Firm that Recommended Investment in Ponzi Scheme Not Liable for Securities Fraud
The US Court of Appeals for the Second Circuit has dismissed the securities fraud claim brought against a firm that recommended investing in a hedge fund that was a Ponzi scheme. The Court opined that the Defendant lacked the necessary intent to deceive required by Section 10(b) and Rule 10b-5 because it did not have actual knowledge that the recommended investment was a Ponzi scheme and that its representations about the fund were untrue. Rejecting the Plaintiff’s argument that the Defendant’s purported due diligence should have uncovered the fraud, the Court stated that the Plaintiff’s complaint did not allege that there were “obvious signs of fraud, or that the danger of fraud was so obvious that [the Defendant] must have been aware of it.”
OUR TAKE: This case will serve as a significant precedent for feeder funds and advisers that have recommended bad investments resulting from the fraud by the underlying sponsor. While the Second Circuit does not give permission to intentionally (recklessly?) ignore warning signs, a plaintiff must still prove that the adviser had actual knowledge of the fraud. One open question is whether the SEC will apply the same standard in regulatory enforcement actions against registered advisers.