$19 Million Settlement Reached in Hedge Fund Case

Date: Friday, February 1, 2008
Author: Shannon P. Duffy, The Legal Intelligencer, Law.com

he court-appointed receivers for a defunct King of Prussia, Pa., hedge fund that allegedly defrauded its clients out of more than $200 million have struck a $19 million settlement with a Cayman Islands company that served as the fund's administrator.

The settlement with UBS Fund Services comes on the heels of a $75 million settlement struck in December with Man Financial Inc., now known as MF Global Inc., which served as the merchant for the hedge fund.

Another $75 million had already been recovered prior to the Man Financial settlement, bringing the total recovery to date to nearly $170 million, according to court papers.

The civil suit began in June 2005 when the U.S. Commodity Futures Trading Commission filed suit against Paul Eustace, the founder, president and principal trader of the Philadelphia Alternative Asset Management Co., alleging massive fraud in his operation of a hedge fund known as the Offshore Fund.

In November, a federal grand jury handed up an indictment charging Eustace, now of Oakville, Ontario, Canada, with commodities fraud. Eustace is currently in Canada and has not yet agreed to surrender to U.S. authorities to face the charges.

The indictment alleges that Eustace created account statements that inaccurately depicted the health and viability of the commodity pools, showing the funds under his control were profitable when they were actually losing money.

Eustace induced investors to participate or increase their investment in commodity pools while failing to disclose their actual losses, the indictment charges, and increased his management fees based on the phony profits.

According to the indictment, defendant Eustace also made loans to himself using the funds that belonged to investors, transferred money belonging to investors into his personal accounts, and used approximately $500,000 in investors' monies to pay a settlement in a legal case that Eustace allegedly knew should not be charged to the fund.

U.S. District Judge Michael M. Baylson appointed attorney C. Clark Hodgson Jr. of Stradley Ronon Stevens & Young to serve as receiver for PAAMCo., and Hodgson quickly moved to freeze assets and begin the process of recovering funds for Eustace's alleged victims.

Stradley Ronon attorneys Keith R. Dutill, Lee A. Rosengard and Michael Cordone took the lead in pursuing claims against Man Financial and struck the $75 million settlement after a series of negotiations conducted by U.S. Magistrate Judge David R. Strawbridge.

Man Financial had also lodged counterclaims against UBS Fund Services. Baylson later appointed attorney Stephen J. Harmelin of Dilworth Paxson to serve as receiver ad litem to pursue possible claims against UBS.

Dilworth Paxson attorneys James J. Rodgers, Laura E. Vendzules and Thomas Vecchio took the lead in pursuing the claims against UBS.

Strawbridge again conducted a series of settlement talks between the receiver and UBS' lawyers, Gaetan Alfano of Pietrogallo Gordon Alfano Bosick & Raspanti in Philadelphia and Keith W. Miller of Paul Hastings Janofsky & Walker in New York.

In an interview, Alfano declined to comment on the settlement except to say that it was a "business decision" designed to end the litigation.

Dutill said in an interview that $43 million of the recovered funds have already been distributed to Eustace's alleged victims and that a motion is currently pending before Baylson to distribute another $72 million.

Together, Hodgson and Harmelin pursued claims that Man Financial and one of its brokers, Thomas Gilmartin, and UBS Fund Services "participated in and permitted Eustace's fraud."

In their suits, the receivers alleged that Eustace would never have succeeded with his fraud schemes without the help of Man Financial and UBS Fund Services.

Man Financial filed counterclaims against two Cayman Islands businessmen -- David Lashbrook and Scott Somerville, who had served as directors of the Offshore Fund –– and two of Eustace's employees in PAAMCo.'s King of Prussia offices, Edward Gobora and John Wallace.

In a series of opinions last year, Baylson rejected motions for summary judgment from all of the defendants.

Lawyers for Man Financial argued in their motion that the company complied with all of its contractual obligations and that it was as much a victim of Eustace's frauds as any of the investors.

As an executing and clearing broker for Eustace's Offshore Fund, they argued, Man Financial followed instructions and had no knowledge or reason to believe that Eustace was acting fraudulently.

But the receivers argued that the evidence showed that Man Financial did not comply with all of its contractual obligations and that its employee, Gilmartin, who was in charge of the Offshore Fund account, was not adequately supervised.

There were a number of improper activities in the setting up of various Man Financial accounts, they argued in court papers, and as a result of the activity in those accounts, Man Financial is responsible under theories of respondeat superior because Gilmartin and its other officers and employees had knowledge of and/or enabled those activities.

Baylson decided there were factual disputes that would have to be resolved by a jury.

Harmelin's evidence, Baylson said, could allow a jury to find that "Gilmartin had motivation to assist Eustace in using Man [Financial]'s facilities to perpetuate the fraud."

Baylson said the evidence was "sketchy as to whether Gilmartin had specific knowledge of any details of Eustace's scheme," but that a jury could infer he had enough knowledge of the alleged fraud from evidence of Eustace's "manufactured e-mail," as well as Eustace's "requests for ignoring Man [Financial]'s rules and regulations on a number of instances."

The evidence, Baylson said, could also support the argument that other individuals at Man Financial were aware that Gilmartin's conduct was not in accordance with either the company's or the Commodity Exchange regulations.

"If a jury finds Man [Financial]'s employees possessed this knowledge," Baylson wrote, "the jury may also find that Man [Financial] is responsible for this conduct."

Baylson found that Man Financial's lawyers were asking for too lenient a standard for the role of a broker. "Taking Man [Financial]'s formalistic argument to its logical conclusion would require this court to hold that Man [Financial] is absolved of committing a knowing fraud simply because that fraud was perpetrated pursuant to its customer's instructions. This is a proposition with which this court cannot agree," Baylson wrote.

UBS argued in its motion for summary judgment that it could not be held liable because Eustace committed a series of fraudulent acts which prevented UBS from accurately calculating the hedge fund's net asset value each month.

But the receivers argued that if UBS had performed the verification and independent investigation required by its internal policies, it would have prevented or lessened the Offshore Fund's losses.

Baylson rejected UBS' argument that it should be dismissed from the case because its actions were not a "substantial factor" in bringing about the alleged trading losses and thus cannot be the proximate cause of those losses.

UBS' theory, Baylson said, was that since Eustace intentionally committed fraud, any negligence on the part of other actors could not be a "substantial factor" in causing the alleged harm.

"This theory is misguided," Baylson wrote. "If an entity negligently creates the opportunity for a fraudulent or even criminal act, the crime or fraud does not necessarily relieve the entity of its negligence. If the superseding crime or fraud was foreseeable, the negligence is not excused."

A jury, Baylson said, "could rationally conclude that it was foreseeable that an individual, here Eustace, intending to commit fraud, realized that he could take advantage of the alleged absence of independent verification by UBS."