The amount of due diligence that hedge fund prime brokers should conduct with respect to the source of funds deposited and maintained in brokerage accounts has been a topic of keen interest for hedge fund managers, investors and prime brokers, particularly in light of the ongoing litigation between the creditors of the defunct Bayou Group funds and the funds’ prime broker, Goldman Sachs Execution & Clearing, P.C. (GSEC). See “Does a Prime Broker Have a Due Diligence or Monitoring Obligation When Paying With Soft Dollars for a Hedge Fund Customer’s Access to Expert Networks or Other Alternative Research?
,” Hedge Fund Law Report, Vol. 3, No. 49 (Dec. 17, 2010). In the latest round of that litigation, a three-judge panel of the U.S. Court of Appeals for the Second Circuit denied GSEC’s appeal of a district court ruling that upheld a $20.6 million arbitration award against GSEC. See “District Court Suggests That Prime Brokers May Have Expanded Due Diligence Obligations
,” Hedge Fund Law Report, Vol. 3, No. 44 (Nov. 12, 2010). The arbitrators’ decision, seemingly based in part on the theory that GSEC should have identified red flags in connection with the Bayou fraud, was not rendered in “manifest disregard of the law,” suggesting that prime brokers are indeed at risk for such types of claims. See “Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices
,” Hedge Fund Law Report, Vol. 4, No. 25 (Jul. 27, 2011). This article analyzes the Second Circuit’s Summary Order.