In a highly anticipated decision, the United States Court of Appeals for the Second Circuit affirmed last week that investment advisor Hennessee Group LLC could not be liable on the claims asserted by one of its clients for recommending that the client invest in a hedge fund that turned out to be nothing more than a Ponzi scheme perpetrated by Bayou Group LLC. South Cherry Street, LLC v. Hennessee Group LLP, et al., No. 07-3658-cv (2d Cir. July 14, 2009). The plaintiff, South Cherry Street LLC, accused Hennessee of failing to conduct rigorous due diligence before recommending the Bayou hedge fund. According to South Cherry, Hennessee violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder by misrepresenting the level of due diligence that it would conduct before recommending the investments. South Cherry also accused Hennessee of violating under state law its oral agreement to perform that due diligence as well as breaching its fiduciary duty to perform that due diligence.

South Cherry allegedly invested $1.15 million in Bayou Group affiliates based on the Hennessee’s recommendation. Hennessee is an investment advisor that specializes in advising clients about investments in hedge funds. Hennessee allegedly told South Cherry that it conducted a “rigorous five-step due diligence review” before recommending that any client invest in a particular hedge fund. Hennessee then issued positive reports about Bayou Group and recommended that South Cherry invest in certain hedge funds managed by Bayou. South Cherry claimed that once the Ponzi scheme came to light, it became apparent that Hennessee Group either failed to perform the promised due diligence or that it did so in a deficient manner.

The Second Circuit, however, upheld the dismissal of both the federal securities and state law claims asserted by South Cherry. With respect to the securities claim, the Second Circuit concluded that the Complaint “lack[ed] sufficient factual allegations to give rise to a strong inference of either fraudulent intent or conscious recklessness.” According to the Second Circuit, the Complaint contained no allegations that Hennessee thought the actual disclosures by the Bayou hedge funds were inaccurate or that Hennessee ignored obvious signs of fraud. On the contrary, the Complaint only alleged that Hennessee failed to perform due diligence sufficient to uncover the fraud.

The Second Circuit also rejected the idea that Hennessee intentionally mislead South Cherry about the level of due diligence it would perform in order to induce South Cherry to invest in Bayou's fund. According to the court, “the factual allegations in the Complaint [did] not give rise to a strong inference that the alleged failure to conduct due diligence was indicative of an intent to defraud.” According to the Second Circuit, the only motive cited in the Complaint that would suggest that Hennessee intentionally misled investors about its level of due diligence was the fact that Hennessee received a fee when investors followed its recommendations. That motive, according to the Second Circuit, was far from cogent or compelling, as required under Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 814 (2007) (“[A]n inference of scienter must be more than merely plausible or reasonable – it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.”). Although the Second Circuit concluded that Hennessee may very well have been negligent in failing to perform adequate due diligence, it concluded “(a) that the factual allegations in the Complaint do not give rise to a strong inference of either fraudulent intent or conscious recklessness, and (b) that the inferences advocated by South Cherry are not as compelling as an inference of negligence.”

The Second Circuit also upheld the District Court’s dismissal of the state law contract claim based on the statute of frauds, concluding that the oral agreement relied upon was not enforceable. According to the Second Circuit, the plaintiff, South Cherry, had unilateral discretion over whether the oral contract would last over a year. Under such circumstances, New York’s statute of frauds requires that such contracts be in writing. The alleged contract here, however, was oral and, therefore, violated New York's statute of frauds.

Finally, on an issue unique to New York state law, the District Court had ruled that New York's Martin Act precluded any state law remedy based on breach of fiduciary duty and the Martin Act affords investors no private right of action. The District Court also ruled that there is no private right of action for breach of fiduciary duty claims under the Investment Advisers Act of 1940. South Cherry did not appeal either of those rulings and the Second Circuit did not consider those issues.

The Second Circuit’s decision could have a significant impact on feeder fund and fund of funds claims against investment advisors that have been filed in the last year over different fraudulent hedge fund schemes to the extent that those claims are based either on the Exchange Act or New York state law. The fact that the advisor cannot be held liable under the Securities Exchange Act for failing to perform adequate due diligence without evidence that the advisor had no intention of doing so at the time the representation was made substantially decreases the advisor’s potential exposure under the Exchange Act. Likewise, although the Martin Act is a powerful tool in the hands of the New York Attorney General, it unfortunately eviscerates state law remedies that otherwise would be avaialble to New York investors.

For a copy of the decision, please click here.