SEC Action Against Custodian to Fraudulent Hedge Fund Manager Limns the Spectrum of Service Provider Culpability

The SEC recently charged a brokerage firm and its president (Defendants) with helping a hedge fund manager conceal trading losses from investors and misappropriate investor funds.  According to the SEC, the Defendants were necessary to the success of the fraud, and the Defendants received payments from the manager for participating in his scheme.  If the SEC’s factual allegations are accurate, then the Defendants were knowingly complicit in the underlying fraud, and thus effectively participants.  But what if the Defendants were not knowingly complicit but rather received “storm warnings” of the fraud, or identified red flags then did nothing, or not enough?  Or what if red flags could have been uncovered with reasonable investigation, but the Defendants failed to uncover them?  This article describes the factual and legal allegations in this matter, and briefly considers the foregoing questions.  For a stark illustration of the challenges facing a service provider to a fraudulent hedge fund manager, 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).

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