As courts have lamented, “[d]etermining whether an action is derivative or direct is sometimes difficult.” Difficult though it may be, this determination is generally an important issue in litigation initiated by investors in hedge funds and other investment companies. Indeed, the proper characterization of a claim brought by a fund investor against the fund’s adviser and others involved in the management and administration of the fund has many legal consequences, some of which may be outcome determinative. See “U.S. District Court Holds That Hedge Fund Investors Do Not Have Standing to Bring a Direct, As Opposed to Derivative, Claim against Hedge Fund Auditor PwC
,” Hedge Fund Law Report, Vol. 3, No. 47 (Dec. 3, 2010). While courts have sought to simplify the direct vs. derivative analysis in recognition of its significance, they continue to be challenged when attempting to apply the proper test. A noteworthy example is a recent decision by the Ninth Circuit in which the court applied the wrong direct/derivative test and then compounded the error by suggesting that courts should abandon the test whenever faced with claims involving investments in mutual funds. Although the case involved a mutual fund, it will likely sow confusion in future hedge fund litigation where courts must decide whether a claim is direct or derivative in nature. In a guest article, Seth Schwartz and Jason Vigna, a partner and a counsel, respectively, at Skadden, analyze the Ninth Circuit’s decision and identify potential ramifications for the hedge fund and alternative mutual fund industry. For additional insight from Skadden, see “What Do the Investor Advisory Committee’s Recommendations Mean for the Future of Marketing of Hedge Funds to Natural Persons?
,” Hedge Fund Law Report, Vol. 7, No. 40 (Oct. 24, 2014); and our two-part series on Structuring Hedge Funds to Avoid ERISA While Accommodating Benefit Plan Investors: Part One
, Vol. 8, No. 5 (Feb. 5, 2015); and Part Two
, Vol. 8, No. 6 (Feb. 12, 2015).