Special Issue: The 'Hottest Issues' Get Hotter; The Bayou Hedge Funds Fraud

On May 28, 2006, the Bayou Hedge Funds commenced voluntary petitions for relief under Chapter 11 of the United States Bankruptcy Code (the 'Chapter 11 Cases'). Upon commencement of the Chapter 11 Cases, Bayou filed fraudulent conveyance avoidance action lawsuits against certain redeeming investors seeking to recover what, in effect, were more than $135 million of Ponzi scheme distributions (the 'Lawsuits'). The purpose of the Lawsuits and the Chapter 11 Cases are to pursue recoveries on behalf of defrauded investors such that all Bayou Hedge Fund investors share ratably, on a fair and equitable basis, as victims in the losses resulting from the alleged fraud.

The Lawsuits

The allegations contained in the Lawsuits are as follows:

• The Bayou Hedge Funds bankruptcy cases arise from a massive Ponzi scheme perpetrated by the former principals of the Hedge Fund.
• During the course of this fraud, Bayou attracted more than $450 million in investments.
• After suffering millions of dollars in trading losses, Bayou attempted to stay afloat, and indeed prolonged the scheme, by disclosing false investment performance and creating false financial statements.
• The Bayou Hedge Funds also attempted to conceal losses through a series of fraudulent transfers to certain of their investor creditors, including defendants in adversary proceedings pending in the Lawsuits.
• Bayou seems to have used capital from new investors to pay redemption proceeds to investor creditors seeking to exit the Bayou Hedge Funds.
• Ultimately, Bayou's Ponzi scheme collapsed, with approximately $250 million in principal unpaid to hundreds of creditors. As a result, it is inequitable for the early redeemers to retain these payments to the detriment of the remaining investors who lost everything.
• The Lawsuits seek the return of the non-existent principal and investment gains 'returned' to the early redeemers so that those funds can be equitably redistributed to creditors as prescribed by the Bankruptcy Code.

In the wake of their financial collapse and after this author's appointment as the sole managing member of each of the Bayou Hedge Funds pursuant to order of the Federal District Court for the Southern District of New York, the Bayou Hedge Funds filed Chapter 11 bankruptcy cases, and commenced the Lawsuits against approximately 125 redeeming investors seeking recovery of approximately $135 million. The Lawsuits seek to set aside and recover certain fraudulent transfers made by the Bayou Hedge Funds on legal theories, including avoidance of fraudulent transfers based on the commission of actual fraud.

The Bayou Hedge Funds were an affiliated group of entities that created, operated, comprised, and controlled private pooled investment funds (commonly known as 'hedge funds'). Bayou operated the hedge funds as a fraudulent Ponzi scheme, and engaged in a series of fraudulent actions and transactions in furtherance of their criminal scheme.

The first Bayou Hedge fund was launched by Samuel Israel and Daniel Marino in 1996 with $1.2 million in capital. The Bayou Fund was a single-manager hedge fund marketed to 'accredited investors' and large institutions. During a reorganization in January 2003, the Bayou Fund was liquidated and four separate on-shore hedge funds were created: Bayou Accredited, Bayou Affiliates, Bayou No Leverage, and Bayou Superfund. At year-end 2004, the Bayou Hedge Funds claimed to have approximately $411 million in capital under management.

Within months after the Bayou Hedge Funds opened and started trading, they sustained heavy trading losses and began falsifying their financial disclosures and fraudulently misrepresenting their investment performances. In financial summaries that were sent to clients, the volatile swings of the trading gains and losses were concealed by padding and fabricating the results through a pattern of fraud. After sustaining a net loss of millions of dollars, the Bayou Entities concealed their losses, created false investment performance reports, and created false financial statements.

The Bayou Hedge Funds' mounting losses could not withstand an independent audit of the year-end 1998 financial results. To avoid detection, Marino, a certified public accountant, created a fictitious accounting firm ' Richmond-Fairfield Associates, CPA, PLLC ('Richmond-Fairfield') ' to pose as the independent auditor, replacing Grant Thornton LLP. Beginning in 1999, Israel and Marino caused the Debtors, under cover of 'audits' by Richmond-Fairfield, to continue to generate false performance summaries and false financial statements designed to mislead investors. The Bayou Hedge Funds were self-administered. Without a truly independent auditor and without an independent administrator, the Bayou Entities' own books and records did not accurately reflect the true financial performance of the Bayou Hedge Funds.

Over the course of their fraudulent existence, the Bayou Entities induced investments of a reported $450 million into the Bayou Hedge Funds and their off-shore counterparts. (The off-shore Bayou funds are the subject of liquidation proceedings under the laws of the Cayman Islands and are not directly at issue in the Bayou bankruptcy cases.) The Bayou Entities used the incoming capital from new investors to continue operations and pay redemption proceeds to investors who sought to exit the hedge funds, all as part of the fraudulent concealment of the Ponzi scheme.

In a letter dated July 27, 2005, the Bayou entities abruptly advised their investors that the Bayou Hedge Funds were voluntarily liquidating. All investor creditors were promised a 100% redemption of the investments upon completion of a final audit. Despite this assurance, the Bayou Entities failed to repay its investor creditors. The vast majority of investor funds under the Bayou Entities' control vanished in a final scheme of deception and fraud. It currently appears that the Bayou Entities' creditors lost approximately $250 million.

Following the Bayou Entities' collapse, numerous civil and criminal investigations were commenced by state and federal authorities. In particular, the United States Attorney for this District, the Securities and Exchange Commission and the Commodity Futures Trading Commission each have commenced separate law enforcement actions against the Bayou Entities, Israel, Marino and others alleging violations of numerous laws and regulations.

On Sept. 29, 2005, criminal information were filed in the District Court against Israel and Marino as a result of their activities related to the Debtors. That same day, Israel and Marino pleaded guilty to conspiracy to commit fraud, mail and wire fraud, and investment advisor fraud after acknowledging their widespread fraudulent financial reporting to investors.

The Investors Were Victims

During the period of the Bayou Entities' fraudulent financial scheme, various investors in the Bayou Hedge Funds redeemed all or part of their investment to the detriment of the remaining investor creditors. Of course, at the time of these redemptions, the financial statements of the Bayou Hedge Funds indicated that these early redeemers were entitled to the return of all of their principal as well as substantial profits. In truth, there were no profits, and the 'principal' returned was in reality monies invested in the Bayou Hedge Funds by recent investors. Ultimately, the combination of: 1) investment losses; 2) redemptions that included fictitious profits and non-existent principal; and 3) investors' redemption requests, all outpaced new investor deposits, causing Bayou's collapse. In a final effort of deceit, Bayou's principals allegedly transferred more than $100 million to themselves. A portion of these funds were recovered by the State of Arizona, and were recently transferred to the United States Marshall's Service for eventual distribution to victimized investors. The proceeds of the Lawsuits will also be made available to compensate investors for their losses.

The ultimate goal of the Bankruptcy Cases is to create a distribution scheme for proceeds of the Lawsuits such that all investors receive a fair and equitable result, and such that each of the investor's losses are ratable under the circumstances. Bayou is principally relying on the well-developed legal theory of fraudulent conveyance to obtain appropriate recoveries from redeeming investors and will use a distribution scheme approved in the bankruptcy cases under a Chapter 11 Plan to effect a fair and equitable result for all investors.

Fraudulent conveyances ' transfers made with the intent to hinder, delay or defraud creditors ' can be recovered for the benefit of creditors. Investors in Bayou that received redemptions are being pursued for a return of all fictitious profits, as well as the principal portion of the redemptions. Certain of the investor/defendants may be able to keep the principal portion of the redemption payment if such investors can prove they acted in good faith ' in other words, that they did not know, or should not have known, of the existence of the indicia of fraud or insolvency at the time of their original investment or at the time of the redemption. The issues are in the process of being litigated in the Lawsuits.

The Impact on the Industry

In the meantime, more generally, the Federal government continues investigating the degree to which government oversight should be imposed on the hedge fund industry. In the end, however, no level of government oversight will insure against fraud. Investors themselves should remain vigilant in their pre-investment due diligence and in monitoring their hedge fund investments. Checking and verifying independent auditors and administrators and verifying backgrounds and reported experience of managers are all essential.

Jeff Marwil is a partner in the Bankruptcy, Workout and Corporate Reorganization practice group at Jenner & Block LLP. With more than 20 years of experience in the bankruptcy, workout and corporate reorganization community, Marwil regularly represents public and private companies (in and out of court) in restructuring sophisticated and complex capital structures and reorganizing their financial affairs and business operations, hedge fund investors in hedge fund restructuring, and represents senior secured lenders, and in certain cases, official committees in large and complex workouts, restructurings and reorganizations, as well as hedge fund investors in hedge fund restructuring.

Investor confidence and market behavior can be impacted greatly by events that do not necessarily correlate. In the case of the Bayou Hedge Funds fraud, these unique and non-recurring events fueled a fire in the hedge fund industry that has spread, but not necessarily due to the particulars of the Bayou Hedge Funds failure. But, when dealing with significant investments made by pension funds, corporate entities, along with foundations and trusts, a healthy dose of skepticism is natural and appropriate. Not unlike the transition from the Enron scandal to the formation of the Public Company Accounting Oversight Board, hedge fund investors may extrapolate the troubles at the Bayou Hedge Funds to all hedge funds. As a result, questions of the need for regulatory oversight for a stronger accountability within the industry arise.

The underlying premise of this article is to identify and review the events that occurred in the Bayou Hedge Funds as a tool for identifying risk in other hedge fund situations. Every investor individually must determine the level of due diligence required to seek comfort in making an investment. Could additional regulation support that goal? It is a question that is being posed now by several major investor groups. Understanding the Bayou Hedge Fund fraud will provide additional ammunition in addressing issues that they may encounter. Following is a digest of the developments that took place in that case. [Note, the author of this article is the presiding corporate officer of each of the Bayou entities. H. Jeffrey Schwartz of the Dechert law firm, resident in its New York office, is lead counsel for the Bayou entities in the Chapter 11 Cases. The Honorable Adlai S. Hardin, Bankruptcy Judge, in the Southern District of New York, presides over the Chapter 11 Cases and the Lawsuits. Nothing herein shall be or be deemed to be an admission or waiver of any type or nature whatsoever, whether in connection with the Chapter 11 Cases, the Lawsuits or otherwise.]

Introduction

On May 28, 2006, the Bayou Hedge Funds commenced voluntary petitions for relief under Chapter 11 of the United States Bankruptcy Code (the 'Chapter 11 Cases'). Upon commencement of the Chapter 11 Cases, Bayou filed fraudulent conveyance avoidance action lawsuits against certain redeeming investors seeking to recover what, in effect, were more than $135 million of Ponzi scheme distributions (the 'Lawsuits'). The purpose of the Lawsuits and the Chapter 11 Cases are to pursue recoveries on behalf of defrauded investors such that all Bayou Hedge Fund investors share ratably, on a fair and equitable basis, as victims in the losses resulting from the alleged fraud.

The Lawsuits

The allegations contained in the Lawsuits are as follows:

• The Bayou Hedge Funds bankruptcy cases arise from a massive Ponzi scheme perpetrated by the former principals of the Hedge Fund.
• During the course of this fraud, Bayou attracted more than $450 million in investments.
• After suffering millions of dollars in trading losses, Bayou attempted to stay afloat, and indeed prolonged the scheme, by disclosing false investment performance and creating false financial statements.
• The Bayou Hedge Funds also attempted to conceal losses through a series of fraudulent transfers to certain of their investor creditors, including defendants in adversary proceedings pending in the Lawsuits.
• Bayou seems to have used capital from new investors to pay redemption proceeds to investor creditors seeking to exit the Bayou Hedge Funds.
• Ultimately, Bayou's Ponzi scheme collapsed, with approximately $250 million in principal unpaid to hundreds of creditors. As a result, it is inequitable for the early redeemers to retain these payments to the detriment of the remaining investors who lost everything.
• The Lawsuits seek the return of the non-existent principal and investment gains 'returned' to the early redeemers so that those funds can be equitably redistributed to creditors as prescribed by the Bankruptcy Code.

In the wake of their financial collapse and after this author's appointment as the sole managing member of each of the Bayou Hedge Funds pursuant to order of the Federal District Court for the Southern District of New York, the Bayou Hedge Funds filed Chapter 11 bankruptcy cases, and commenced the Lawsuits against approximately 125 redeeming investors seeking recovery of approximately $135 million. The Lawsuits seek to set aside and recover certain fraudulent transfers made by the Bayou Hedge Funds on legal theories, including avoidance of fraudulent transfers based on the commission of actual fraud.

The Bayou Hedge Funds were an affiliated group of entities that created, operated, comprised, and controlled private pooled investment funds (commonly known as 'hedge funds'). Bayou operated the hedge funds as a fraudulent Ponzi scheme, and engaged in a series of fraudulent actions and transactions in furtherance of their criminal scheme.

The first Bayou Hedge fund was launched by Samuel Israel and Daniel Marino in 1996 with $1.2 million in capital. The Bayou Fund was a single-manager hedge fund marketed to 'accredited investors' and large institutions. During a reorganization in January 2003, the Bayou Fund was liquidated and four separate on-shore hedge funds were created: Bayou Accredited, Bayou Affiliates, Bayou No Leverage, and Bayou Superfund. At year-end 2004, the Bayou Hedge Funds claimed to have approximately $411 million in capital under management.

Within months after the Bayou Hedge Funds opened and started trading, they sustained heavy trading losses and began falsifying their financial disclosures and fraudulently misrepresenting their investment performances. In financial summaries that were sent to clients, the volatile swings of the trading gains and losses were concealed by padding and fabricating the results through a pattern of fraud. After sustaining a net loss of millions of dollars, the Bayou Entities concealed their losses, created false investment performance reports, and created false financial statements.

The Bayou Hedge Funds' mounting losses could not withstand an independent audit of the year-end 1998 financial results. To avoid detection, Marino, a certified public accountant, created a fictitious accounting firm ' Richmond-Fairfield Associates, CPA, PLLC ('Richmond-Fairfield') ' to pose as the independent auditor, replacing Grant Thornton LLP. Beginning in 1999, Israel and Marino caused the Debtors, under cover of 'audits' by Richmond-Fairfield, to continue to generate false performance summaries and false financial statements designed to mislead investors. The Bayou Hedge Funds were self-administered. Without a truly independent auditor and without an independent administrator, the Bayou Entities' own books and records did not accurately reflect the true financial performance of the Bayou Hedge Funds.

Over the course of their fraudulent existence, the Bayou Entities induced investments of a reported $450 million into the Bayou Hedge Funds and their off-shore counterparts. (The off-shore Bayou funds are the subject of liquidation proceedings under the laws of the Cayman Islands and are not directly at issue in the Bayou bankruptcy cases.) The Bayou Entities used the incoming capital from new investors to continue operations and pay redemption proceeds to investors who sought to exit the hedge funds, all as part of the fraudulent concealment of the Ponzi scheme.

In a letter dated July 27, 2005, the Bayou entities abruptly advised their investors that the Bayou Hedge Funds were voluntarily liquidating. All investor creditors were promised a 100% redemption of the investments upon completion of a final audit. Despite this assurance, the Bayou Entities failed to repay its investor creditors. The vast majority of investor funds under the Bayou Entities' control vanished in a final scheme of deception and fraud. It currently appears that the Bayou Entities' creditors lost approximately $250 million.

Following the Bayou Entities' collapse, numerous civil and criminal investigations were commenced by state and federal authorities. In particular, the United States Attorney for this District, the Securities and Exchange Commission and the Commodity Futures Trading Commission each have commenced separate law enforcement actions against the Bayou Entities, Israel, Marino and others alleging violations of numerous laws and regulations.

On Sept. 29, 2005, criminal information were filed in the District Court against Israel and Marino as a result of their activities related to the Debtors. That same day, Israel and Marino pleaded guilty to conspiracy to commit fraud, mail and wire fraud, and investment advisor fraud after acknowledging their widespread fraudulent financial reporting to investors.

The Investors Were Victims

During the period of the Bayou Entities' fraudulent financial scheme, various investors in the Bayou Hedge Funds redeemed all or part of their investment to the detriment of the remaining investor creditors. Of course, at the time of these redemptions, the financial statements of the Bayou Hedge Funds indicated that these early redeemers were entitled to the return of all of their principal as well as substantial profits. In truth, there were no profits, and the 'principal' returned was in reality monies invested in the Bayou Hedge Funds by recent investors. Ultimately, the combination of: 1) investment losses; 2) redemptions that included fictitious profits and non-existent principal; and 3) investors' redemption requests, all outpaced new investor deposits, causing Bayou's collapse. In a final effort of deceit, Bayou's principals allegedly transferred more than $100 million to themselves. A portion of these funds were recovered by the State of Arizona, and were recently transferred to the United States Marshall's Service for eventual distribution to victimized investors. The proceeds of the Lawsuits will also be made available to compensate investors for their losses.

The ultimate goal of the Bankruptcy Cases is to create a distribution scheme for proceeds of the Lawsuits such that all investors receive a fair and equitable result, and such that each of the investor's losses are ratable under the circumstances. Bayou is principally relying on the well-developed legal theory of fraudulent conveyance to obtain appropriate recoveries from redeeming investors and will use a distribution scheme approved in the bankruptcy cases under a Chapter 11 Plan to effect a fair and equitable result for all investors.

Fraudulent conveyances ' transfers made with the intent to hinder, delay or defraud creditors ' can be recovered for the benefit of creditors. Investors in Bayou that received redemptions are being pursued for a return of all fictitious profits, as well as the principal portion of the redemptions. Certain of the investor/defendants may be able to keep the principal portion of the redemption payment if such investors can prove they acted in good faith ' in other words, that they did not know, or should not have known, of the existence of the indicia of fraud or insolvency at the time of their original investment or at the time of the redemption. The issues are in the process of being litigated in the Lawsuits.

The Impact on the Industry

In the meantime, more generally, the Federal government continues investigating the degree to which government oversight should be imposed on the hedge fund industry. In the end, however, no level of government oversight will insure against fraud. Investors themselves should remain vigilant in their pre-investment due diligence and in monitoring their hedge fund investments. Checking and verifying independent auditors and administrators and verifying backgrounds and reported experience of managers are all essential.

Jeff Marwil is a partner in the Bankruptcy, Workout and Corporate Reorganization practice group at Jenner & Block LLP. With more than 20 years of experience in the bankruptcy, workout and corporate reorganization community, Marwil regularly represents public and private companies (in and out of court) in restructuring sophisticated and complex capital structures and reorganizing their financial affairs and business operations, hedge fund investors in hedge fund restructuring, and represents senior secured lenders, and in certain cases, official committees in large and complex workouts, restructurings and reorganizations, as well as hedge fund investors in hedge fund restructuring.