FREE DOWNLOAD: Daniel Glosband on In re Manhattan Fund Ltd.
Not Just Cocktail Party Talk: Prime Brokers and the Need to Know Your Hedge Fund Clients
In the case of In re Manhattan Investment Fund Ltd., 2007 U.S. Dist. LEXIS 92194 (Bankr. S.D.N.Y. 2007), the United States District Court for the Southern District of New York overturned a bankruptcy court ruling which would have held Bear Stearns liable for almost $160 million in connection with its role as prime broker for the Manhattan Investment Fund, a technology stock focused short-selling hedge fund, alleged to have enticed investors into a Ponzi scheme. Daniel Glosband discusses the case, in which the district court has given Bear Stearns an opportunity to prove that it accepted the nearly $141.4 million transferred by the hedge fund into a Bear Stearns margin account in good faith. He writes:
First, the District Court affirmed that actual fraud existed as a matter of law under Section 548(a)(1)(A)7 [of the Bankruptcy Code], which provides for avoidance of any transfer made by the debtor in the year prior to the filing of its bankruptcy petition as a fraudulent conveyance provided that the transfer was made with actual fraudulent intent. The District Court concurred with the bankruptcy court’s finding that the Fund operated as a Ponzi scheme, and the transfers to its margin account were made in furtherance of the scheme because the Fund had to maintain its margin account in order to continue with its strategy of short-selling stocks. Under the Ponzi scheme presumption, such a scheme demonstrates actual intent as a matter of law because transfers made in the course of a Ponzi scheme could have been made for no purpose other than to hinder, delay or defraud creditors.
The District Court further affirmed that Bear Stearns was an “initial transferee” under section 550(a)11 of the Code because Bear Stearns, while not a “mere conduit,” had “dominion and control” over the transferred funds. The District Court reasoned that Bear Stearns had control over the transfers while the Fund’s short positions were open, had the ability to close out the Fund’s short positions at any time and that Bear Stearns in fact used the money to cover certain of the Fund’s positions. Accordingly, Bear Stearns was an “initial transferee.” Under section 550(a), a transfer which can be avoided under the Code can be recovered from an initial transferee, unless the transferee can establish that it accepted such transfers in good faith.
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Next, the District Court considered whether Bear Stearns could prevail on its good faith defense by showing that its investigation was diligent. The Trustee argued that Bear Stearns was not diligent because the Fund’s fraudulent activity would have been exposed earlier had the actions taken by Bear Stearns in December 1999 of running a credit check and contacting other prime brokers been taken in 1998. Under the summary judgment review standard, viewing the facts and inferences in favor of Bear Stearns, the District Court could not find as a matter of law that Bear Stearns should have taken the actions in December 1998 that it eventually took in December 1999. First, the circumstances changed between 1998 and 1999 in that Bear Stearns begin to witness investor redemptions, increased margin calls and correspondence with an investor about its inquiries into the Fund. Additionally, Bear Stearns took other steps such as notifying Deloitte of a potential problem, obtaining the Fund’s financial statements and informing the SEC of the Fund’s misrepresentation. Therefore, the District Court could not find that no reasonable jury could find Bear Stearns’ actions diligent.
(footnotes omitted)