Second Circuit Panel Affirms FINRA Arbitration Award against Hedge Fund Prime Broker

A FINRA arbitration award against the sole clearing broker and prime broker for a hedge fund that turned out to be a massive Ponzi scheme was affirmed by a Second Circuit panel. The court found that the prime broker failed to satisfy the difficult standard for demonstrating that the arbitrators manifestly disregarded the law. (Goldman Sachs Execution & Clearing, L.P. v. The Official Unsecured Creditors’ Committee of Bayou Group, LLC, CA-2, July 3, 2012)

When the fund filed for bankruptcy, the bankruptcy trustee authorized a committee of unsecured creditors of the fund to pursue claims against the prime broker. Pursuant to an arbitration agreement between the fund and the prime broker, the committee pursued a FINRA arbitration proceeding against the prime broker, which resulted in an award in favor of the committee by a FINRA arbitration panel in the amount of $20.5 million.

The arbitration award was judicially reviewed under the manifest disregard standard, which the appeals panel called a standard that is highly deferential to arbitrators. In applying the manifest disregard standard, courts in the Second Circuit consider first whether the governing law alleged to have been ignored by the arbitrators was well defined, explicit, and clearly applicable, and, second, whether the arbitration panel knew about the existence of a clearly governing legal principle but decided to ignore it. The manifest disregard standard is designed to be exceedingly difficult to satisfy, noted the appeals court, and the prime broker did not satisfy it in this case. 


The committee alleged in the arbitration that deposits transferred into four new hedge funds in the fund group were fraudulent transfers under the Bankruptcy Code and were recoverable from the prime broker because it was an initial transferee under the Code. The prime broker did not contest that the transfers were fraudulent, said the court, or even that it was on inquiry notice of the fraud, but it argued that it is not an initial transferee and that the arbitration panel manifestly disregarded the law in concluding that it was. The argument failed because the most recent case on point in the Southern District of New York, where the arbitration was held, cuts in favor of the committee. Bear Stearns Securities Corp. v. Gredd, 397 BR 1 (SD NY 2007).

Much like Bear Stearns in the Gredd case, the prime broker here possessed considerable control with respect to the fund’s deposits under the relevant account agreements. Not only did the prime broker possess a security interest for payment of all of the hedge fund’s obligations and liabilities, but it also had the rights to require the fund to deposit cash or collateral with to assure due performance of open contractual commitments; to require the hedge fund to maintain such positions and margins as the prime broker deemed necessary or advisable, to lend either to itself or to others any of the fund’s securities held by the prime broker in a margin account and to liquidate securities and/or other property in the account without notice to ensure that minimum maintenance requirements are satisfied.

The appeals panel emphasized that these provisions gave the prime broker broad discretion over the funds in the hedge fund accounts and allowed it to use the funds to protect itself. While the Second Circuit has not previously endorsed the district court's decision in Gredd, and did not do so here, neither has the appeals court rejected it. It is enough, said the Second Circuit panel, under the manifest disregard standard, that the Gredd opinion reveals considerable uncertainty as to whether cases like this one come within an exception to the mere conduit principle on which the prime broker relies. Under these circumstances, the appeals court could not conclude that the arbitrators manifestly disregarded the law in applying the legal principles set forth in Gredd to impose transferee liability on the prime broker.