Early Lessons From the Bayou Fiasco
By Paul D. Wexler

It is likely that virtually every reader is familiar with the Bayou saga. However, it is unlikely that members of the hedge fund community are familiar with current developments in the courts involving Bayou. Recent decisions by the court in the Bayou bankruptcy proceeding should be carefully considered by the hedge fund community as they can have serious ramifications for investors, especially Funds of Funds.

Bayou Superfund LLC, Bayou No Leverage Fund LLC and Bayou Accredited Fund LLC  (the “Funds”) are all debtors in possession in the U.S. Bankruptcy Court for the Southern District of New York. The Funds’ new management alleges in court pleadings that the Funds were operated as a Ponzi scheme by which the old managers would use new investor money to pay off investor redemptions in order to conceal the fact that the Funds were unprofitable. In essence, the Funds’ current management charge that the investors who redeemed their interests before bankruptcy received money to which they were not entitled because the net assets values were fraudulent.

The Funds brought 95 lawsuits against former investors who had redeemed their interests prior to bankruptcy. The theory of the lawsuits is that the distributions to the redeeming investors represent fraudulent transfers that are recoverable by the Funds under the bankruptcy law. The redeeming investors moved to dismiss these claims on various grounds, including the defense that they gave up value for the redemptions and that they had no knowledge of any fraud. In a February 2007 decision, the bankruptcy court denied those motions holding that the complaints were viable and that the redeeming investors would be required to prove their defenses after discovery and perhaps a trial. In a decision dated August 9, 2007, Bankruptcy Judge Hardin essentially reaffirmed his decision, finding that the Funds had standing to assert claims against the redeeming investors and also noting that the number of lawsuits against the redeeming investors now totaled 110.

The import of this decision is especially troubling for investors who have received redemptions from hedge funds that find themselves in US-based insolvency proceedings. Even investors who are totally innocent of fraud and who had no knowledge of any wrongdoing could potentially be liable to return the amount of redemptions, perhaps with interest. Even if these investors are ultimately not liable, they could become enmeshed in costly discovery and litigation. Until this case proceeds further and more learning is revealed, investors who receive redemptions from troubled funds should carefully document the circumstances of the withdrawals and be prepared to establish that they acted in good faith without knowledge of the fraud.