United States v. Lay
612 F.3d 440, 2010 U.S. App. LEXIS 14380, 2010 WL 2757123 (2010)
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Rule of Law:
An investment adviser to a hedge fund can owe a fiduciary duty directly to an investor, not just to the fund entity itself, when circumstances indicate a special relationship exists beyond that of a typical, passive investor.
Facts:
- In 1992, Mark D. Lay's company, Capital Management, Inc., began serving as an investment adviser to the Ohio Bureau of Workers’ Compensation (Bureau) for its Long-Term Bonds Fund (Long Fund).
- In 1998, Lay founded a hedge fund named the Active Duration Fund.
- In 2003, Lay represented to the Bureau that the Active Duration Fund would hedge against potential losses in the Long Fund and would adhere to a non-binding 150% leveraging guideline.
- Based on this understanding and the pre-existing relationship, the Bureau transferred $100 million from the Long Fund to the Active Duration Fund in September 2003, becoming its sole investor.
- Lay proceeded to leverage the Active Duration Fund's assets far in excess of the 150% guideline, with some trades exceeding 1,000% and even 10,000% leverage.
- After the fund lost $7 million, Bureau officials met with Lay, and in May 2004, the Bureau invested an additional $100 million, believing Lay was operating within the agreed-upon guidelines.
- The Bureau ultimately invested a total of $225 million in the Active Duration Fund but recovered only about $9 million.
Procedural Posture:
- A federal grand jury indicted Mark D. Lay on one count of investment adviser fraud and multiple counts of mail and wire fraud.
- The case was tried before a jury in the U.S. District Court for the Northern District of Ohio.
- The jury returned a verdict of guilty on all counts.
- Lay filed a motion for judgment of acquittal and a motion for a new trial with the district court.
- The district court denied both of Lay's post-trial motions.
- The district court sentenced Lay and ordered him to pay restitution and forfeiture.
- Lay (appellant) appealed his convictions and sentence to the U.S. Court of Appeals for the Sixth Circuit.
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Issue:
Does a hedge fund investment adviser owe a fiduciary duty to an investor for purposes of the Investment Advisers Act's anti-fraud provisions when there is a pre-existing advisory relationship, the investor is the sole shareholder, and there is direct communication between the adviser and investor about the fund's strategy?
Opinions:
Majority - Rogers, J.
Yes. A hedge fund adviser can have a fiduciary relationship with an investor under certain circumstances. The court distinguished this case from Goldstein v. SEC, which held that not all hedge fund investors are automatically clients of the adviser for registration purposes. Goldstein did not preclude finding a client relationship on a case-by-case basis for the purpose of anti-fraud statutes. The evidence here supported the jury's finding of a fiduciary duty because: 1) Lay and the Bureau had a pre-existing fiduciary relationship regarding the Long Fund, which continued as a single investment strategy; 2) the Bureau was not a passive investor, but had direct and regular communication with Lay about the Active Duration Fund; and 3) the Bureau was the sole investor in the fund at the relevant time. Therefore, sufficient evidence supported Lay's conviction for investment adviser fraud and the related mail and wire fraud counts.
Concurring in part and dissenting in part - Kethledge, J.
No, as to the mail fraud conviction. While the author concurs with the affirmance of the investment adviser fraud and conspiracy convictions, he dissents from the mail fraud conviction. The government failed to prove that the charged mailings—routine trade confirmation slips sent between banks—were 'in furtherance of' the fraudulent scheme. These slips were too remote from Lay's misrepresentations to the Bureau and did not serve to 'lull' the victim into a false sense of security. The government should have based the mail fraud charge on a communication more directly related to the fraud itself. Despite this disagreement, the author concurs in affirming Lay's overall sentence, as it was based on concurrent sentences for multiple counts, including the valid conspiracy conviction.
Analysis:
This decision significantly clarifies the scope of a hedge fund adviser's fiduciary duties in the wake of Goldstein v. SEC. It establishes that the determination of a client relationship is a fact-specific inquiry, preventing advisers from using the fund's corporate form as an absolute shield against fraud liability to investors. The case sets a precedent that advisers with direct, ongoing, and substantive relationships with investors—especially in single-investor funds or where there's a pre-existing advisory relationship—can be held to have a direct fiduciary duty to that investor. This increases the legal risk for advisers who manage funds for a small number of sophisticated or actively involved clients.
