A New York State trial court (the “Court”) dismissed a complaint filed by limited partners of a hedge fund now in receivership against the fund’s former prime broker, custodian and clearing broker (the “Prime Broker”). The complaint alleged that the Prime Broker had engaged in fraud, constructive fraud, breach of fiduciary duty, aiding and abetting fraud and breach of fiduciary duty, negligence, unjust enrichment and tortious interference with a contract, in connection with activity engaged in by the Prime Broker in a particular company’s microcap stock, the decline in whose price ultimately resulted in the fund’s failure.
Plaintiffs’ Claims. As alleged in the complaint, the fund’s investment manager caused the fund to accumulate a large position in the microcap stock, in excess of limitations in the fund’s offering memorandum. The Prime Broker was allegedly aware that the position was in excess of the fund’s investment restriction and that the position also triggered SEC reporting requirements with which the fund was not complying. The complaint averred that the Prime Broker began manipulating the market for the microcap stock by artificially creating a short market in the security that eventually caused a reduction in the value of the fund’s portfolio such that the fund was unable to honor redemption requests. The fund was subsequently placed into receivership. The fund’s portfolio manager eventually pleaded guilty to violations of federal securities laws in connection with his management of the fund.
The Court’s Analysis. The Court rejected the plaintiffs’ attempt to characterize their causes of action against the Prime Broker as direct rather than derivative. The Court found that the injury for which the plaintiffs sought redress was foremost an injury to the fund rather than an independent injury to the investor plaintiffs, and thus any claims arising out of the Prime Broker’s alleged wrongdoing that caused the decline in the value of the fund’s holdings must be asserted directly by the fund, or derivatively on its behalf. On this basis the Court held that the plaintiffs lacked standing to assert their fraud, constructive fraud, breach of fiduciary duty, aiding and abetting fraud and breach of fiduciary duty, and negligence claims.The Court also found that mere allegations that the Prime Broker served as the fund’s prime broker, clearing broker and custodian were, without more, insufficient to establish a fiduciary relationship between the Prime Broker and the fund’s investors. The Court further found that the plaintiffs did not plead facts demonstrating that the Prime Broker rendered substantial assistance to the fund’s investment manager in breaching his duty to the fund’s investors, sufficient to support the aiding and abetting causes of action, and noted that “[i]n fact, plaintiffs’ allege that [the investment manager’s] alleged scheme ran counter to [the Prime Broker’s], insofar as [the investment manager] allegedly could not complain to the authorities, because that would have revealed his own violation of federal securities laws.”