Not Time Yet for Third-Party Service Providers to Breath Easy

This week’s Stoneridge Investment Partners decision from the U.S. Supreme Court, along with the recent Seward & Kissel decision from New York’s Appellate Division, First Department (both of which are noted below), are being celebrated by third-party service providers to hedge funds, among others. However, these cases should not be viewed as a blanket protection. Investor lawsuits seeking to reach into the perceived “deep pockets” of third-party service providers are not simply going to go away. They will merely come at the service providers from a different angle. Some possibilities that immediately come to mind:

Direct actions in the name of the investor

Common law fraud. While the Stoneridge decision insulated third party providers from 10(b)(5) claims for securities fraud, it does not eliminate the possibility that third party providers could be liable on a theory of common law fraud for making false or misleading statements upon which investors rely. The Seward & Kissel decision doesn’t insulate service providers accused of fraud as much as some may think; the basic analysis is still whether a defendant who makes a fraudulent statement anticipated and intended that the plaintiff would rely on that statement (the discussion of the need for a fiduciary relationship in the Seward & Kissel case dealt with omissions, not affirmative statements). In certain cases, this requirement of forseeability may protect the defendant, but in others it may not.

Aiding and abetting. A defendant may be held liable for aiding and abetting a breach of fiduciary duty if that defendant is found to have had knowledge of the fiduciary duty that was owed and provided substantial assistance in the breach. Defendants can also be civilly liable for aiding and abetting fraud under a similar analysis.

RICO. An investor may bring a civil RICO action if it appears that an outside service provider acted in concert with the management of a fund to violate securities laws or other laws.

Actions in the name of the hedge fund

Derivative actions. Most funds are set up as LLCs or limited partnerships. The statutes and court decisions in most states allow minority members of LLCs and LPs to bring derivative actions (under the appropriate circumstances) on behalf of the company to enforce the rights of the company. In other words, even if the management of a fund does not want to sue its third-party providers, a minority member may be able to force the issue.

Financial pressure. Large investors, especially if they band together, may be able to pressure the fund’s otherwise reluctant management to bring actions in the name of the fund against third-party service providers.

Trustees and Receivers. If a hedge fund really begins to struggle, watch out. Courts can appoint receivers, and bankruptcy courts routinely appoint trustees, to manage the financial matters of a failing business during dissolution, liquidation or reorganization. Trustees and receivers will have the ability to assert claims and bring lawsuits on behalf of the hedge fund. Thus, even though an investor may not be able to make a direct claim for securities fraud or malpractice against a third-party provider, the trustee or receiver can. Moreover, while the management of a fund may be very reluctant to sue its trusted accountants, lawyers, or business partners, a receiver or trustee will have no hesitation if it appears that those third-party providers may be liable to the fund.

While the Stoneridge and Seward & Kissel decisions will provide some measure of protection for third-party service providers, dogged investors and creative attorneys will keep coming after the deep pockets when hedge funds stumble and fall.

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About Amir

I hate doctors!
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