NY Appeals Court Rules Goldman Must Pay Bayou's Creditors
A New York appeals court has sent clearing firms a warning: they may be held responsible for the losses suffered by investors for fraud committed by their clients.
In the case involving collapsed hedge fund Bayou Group, the three-man panel of judges let stand a lower court ruling that Goldman Sachs must pay creditors of the fund $20.5 million. Goldman, who was Bayou's prime broker, cleared trades for Bayou and the fund's unsecured creditors committee filed a claim against Goldman in 2008 accusing the bank of helping Bayou perpetrate a Ponzi scheme.
The creditors said Goldman had plenty of evidence to suggest Bayou was running a scam based on how it shuffled money around accounts it held at Goldman. Samuel Israel III, former chief executive of Bayou, is now serving 20 years in jail for fraud. He pleaded guilty to misrepresenting the value of Bayou's funds and milking clients out of more than $400 million
Legal experts say the award is significant not only because of its size but also the ramifications it might have on clearing firms which have historically argued that they play an administrative role and do not have a "fiduciary" duty to make investors whole in the event of wrongdoing by their clients. The New York appeals court ruling -- and that of a lower court -- suggest that clearing firms should be subject to a higher standard of care but several attorneys contacted by www.iss-mag.com were hesitant to specify just how far that should be taken.
Founded in 1996, Bayou was exposed as a scam in 2005. Goldman Sachs served as its prime broker and clearing firm from 1999 until that year.
The Financial Industry and Regulatory Authority, the self-regulatory authority for broker-dealers, awarded Bayou's creditors the $20.5 million in 2010 -- two years after they filed their original claim. Goldman then appealed the decision to a New York district court and lost that case. The district court ruled against Goldman Sachs' stance that the decision showed a "manifest disregard" of the law in the arbitration process. That is one of the rare reasons a ruling made during an arbitration can be overturned.
"We have considered all of the parties' remaining attacks on the district court judgment and find them to be without merit," wrote the three appeals court judges in their ruling on the case. "Accordingly we affirm the judgment of the district court."
In siding with Goldman Sachs, the influential broker-dealer trade group Securities Industry and Financial Markets Association told a New York district court that imposing liability on Goldman Sachs disregarded the "longstanding principle" that a clearing firm cannot be held liable for merely processing transactions received from an authorized source.
"If a clearing firm were required to analyze trading in introduced accounts, the speed and efficiency demanded in the contemporary securities markets would not be possible," said SIFMA in its friend-of-the-court brief. Introducing brokers hire third-party clearing firms to process their transactions.
The New York appeals court's ruling isn't the first legal setback for Goldman Sachs. In March it agreed, without confirming or denying guilt, to pay the Commodity Futures Trading Commission over allegations of failing to supervise accounts for a broker-dealer client. The investment bank is reportedly also interested in selling its hedge fund administration business.
Written by Chris Kentouris, Editor-in-chief (Chris can be contacted through Chris.Kentouris@hotmail.com)