Hedge Fund Fraud: An English Law Perspective On The Potential Exposure Of Prime Brokers

It was revealed in early January 2007 that the Financial Services Authority ('FSA') is conducting a study with the Federal Reserve Bank of New York and the US Securities and Exchange Commission (amongst others) to examine counterparty credit risk exposures to hedge funds, and collateral policies, procedures and practices.1 One concern of the regulators is that prime brokers may be allowing hedge funds to reduce their margin requirements by using illiquid collateral (such as credit default and total return swaps) that may lose its value in the event of a financial crisis, in an attempt to secure a competitive advantage.

This article reviews a New York case in which Bear Stearns has recently been ordered to pay US$125m plus interest to the estate of Manhattan Investment Fund ('MIF') because Bear Stearns ignored clear signs (and its suspicions) that MIF's manager was defrauding investors. Allegations were also made that margin requirements were waived or reduced. We analyse how this case might be treated under English law.


In 1995, Michael Berger (a 28-yearold investment manager) established MIF as an open end investment company under the laws of the British Virgin Islands ('BVI'). Th rough a wholly owned New York company, Manhattan Capital Management Inc ('MCM'), Berger served as the investment manager and advisor for MIF. All of MIF's assets were held in custody in New York by Bear Stearns.

MIF commenced trading in spring 1996, with an investment strategy that primarily involved the concentrated short selling of securities of overvalued US technology companies. Bear Stearns was the prime broker and the only broker to extend margin credit in connection with the clearing and settlement of MIF's trades.

According to Bear Stearns' reports, Berger began losing money from MIF's inception, but its monthly account statements showed profitable performance. Berger was operating a 'Ponzi scheme' in which the performance and assets of MIF were inflated to encourage new infusions of investor cash. Th e new investor cash was being used to conceal MIF's mounting losses. In early 2000 Berger admitted the fraud, following an SEC investigation. A Chapter 11 Trustee was appointed to MIF in April 2000.


The Chapter 11 Trustee's claims against Bear Stearns were for:

Count I: US$141.1m in margin payments transferred to Bear Stearns in the year before the commencement of Chapter 11 proceedings (the 'Transfers').

Count II: US$1.7bn in short sale proceeds generated by the sale of stock that MIF had borrowed from Bear Stearns.

Count III: US$1.9bn worth of securities purchased with the short sale proceeds (plus other monies in the MIF margin account) and delivered to Bear Stearns to cover stock loans to MIF.

Count IV: Equitable subordination of any claim that Bear Stearns might assert in the MIF Chapter 11 proceedings.

In March 2002, the New York Court granted Bear Stearns' motion to dismiss Counts II and III, on the grounds that MIF did not have an interest in the transfers underlying those two counts.

As regards Count I, in summary Bear Stearns contended that (i) it lacked control over the Transfers and was therefore not a 'transferee' within the meaning of s 550(a) of the Bankruptcy Code; (ii) the Trustee had not met her burden of proof that the Transfers were to defraud MIF creditors; (iii) the Transfers should not be recoverable from Bear Stearns on policy grounds; and (iv) Bear Stearns acted in good faith in accepting the Transfers.

The New York Court decided that there was sufficient evidence that Berger was operating a Ponzi scheme. Accordingly the question was whether the Transfers should be recovered from Bear Stearns as a 'transferee' under s 550(a) of the Bankruptcy Code. Th e key issue was whether Bear Stearns had control over the Transfers. Th e Court decided that it did: Bear Stearns had security over the monies transferred; it held those monies as collateral for short sales; it had the right to and did prohibit MIF from withdrawing the monies transferred as long as any short position remained open; and it had the right to and did use the monies transferred to purchase covering securities, with or without MIF's consent. Bear Stearns' policy arguments were dismissed, given the express provisions of the Bankruptcy Code permitting the avoidance of margin payments. Further, Bear Stearns was on 'inquiry notice' as from December 1998 after it was told by those representing investors in MIF that MIF was reporting a 20 per cent profit for the year, when its own calculations were that MIF was losing money (in fact MIF had lost US$180m in 1998). Berger's explanation was that Bear Stearns was not the only prime broker for MIF. Bear Stearns did not verify this false statement, which would have been revealed as false from MIF's financial statements. Moreover, Bear Stearns' actions afterwards demonstrated that it was not entirely comfortable with Berger's explanation. Th e New York Court considered that Bear Stearns was required to do more than simply ask Berger if he was doing wrong. It had to consult any 'easily obtainable sources of information that would bear on the truth of any explanation received from the potential wrongdoer'. Summary judgement was ordered in favour of the Chapter 11 Trustee on Count I.2 Bear Stearns has said that it will appeal.3

In a separate action, MIF investors brought a class action against Bear Stearns, claiming over US$400m. In summary, the investors alleged that Bear Stearns permitted MIF to exceed margin regulations set down by the Federal Reserve Bank, the NYSE and Bear Stearns' internal rules. Berger used that credit to trade and generate huge losses that further increased the margin debt. Bear Stearns then agreed to await an influx of new investor monies to satisfy the debt, and once the new money was used to repay the margin debt, the cycle recommenced. As a result...

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