A New York state court recently dismissed claims brought by the liquidator of a hedge fund against the fund’s accountants on the ground that the claims were barred by the doctrine of in pari delicto. Bullmore v. Ernst & Young Cayman Islands, No. 104314/05 (June 19, 2008). The decision diverges from the current general trend in the law in which many courts have held that a liquidator/receiver who commences an action on behalf of a corporation is not bound by the in pari delicto doctrine.

In August 2002, Beacon Hill Master Ltd., a Cayman Islands hedge fund that invested mainly in mortgage-backed securities, sustained major trading losses and ultimately collapsed. The SEC initiated an action against the investment managers of the fund after being alerted to the fund’s alarming financial condition. The SEC alleged that fraudulent valuation methods employed by the fund’s investment managers were the cause of the fund’s demise. The investment managers accepted an entry of a consent judgment against them and resigned without admitting any wrongdoing.

In March 2005, plaintiffs Theo Bullmore and Phillip Stenger, as joint official liquidators of the fund appointed by a Cayman Islands court, filed a lawsuit on behalf of the fund against various defendants, including the Fund managers, auditors (Ernst & Young Cayman Islands), and administrator (ATC Fund Services (Cayman) Limited). The liquidators alleged that Ernst & Young failed to conduct an audit in accordance with GAAP, failed to detect the managers’ fraudulent valuation and failed to alert the directors of the fund, resulting in the fund’s losses.

Ernst & Young moved for summary judgment and argued, among other things, that the wrongful actions of the managers were imputed to the fund, and therefore, based on the in pari delicto doctrine, the liquidators were barred from asserting a claim for negligence. The liquidators responded by arguing that the managers by their acts had abandoned their duties to the fund and that the liquidators were seeking to recover damages to the fund that would benefit innocent investors only, not the ousted managers who perpetrated the alleged fraud. The court concluded that the in pari delicto doctrine applied because the fund managers were acting within the scope of their employment when they allegedly inflated the value of the fund’s portfolio, and thus their acts were properly imputed to the fund. The court found the exceptions to the doctrine for “adverse interest” and “innocent investor” to be inapplicable.

For a copy of the decision, please click here.