In The matter of BAYOU GROUP LLC. .

• Decision Date: 17 September 2010
• Docket Number: 09 Civ. 02353 (PGG).,09 Civ. 02343 (PGG),09 Civ. 02313 (PGG),09 Civ. 02345 (PGG),No. 06-22306 (ASH),09 Civ. 02351 (PGG),09 Civ. 02340 (PGG),09 Civ. 02347 (PGG),09 Civ. 02577 (PGG),06-22306 (ASH)
• Citation: 439 B.R. 284
• Parties: In the matter of BAYOU GROUP, LLC, et al., Debtors. Christian Brothers High School Endowment, Appellant, v. Bayou No Leverage Fund, LLC, Appellee. Redwood Growth Partners, Appellant, v. Bayou Accredited Fund, LLC, Appellee. D. Canale Beverages, Inc., Appellant, v. Bayou Superfund, LLC, Appellee. Heritage Hedged Equity Fund, L.P., Appellant, v. Bayou Superfund, LLC, Appellee. John D. Canale, III, Appellant, v. Bayou Superfund, LLC, Appellee. Mary P. Smythe Residuary Trust, Appellant, v. Bayou Superfund, LLC, Appellee. Marvin E. Bruce Living Trust, Appellant, v. Bayou Superfund, LLC, Appellee. Freestone Low Volatility Partners, LP, Appellant, v. Bayou Accredited Fund, LLC, Appellee.
• Court: U.S. District Court — Southern District of New York

439 B.R. 284

In the matter of BAYOU GROUP, LLC, et al., Debtors.

Christian Brothers High School Endowment, Appellant, v. Bayou No Leverage Fund, LLC, Appellee.

Redwood Growth Partners, Appellant, v. Bayou Accredited Fund, LLC, Appellee.

D. Canale Beverages, Inc., Appellant, v. Bayou Superfund, LLC, Appellee.

Heritage Hedged Equity Fund, L.P., Appellant, v. Bayou Superfund, LLC, Appellee.

John D. Canale, III, Appellant, v. Bayou Superfund, LLC, Appellee.

Mary P. Smythe Residuary Trust, Appellant, v. Bayou Superfund, LLC, Appellee.

Marvin E. Bruce Living Trust, Appellant, v. Bayou Superfund, LLC, Appellee.

Freestone Low Volatility Partners, LP, Appellant, v. Bayou Accredited Fund, LLC, Appellee.

Nos. 06-22306 (ASH), 09 Civ. 02577 (PGG), 09 Civ. 02313 (PGG), 09 Civ. 02340 (PGG), 09 Civ. 02343 (PGG), 09 Civ. 02345 (PGG), 09 Civ. 02347 (PGG), 09 Civ. 02351 (PGG), 09 Civ. 02353 (PGG).

United States District Court,S.D. New York.

Sept. 17, 2010.

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MEMORANDUM OPINION AND ORDER PAUL G. GARDEPHE, District Judge.

These eight appeals arise from adversary proceedings Bayou Hedge Funds (the “Funds,” “Bayou,” or “Debtors”) brought under §§ 548(a) and 544 of the Bankruptcy Code and §§ 273-76 of the New York Debtor and Creditor Law (“DCL”) to recover-as fraudulent conveyances-redemption payments the Funds made to Appellants within two years of the Funds' collapse in August 2005. ¹ (Am. Cmplt. ¶ 3 (CBHSE Ex. 1)) Appellants ² appeal from a decision and orders of the United States Bankruptcy Court for the Southern District of New York, dated October 16, 2008, and January 28, 2009, respectively, granting Debtors summary judgment on their claims to avoid and recover payments made to Appellants in redemption of their principal investments and fictitious profits, and denying Appellants' cross-motions for summary judgment on their good faith defense under 11 U.S.C. § 548(c). ³ In granting Debtors summary judgment, the Bankruptcy Court held that $24.7 million in pre-petition redemption payments made to Appellants-reflecting both return of investment principal and fictitious profits-could be avoided under Section 548.

Critical to the Bankruptcy Court's determination that the redemption payments could be avoided as actual fraudulent conveyances was its ruling, as a matter of law, that Appellants could not prevail on their good faith affirmative defense. That finding is premised on a novel interpretation of the test for good faith under Section 548(c) of the Bankruptcy Code, which the lower court conceded “may be thought to differ in some respects from the case law.” Bayou III, 396 B.R. at 847. In contrast to the vast weight of authority holding that a transferee is put on “inquiry notice” only upon receiving information indicating that the transferor is insolvent or that the transfer is being made for a fraudulent purpose, the Bankruptcy Court broadly held that information suggesting “some potential infirmity in the investment” or “some infirmity [in the] integrity of its management” is a sufficient trigger. Id. at 848. The Bankruptcy Court's expansion of the scope of information sufficient to trigger inquiry notice is not supported by the case law and requires reversal of its decision granting Bayou summary judgment.

BACKGROUND

The factual background of these appeals is discussed in detail in three prior decisions issued by the Bankruptcy Court, with which this Court presumes familiarity. See In re Bayou Group, LLC, 362 B.R. 624 (Bankr.S.D.N.Y.2007) ( “Bayou I” ); Bayou II, 372 B.R. 661; Bayou III, 396 B.R. 810. The essential facts concerning the rise and fall of the Bayou Funds are not in dispute.

A. The Bayou Funds

In 1996, Sam Israel, Daniel Marino, and James Marquez organized the Bayou Fund, a hedge fund that served large, primarily institutional investors. Bayou III, 396 B.R. at 822. In 2003, the original Bayou Fund was liquidated and was replaced by four on-shore hedge funds, all of which were limited liability companies. Id. Three of these funds-Bayou No Leverage Fund, Bayou Accredited Fund, and Bayou Superfund-are Appellees in this action. ⁴ (Am. Cmplt. ¶ 17)

Throughout their existence, all the Bayou funds were managed by Bayou Management LLC, which was owned by Israel, and all related trading activity was conducted through Bayou Securities, a broker-dealer owned by Bayou Group, LLC. Bayou III, 396 B.R. at 822. Until Bayou's collapse in 2005, Israel and Marino controlled the operation of all the Bayou entities, serving respectively as chief executive officer and chief financial officer of Bayou Management. Id.

The Bayou Fund began losing money soon after it began trading, and neither it nor its successor funds was ever profitable. Id. In addition to the trading losses they incurred, Israel and Marino plundered the Funds for their personal financial gain, generating millions of dollars in excessive trading commissions and awarding themselves millions in incentive bonuses based on non-existent profits. Id. at 823. In order to conceal their trading losses and self-dealing, and to attract additional investment, the Funds misrepresented their performance through false and fraudulent reports, releases, and financial statements. Id.; ( see also Am. Cmplt. ¶ 12). For example, false performance returns were reported to investors in weekly, monthly, quarterly and annual financial reports, in individual account statements, and in Bayou's marketing materials. Bayou III, 396 B.R. at 823.

In 1998, in furtherance of their fraudulent scheme, Israel and Marino fired Bayou's independent auditor and replaced that firm with Richmond-Fairfield Associates, CPA, PLLC, a fictional accounting firm created by Marino to pose as an independent auditor. Id.; ( see also Sonn. Ex. 1, ¶¶ 21-22). The Bayou Funds' subsequent annual financial statements contained a certification from Richmond-Fairfield stating that it was an independent firm of certified public accountants, that it had audited the financial statements of the applicable Bayou fund, that the audit had been conducted in accordance with generally accepted accounting standards, and that the Fund's financial statements “present fairly, in all material respects, the financial position of [the fund] and the results of its operations.” Bayou III, 396 B.R. at 823. All of these representations were false. Id.

Another critical component of the fraud scheme was the Bayou Funds' consistent execution of investors' redemption requests in accordance with the Funds' operating agreements:

To avoid detection of the fraud, to retain existing investors and to lure new investors, the Bayou Hedge Funds invariably honored requests by investors who sought to exercise their contractual right to redeem their investments as falsely reported in the fraudulent financials, both as to impaired or non-existent principal and fictitious profits. These redemption payments thus constituted an integral and essential element of thealleged fraud, necessary to validate the false financials and to avoid disclosure.

Bayou II, 372 B.R. at 663.

Although one investor learned from New York Department of State records in July 2004 that the registered agent for Richmond-Fairfield was Dan Marino, Bayou III, 396 B.R. at 865-indicating that Bayou's representation of Richmond-Fairfield as an independent auditing firm was a fiction-the Bayou Funds' fraudulent scheme was apparently never detected by investors or by regulators prior to the Funds' collapse. The end came in July 2005, when the Bayou Funds notified investors that they were voluntarily liquidating, and that all investors would receive a 100% redemption of their investments upon completion of a final audit. (CBHSE Ex. 1, ¶ 22) Bayou's investors received no further distributions from the funds, however. Bayou III, 396 B.R. at 823.

Over their lifespan, the Bayou Funds attracted more than $450 million from investors. Id. at 829. When the funds collapsed in the summer of 2005, investors sustained losses of approximately $250 million in invested principal. Id. at 823.

B. Criminal Proceedings

On September 29, 2005, Israel and Marino pleaded guilty in the United States District Court for the Southern District of New York to criminal informations charging them with, inter alia, conspiring to commit, and with the commission of, investment adviser fraud and mail fraud. (Sonn. Ex. 3) The informations charged that Israel and Marino had provided newsletters, reports, and financial statements setting forth inflated rates of return for the Bayou Funds, and had falsely represented to investors that Bayou's financial statements had been audited by an independent certified public accounting firm, when in fact Israel and Marino had created a sham accounting firm that conducted no audits. ( Id.) The informations further alleged that between July 1996 and August 2005, Israel and Marino had, through this fraudulent scheme, “induced investors to contribute in excess of $450,000,000 to the Bayou Hedge Funds.” ( Id. at 4)

During his plea allocution, Israel admitted that he had “caused Bayou to send various kinds of documents containing false financial information about Bayou's performance to current and prospective clients of Bayou which made it appear that Bayou was performing better than it truly was. My purpose was to induce these people to invest in Bayou or continue to keep their money in Bayou.” (Pltf. Ex. 3 at 24 (Israel Plea Tr.)); see Bayou III, 396 B.R. at 830. Marino similarly admitted that while serving as chief financial officer of Bayou he and others had intentionally sent false information to investors concerning “the true status of their investment,” and that he had “set up an accounting firm that would give the appearance of an independent auditor to further the conspiracy to deceive Bayou investors.” (Pltf. Ex. 4 at 27-28 (Marino Plea...