Six Important Lessons for Hedge Fund Managers, Investors, Administrators and Others in Structuring Side Pockets and Monitoring Their Use

The SEC recently charged hedge fund manager Baystar Capital Management, LLC (BCM) and its principal, Lawrence Goldfarb, with fraud in connection with the use of side pockets in a hedge fund.  The alleged fraud in this case was unorthodox: rather than stashing a poor-performing investment in a side pocket in order to slow redemptions, BCM and Goldfarb allegedly placed a good-performing asset in a side pocket, but diverted the cash flows from the asset to improper uses and misrepresented to fund investors various facts relating to the side pocket.  See generally “SEC Brings Civil Securities Fraud Action Against Principals of Hedge Fund Palisades Master Fund, Alleging Fraud, Self-Dealing, Misuse of Fund Assets and Use of a ‘Side Pocket’ to Misrepresent the Fund’s Value to Its Investors,” Hedge Fund Law Report, Vol. 3, No. 42 (Oct. 29, 2010).  Despite these somewhat atypical facts, and despite the diminishing relevance of side pockets in hedge fund structuring (discussed in more detail below), the SEC’s complaint in the matter yields at least six important lessons for hedge fund managers, investors, administrators and others – lessons on topics including structuring, drafting, valuation, transparency and the appropriate role of administrators.  This article details the relevant factual and legal allegations in the matter, then discusses those six important lessons.

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