Morgado Family Partners, LP v Lipper

[*1] Morgado Family Partners, LP v Lipper 2004 NY Slip Op 51791(U) Decided on November 9, 2004 Supreme Court, New York County Moskowitz, J. Published by New York State Law Reporting Bureau pursuant to Judiciary Law § 431. This opinion is uncorrected and will not be published in the printed Official Reports.

Decided on November 9, 2004
Supreme Court, New York County

MORGADO FAMILY PARTNERS, LP, MATTHEW SERINO and LUCILLE SERINO, individually and on behalf of all others similarly situated, Plaintiffs,

against

KENNETH LIPPER, LIPPER HOLDINGS, LLC and PRICEWATERHOUSECOOPERS LLP, LIPPER & COMPANY, INC., ABRAHAM BIDERMAN, LAWRENCE BLOCK, EDWARD STRAFACI, and MICHAEL VISOVSKY, Defendant.



604396/2002

Karla Moskowitz, J.

The court discussed the facts underlying this dispute in prior decisions and in the decision and order of today in Jones v. PriceWaterHouseCoopers Index No. 602962/2003, (the "Jones companion case"). The court presumes familiarity with these decisions and will not repeat the facts except as necessary to this decision.

Plaintiffs the Morgado Family Partners, LP, Mathew Serino and Lucille Serino individually and on behalf of all others similarly situated, (collectively "Morgado" or "Plaintiffs") and the class they purport to represent are investors in a private investment hedge fund, Lipper Convertibles, L.P. ("Lipper Convertibles" or the "Partnership"). Defendant Lipper Holdings LLC was the general partner of Lipper Convertibles. Ken Lipper was the majority shareholder of Lipper Holdings and the managing director and president of Lipper Convertibles.

Defendant PricewaterhouseCoopers ("PwC") was the independent auditor of Lipper Convertibles and prepared audit reports of Lipper Convertibles' financial statements and form K-1s. Defendant Ed Strafaci was the Executive Vice President and managing director of Lipper Convertibles. Defendant Abraham Block was the Chief Legal Officer and Compliance Officer of the Fund. Defendant Lawrence Biderman was an employee of Lipper Holdings and a registered securities principal of Lipper Convertibles.

This lawsuit arises out of the demise of Lipper Convertibles. Morgado accuses PwC of, among other things, failing to discover that Lipper Convertibles had overstated its earnings. Morgado has sued PwC for professional malpractice and negligent misrepresentation.

By this motion (sequence no. 4), PwC moves to dismiss the complaint against it. In the alternative, PwC moves to stay this action. In addition, the Successor Liquidating Trustee that [*2]this court appointed on July 7, 2003 in the liquidation proceeding, In the Matter of the Application of Lipper Holdings, LLC, Case No. 603563/2002 (the "Trustee"), has applied, via letter brief dated April 30. 2004, for a stay of this action pending resolution of the Trustee's own derivative action against PwC. Plaintiffs have opposed PwC's motion. They have also opposed the Trustee's application in letters dated May 10, 2004 and May 19, 2004. Plaintiffs have also submitted a sur-reply letter dated July 23, 2003 to PwC's Reply Memorandum of Law dated June 11, 2003. Because Plaintiffs do not appear to have permission to file a sur-reply, the court declines to consider it.

For the following reasons, and for the reasons stated in this court's decision and order of today in the Jones companion case, the court denies both PwC's motion and the Trustee's application insofar as the claims Plaintiffs assert are direct. To the extent Plaintiffs assert claims that are derivative in nature against PwC, the court stays them. The court stays these derivative claims of Plaintiffs as opposed to dismissing them because the applicability of the doctrine of in pari delicto is not clear from the record on this motion. (See discussion, pages 6 - 7 infra).

IPresent Injury

In the Jones companion case, I rejected PwC's argument that the Jones Plaintiffs' case was premature because until the Trustee completes the winding up of the Partnership, it is impossible to know whether Plaintiffs have suffered any damage. PwC makes the same argument in support of its motion to dismiss this lawsuit. However, as I stated in the decision in the Jones companion case, whether Plaintiffs sustained actual losses is an issue of fact and is not a reason to dismiss the lawsuit.. (See Nevelson v. Carro, Spanbock, Kaster & Cuiffo, 290 AD2d 399 [legal malpractice]). Accordingly, that part of PwC's motion seeking dismissal because Plaintiffs' damages are indeterminate at the present time is denied.

II.Standing

As PwC argues in the companion case, PwC argues here that the Morgado plaintiffs lack standing to assert claims for incentive and management fees because these claims are derivative. As I held in the companion case, Morgado's claims for incentive and management fees are derivative of claims of the Partnership and therefore Morgado cannot assert them in this direct action. (See Broome v. ML Media Opportunity Partners L.P., 273 AD2d 63, 64). This decision is particularly appropriate as the Trustee is already pursuing these claims against PwC on behalf of the Partnership before this court so that the individual limited partners may still recover, just via a different lawsuit.

Plaintiffs make several arguments in an attempt to characterize their attempt to recover management and incentive fees as a direct claim. First, Plaintiffs argue that there is no injury that accrued separately to the Partnership in this case and therefore the Trustee cannot assert a claim for the incentive or management fees. Plaintiffs cite Hirsch v. Arthur Andersen & Co., 72 F3d 1085, 1094 to support this proposition and characterize that case as holding that, where limited partners are the ultimate injured party, the Trustee has no standing. (Letter, dated May 10, 2004 from Richard Stone, Esq. at pg. 25). However, Hirsch did not involve the overpayment of management fees, but rather involved misleading private placement memoranda ("PPM") that induced the investment in the partnership an obvious direct claim. In addition, the Hirsch [*3]decision left open the "theoretical possibility" that, even in a lawsuit involving misleading PPMs, there might be some "independent financial injury to the Debtors that might be established." (Id.) Hirsch then precluded the Trustee's suit on in pari delicto principles.

Plaintiffs next argue that, because hedge fund accounting requires the pro rata charging of the individual partners' capital accounts to pay for the management and incentive fees, the injury is direct to the individual partners rather than the Partnership. However, the requirements of hedge fund accounting do not diminish that it was on the Partnership's behalf that the capital accounts became charged. There is nothing about the payment of fees that was personal or different among the partners. Rather, the management fees were presumably for managing the Partnership and the method of paying the management fees was part and parcel of how the Partnership operated. The incentive fees were presumably to encourage management to make the Partnership more profitable. Neither effort has anything to do with the limited partners personally. (See In re Granite Partners, L.P., 194 BR 318, 327 [denying direct action where "[n]one of the alleged injuries existed independently of the partnership or were inflicted directly on the limited partners"]). Plaintiffs cite Schmutz v. Fleet Bank, 278 AD2d 19 as standing for the blanket proposition that, when partnership trust accounts are affected, the injury is direct. (May 10, 2004 letter from Richard Stone, Esq. at pgs 29-30). However, as in Hirsch, Schmutz did not involve incentive or management fees and other courts have held claims seeking recovery of these fees are derivative. ( See Broome v. ML Media Opportunity Partners, 243 AD2d 63, 64; Abeloff v. Barth, 119 FRD 332, 334 [D. Mass 1988]).

Plaintiffs also make the creative argument that, although the Trustee has a claim for restitution against the general partners for return of the amount of excess incentive fees, Plaintiffs' claim against PwC to recoup the same management fees is direct because it seeks compensatory damages for PwC's negligent failure to detect the General Partner's unauthorized taking of excess fees. (Richard Stone Letter dated May 10, 2004 at pg. 28). This is a meaningless distinction. As Plaintiffs recognize, the right to assert the claim depends upon who suffered the injury, the individual partners or the partnership. (Hirsch, 72 F3d at 1091). The sufferer does not change merely because the theory of damages changes. As stated earlier, it is the Partnership that suffered the injury from paying excessive management fees.

Finally, Plaintiffs, in their May 10, 2004 letter, argue that the rule of in pari delicto prevents the Trustee from suing PwC. This doctrine prevents a trustee from asserting a claim against a third-party where management has participated with that third-party in the wrongful acts. "Because management's misconduct is imputed to the corporation, and because a trustee stands in the shoes of the corporation, the rule bars a trustee from suing to recover for a wrong that he himself essentially took part in." (Wight v. BankAmerica Corp., 219 F3d 79, 86-87 [2d Cir 2000]; Shearson Lehman Hutton,. Inc. v. Wagoner, 944 F2d 114, 117 [2d Cir. 1991]).[FN1] This doctrine, sometimes known in the federal courts as the "Wagoner rule" derives from presumptions in agency law that presumes an agent communicates with and acts for his or her principal and that the principal has control over the agent. (See In re CBI Holding Co, 311 B.R. [*4]350, 367 [SDNY 2004]) It is undisputed that at least Strafaci committed acts of fraud that PwC failed to discover. If Strafaci's knowledge and possibly that of other members of management can be imputed to the Partnership, then the Trustee lacks standing to sue PwC for failure to discover that fraud, unless there is some other reason not to impute.

The "adverse interest" exception precludes application of the Wagoner rule. According to this exception, if the actions of management are adverse to the corporation and benefit management or a third party, a court will not impute those actions to the corporation. (See In re Bennett Funding Group, 336 F3d 94, 100 [2d Cir. 2003]) For this exception to apply, however, the officer, board member or the like (as agent) "must have totally abandoned his principal's interests and be acting entirely for his own or another's purposes." (Center v. Hampton Affiliates, Inc., 66 NY2d 782, 783).

Here, it would appear that the Fund's co-manager, Edwards Strafaci, was the main culprit in overstating the value of Lipper Convertibles' security holdings and the corresponding value of the limited partners' investments so that Strafaci and others could receive inflated incentive and management fees to the detriment of the Partnership. These facts suggest that the "adverse interest" exception may apply.

However, on this record, where the parties primarily support their position through letter briefs, the court has had great difficulty in determining whether Strafaci acted in his own interest entirely without any benefit to the Partnership. Therefore, whether the adverse interest exception applies remains a question of fact in this lawsuit. (See Capital Wireless Corp., v. Deloitte & Touche, 216 AD2d 663, 666-67 [whether mismanagement was vehicle to advance manager's own interest or simply incidental to his continued efforts to retain some economic viability in the company was issue of fact]).

Morgado argues that the "adverse interest" exception does not apply in the first instance because the General Partner was the only entity with authority to act on behalf of the Partnership and therefore the "sole actor" exception (itself an exception to the adverse-interest exception) applies. (May 10 Stone letter at 23). The "sole actor" rule comes into play "where the principal and agent are one and the same." (In re Bennett Funding Group, 336 F3d 94,100 [2d Cir 2003]). Its most obvious applicability is where a single person owns and manages a corporation. (CBI, 311 BR at 372). The reason behind the rule is because where the principal and agent are one and the same, it makes no sense not to impute the agent's acts of fraud to the corporation even if there was a total abandonment of the corporation's interests. (See In re Mediators, 105 F3d 822, 827 [2d Cir. 1997]).

However, in a larger company, where there may be others in management who were innocent of the fraud, the "sole actor" rule is the second part of a larger analysis. As Judge Kimba Wood explained in CBI: Where only some of a corporation's owners were involved in a fraud in their role as managers, courts consider whether those insiders who were innocent and unaware of the misconduct had sufficient authority to stop the fraud. . . When the innocent insiders lack authority to stop the fraud, the "sole actor" exception to the "adverse interest" exception applies, and imputation is thus proper, because all the relevant shareholders and decision makers were involved in the fraud. However, when the innocent insiders possessed authority to stop the fraud, the "sole actor [*5]rule" does not apply, because the culpable agents who had totally abandoned the interests of the principal, and were thus acting outside of the scope of their agency, were not identical to the principal.

(CBI, 311 BR at 373)

Here, it was Strafaci primarily that perpetrated the alleged fraud while there may have been others in management who possessed the authority to stop the fraud, but who were unaware of it. Even Plaintiffs refer to a report from the law firm of Fried, Frank, Harris, Shriver & Jacobson that found Ken Lipper to have been unaware of the fraud "taking place under his nose." (May 10, 2004 letter at 21). In addition, the Trustee's complaint[FN2] against PwC in Williamson v. PriceWaterHouseCoopers, LLP, index no. 602106/2004, alleges that PwC never discussed with senior management the Fund's failure to use adequate internal accounting controls to ensure the accuracy of the valuation of the securities so that senior management never took corrective action (Trustee's complaint against PwC ¶ 4).

In discussing the "innocent insider" and "sole actor" rules, the court does not endorse either as being a statement of New York law. Indeed, the court notes that some courts have refused to recognize the "innocent insider" rule, reasoning that it is more important to encourage management to choose carefully and then police its agents. Imputation of agent misconduct to innocent management accomplishes this goal. ( See, e.g., CBI 311 BR at 372). The court's discussion is only in the context of Plaintiffs' argument to show how the interplay between the two rules and how the "sole actor" rule is not applicable to this case.

Plaintiffs also assert that, because Ken Lipper has retained the excess management fees, despite all these lawsuits, he is implicated in the fraud. This does not necessarily follow. Perhaps Lipper has retained his fees because he disputes the amount he must return. Perhaps he spent the money and is incapable of paying back the fees at this time. Accordingly, the court grants the Trustee's application to stay Morgado's claims insofar as the claims are derivative. This includes claims for incentive and management fees. The court stays rather than dismisses these claims, as PwC has requested, pending further development of the record regarding whether the Trustee lacks standing because of in pari delicto or whether the "adverse interest" exception applies.

As a practical matter, the Trustee is still the best choice to bring this suit. The Trustee, standing in the shoes of the Partnership, can assert a claim that will benefit all the partners, not just Plaintiffs in this lawsuit. Further, if the Trustee is successful, the Plaintiffs in this lawsuit will receive benefits without lifting a finger. This Trustee is an independent person that this court appointed to represent the interests of the Partnership. There are already several other lawsuits from other plaintiffs competing with this one. To have at least those claims that the Trustee can bring adjudicated in a central forum is preferable.

However, to the extent that Plaintiffs assert direct claims, such as fraud in the inducement [*6]of their initial investment in the Partnership, they are not derivative and the court therefore declines to dismiss or stay them. (See In re Bennett Funding Group, 336 F3d at 102; Hirsch, 72 F3d at 1094).

Accordingly, it is

ORDERED THAT that part of the motion of PriceWaterhouseCoopers to dismiss this action is denied; and it is further

ORDERED THAT that part of the motion of PriceWaterhouseCoopers to stay this action is granted to the extent of staying only those claims Plaintiffs have asserted that are derivative in nature (i.e. the claims to recover excessive management fees and incentive compensation) and is otherwise denied; and it is further

ORDERED THAT the application of the liquidating Trustee to stay this action is granted to the extent of staying only those claims Plaintiffs have asserted that are derivative in nature (i.e. the claims to recover excessive management fees and incentive compensation) and is otherwise denied; and it is further

ORDERED THAT the remainder of the action is severed and shall continue.

The parties are directed to attend a status conference on November 9, 2004 at 10:00 a.m. in the courtroom, room 248, 60 Centre Street.

Dated: November 9, 2004 /s/ Karla Moskowitz_______

J.S.C. Footnotes

Footnote 1:In this case, the Trustee is not a bankruptcy trustee, but is in a sufficiently analogous position that he has standing to institute any suit that the Partnership could have instituted were it not winding down

Footnote 2: Plaintiffs refer to their own complaint that alleges that Ken Lipper participated in and directed the wrongdoing. (May 10, 2004 letter at 21 n. 24). However, crediting only Plaintiffs complaint would allow them to defeat with only bare allegations a competing lawsuit from a trustee.