13.02.19 | Efrat Neuman
Thirteen years after approximately 100 investors filed a lawsuit against collapsed hedge fund, Integral, a judgment on the lawsuit against the Fund and its managers was recently handed down in the Tel Aviv District Court. Economic Judge Danya Kareth Meyer (who is in the process of retirement) accepted the plaintiffs’ claims with regard to the responsibility of the Fund managers and Mizrahi Bank Trust Company for the damages caused to them and called on the legislator and the regulator to regularize the operations of hedge funds.
At its peak, Integral Hedge Fund managed approximately 30 million dollars. The Fund achieved a return of approximately 120%, as of its inception in 2000 and through to March 2006 but in May the company recorded a negative return that resulted in a general tendency to take money out of the funds. In consequence, the Fund was locked to deposits. When the Fund was released from the lock in August, it became apparent to investors that there was not much left of their money.
According to the judgment, Mizrahi Trust had three opportunities when it could have prevented the damage caused – but it did not do so. It ignored its obligations, did not prevent the transfer of 100 million shekels of investors’ money to a body that was not a trustee, and allowed the damage to occur. “Mizrahi Trust believed that it had no obligation whatsoever and that money could be transferred to Ferrari or to a cat on the street,” noted the Judge.
Over the years, the case passed through several incarnations and judges. During this time, claims were dismissed against some of the defendants (including directors) and the Swiss bank Credit Suisse, and settlement agreements were signed with several of the defendants. At the end of 2008, an amended claim was filed whereby compensation of 33 million shekels was claimed. The judgment now deals with the main questions that arose in the case and on the responsibility of the main defendants.
The plaintiffs are salaried employees and retirees who invested their money in Integral Fund. Some of them were acquaintances of the Fund’s director, Adrian Davidescu, from the period of their joint military service in the Air Force’s construction division. The rest of the plaintiffs joined the Fund based on recommendations passed along by word of mouth by the initial investors, as well as following the marketing activities of Integral Fund employees.
A trust fund or a financial investment entity?
The lawsuit, filed by Attorney Itzhak Aviram, stated that they had invested money in a trust fund that promised an excess return in accordance with a conservative, low-risk investment model. The plaintiffs did not request and did not wish to be exposed to capital market gambling. They claimed they had fallen victim to acts of swindling and fraud under the auspices of a trust fund that led to a loss of 73% of the money they had invested. They therefore asked the court to oblige a line of defendants, headed by Davidescu, to compensate them for the loss of their investments.
One of the main questions that arose was whether a hedge fund should be treated as a trust fund in terms of regulatory supervision, or whether it could be considered as a financial investment entity that is not subject to such supervision. The Judge accepted the plaintiffs’ claim that the Join Investments Trust Law also applies to hedge funds such as Integral, since the rationale for protecting investors in an arrangement whose purpose is joint investment in securities applies equally to a trust fund and to investors’ investment in hedge funds.
“One may assume that at the time of the enactment of the Joint Investment Trust Law 1994, the legislator did not see hedge funds differently when he sought to regulate financial instruments whose purpose is joint public investment, since such funds were not available in Israel at that time, although they were already active in the United States”.
The Judge ruled that Davidescu and the Fund unequivocally violated the provisions of the Joint Investment Trust Law and its obligations, including their having invested in contradiction to the Fund’s policy. She set a formula for calculating payment of the damages estimated by the plaintiffs at ILS 37 million (after interest and linkages since the lawsuit was filed).
“The factor without which the damage would not have occurred”
The Judge ruled that Mizrahi Bank Trust Company, which was presented as a trustee on behalf of the Fund, had a duty to the investors. “The duty of Mizrahi Trust was to inform the investors and return their money to them when it came to realize that the structure of the Fund was problematic. There is no basis for Mizrahi Trust’s assertion that no supervisory obligations applied to it, and that it was merely a banking and technical trustee on which were conferred only limited tasks explicitly defined in the provisions and that these obligations did not include supervisory obligations or inspecting the ‘kashrut’ of a future trustee”.
Kareth-Meyer ruled that the conduct described amounts to a breach of the duty of care that Mizrahi Trust owed to the plaintiffs – both by virtue of the Joint Investment Trust Law, and by the law of torts.
The Judge noted that from the testimony of Adv. Eliezer Zweig, who served as CEO of Mizrahi Trust until November 2003, it appears that Mizrahi Trust opened trust accounts for the Fund without conducting basic checks on the nature of the Fund and without questioning which law applied to it. She also noted that there were issues of credibility in Zweig’s version.
The Judge also ruled that the plaintiffs could not be seen as having knowingly agreed to invest in a fund in the Cayman Islands (to which the funds were transferred at a certain point) and that Mizrahi Trust breached its duty to the investors when it transferred their money to an entity that was not a trustee (Credit Suisse). She said that the way in which investors’ money was transferred by Mizrahi Trust is the factor without which damage to the plaintiffs would not have occurred. The trustees had the best chance of preventing the damage, but they ignored their obligations. She ruled that the trust company has a responsibility even though time passed between its transfer of the Fund’s money and collapse of the Fund.
According to the judgment, Mizrahi Trust had three opportunities when it could have prevented the damage caused: First, when it was asked to open trust accounts and did not conduct a comprehensive examination of the structure of the Fund. Second, when doubts arose with regard to the structure and regulation of the Fund, and a third time when Mizrahi Trust began to take steps to end the trust and transferred approximately 100 million shekels of investors’ money to a new beneficiary in the absence of a trust account and in the absence of a trustee.
What is considered advertising?
Another important question that arose was whether in this case section 2(b) of the Joint Investment Trust Law, which excludes application of the Law on the arrangement of investments of individuals when it meets two cumulative conditions: their number does not exceed 50, and it is made without an offer to the public. The Judge ruled that these two conditions had not been met. In respect of the second condition, she stated that that even if the first investors had come in response to a private offer by Davidescu, later investors came by method of one friend introducing another, which is to be seen as an appeal to the public.
“Integral Fund and the management company initiated and actively conducted many and varied marketing activities, as of the start of the Fund’s operations. There is no doubt that Integral Fund and Davidescu were highly alert to the topic of marketing and this is reflected in the and varied marketing avenues used. The Fund conducted many marketing activities, where each one took the form of a public appeal/offer,” she ruled.
Kareth-Meyer added that “it is desirable that specific regulations be enacted to regulate the way in which hedge funds operate with reference to their unique characteristics, such as the composition of a fund’s assets and the manner in which they are invested, as well as reporting and registration requirements such as the reporting and registration requirements in American law. This sort of arrangement is required in view of the rise in the number of hedge funds in Israel and also in view of the fact that hedge funds refrain from applying the obligations stipulated in the Joint Investment Law by keeping the number of investors below 50. They do so even though there is a high probability that they will make a public offering”.
Adv. Achai Gomeh, a partner at law firm Hamburger Evron & Co. and head of its Capital Markets, Securities and Venture Capital Department (which was not involved in the case) says that the accepted legal interpretation in the hedge fund market is that in order for there to be “advertising to the public”, publication of a prospectus or public advertising is required whereas, if marketing is done privately, and under the limitations of the Securities Law, there is no violation of the provisions of the law.
“In the judgment, the Judge pulls the carpet from under this accepted interpretation: The court ignores the reservations in the Securities Law (which allow for offering and selling to the public even without a prospectus), and rules that from the moment the fund manager engages marketers – be they entities that do so for a fee, such as insurance agents or a family office, or be they investors in the fund who bring further investors on the basis of personal introductions, this subjects the hedge fund to the Joint Investment Trust Law, and the fund is considered a trust fund in every respect. This means that both the fund manager and the trustee must comply with all the obligations stipulated in law”.
Adv. Gomeh believes that in light of the Court’s explicit call to impose supervision on the field and the new interpretation that this presents, the Securities Authority needs to give its opinion on the judgment and publish its position with regard to the interpretation it deems appropriate in order to create certainty among hedge fund operators in Israel.
This is not the final word since the trust company plans to appeal the judgment to the Supreme Court.