In a decision that could spell trouble for innocent hedge fund investors, a federal bankruptcy judge in New York ruled that investors in the now infamous Bayou Hedge Funds—which were found to have operated a massive Ponzi scheme—qualified as creditors, and therefore could be subject to the fraudulent conveyance provisions of the Bankruptcy Code.

In re: Bayou Group, LLC, 372 B.R. 661 (Bankr. S.D.N.Y. Aug. 9, 2007) involved fraudulent conveyance allegations relating to the failure of three hedge funds—the Bayou Superfund, Bayou No Leverage Fund, LLC and Bayou Accredited Fund (collectively, the "Bayou Hedge Funds" or the "Funds"). The defendants in these adversary proceedings were persons and entities that invested in the Bayou Hedge Funds.

Federal bankruptcy Judge Adlai S. Hardin, Jr. of the Southern District of New York heard the case. The court characterized the operations of the Bayou Hedge Funds as a classic Ponzi scheme—to conceal the fraudulent financials of the Funds, the Bayou Hedge Funds honored redemption requests by investors, thereby retaining existing investors and luring new investors.

Victims and Fraudulent Transfers

The Funds filed 110 adversary proceedings against investors, arguing that the redemption payments received by certain investors were fraudulent transfers.

The funds acknowledged that the investors, in one respect, were victims of fraud because they had been fraudulently induced to invest in the Bayou Hedge Funds. Nonetheless, the Funds sought the returns of transferred funds to the extent they were payments to the defendant-redeeming investors of "non-existent principal and fictitious profits" in redemption of defendants' purported, but non-existent, interests in the Bayou Hedge Funds.

Before the court were motions for summary judgment that the court noted were effectively motions to dismiss and somewhat duplicative of prior motions to dismiss that previously had been denied by the court.

The defendants argued for summary judgment in their favor, on the following grounds:

(1) Fraudulent transfer claims only can be brought for the benefit of creditors—not equity holders—and only to the extent necessary to satisfy such creditors.

(2) The non-redeeming investors in the Bayou Funds do not qualify as creditors eligible to support the debtors' fraudulent transfer claims. The defendants argued that because there were no assets in the Funds, there was no creditor pool to benefit from the fraudulent conveyance actions.

(3) All claims by Bayou investors to recover for losses in their investments must be treated as equal or subordinate to equity interests pursuant to section 510(b) of the Bankruptcy Code, and must be disallowed.

Decision

The judge denied the plaintiff redeeming investors' motions for summary judgment. The court found that the non-redeeming investors were creditors of the Bayou Hedge Funds and therefore could benefit from the fraudulent conveyance claims. Further, although section 510 of the Bankruptcy Code may operate to subordinate the non-redeeming investors' claims as tort creditors, it does not disallow those claims, the court found.

Regarding the movants' argument that the non-redeeming investors could never benefit from a fraudulent conveyance action, the court did not agree. In what is arguably dicta, the court determined that permitting a debtor-in-possession to assert fraudulent conveyance claims for the benefit of innocent equity investors would not offend any statutory language and would serve Bankruptcy Code objectives.

The court further held that the non-redeeming investors were creditors of the debtors, in fact and in law, arguably expanding the rights of non-redeeming investors. Because investors in the Funds had a contract claim for redemption of their investments, the court ruled that a party with a contract claim is in all respects a creditor of the debtor. Alternatively, because all such investors would have a tort claim because they were fraudulently induced into investing in the Funds, such facts would serve as a separate basis for finding that such investors were creditors.

Regarding the movants' argument for subordination under section 510(b) of the Bankruptcy Code, the court noted that section 510 does not operate to disallow a claim, refusing to read any such meaning into the plain language of the statue, and opined that the section only deals with the priority of allowed claims.

Outlook

This opinion, in connection with the court's prior opinion denying motions to dismiss, may be very troubling for fund investors. Here, innocent investors who validly exercised their contractual rights nevertheless were determined to be subject to disgorgement pursuant to fraudulent conveyance law. Fund investors likely will find this an inequitable result, and will await further decisions in this case and in this area of law to see how the court's ruling is applied.

This article is presented for informational purposes only and is not intended to constitute legal advice.