Asset Allocators Take Notice: Recent Ruling Affords Little Protection For Due Diligence Failures

Aug 7 2009 | 9:17am ET

By David Benoit -- In a recent ruling by the U.S. Court of Appeals for the Second Circuit involving investment losses stemming from the Bayou Ponzi scheme, an important decision was issued concerning the due diligence practices of investment advisers and the liability they face for failures to conduct thorough due diligence on investment managers. 

While the recent decision provides guidance to advisers who are sued for securities fraud under Section 10(b) of the ’34 Act (for recommending their clients to invest in funds later revealed to be fraudulently managed), the decision does little to provide relief for other causes of action involving claims of negligence, misrepresentation or breach of contract.  Furthermore, investment advisers who misrepresent the level of due diligence they perform still face liability to the SEC under the Investment Advisers Act, in addition to the loss of goodwill and reputation in the investment marketplace.

The Court’s Point of View

In the recent case, South Cherry Street, LLC v. Hennessee Group LLC 2009 U.S. App LEXIS 15467 (2d Cir. 2009), South Cherry alleged that Hennessee Group, an investment adviser, made an oral and written presentation to South Cherry during which it represented that it performed due diligence on a hedge fund according to “five levels of scrutiny” before recommending it to an investor.  South Cherry alleged that is entered into an oral contract with Hennessee whereby the adviser agreed to recommend appropriate hedge funds that withstood its due diligence program in return for an asset based fee.  South Cherry further alleged that it subsequently invested in Bayou Accredited Fund LLC in reliance on Hennessee’s representations that Bayou passed Hennessee’s due diligence program.  In 2005 the SEC reported that Bayou was part of a Ponzi scheme and South Cherry lost its entire investment.

South Cherry filed suit alleging that Hennessee: (i) breached its oral contract by failing to perform the five levels of due diligence, and (ii) engaged in securities fraud under Section 10(b) of the ’34 Act by “misrepresenting the financial status and performance” of Bayou.  The district court dismissed the breach of contract claim (on the ground that the contract was unenforceable because it was not in writing as required by New York’s statute of frauds) and dismissed the securities fraud claim on the ground that South Cherry had not adequately pled scienter, or an intent to defraud.  The district court ruled that South Cherry failed to allege facts that created a strong inference of Hennessee’s intent to deceive that was at least as compelling as any opposing inference of negligence on the part of Hennessee.

On appeal, the Second Circuit affirmed the lower court’s decision finding that South Cherry’s allegations that Hennessee “would” have discovered the Bayou fraud had it conducted the proper due diligence was insufficient to prove that Hennessee intentionally issued false statements regarding Bayou (and therefore it did not act in a manner that constituted actual fraud).  The court did note that Hennessee may have been negligent with respect to the Bayou investment, however, because the court was only asked to decide whether or not Hennessee’s conduct violated Section 10(b) (and negligent conduct is not a violation thereof), the court affirmed the decision to dismiss the complaint against Hennessee.  It is worth further noting that the Second Circuit ruling did not affect Hennessee’s previous settlement with the SEC in which Hennessee and its principals agreed to pay a fine and disgorge fees to settle charges that it violated the Investment Advisers Act by misleading clients regarding the due diligence it performed on Bayou. 

The Growing Value of Independent Due Diligence: Providing the Necessary ‘Check and Balance’

The recent South Cherry court decision and the multitude of other Ponzi-related cases pending before the courts are going to have broad implications in shaping the future business practices of asset allocation firms with respect to the performance of fund manager due diligence.  Investment clients and the allocators who traditionally have provided them with both investment selection and due diligence services are finding themselves financially exposed and vulnerable as a result of this comprehensive services offering. 

In response to their clients’ growing concerns, asset allocators are taking strategic actions to implement fund-selection best practices aimed at restoring client confidence, reducing future liability, and positioning themselves ahead of their competition.  Key to achieving these objectives, allocators are being advised to turn to independent, expert due diligence firms to provide an extra layer of fund validation and risk mitigation.  Third-party diligence providers that have neither a financial interest in the asset allocator, the fees it collects or the allocator’s stable of fund managers are able to render objective, independent and unbiased reports about a fund manager’s operational control structures.  More importantly, third party diligence firms are best positioned to perform the appropriate level of operational due diligence necessary to identify a fund manager’s high-risk practices that are often lurking behind the delicate “privacy” curtains that have come to exist as a result of the long-term personal relationships forged between the asset allocator and the fund manager. 

Most importantly, by vetting existing or new fund managers through a third party diligence review prior to recommending clients to invest in them, leading asset allocators are able to “get ahead of the curve” and identify potential risky practices that could ultimately lead to significant liability down the road.  In a role similar to that of independent financial auditors, third-party due diligence firms offers both a “seal of approval” and an invaluable risk mitigation service. 

David Benoit is a founder and managing partner of Pelorus Advisors, a leading authority on Capital Risk Management.  As former counsel to a large insurance-based investment adviser, David brings practical experience and legal insight to the firm’s Hedge Fund Investor Assurance practice group.  Pelorus supports leading investors in the alternatives space, including pension funds, endowments, fund of funds and asset allocation organizations.

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