Judge OKs Suit V. Law Firm Over Hedge Fund Fraud

By Ron Zapata, ron.zapata@portfoliomedia.com
Wednesday, Apr 02, 2008

A federal judge has ruled that federal law does not preempt shareholder cases brought under Oregon securities law, allowing a federal fraud suit seeking to hold law firm Seward & Kissel LLP liable for alleged misrepresentations made by a hedge fund to continue.

However, U.S. District Judge Harold Baer of the Southern District of New York did toss investor Howard Houston's claims that Seward & Kissel violated registration requirements under Oregon's Blue Sky laws. Houston accused Seward & Kissel of aiding and abetting in misrepresentations and omissions made in offering documents by hedge fund Wood River Partners LP, which has been placed in receivership.

“Because Oregon's securities law grants a private right of action against aiders and abettors and the plaintiff has successfully alleged facts sufficient to state a claim for fraud, defendant's motion to dismiss that claim is [denied],” Judge Baer said in his ruling on March 27.

“However, because the plaintiff has failed to plead facts alleging that the Wood River securities are not exempt from registration, the defendant's motion to dismiss this claim is [granted],” Baer said.

Wood River allegedly told investors in its offering documents that it would not invest more than 10% of its portfolio in one security, when it actually had 68% of its assets tied up in stock for technology company EndWave Corp. by the summer of 2005. When EndWave's share price dropped dramatically in September 2005, the hedge fund's value also dropped, preventing the fund from fulfilling redemption requests from investors.

Seward & Kissel argued in its motion that the case involved federally-covered securities which are covered by the federal National Securities Markets Improvement Act. The firm claimed all statements made in offering materials were regulated by the act and preempted state regulation of offering materials in relation to securities.

Judge Baer denied Seward & Kissel's claim, ruling that the NSMIA preserves state power to regulate securities fraud for federally-covered securities.

“Congress and the courts, most recently the Supreme Court in dicta, have repeatedly recognized state authority to regulate and enforce its own fraud statutes in the securities realm independent of federal law,” Baer said, noting statements made by legislators in passing the act as well as the U.S. Supreme Court's recent decision in Stoneridge Investment Partners LLC v. Scientific-Atlanta.

Seward & Kissel also claimed that the Oregon Blue Sky laws, which establish derivative liability for aiders and abettors of securities fraud and registration violations, violated the dormant commerce clause of the U.S. Constitution by regulating conduct that occurred outside Oregon. The firm claimed the statute interfered between the New York law firm's relationship with Wood River's former principal, John Whittier of Idaho.

Judge Baer, however, ruled that the suit involved Oregon resident Houston's receipt of offering materials from Wood River at his home, which is covered by the Blue Sky laws.

Judge Baer also ruled that Houston made sufficient pleadings to pursue fraud claims against the firm by alleging that Seward & Kissel had prepared legal materials for the fund's offering.

However, Judge Baer ruled that Houston could not pursue his state registration violation claims against the law firm. The Blue Sky laws regarding state registration requirements do not allow for civil liability of federally covered securities, and Judge Baer said Houston failed to show that the securities were not federally covered.

Robert Banks, an attorney for Houston, said the ruling confirms that law firms involved in an offering "are doing so at their own peril if their clients are crooks, unless they can show that they didn't know [about the fraud] or couldn't figure that out."

He said the decision could be followed closely by lawyers following Blue Sky cases, which generally refer to state securities laws that protect the public from fraud.

An attorney for Seward & Kissel did not immediately return requests for comment on Wednesday.

Houston filed his suit against Seward & Kissel in July 2007, claiming that the firm was liable for actual damages plus 9% interest under Oregon law.

He said Seward & Kissel drafted, edited, reviewed and approved a prospectus and marketing materials which contained false representations and omissions about the fund, making the firm liable for the $2.75 million investment he lost through Wood River.

Seward & Kissel had faced a similar suit in New York State Supreme Court by Wood River investor Eurycleia Partners LP, but the court dismissed the suit for deficient pleadings to show that the firm knowingly made misrepresentations about the fund. That decision was affirmed by a New York appellate court in December.

In August, the fund and Whittier settled a civil case brought by the U.S. Securities and Exchange Commission for $6.3 million. Whittier had also been sentenced to 36 months in prison in a criminal case brought against him over the fraud allegations.

In their indictment, the U.S. Department of Justice and Federal Bureau of Investigation allege that Whittier lied to investors by saying his funds had a broad investment strategy and that no investment would be more than 10% of the hedge funds’ holdings, and by purposely withholding information about his concentrated holdings in one stock from the SEC.

From fall 2004 through September 2005, prosecutors said Whittier gained ownership interest of Endwave by buying a majority of the telecommunication company’s common stock through Wood River. Whittier then allegedly purposefully failed to disclose that ownership interest to his hedge fund investors and to the public in required filings with the SEC.

Prosecutors also accused Whittier of breaching his promises to investors by failing to diversify Wood River's $127 million portfolio.

In mid-September 2005, a company for which Whittier had been managing investments terminated its relationship with Whittier because of problematic trades and Whittier’s suspicious trading activity in Endwave stock, prosecutors said. The company then liquidated its Endwave holdings.

Endwave’s stock price plummeted, dropping the value of the Wood River hedge funds and triggering margin calls by the funds’ brokers. Because such a large portion of the funds was invested in Endwave stock, Whittier was unable to meet those margin calls and various brokers began liquidating the hedge funds’ Endwave stock positions.

Around the same time, Whittier informed investors that he could not pay redemption requests because of liquidity problems. By October 2005, Whittier and the Wood River funds were no longer doing business. As a result, prosecutors said investors in the Wood River hedge funds lost approximately $88 million.

Houston is represented by Kaufmann Feiner Yamin Gildin & Robbins LLP and Banks Law Office PC.

Seward & Kissel is represented by Paul Weiss Rifkind Wharton & Garrison LLP.

The case is Howard Houston v. Seward & Kissel LLP, case number 07-cv-6305 in the U.S. District Court for the Southern District of New York.

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