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

Last Updated: 24 August 2007
Article by Kit Jarvis and Zachary Segal

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-year old 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, Bear Stearns earned fees and margin interest on the fund's account. Th e investors alleged that Bear Stearns knew, or should have known, that new investors in the fund were unaware of MIF's true financial position. Consequently, Bear Stearns enabled Berger to raise money from unsuspecting investors to pay off margin debts, thereby generating income for the broker. Th e investors also alleged that Bear Stearns extended margin credit to MIF in order to keep MIF liquid long enough to enable an inner circle of investors to withdraw from MIF, at the expense of unsuspecting investors.

Th e investors' legal claims against Bear Stearns were for aiding and abetting Berger's common law fraud and breach of fiduciary duty. Under New York law, a claim for aiding and abetting fraud requires a claimant to demonstrate:

  • the existence of a fraud;
  • the defendant's knowledge of the fraud; and
  • the defendant's 'substantial assistance' to advance the fraud.

Bear Stearns brought a motion to dismiss the investors' claim on the basis that Bear Stearns' actions did not substantially assist Berger's fraud. For the purpose of that motion, Bear Stearns did not contest the first two limbs above. Th e New York Court granted the motion to dismiss: a clearing broker does not provide substantial assistance to a fraud simply by clearing trades. Failing to enforce margin requirements, continuing to execute trades despite margin violations, or executing trades in order to reduce a loan of money under margin do not constitute substantial assistance, because credit and margin regulations are designed to protect the viability of brokers, not investors.4


Under English law the investors could have considered various different direct claims against Bear Stearns. We examine the two most obvious claims below, namely (1) dishonest assistance and (2) unlawful means conspiracy. We then review the difficult area of attribution, causation and contribution.

Dishonest assistance in breach of fiduciary duty

In Royal Brunei Airlines Sdn Bhd v Tan5 the Privy Council decided that dishonesty was a necessary and sufficient ingredient of accessory liability: a party who dishonestly procures or assists in a breach of trust or fiduciary obligation has a liability in equity to make good resulting loss. Th e standard of proof of dishonesty involves a high level of probability. In Twinsectra Ltd v Yardley,6 the House of Lords held that the defendant had to have a dishonest state of mind, an awareness that he was transgressing ordinary standards of honest behaviour. In Barlow Clowes International Ltd (in liquidation) and others v Eurotrust International Ltd,7 the Privy Council decided that the test for dishonesty was essentially an objective one, despite commentary to the contrary following Twinsectra. Lord Hoff man stated that:

'If by ordinary standards a defendant's mental state would be characterised as dishonest, it is irrelevant that the defendant judges by different standards.'

Most recently, in Abou-Rahmah v Abacha8 the Court of Appeal considered proceedings against a Nigerian bank that transferred payments by the claimants to customers who turned out to be accomplices to fraudsters. Arden LJ decided that the bank did not breach the standards of objective dishonesty if it had only general suspicions of impropriety: knowledge that use of a bureau d'exchange was a common means of laundering money and that certain Nigerian politicians, if corrupt, might seek to transfer money out of Nigeria was not sufficient

The investors' NY claims against Bear Stearns failed because the investors were unable to demonstrate that Bear Stearns' actions amounted to 'substantial assistance'; Bear Stearns had agreed that its knowledge was irrelevant for the purposes of the motion to dismiss. In contrast, the English Court has not decided precisely what amounts to assistance. However, if, as seems likely, the investors could demonstrate that Bear Stearns had more specific knowledge than was identified in Abou-Rahmah, it is possible that an English court would have decided that Bear Stearns did indeed assist Berger's fraud.

Unlawful means conspiracy

The MIF investors would have to demonstrate four elements:

  • a concerted action between Berger and Bear Stearns;
  • an overt act causing damage;
  • an intention to injure; and
  • unlawful means by which the injury is to be caused.

Th e existence of concerted action is a question of fact in every case. Th e investors would not need to demonstrate an express agreement between Berger and Bear Stearns – a combination and common intention is enough.9 Th ere would appear to be no difficulty identifying an overt act causing damage – Bear Stearns continued to extend margin credit to MIF, and/or any suggestion by Bear Stears to an inner circle of investors that they should pull their investment out of MIF ahead of the impeding collapse of MIF would have caused damage to those investors who were not warned.

As to intention, the investors would not need to show that those persons combining had a predominant purpose to injure the MIF investors.10 However, an intent to injure is necessary. Merely resulting or incidental damage will not do, even if foreseeable or even inevitable.11 Therefore, the investors would need to show that Bear Stearns had an intent to inflict damage on the MIF investors, which might be difficult. However, there is some authority to suggest that a court may be prepared to infer intent to injure where wrongdoing is established. In Grupo Torras SA v Al-Sabah (No 5),12 Mance J stated that:

'in circumstances where persons combine to abstract monies from a group and then to cover up and account for the abstraction in any way they can, an intent to injure or defraud any company which, as a result of their operations, ends up bearing the loss, may readily be inferred.'

Given that comment, it is at least possible that an English court would be prepared to infer an intent to injure where a prime broker had made a profit (Bear Stearns made US$2.4m) from transactions which it knew were facilitating a Ponzi scheme.

A further difficulty facing the investors under this head of claim would be to demonstrate unlawful means. English cases are divided on whether the unlawful means complained of needs to be actionable per se by the claimant. Th e strict precedent position appears to be that it must: Powell v Boladz.13 Powell was a medical negligence claim, far removed from the facts of the MIF fraud. In a very recent case, Total Network SL v Customs and Excise Commissioners,14 the Court of Appeal held that it was bound by the decision in Powell. However, Ward LJ indicated that he disagreed with the reasoning in Powell.

Ward LJ's discomfort has been echoed by other senior judges. As Lord Phillips MR commented in Douglas v Hello! Ltd (No 3):15

'... it cannot be necessary for the unlawful means to amount to an actionable infringement of the claimant's own rights. Otherwise the tort [of unlawful means conspiracy] would be largely ineffective'.16

Clearly there is judicial support for a change in the law. However, until the House of Lords overturns Powell, English law may well deny the MIF investors a claim in unlawful means conspiracy against Bear Stearns because the MIF investors are unable to establish directly actionable unlawful means.

If Powell is overturned, the MIF investors might be able to rely on breaches of margin requirements to bring a claim in conspiracy against Bear Stearns. Th ere is no additional requirement of dishonesty in a claim for unlawful means conspiracy.

Attribution, causation and Contribution

Under English law, claims of dishonest assistance and/or conspiracy by an insolvency practitioner representing MIF are likely to raise difficult issues of attribution, causation and contribution. This is why, if possible, the investors might wish to focus on a direct claim against Bear Stearns.


In response to any claim by an insolvency practitioner representing MIF, Bear Stearns could reasonably respond that the knowledge and actions of Berger should be attributed to MIF, under the principles in Meridian Global Funds Management Asia Ltd v Securities Commission.17 Even if MIF board meetings were fairly frequent and the MIF board included independent non-executive directors, in circumstances where the investment management agreement between MCM and MIF will have given MCM a wide discretion to enter into investments on behalf of MIF, it seems likely that Berger's knowledge will be attributed to MIF.

Causation and contribution

So long as Bear Stearns provided relevant assistance to Berger's fraud, Bear Stearns will be liable for losses resulting from that fraud: Royal Brunei. Mance J held in Grupo Torras that proof of the specific causal connection between the assistance and loss is not necessary. However, it is difficult to envisage how dishonest assistance would not have some causative effect.

Once causation can be established, the question then is to what extent should Bear Stearns be entitled to a reduction in damages as a result of the actions of Berger which, as we have seen, are likely to be attributed to MIF. In Corporacion Nacional Del Cobre De Chile v Sogemin Metals and others,18 the claimants brought an action alleging (inter alia) that the defendants were parties to a conspiracy to bribe an employee to enter into contracts on terms which were unfavourable to the claimant. Th e claimant sought restitution in respect of bribes, damages for fraud and conspiracy and also claimed that the defendants had dishonestly assisted in breaches of trust. Th e defendants sought to reduce their liability on the basis that the claimant had not competently supervised its employee's activities and that senior executives should have looked more closely at the relevant contracts. Carnwarth J held that the mere fact that the claimant had an opportunity to discover the fraud and failed to take it was insufficient to constitute a defence or a ground for reducing damages.

In the present case, Bear Stearns could reasonably argue that even if it was liable in knowing assistance and/or unlawful means conspiracy, it was Berger who initiated the fraud and caused the investors' loss. Further, the argument goes, Corporacion Nacional could be distinguished because in MIF's case the fraud was perpetrated in the name of the fund itself. It is unclear whether the English court would be prepared to adopt this distinction.

Th e consequences of a finding that any damages payable by Bear Stearns should be reduced to take account of the blame attributed to the fund could be very serious for the MIF investors. By analogy, Barings Plc (in liquidation) v Coopers & Lybrand (a firm),19 was an audit negligence case, in which the auditors claimed contributory negligence by Barings. Evans-Lombe J held that Barings' own responsibility for its losses rose as it failed to manage Nick Leeson (also at the relevant time 28 years old) and continued to provide him with funds to trade. Accordingly, Barings' damages against its auditors were reduced by 50 per cent, rising to 80 per cent. Finally, the fault was attributed to Barings entirely, because the chain of causation was broken between the auditors' negligence and Barings' losses.

At this point in our analysis, it appears that the investors might be well advised to pursue direct causes of action for dishonest assistance or conspiracy by unlawful means against Bear Stearns, if those claims could be made out on the evidence. However, we have not yet considered fully the corporate structure of MIF. Another factor to weigh in the balance will be the additional cause of action that a liquidator of MIF could consider against Bear Stearns under s 213 Insolvency Act 1986. We now turn to these two issues.

MIF corporate structure

MIF was registered in BVI. If English law applied to the question whether MIF investors should be entitled to bring direct claims against Bear Stearns, the English Court would be reluctant to permit MIF investors (who have chosen to invest through a particular corporate structure) to bring direct claims to enforce MIF's rights. Exceptionally, a minority shareholder may bring a derivative action where a fraud has been committed on the company and the shareholder can demonstrate that the wrongdoers remain in control of the company and will not permit a claim to be brought (or that the wrongdoers have received some benefit),20 or where the shareholder can demonstrate (i) a breach of duty owed personally to him; and (ii) a personal loss separate and distinct from the company's loss.21 Diminution in the value of shares by reason of misappropriation of company assets is recoverable only by the company, as the shareholder has not suffered a distinct loss.22 A Chapter 11 Trustee was appointed to MIF who controlled potential claims on behalf of MIF, and it is unlikely that a MIF investor could demonstrate a sufficiently distinct duty or personal loss.23

Therefore, the MIF investors would be left to persuade the English court that this was one of the limited circumstances in which the court should lift the corporate veil. Even where a company was wholly owned and controlled by a single claimant, the purchase of high-risk investments by the claimant from the bank through the company did not lead to the bank owing a duty of care directly to the claimant, because the company was the bank's customer and the duty of care was owed to the company: Diamantides v JP Morgan Chase Bank.24 In Dadourian Group International Inc & Ors v Simms & Ors25 the court emphasised that ownership and control of a company are in themselves not sufficient to dislodge the principle of separate corporate identity, special circumstances must exist indicating that the company is a mere façade concealing the true facts. It was also held that the veil should only be lifted to provide a remedy for wrongs committed by those controlling the company. It seems highly unlikely that MIF could be demonstrated to be a mere façade. Further, the MIF investors would be claiming against Bear Stearns, and Bear Stearns did not control MIF.

BVI law is likely to be similar to English law on these issues. If so, MIF investors are likely to be prevented from bringing direct claims against Bear Stearns. However, if BVI law took a different approach (or MIF was registered in another jurisdiction that took a different approach), MIF investors should consider whether the English court might be persuaded that:

  • the issue whether MIF investors should bring an direct action concerned MIF's constitutional affairs;
  • the English court should apply foreign law to decide that issue; and
  • the foreign law applied would permit a direct claim.

Fraudulent trading

MIF was incorporated in the BVI. If MIF was subject to English insolvency proceedings,26 an insolvency practitioner might consider putting MIF into liquidation in order to pursue a claim against Bear Stearns under s 213 Insolvency Act 1986.27 If a liquidator of MIF could demonstrate that Bear Stearns knowingly participated in fraudulent trading by Berger, Bear Stearns could be ordered to make such contribution to the assets of the company as the court considered proper.

Section 213 requires intent to defraud, which in the case of Berger should be straightforward. If Bear Stearns could be demonstrated to have participated in Berger's fraudulent trading, then it could be required to contribute. A recent example of such a claim is Bank of India v Morris,28 in which the BCCI liquidators were not required to demonstrate that members of the board of Bank of India ('BOI') had knowledge of the fraud – BOI was fixed with the knowledge of the BOI employee who concluded the fraudulent transactions which were within his authority, even though he had acted dishonestly and in breach of his duty to BOI. BCCI claimed US$110m from BOI. However, Patten J (as upheld by the Court of Appeal) thought it appropriate to order BOI to make a contribution of US$82m29 to the BCCI insolvency, bearing in mind the contribution of others to BCCI's loss in the relevant period. Th e contribution ordered might be substantially greater than the amount Bear Stearns profited from MIF's trades (US$2.4m): BOI's profit on the relevant trades was less than US$500,000.


If the proceedings arising from the collapse of MIF against Bear Stearns had been brought under English and not New York law, Bear Stearns may well have been found liable to contribute to MIF's assets. English law, and probably BVI law, is likely to prohibit direct claims by MIF investors. However, a claim by a MIF liquidator under s 213 Insolvency Act 1986 is likely to prove particularly dangerous for prime brokers, bearing in mind the court's broad discretion to determine the level of contribution that should be ordered.

Th e lesson for prime brokers is that, in line with the New York Court's decision in the Manhattan case, the temptation to gain a competitive advantage by offering illegitimate benefits to hedge funds may well lead to substantial liability under English law if the prime broker finds itself mixed up in fraud at the fund.


1 Bloomberg, 9 January 2007, 'Hedge fund borrowing examined by FED, SEC, European Regulators', Miller and Westbrook.

2 In re Manhattan Investment Fund Ltd, 2007 WL 60843 (Bankr. SDNY Jan. 9, 2007); and 00-10922 (Bankr. SDNY 15 Feb 2007).

3 Financial Times, 16 February 2007, 'Bear Stearns ordered to return $125m', White.

4 Cromer Finance Ltd and others v Berger and others, 137 F Supp 2d 452.

5 [1995] 2 AC 378.

6 [2002] 2 AC 164.

7 [2006] 1 WLR 1476.

8 [2006] EWCA Civ 1492.

9 Belmont Finance Corp v Williams Furniture Limited (No 2) [1980] 1 All ER 393.

10 Lonrho Plc v Fayed [1992] 1 AC 448.

11 Douglas v Hello! Ltd (No 3) [2005] EWCA Civ 595. At the time of writing, the House of Lords had yet to deliver their judgment in Douglas.

12 [1999] CLC 1469. Th e first instance decision in Grupo Torras was reversed on appeal, although the judgment of the Court of Appeal did not comment directly on the passage cited here.

13 [1998] 1 Lloyd's Rep (Medical) 116.

14 Total Network SL v Customs and Excise Commissioners [2007] EWCA Civ 39. 15 [2005] EWCA Civ 595.

16 See also the Court of Appeal's comments in Mbasogo v Logo Ltd (No 1) [2006] EWCA Civ 1370.

17 [1995] 3 All ER 918.

18 [1997] 1 WLR 1396.

19 [2003] EWHC 1319 (Ch).

20 Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] 1 All ER 354, CA. Th e shareholder will require court permission to issue such proceedings. Th e test for granting permission is whether a reasonable independent board could take the view that the proceedings were appropriate: Airey v Cordell and others [2006] All ER (D) 111 (Aug). Th e Companies Act 2006 replaces the existing rules on derivative claims. Its provisions in this regard are expected to come into force by October 2007.

21 Johnson v Gore Wood & Co [2002] 2 AC 1, HL.

22 Stein v Blake [1998] 1 All ER 724, CA.

23 Th e provisions of the Companies Act 2006 dealing with shareholder derivative claims are due to be brought into force in October 2007.

24 [2005] EWCA Civ 1612.

25 [2006] EWHC 2973 (Ch).

26 Either because there are assets belonging to MIF in England over which an English insolvency practitioner should be appointed, or because a BVI insolvency practitioner appointed to MIF has applied to be recognised in England in order to pursue claims against Bear Stearns (and possibly others).

27 The s458 Companies Act 1985 offence of fraudulent trading is also relevant.

2 8 [2005] EWCA Civ 693.

29 Including US$39m interest.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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