In Bullmore v. Ernst & Young Cayman Islands, a New York County Supreme Court justice held that a malpractice claim asserted against the auditor of a failed hedge fund was barred by the fraudulent conduct of the investment managers who controlled the operation of the fund. The decision is notable for its analysis and application of the in pari delicto and Wagoner rules of law, which generally are encountered in the bankruptcy courts, rather than the state courts. The Bullmore decision aptly summarizes the basis for what can be an absolute defense to an audit failure claim arising out of a business failure caused by the conduct of management.
Bullmore v. Ernst & Young Cayman Islands
Beacon Hill Asset Management, LLC (â€œAsset Mgt.â€) was formed in 1997 as an investment manager for hedge funds investing in mortgage-backed and related securities. Asset Mgt. and its principals formed several such hedge funds, including Beacon Hill Master Ltd. (the â€œFundâ€), which was formed in January 2002. The operation and investment decisions for the Fund were handled exclusively by Asset Mgt. Although the Fund had a board of directors, which included two outside directors, the directors never held any meetings and delegated all day-to-day decisions to Asset Mgt. Asset Mgt. had â€œunfettered controlâ€ over the operation and investment decisions of the Fund.
The Fund engaged Ernst & Young Cayman Islands (â€œEYCIâ€) to audit its financial statements for the period January 2, 2002 through March 31, 2002. EYCI issued a clean audit opinion on these statements.
In August 2002, the Fund sustained heavy trading losses, apparently based on the Fundâ€™s poorly timed bet on the future movement of interest rates. In October 2002, Asset Mgt. told the outside directors that the Fund had lost nearly half of its net asset value. That same month, the Fundâ€™s broker, Bear Sterns, also learned of the Fundâ€™s deteriorated financial condition, determined that it would discontinue financing the Fund, and alerted the SEC.
On November 7, 2002, the SEC commenced an action against Asset Mgt. and its principals for securities fraud based upon allegedly fraudulent valuation of the securities in the Fund. In 2004, joint official liquidators (â€œJOLâ€) were appointed to pursue claims on behalf of the Fund, and, in March 2005, they commenced suit against a number of parties, including EYCI. The JOL alleged that EYCI was negligent in failing to identify the fraudulent valuations during the audit.
After reviewing the in pari delicto and Wagoner rules of law, the court granted EYCIâ€™s motion and dismissed the JOLâ€™s negligence claim. In pari delicto and the Wagoner doctrine are related legal theories most often encountered in the bankruptcy context. In pari delicto literally means â€œin equal fault.â€ It is a common law theory, which bars a plaintiff from recovering from a defendant where each is equally at fault. The Wagoner doctrine comes from a line of cases holding that the misconduct of the debtorâ€™s management deprives the debtorâ€™s representative, typically the trustee, of the right to sue third parties because the actions of the managers are â€œimputedâ€ to the debtor. Application of the in pari delicto defense and the Wagoner rule has been uneven in prior cases.
In Bullmore, the court concluded that both doctrines were applicable to the JOLâ€™s claims against EYCI and that dismissal of the JOLâ€™s claims against EYCI was appropriate. In reaching this conclusion, the court determined that Asset Mgt. was acting within the scope of its responsibility and had not â€œtotally abandonedâ€ its fiduciary duties owed to the Fund such that its conduct should not be imputed to the Fund. In particular, the court noted that Asset Mgt.â€™s actions permitted the Fund to attract and retain investors and keep its much needed financing open with Bear Stearns. The court particularly emphasized the fact that Asset Mgt. was not stealing from the Fund or diverting its assets and, even though Asset Mgt. may have received higher fees as a result of the fraudulent valuations, the Fund also benefited.
The court then went on to analyze the JOLâ€™s assertion that EYCIâ€™s conduct caused, or at least contributed, to the Fundâ€™s demise because the outside directors would have taken action if EYCI properly advised them of the fraudulent valuations. Sometimes referred to as the â€œinnocent insiderâ€ exception to the Wagoner rule, the court determined that the exception did not apply because the directors had delegated all responsibility to Asset Mgt., giving it â€œunfettered controlâ€ over day-to-day operations. Since the directors had not taken any action when advised in October 2002 of the huge decrease in the Fundâ€™s NAV â€” there was no investigation initiated, Asset Mgt. was not removed as managers and, Bear Stearns, not the directors, reported the problem to the SECâ€”the court concluded the directors were unwilling or unable to stop the fraud. In addition to rejecting the â€œwould-a, could-a, should-aâ€ standard for determining imputation, the court also concluded that the directors were not innocent, since they abdicated all responsibility and even signed a management representation letter for EYCI confirming the accuracy of the Fundâ€™s financial statements without ever having reviewed those financial statements.