Hedging on Hedge Fund Scrutiny Fine With Court

Date: Wednesday, July 22, 2009
Author: Commentary by Ann Woolner, Bloomberg

Let’s say you hand a million dollars or more to an investment advisory firm that boasts a sterling reputation, grand results and a promise to thoroughly investigate hedge funds before recommending them.

For all the claims of super due diligence, this fine firm sinks your money into what turns out to be a Ponzi scheme.

Now your money is gone and the hedge fund founder who lost it is serving 20 more than years. Federal regulators belatedly find that your adviser didn’t actually do that much due diligence.

The Bayou Group hedge fund it put you into hadn’t had an independent audit almost since its beginning when an initial auditor noticed consistent losses and was let go, according to the Securities and Exchange Commission.

You think you have an open and shut case against the folks who told you they would be careful and then advised you to put your money down that rat hole? You don’t.

So says a key federal court in a ruling last week that is bound to trouble the ever-growing hordes of Ponzi victims. The case comes as more bad news to Bernard Madoff’s investors.

A unanimous three-judge panel of the 2d U.S. Circuit Court of Appeals in New York threw out a suit that South Cherry Street LLC brought against Hennessee Group LLC for steering South Cherry’s money into Bayou Group funds. Those were the ones run by since-convicted felons Samuel Israel III and Daniel Marino.

The court said Hennessee can’t be held responsible under a 1995 law Congress passed to make securities fraud lawsuits harder to win. The law works.

Tougher to Win

The U.S. Supreme Court made it even tougher to win such cases in 2007. And now, the 2d Circuit has arguably made it harder yet.

The upshot is this: No matter how careless the financial adviser, no matter how many broken promises of scrutiny, no matter how many warning signs ignored, unless the investor has compelling evidence of intentional chicanery, the securities fraud claim is dismissed.

Plus, getting that evidence is almost impossible because the 1995 law requires the investor to somehow find it before getting access in court to the other side’s records.

Before the case goes further, the judge must balance the allegation that the adviser meant to cheat against a defense claim that any failures were unwitting. The plaintiff is must somehow show that it knows what’s in the defendant’s mind.

Intentional Fraud

The claim fails unless the judge decides the allegation of intentional fraud is at least as plausible as an explanation it was an innocent mistake.

The timing is especially infuriating to the plaintiffs in the Hennessee case. In April the SEC found that Hennessee hadn’t performed the due diligence it had advertised and had ignored red flags.

Bayou had given conflicting reports about its auditor, for example, and at one point simply invented an auditor. State accounting board records listed the bogus firm and named a Bayou principal as its registered agent.

Surely even minimal scrutiny would have turned that up.

The trial judge found otherwise.

“Hennessee Group’s failure to discover the fraud merely places it alongside the SEC, the IRS and every other interested party that reviewed Bayou’s finances,” U.S. District Judge Colleen McMahon wrote in 2007.

She might have thought differently about the SEC’s ability to catch these things if she had known how steadfastly it refused to investigate a tipster’s claim that Madoff had been ripping people off for years.

Catching Bayou

Likewise, the SEC caught onto Bayou only after Israel said he would be shutting his funds and distributing assets, then left investors high and dry.

As for Hennessee, it has agreed to settle SEC charges by paying more than $800,000 for having put about 40 clients into Bayou funds.

The firm neither admits nor denies the SEC’s charges, as is standard in this sort of thing. Its lead lawyer in the litigation, Bennett Falk of Miramar, Florida, says Hennessee knew nothing of Bayou’s deceit.

South Cherry Street also lost a claim that Hennessee breached a contract, because its promises of due diligence were oral and not part of a signed agreement. And when the trial judge kicked out a claim that Hennessee breached its fiduciary duties, South Cherry didn’t appeal.

There may be other avenues for other Ponzi victims. And each case is heavily dependent on individual facts.

For now, when it comes to proving securities fraud against an adviser who promised scrutiny that wasn’t delivered, that becomes harder at the very time that victims need it most.

(Ann Woolner is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Ann Woolner in Atlanta at awoolner@bloomberg.net.