The opinion of the court was delivered by: Lewis A. Kaplan, District Judge
Investors in several hedge funds bring this action against the funds' managers and certain financial institutions for participating in an alleged fraud. Banc of America Securities, LLC ("BAS") and Prudential Financial, Inc., Prudential Equity Group, LLC, and Wachovia Securities, LLC (collectively "Prudential") are charged with aiding and abetting fraud and breach of fiduciary duty by the funds' managers. They move to dismiss the complaint as to them.
I. The Funds Plaintiffs are investors in Bristol Fund, Ltd. ("Bristol"), Safe Harbor Fund, LP ("Safe Harbor"), and/or Milestone Plus Partners, LP ("Milestone") (collectively, the "Funds"),*fn1 hedge funds that invested primarily in mortgage-backed and related securities.*fn2 The Funds were managed directly or indirectly by Beacon Hill Asset Management, LLC ("Beacon Hill")*fn3 and its four principals, John Barry, Thomas Daniels, John Irwin, and Mark Miszkiewicz (together with Beacon Hill, the "Beacon Hill Defendants").*fn4 In 2002, the Funds became "feeder funds" into a master fund managed by
Beacon Hill (the "Master Fund").*fn5
The Funds consisted of portfolios of investments including collateralized mortgage obligations ("CMOs") and, it appears, short positions in U.S. treasury securities.*fn6 The stated approach was to hedge the positions in CMOs, mostly by shorting U.S. treasury bonds in an effort to achieve a low risk, stable return that would be sheltered, at least to a significant extent, from fluctuations attributable to interest rate movements.*fn7
The Beacon Hill Defendants reported the Funds' net asset values ("NAVs") to investors each month and provided annual audited financial statements.*fn8 They allegedly represented also in communications to investors that the NAVs had been or would be calculated in good faith using independent prices.*fn9 Plaintiffs claim that they relied on these statements when making or retaining investments in the Funds.*fn10
According to the second amended complaint (the "SAC"), these statements were fraudulent. The Beacon Hill Defendants allegedly overstated the Funds' NAVs by using phony prices for individual securities in the Funds' portfolios in order to create the false appearance of steadily rising values.*fn11 Rather than using independent prices, the Beacon Hill Defendants allegedly used their own fraudulent valuations.*fn12
Plaintiffs allege that from March 2000 through the fall of 2002, the Beacon Hill Defendants misrepresented the Funds' NAVs in order to make it appear as though "each Funds' [sic] NAV was steadily increasing with little volatility and virtually no negative months . . . . [when] [i]n fact the Funds were losing money."*fn13 They allegedly did so primarily by means of a two step process relating to the valuation of the funds' CMOs.
The first step involved calculating a so-called "hedge-adjusted" NAV for a fund by determining the gain or loss in a fund's short U.S. treasury hedge position and then "plug[ging] the change in value in the treasury position into a computer spreadsheet [the 'Hedge Alloc Spreadsheet'] that allocated value changes to the portfolio's CMOs that matched, in the opposite direction, any loss or gain in the short U.S. treasury position."*fn14 These calculated CMO values therefore increased in response to any decline in the value of the short treasury position and decreased in response to any gain.*fn15 In fact, plaintiffs allege, the values thus determined for individual CMOs did not necessarily reflect their market values.*fn16
The second step involved manual adjustments to the values of individual CMOs, allegedly to maintain the appearance that the Funds' portfolios steadily increased in value over time.*fn17
The Funds were audited on an annual basis by Ernst & Young Cayman Islands and
Ernst & Young LLP (collectively, "E&Y"). Before the creation of the Master Fund in early 2002, Bristol was audited following the conclusion of years ending March 31, while Milestone and Safe Harbor were audited following the conclusion of calendar years. After the creation of the Master Fund, all of the Funds were audited by E&Y for years ending March 31.*fn18 Beacon Hill sent investors audited financial statements following each audit.*fn19
According to the SAC, Beacon Hill was required to provide E&Y with independent corroboration of the Funds' stated values for the CMOs in the Funds' portfolios. In addition, E&Y's internal guidelines provided that E&Y was required to evaluate price differences for all securities where the difference between the Beacon Hill-provided value and the independently-obtained value exceeded five percent.*fn20
Plaintiffs allege that Beacon Hill satisfied its need to provide corroborating values by accumulating "from a wide array of sources" numerous independently determined price marks for each CMO in a fund's portfolio and then providing to E&Y "only that mark or value . . . that came closest to the manipulated results" of its two-step valuation method.*fn21
The SAC alleges that the Beacon Hill Defendants occasionally were unable to "cherry pick" independently determined values sufficiently close to their internally generated values for some CMOs. In some instances, this led them to make further manual adjustments to CMO values in order to bring them within a range of values for which independent corroboration existed.*fn22 In others, Beacon Hill turned to Prudential and BAS to obtain "false" corroboration. According to the SAC, "unlike other brokers that provided marks to the Beacon Defendants, Prudential and BAS did not determine CMO values and provide them to Beacon Hill. Rather, Beacon Hill requested that these brokers provide it with specific marks and then confirm those values to the Funds' auditors as if the brokers had determined the prices themselves."*fn23
In connection with Bristol's audit for the year ending March 31, 2000, plaintiffs allege that Beacon Hill first determined the fund's NAV using the Hedge Alloc Spreadsheet. It then cherry picked CMO values from a range of independent sources including Bear Stearns, its primary broker, as well as DLJ, Merrill Lynch, IDC, and Bloomberg, but not Prudential. Next, it made manual downward adjustments because the values produced by the Hedge Alloc Spreadsheet were "dramatically inconsistent" with the values obtained from the independent sources. This, however, resulted in a $2 million decrease in Bristol's NAV. Beacon Hill therefore manually increased the values of 31 CMOs. According to plaintiffs, these upward adjustments more than eliminated the decrease in NAV.*fn24
Beacon Hill then sought corroboration from Prudential for its adjusted values. On April 12, 2000, Daniels sent a list of the 31 CMOs in Bristol's portfolio to Isaac Kearney, a Prudential broker, along with their "prices" as determined by Beacon Hill. Two days later, Kearney faxed to Beacon Hill on Prudential letterhead an identical list of securities with identical prices. According to the SAC, "Kearney did not even bother to retype the list of CMOs; rather, he took the e-mail from Beacon Hill, cut out the price list, and pasted it to Prudential's letterhead with the indication, 'Prices as of 3-31-00 for Beacon Funds.'"*fn25 This, plaintiffs allege, made it look as though Prudential had arrived independently at the values provided.*fn26
According to the SAC, Beacon Hill then manually reduced certain values because its upward adjustments to the values of the 31 CMOs increased Bristol's NAV above Beacon Hill's target for the period ended March 31, 2001. Bristol's NAV after this round of adjustments was within $50,000 of the original output from the Hedge Alloc Spreadsheet. Beacon Hill then sent the newly adjusted values to E&Y with a cherry picked selection of independent prices as well as the list of prices obtained from Prudential. Prudential allegedly confirmed to E&Y the accuracy of the marks it provided to Beacon Hill.*fn27
Plaintiffs allege also that Beacon Hill's manipulation of CMO values "was not limited to its collusion with Prudential." It adjusted also the values of other CMOs "in order to enable the collection of cherry-picked independent marks." When some of the CMOs were "clearly overvalued," plaintiffs allege, Beacon Hill made manual downward adjustments to those values. In order to offset these decreases, it allegedly made upward adjustments to the values of other CMOs.*fn28
According to plaintiffs, Beacon Hill made these upward and downward adjustments for purposes of Bristol's 2000 audit and then largely reversed them for purposes of its April 2000 valuation of Bristol's portfolio.*fn29
On May 12, 2000, Beacon Hill released Bristol's audited financial statements as of and for the year ending March 31, 2000, which reported the fund's NAV and included a statement by E&Y that the financial statement "present[ed] fairly, in all material respects, the financial position of Bristol Fund Ltd. at March 31, 2000."*fn30
2. Safe Harbor's 2000 Audit
Plaintiffs allege that Kearney no longer worked at Prudential when it came time for the audit of Safe Harbor for the year ending December 31, 2000. When Beacon Hill was unable to cherry pick corroborating values for some of the CMOs in Safe Harbor's portfolio, it could not turn to Prudential for assistance.*fn31
On January 18, 2001, Irwin sent an email to IDC, an independent pricing service, which previously had published prices as of December 29, 2000 for certain CMOs in Safe Harbor's portfolio. The e-mail asked IDC to take a "second look" at some of the prices and issue new values as of December 29. On January 31, David Levy of IDC responded that IDC would not "reprice bonds once those prices have already been released," but that it would "re-evaluate sectors going forward" based on newly available information. Levy provided Irwin with a list of reevaluated prices for 10 CMOs as of December 29, 2000, and reemphasized that IDC would not change the prices it had released.
According to the SAC, Irwin "secretly altered the IDC e-mail. He took out those parts of the IDC e-mail that were not helpful," such as the prices for five of the CMOs and the portions of the e-mail emphasizing that IDC would not release new prices. Irwin then printed the "altered" email and sent it to auditors.*fn32 Allegedly, "Beacon Hill created a second secretly altered e-mail using the exact same technique" and"[f]rom the two fake e-mails, Beacon Hill drew new values for 10 of the CMOs in Safe Harbor's portfolio," thus allowing it to overstate Safe Harbor's NAV.*fn33
Plaintiffs allege that, starting around December 2000, the value of the Funds' short U.S. treasury position began to fall. Beacon Hill's stated CMO values grew accordingly as a result of the calculations performed by the Hedge Alloc Spreadsheet. For many CMOs, plaintiffs allege, "the resulting prices were simply absurd." This is indicated, they claim, by the fact that one CMO in Milestone's portfolio and another in Bristol's portfolio each was determined months later to have a strongly negative option adjusted spread ("OAS").*fn34 According to the SAC, a strongly negative OAS signals that a CMO is overvalued.*fn35
Plaintiffs allege further that Kearney got a new job at BAS just prior to Bristol's audit for the year ending March 31, 2001, in part because Beacon Hill offered to provide BAS with lucrative business if it would hire Kearney.*fn36 While at BAS, Kearney allegedly continued to assist the Beacon Hill Defendants in deceiving auditors.
According to the SAC, Bristol on March 29, 2001 purchased from Milestone a CMO called GECMS 1998-13 at a price of $99.8125. On April 9, 2001, Bear Stearns allegedly sent Beacon Hill a list of March month-end prices for 32 CMOs that included a price of $100.7028 for GECMS 1998-13. According to plaintiffs, Beacon Hill then assigned GECMS 1998-13 a March month-end value of $118.04 and requested that Bear Stearns send a new list of values. On April 11, Bear Stearns partially complied, although its list did not contain a price for GECMS 1998-13. This list was sent to E&Y as corroboration for some of Beacon Hill's prices. "Beacon Hill then obtained the inflated value of 118.31 from BAS to corroborate its obviously inflated month-end value" of $118.04.*fn37
Plaintiffs claim that the $118.04 value for GECMS 1998-13 that Beacon Hill used to determine NAVs "increased Bristol's portfolio value by more than $585,000, or approximately 46% of Bristol's net income for the preceding month." Allegedly, the Beacon Hill Defendants used in total "35 'corroborating' values from BAS," allowing them to overstate Bristol's portfolio value even further.*fn38 The SAC does not specify when these values were sent to E&Y or who sent them.
Bristol's 2001 audited financial statement was released on May 24. Beacon Hill reported the fund's NAV as of March 31, 2001, and E&Y once again stated that the information in the financial statement was fair and accurate.*fn39
4. The Master Fund's 2002 Audit
BAS allegedly assisted Beacon Hill in misstating NAVs in connection with the Master Fund's March 31, 2002 audit.*fn40 According to plaintiffs, Beacon Hill was unable to cherry pick independent marks to corroborate the manipulated values for all of the CMOs in the Master Fund's portfolio and so once again turned to Kearney at BAS.*fn41
On May 20, 2002, plaintiffs allege, Irwin e-mailed to Kearney a list of 31 CMOs in the Master Fund's portfolio and their Beacon Hill-determined prices. Irwin asked Kearney to transfer the prices to BAS's letterhead "so we can double check them one more time before we give you the go ahead to send them to auditors." The next day, Kearney complied and sent an identical list of prices on BAS letterhead to E&Y.*fn42 Plaintiffs allege that BAS was aware that the figures it provided were not legitimate valuations and that they would be used for the purpose of deceiving Beacon Hill's auditors.*fn43
On May 31, 2002, Beacon Hill released the Master Fund's audited financial statement for the period January 2 to March 31, 2002. E&Y signed off on the statement as a fair representation of the Master Fund's financial position.*fn44
The Beacon Hill Defendants allegedly employed their scheme in order to conceal that the Funds actually were suffering substantial losses. In October and November 2002, however, Beacon Hill made three disclosures that revealed the extent of the Funds' losses.
First, "[o]n October 8, 2002, Beacon Hill disclosed to investors, including the plaintiffs, that the NAVs of the Funds declined by an estimated 25% in September. This disclosure was prompted by Bear Stearns' refusal to provide additional financing due to the material over-valuation of the portfolios and Bear Stearns reporting this situation to the SEC."*fn45
Second, "[o]n October 17, 2002, following inquiries from the SEC, Beacon Hill disclosed to investors, including the plaintiffs, that, as of September 30, 2002, the NAVs for the Funds actually declined by 54% from the reported NAVs as of August 31, 2002. In this disclosure, Beacon Hill admitted that a portion of the Funds' losses occurred prior to August 31, 2002."*fn46
Finally, "[o]n November 27, 2002, Beacon Hill disclosed that the NAV of the Funds had actually declined by 61.22% from the NAV reported as of August 31, 2002."*fn47 The SAC alleges that, "[i]n actuality, the NAVs of the Funds had been declining for years."*fn48
Plaintiffs allege that the Funds now are in liquidation and that "it has become increasingly . . . clear that much of the capital invested in these Funds has been lost."*fn49
The disclosures by Beacon Hill in the fall of 2002 prompted an action in this Court by the SEC.*fn50 Without admitting or denying liability, the Beacon Hill Defendants consented to entry of a final judgment and injunction pursuant to which they were obliged to pay ...