent company.

Hedge funds are often structured in a way so that investors are shareholders in feeder funds, which in turn hold shares in a master fund, which in its turn owns the underlying investment (e.g. shares in a holding company) which has entered into contracts with third parties (e.g. a board of directors) to manage the investment. Therefore, it may seem that the investors in the hedge fund are too far removed from the actual company that suffers a loss and cannot bring an action on behalf of the company. This would result in there being no remedy available for the company since the wrongdoers who are in control of the company would not take a decision to allow it to sue them.

Many courts in common law jurisdictions have, therefore, decided that a “multiple derivative” action can be allowed if there are no good reasons as to why it should not be allowed. Such reasons have often been argued but rejected by courts as not strong enough to outweigh the fact that without multiple derivative actions, the company would have no recourse to redress against the wrongdoers. The question has also been raised as to whether the hedge fund in its capacity as a shareholder has a legitimate interest in the relief claimed such as to justify it bringing an action to obtain the relief. The courts feel that the answer to this is clearly, "Yes". The depletion of a subsidiary’s assets has an indirect effect on the parent company and its shareholders. These court decisions, therefore, provide stronger protection for investors in hedge funds -- investors who are an important part of company ownership today.

Source:“Added protection”, by Peter Hayden, New Law Journal, 27 February 2009, page 313.