Bankruptcy Court Ruling Affects Potential Hedge Fund Risks

A White Plains, New York, bankruptcy judge has recently ruled that investors in a failed hedge fund could try to recoup their losses from other investors who had redeemed their interests before the fund collapsed.

In this situation, the principals of two investment funds were convicted of federal fraud charges.  Both admitted in court that they had operated Ponzi Schemes by paying investors who were redeeming their interests in the funds with new cash inflows in order to perpetuate the fraud.

The principals admitted to providing bogus financials and performance results that had been “audited” by a phony auditing firm.  Current and prospective clients were sent these “audited” financial statements to induce them to invest in the fund and/or to keep them currently invested.   The court determined that these actions constituted not only a fraud against the fund’s investors but also an intent to hinder or defraud creditors, thus making all money paid to third parties (including early redeemers) fair game for recovery under the bankruptcy statutes.

After the funds filed for bankruptcy, the trustee sued investors who had previously redeemed their interests on the grounds that the fund had lost the earlier investors money and could not legally pay them with new money brought in as part of the Ponzi scheme. 

The bankruptcy judge intends to let the plaintiffs proceed with their case unless the early redeemers can prove they accepted the funds in good faith and that such funds were bonafide.  The issue is further complicated by the prospect that the early redeemers may have also relied upon the same falsified finanicals as the later investors when they made their decision to redeem their investment.