Massachusetts Appeals Court Holds That Hedge Fund Investors Can Sue Hedge Fund Auditor Based on Payment of Taxes on Fraudulent “Phantom Income”

Can a hedge fund investor sue the hedge fund’s auditor if the fund turns out to be a fraud?  While courts have come down on both sides of this question, the thrust of the caselaw has thus far been unfavorable to investors and favorable to auditors and other service providers seeking to avoid liability.  See, e.g., “When Can Hedge Fund Investors Bring Suit Against a Service Provider for Services Performed on Behalf of the Fund?,” Hedge Fund Law Report, Vol. 6, No. 18 (May 2, 2013).  However, the Massachusetts Appeals Court (Court) recently upheld a trial court decision allowing investors in a fraudulent hedge fund to proceed with a suit against the funds’ auditor.  In particular, the Court identified various direct claims available to the hedge fund investors based on (among other things) the passing through of profits and losses to investors and the payment of taxes by investors on phantom income that did not exist.  For more on phantom income and the tax consequences of it, see “How Can Hedge Fund Managers Use Profits Interests, Capital Interests, Options and Phantom Income to Incentivize Top Portfolio Management and Other Talent?,” Hedge Fund Law Report, Vol. 6, No. 33 (Aug. 22, 2013).  The Court’s decision may create opportunities for investors in similar factual scenarios (and in disputes governed by Delaware law) to take direct action against auditors and other hedge fund service providers, at least where investors suffer a harm independent of any harm suffered by the fund.  This article summarizes the factual background of the case, the Court’s legal analysis and the implications of the Court’s decision.

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