Registered Investment Advisors Have Liability Exposure for Imprudent Recommendations of Asset Managers


The liability exposure of registered investment advisors for imprudent recommendations of hedge funds and other managed investments is increasing. On April 22, 2009, the U.S. Securities and Exchange Commission (“SEC”) censured Hennessee Group LLC and Charles J. Gradante and ordered them to pay, jointly and severally, over $800,000 for violating Section 206(2) of the Investment Advisors Act of 1940 (the “Act”) and their fiduciary duties owed to clients who relied on their services and recommendations in investing in a group of fraudulent hedge fund known as Bayou Superfund, LLC; Bayou Accredited Fund, LLC; Bayou Affiliates Fund, LLC; and Bayou No Leverage Fund, LLC; all successors to Bayou Fund LLC (“Bayou”).

Hennessee, a “hedge fund consultant” and registered investment advisor subject to the Act, and its chief executive and investment officer, Gradante, operated in New York City. In 2005, Hennessey had approximately 100 clients and $1.35 billion in client assets under management. The SEC found that Hennessee held itself out as “pioneers in Hedge Fund Consulting” with years of experience in helping clients achieve “higher investment returns with lower risk” by recommending “a customized portfolio of hedge funds, properly diversified and managed. Hennessee routinely represented to clients and prospects that it would not recommend investments in hedge funds that did not satisfy all phases of its due diligence.

In particular, the SEC found that Hennessee promoted its “Five Level Due Diligence Process,” which purportedly included: (1) a request for general information and “historical returns” from the hedge fund, (2) a face-to-face interview with the fund manager, (3) a detailed review and portfolio/trading analysis of the fund, (4) an on-site visit to the fund’s offices to meet and interview key personnel, and (5) a reference and background check on the fund’s manager. Hennessey routinely touted the “excellence and rigor” of its process. Hennessey’s due diligence services were particularly important to its clients because information regarding a hedge fund’s trading strategies, solvency and management is typically not publicly available. Hennessee charged an advisory fee of 1% or less of the value of the assets that a client invested in hedge funds recommended by Hennessee.

From February 2003 through August 2005, approximately forty Hennessee clients invested over $56 million in Bayou in reliance upon Hennessey’s recommendation and promises of careful due diligence and monitoring. Unfortunately, the SEC found that Hennessee did not conduct a portfolio/trading analysis on Bayou, failed to verify Bayou’s relationship with its purported independent auditor, disregarded red flags during its due diligence review and subsequent monitoring of Bayou, and failed to investigate a rumor or follow up on conflicting information in its possession that one of Bayou’s founders was a principal of Bayou’s “independent” auditor.

Bayou’s purported investment strategy was day trading and it told investors that it had developed “a unique trading system and technical analysis” that enabled it to day trade profitably regardless of market conditions. Almost fro its inception, however, Bayou lost money from trading. What Bayou had really developed was a scheme to defraud its investors by fabricating the fund’s performance. Realizing that the fund could not withstand an independent audit, Bayou’s principal’s dismissed the fund’s auditor, Grant Thornton LLP, and began generating phony auditor opinion letters written on the stationery of a non-existent firm it called “Richmond-Fairfield Associates.” From 1996 through mid-2005, Bayou gave the false impression that it was generating modest and steady returns, and thereby attracted over $400 million in investor capital. The fraud came to light when Bayou issued worthless redemption checks to investors from overdrawn bank accounts and began shutting down its operations.

Hennessey’s and Gradante’s apparent reckless indifference in the way they handled the red flags is particularly egregious. Fro example, in January 2005, Hennessey received an investor’s email reporting a rumor that “the head of back office at Bayou is also a principal in the firm that does their annual audit’.” Four days later, Gradante emailed Bayou’s principals: “RUMOR WITH POTENTIALLY DAMAGING IMPACT ON BAYOU’ A CLIENT of hennessee and bayou has heard that dan marino is a principal or has an economic interest in your accounting firm’.i know you guys are always doing the right thing so I wouldn’t be surprised if this is a stretch of the truth’.can you go on the record for me so I can help us all “NIP THIS IN THE BUD.” Gradante subsequently received conflicting information from Marino that, at the very least, invited scrutiny, but he failed to follow up and told the investor who had called the matter to his attention and had requested him to investigate, that the rumor was false and that Marino had provided a full explanation.

As we reported in this space, the Federal Bureau of Investigation reported that corporate fraud more than doubled from 279 cases in 2003 to 529 in 2007, and financial fraud is becoming even more common in the deteriorating economy. Investors who believe that they may have been defrauded should consult with legal counsel to determine their options.

Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in representing investors in claims against registered investment advisors. For further information, please contact us