Recent financial frauds are raising questions about the role and potential liability of fiduciaries that have invested in fraudulent enterprises. Those who control hedge funds, private equity funds or other investment vehicles, including investment advisers and ERISA trustees, should take steps to evaluate their exposure to liability and determine if their policies and procedures require improvement. Investors will scrutinize a fiduciary's initial investment decision, the monitoring of the investment and their reaction to a financial fraud. All fiduciaries, whether or not a victim of a fraudulent enterprise, should keep some key points in mind to help avoid or minimize their liability.
Why Fraud is So Hard to Detect
Even vigilant fiduciaries can become victims of fraud. Perpetrators are becoming more sophisticated in concealing their illegal activities and creating the illusion of profitability and effective management systems and controls. Certain scenarios make it easier for fraud to occur. Some facts to consider:
In general, a fiduciary is liable for directing an investment in a fraudulent enterprise if it breached its duty of care or if its conduct violated ERISA or securities laws, such as providing inadequate or misleading disclosures. Whether a fiduciary satisfied its duty of care or other legal obligations will depend on the specific facts, such as what information you obtained, the quality of your analysis, the extent of your reliance on professionals and the care and frequency you used in monitoring the investment performance. For example, fiduciaries that have access to additional information through co-investment structures or participation on advisory boards or committees could be held to a higher standard.
No Guarantees, But Act Fast
Fiduciaries do not guaranty that fraud or other unlawful acts by others will not occur and the fact that something went wrong, even materially wrong, does not necessarily mean that the fiduciaries are liable. But that won't stop victims of fraud from suing them. So if you have acted as a fiduciary and are a victim of a fraudulent enterprise, you should waste no time in taking these steps:
Enhancing Best Practices
Procedures will no doubt continue to improve as fiduciaries analyze past frauds and identify what could have and should have been done to detect them. Reliance on any one procedure or process or merely "piggybacking" on the diligence of others will likely be insufficient. Massive frauds have been perpetrated by large SEC reporting firms with sophisticated executive staff and external auditors. Your procedures should be overlapping and redundant, and be designed to detect red flags such as:
Of course, as procedures develop, so will the audacity and sophistication of perpetrators of fraud. Be sure to regularly review and improve your current procedures and processes.
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Financial Fraud Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.
Copyright © 2008 Herrick, Feinstein LLP.