Kathy Bazoian Phelps
Senior Counsel in Ponzi Scheme Litigation
and Bankruptcy Matters

Kathy is a senior business trial attorney with more than 30 years experience prosecuting and defending claims for high net worth clients involved in Ponzi scheme matters and in bankruptcy proceedings. Kathy’s practice includes recovering assets for clients in complex fraud cases under standard fee and alternative fee arrangements. She also handles SEC and CFTC whistleblower claims. Kathy also serves as a mediator in bankruptcy matters, in complex business disputes, and in matters requiring detailed knowledge about fraud or Ponzi schemes.

Kathy’s Clients in Ponzi Scheme Cases and Bankruptcy Matters
Equity Receivers
Bankruptcy Trustees
High Net Worth Investors
Debtors in Bankruptcy
Secured and Unsecured Creditors

Tuesday, June 26, 2012

Hedge Fund Liability for Inadequate Due Diligence

Posted by Kathy Bazoian Phelps
Due diligence is not just for the buyer, auditor, or investor anymore. It is for everyone, including the hedge fund investing in sub-hedge funds. One court recently found a hedge fund liable for failing to conduct adequate due diligence and then misrepresenting to its investors the amount of due diligence that it actually conducted. Schwarz v. ThinkStrategy Capital Management LLC, 2012 U.S. Dist. LEXIS 79453 (S.D.N.Y. May 31, 2012)
Investors in a hedge fund, ThinkStrategy Capital Management LLC, sued ThinkStrategy and its sole member/managing director, Chetan Kapur, for misrepresenting the amount of due diligence they conducted in the other hedge funds in which they were investing (the “sub-hedge funds”). The plaintiff investors brought claims under New York state law for fraud, negligent misrepresentation, and breach of fiduciary duty against ThinkStrategy and its director.
Many of the sub-hedge funds into which the defendants poured the investors’ funds were fraudulent, causing the investors to suffer losses. The investors alleged that had the “sparse due diligence practices been truthfully disclosed to them, they would never have invested” with the defendants. Additionally, the investors alleged that the defendants concealed problems from them after they had invested which, if disclosed, would have caused the investors to immediately redeem their investments.
The court found for plaintiffs and awarded them $3,068,483, which was the total amount of plaintiffs' investment, net of redemptions that the investors had received.
So what did ThinkStrategy do wrong that led to liability? In summary, the court found that “ThinkStrategy's due diligence was cursory and that this diligence entailed virtually no independent verification of representations made to it by prospective sub-funds.” The decision runs through all kinds of misrepresentations that were made about the due diligence that was done, and the court found that the due diligence conducted by ThinkStrategy did not conform to industry standards. The court found that the four central misrepresentations were that the defendants: “(1) conducted background and reference checks on prospective sub-fund managers; (2) performed in-person interviews of sub-fund managers; (3) invested only in audited sub-funds; and (4) invested only in sub-funds with reputable service providers.”
The testimony revealed that “industry-standard due diligence on these funds would have revealed various red flags and irregularities that would have precluded a rational manager from investing client funds in them.”
The problem here was that ThinkStrategy represented that it was doing substantial due diligence. In reality, it wasn’t. And, as it turns out, seven of the twenty funds that ThinkStrategy invested in were fraudulent.
The court found that the defendants were liable for common law fraud.
The evidence established that Kapur made knowingly false representations to plaintiffs about a variety of subjects. . . The Court also readily finds that these statements were made for the purpose of inducing plaintiffs to rely, by investing in the TS Fund, and that plaintiffs did justifiably rely on those statements. The Court also finds that these false representations caused injury to plaintiffs: The Court fully credits plaintiffs' testimony that, but for these representations, they would not have invested in the TS Fund.
The court also found that the defendants were liable for negligent misrepresentation.
The defendants undeniably had a duty, as a result of their fiduciary role towards the [investors], to give them correct information. Defendants made false representations to the [investors], as set out at length above. The information in question (as to ThinkStrategy's due diligence practices generally, and also as to whether the TS Fund had invested in Bayou) was known by defendants to be desired by the [investors] for a serious purpose. The [investors] intended to rely and act upon the information supplied by the defendants. And, the [investors] reasonably relied on the false and incomplete information supplied by the defendants to their detriment.
The court additionally found that the defendants were liable for breach of fiduciary duty.

The plaintiffs had entrusted their savings to ThinkStrategy and Kapur, and defendants had a duty not only to handle plaintiffs' money with due care but also to make sure that any representations made to plaintiffs with regard to ThinkStrategy's investment of their funds were followed through on . . . . Here, that duty was breached when defendants failed to follow through on various false and misleading representations to plaintiffs, chronicled above, and when defendants failed to correct those representations. For the same reasons as discussed above, defendants' false statements and representations caused damages to plaintiffs, by inducing them to invest money with ThinkStrategy which was later lost, and by leading them not to exercise their right to redeem their investments. The Court therefore finds for plaintiffs on their claim for breach of fiduciary duty.

The court went further to find that the managing director of ThinkStrategy was individually liable for these torts.
When a corporate officer commissions a tort through misfeasance or malfeasance (as opposed to a mere failure to act), that officer may be held individually liable "regardless of whether the officer acted on behalf of the corporation in the course of official duties and regardless of whether the corporate veil is pierced."
The court rejected the defendants’ defense that the Offering Memorandum contained disclaimers that put investors on notice not to rely on statements or representations made, along with the defense that plaintiffs did not demonstrate loss causation as part of the breach of fiduciary duty claim.
The only good news for the defendants was that the court declined to impose punitive damages, noting that:
[A]lthough the evidence revealed dismaying misconduct by Kapur, amply justifying liability for fraud, negligent misrepresentation, and breach of fiduciary duty, it did not, in the Court's view, meet the higher bar of moral culpability required under New York law for the imposition of punitive damages. There was no evidence presented, for example, that Kapur absconded with plaintiffs' money. On the contrary, the evidence suggests that he, too, was decimated by the collapse of the sub-funds, and there is no evidence that Kapur knew of their wrongful machinations, as opposed to his being a gullible, negligent, and inept investor. Thus, although the Court easily finds that defendants engaged in tortious, callous, and unprofessional behavior, plaintiffs have not proven that defendants' conduct reaches the level of gross, willful, or wanton fraud necessary to justify imposition of punitive damages.
A thorough discussion of claims for fraud, negligent misrepresentation, and breach of fiduciary duty may be found in The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes (LexisNexis 2012) by Kathy Bazoian Phelps and Hon. Steven Rhodes.

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