Court Rules for Investors in Lawsuit Over Negligent Hedge Fund Audits

Partner and co-chair of Herrick's Securities Litigation and Enforcement Group, Arthur G. Jakoby, spoke with the Hedge Fund Law Report about a precedent-setting ruling in lawsuit involving his clients, investors in a defunct hedge fund, who successfully sued an auditing firm for negligence, breach of contract and breach of fiduciary duty. 

The article notes that on "January 16, 2026, the Supreme Court of the State of New York issued a ruling in which it rejected a challenge to an arbitration panel’s findings that BDO USA LLP (BDO) and affiliates were negligent and had harmed investors by issuing clean audits of the fraudulent financial statements of several hedge funds managed by Platinum Management LLC and Platinum Credit Management L.P. (together, Platinum Management). In 2016, those fund managers were the targets of SEC and DOJ civil and criminal actions for fraud allegedly intended to cover up a liquidity crisis and defraud third-party bondholders."

Traditionally, courts have held that investors do not have standing to sue third-party service providers of hedge funds in which they invest their money, because the actual contract is between the service provider and the fund manager – not between the investors and the third-party service providers, noted Arthur. Hence, one of the core issues of the investors’ lawsuit is the claim of near-privity with BDO.

For years during the relevant period, BDO addressed its audit to “The Partners,” which a reasonable person would understand to mean the LPs in the funds, Arthur said. Then, something curious happened with the 2013 audit. In contrast to the 2012 audit (and all prior ones), in its 2013 report, BDO left out the investors and addressed it only to the “General Partner,” i.e., Platinum Management. “So, why, after 10 years of addressing it to the partners, plural, did BDO suddenly decide to address it to just the General Partner? Did the auditor know something was wrong?” he asked. A likely explanation, he posited, is that BDO learned the SEC was investigating the valuations of Platinum Management's assets. In fact, just weeks before the release of BDO’s 2013 audit report in February 2015, the SEC sent a demand letter to BDO’s GC, asking to see the work papers related to BDO’s valuations of the PPVA assets for 2012 and 2013, and requesting explanations for certain discrepancies that had come to the SEC’s attention.

One reason the lawsuit has succeeded so far – although appeals have not yet been exhausted – is that it is simply impossible to deny that investors suffered significant economic harm, up to and including the loss of their entire investment, as a consequence of omissions and misstatements in the PPVA funds’ financial statements, Arthur noted. The absence of reliable audits, coupled with misleading statements from Platinum Management, made it impossible for investors to have any realistic expectations about investments going back a decade and further. “When my clients invested in PPVA, they understood that some of their money was being invested in Level 3 assets,” he told the Hedge Fund Law Report. “So, in a situation like that, the only way an investor is going to know that the NAV they are being shown year-to-year is accurate is as a result of an audit by an independent auditor.”

In the absence of an accurate audit, all the investors had to go on were financial statements that – subsequent events showed – bore no relationship to the assets’ actual value. “Prior to the collapse of PPVA, investors were shown financial statements indicating that the assets had grown to $1.1 billion. But when those same assets were liquidated, they fetched about $70 million. So more than 93 percent of the supposed value just wasn’t there,” Arthur related. “And, because the secured creditors were owed approximately $100 million, the investors got zero, after having been told that the net equity value of the assets – after paying off all the loans – would be about $1 billion.”

With Platinum Management itself considered to be judgment-proof as the respective SEC and DOJ actions were underway, continued Arthur, the investors that suffered serious economic harm as a result of such misrepresentations were left with one choice: go after the auditor that had prepared and issued clean audit reports.

Close investigation of PPVA’s investments over time revealed that the Level 3 assets – China Horizon, Black Elk and Golden Gate – made up less than 25 percent of the fund’s total assets in 2010, Arthur shared. A large majority of fund assets were not Level 3, but that changed as investors redeemed and the value of the non-Level 3 assets plummeted from 2010 to 2012. Platinum Management tried to compensate by increasing the value of Level 3 assets to foster the appearance of general NAV growth.

“Golden Gate is just one example. The investment began in 2012, with a $6.5‑million loan. By the year’s end, the fund got some equity in exchange for the $6.5‑million loan, and the asset was valued at $49 million,” Arthur noted. “Platinum Management then increased the value of Golden Gate to $192 million a year later – despite the fact that the company was struggling and performing below expectations. That’s an astonishing 290‑percent increase in just one year,” he continued. “This is typical of what Platinum Management was doing with all of its Level 3 asset valuations during the relevant period. BDO reviewed Platinum Management’s increased Level 3 asset valuations and found them to be fairly presented.”

The Panel, Arthur stated, found that BDO’s analysis of Golden Gate’s 290‑percent increase appeared to be “just numbers on a page designed to bless the client’s valuation number, rather than serious efforts to measure risk” and that BDO “select[ed] risk factors because they support the client’s mark [i.e., Platinum Management’s valuation of the asset] rather than because they accurately measure risk.”

“Although we had not alleged that BDO engaged in fraudulent conduct, by finding that BDO’s valuation efforts were ‘simply not credible’ and that BDO used ‘distorted and inflated’ variables, the Panel did not hold back,” Arthur stated. “Less than three years after BDO concluded that Platinum Management’s $192‑million valuation was fair, PPVA’s Cayman Island Joint Liquidators reported that not only would the liquidation of Golden Gate not result in a monetary recovery for the fund, but ‘it is possible that this asset will result in a net liability’ for the fund.”

“When Platinum Management solicited my clients to invest in PPVA, it touted BDO’s involvement as an independent top-tier auditing firm that would be verifying whether its valuation of the fund’s assets in its financial statements presented fairly and thus provided investors with assurances and transparency,” Arthur said. BDO’s own website similarly claimed “that BDO offers a high quality of auditing that delivers transparency to investors,” he observed.

The legal action against BDO represents a breakthrough for the three-prong privity standard advanced in Credit Alliance, coupled with the demonstration of willful negligence on the part of the auditor. In the post-Madoff world, many investors are understandably reluctant to park their money in a private fund unless they have assurances that a prominent, global auditor – such as BDO – is keeping tabs on the fund’s financials and providing reliable data about its NAV, Arthur reflected. The problem for many investors, he continued, is that “courts in New York have long held that investors in a hedge fund do not have standing to sue the auditors of the fund, because the auditors are retained by management and not the investors, and therefore there is no privity.” In the view of Arthur and the investors that had lost money, the way to change that stance was to demonstrate – within the legal framework of the Credit Alliance three-prong test – that BDO was not only liable for inaccurate audits but also had turned a blind eye to Platinum Management’s malfeasance.

Read the full article in the Hedge Fund Law Report here. Access may require a subscription.