2nd Circuit Affirms Dismissal of Investment Advisor Liability in South Cherry v. Hennessee Group

July 22, 2009

In a highly anticipated decision last week, the U.S. Court of Appeals for the 2nd Circuit unanimously affirmed the Southern District of New York’s dismissal of South Cherry, LLC’s breach of contract and securities fraud claims against the investment advisor Hennessee Group LLC for losses sustained as a result of Hennessee’s recommendation to invest in the Bayou Hedge Fund Group.

The hedge fund turned out to be a Ponzi scheme, and South Cherry lost much of its investment. This decision has important implications for claims being made against feeder funds and investment advisors for putting their clients’ money in Bernard L. Madoff Investment Securities LLC. South Cherry Street LLC v. Hennessee Group LLC, 07-3658-cv (2nd Circuit, July 14, 2009).

Hennessee promoted itself as the “industry leader” and the most recognized hedge fund consulting firm in the industry. In its presentation to South Cherry, Hennessee boasted, among other things, that it had “direct relationships with hedge funds” and reviewed “550 [funds] per month” with its “proprietary database and analytics” and a five-phase “unique due diligence process.” It claimed to consider only “hedge funds with 3 years audited track record” and checked the hedge fund personnel, cash positions, prime banking relationships and other such critical data.

Based on the presentation, South Cherry alleges that it entered into an “oral contract” with Hennessee to recommend hedge fund investments for a fee based on a percentage of the investment. One such recommendation on which South Cherry relied was Bayou Accredited, part of the Bayou group run by Samuel Israel and Daniel Marino.

The Bayou Hedge Fund Ponzi scheme is well-documented elsewhere, and looks a lot like the Madoff scheme. Bayou’s principals diverted moneys from the funds for personal use, and essentially stopped trading in 2003. Arrearages were covered by later investments into the fund. Early on in the scheme, Bayou fired its independent auditors and retained a firm of auditors that was actually owned by Marino, a Bayou insider, that did not issue genuine audited reports. The Bayou Funds liquidated in 2005, with no returns to any of its investors. The principals later pled guilty to securities fraud charges.

South Cherry sued Hennessee claiming it breached its oral agreement to conduct thorough due diligence as promised, and for securities fraud. Hennessee moved to dismiss on two grounds: (1) the alleged oral contract was unenforceable because of the statute of frauds; and (2) South Cherry failed to adequately allege with particularity actual or reckless behavior to satisfy the pleading requirements of the Private Securities Litigation Reform Act of 1995 (PSLRA). The district court agreed and the appeal ensued.

The 2nd Circuit, in a unanimous affirmance written by Judge Kearse, agreed that the oral agreement was not enforceable, because it was not to be performed within one year and thus voidable under the New York statute of frauds. As a result, the due diligence and other representation made by Hennessee were not contractually enforceable.

The court also took a dim view of South Cherry’s securities fraud claims under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, because the plaintiff could not meet the PSLRA’s heightened pleading requirements. Section 21D(b)(2) of the act states in relevant part:

“in any private action arising under this chapter . . . the complaint shall . . . state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”

The court held, as have other courts, that in the absence of a showing of actual fraud, to prove scienter, a plaintiff must make a “strong showing of reckless disregard for the truth,” meaning a “conscious recklessness – a state of mind approximating actual intent, and not merely a heightened form of negligence.”

In the securities fraud context, the plaintiff must allege specific conduct that “at the least [is]highly unreasonable and which represents an extreme departure from the standards of ordinary care to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.” Or that defendants “failed to review or check information that they had a duty to monitor, or ignored obvious signs of fraud,” and hence “should have known that they were misrepresenting material facts.”

Applying these principles to this case, the court found that the complaint failed to allege scienter with sufficient particularity to meet the heightened requirements of the PSLRA. Since there was no enforceable contract, South Cherry was left to allege either actual fraud or some form of especially egregiously reckless behavior tantamount to a knowing disregard of the consequences for the defendants’ actions. South Cherry’s allegations of failure to exercise promised, or even appropriate, due diligence did not meet that threshold.

The significance of this case for those suing the feeder funds and investment managers who placed assets with Madoff is that the securities laws may not provide a remedy – allegations that the advisor “should have known” that Madoff was a fraud is not enough under the PSLRA. A plaintiff must allege specific facts showing that the defendants actually knew of the fraud, consciously disregarded adverse information, or engaged in other reckless conduct when making investments or giving recommendations.

However, South Cherry does not resolve what is likely to be a real battleground in the cases against the feeder funds and investment advisers – the scope of defendants’ contractual obligations (and in some cases, their fiduciary obligations) to their clients in which less stringent non-PSLRA pleading requirements will be applicable.

In fact, most complaints in these cases have paid considerable attention to the contractual obligations based on written agreements, the feeder fund offering memoranda and marketing materials. Plaintiffs argue the funds failed to diversify investments as promised, failed to reveal that Madoff was the investment vehicle for a significant portion of their portfolios, or failed to exercise the promised levels of due diligence before recommending or investing in Madoff and his firm. A likely defense is that the defendants were duped, too, like the SEC, and that further due diligence within the limits of the possible would not have uncovered the fraud.

Whether these traditional common law claims based on state law and not federal securities acts will protect duped investors, remains to be seen.