When money management firm South Cherry Street lost its entire $1.15 million investment in a hedge fund that turned out to be Ponzi scheme, it sued its investment adviser.
The amount of money may have been small by Wall Street standards, but the implications were big in the high-profile case because it resembles dozens of lawsuits against feeder funds that funneled money to the big kahuna of Ponzi schemes--Bernard Madoff.
But a 2005 Securities and Exchange Commission report found Bayou to be a Ponzi scheme. Its principals pleaded guilty and were eventually convicted of securities fraud. South Cherry alleged in its complaint that Hennessee could not have performed any real due diligence beginning in 2003. If it had, it would have learned that Bayou's principal trader, Samuel Israel, wasn't so seasoned after all. Moreover, in 1998 Bayou replaced its independent auditor with Richmond Fairfield, a firm that turned out to be owned by another Bayou principal. Thus, South Cherry charged, Hennessee was grossly negligent or reckless in passing along Bayou's doctored financial figures.
But the 2nd Circuit panel found that Hennessee fell short of the scienter requirement. Nowhere is there any allegation that the adviser had knowledge its representations were untrue, the court held. Instead, the complaint alleges that Hennessee "would have learned the truth" if it had performed the due diligence that it promised. Those allegations "do not give rise to a strong inference that the alleged failure to conduct due diligence was indicative of an intent to defraud," the court found.