When money management firm South Cherry Street lost its entire $1.15 million investment in a hedge fund that turned out to be Ponzi scheme, it sued its investment adviser.

The amount of money may have been small by Wall Street standards, but the implications were big in the high-profile case because it resembles dozens of lawsuits against feeder funds that funneled money to the big kahuna of Ponzi schemes–Bernard Madoff.

In South Cherry Street v. Hennessee Group, the plaintiff made securities fraud and breach of contract claims growing out of losses it suffered from investments made in 2003 in the Connecticut-based Bayou Family Funds. South Cherry’s New York investment adviser, Hennessee Group, recommended the funds. But the 2nd Circuit upheld the lower court’s dismissal of the claims in July.

The three-judge panel held that South Cherry failed to prove scienter, a reckless disregard for the truth, under the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995. “The complaint lacks sufficient factual allegations to give rise to a strong inference of either fraudulent intent or conscious recklessness,” Judge Amalya Kearse wrote in the unanimous opinion.

South Cherry Street is basically a contract case, the judge wrote. But the alleged contract wasn’t in writing and therefore was unenforceable.

Attorneys representing investment advisers caught up in the Madoff scandal and other frauds welcomed the decision, but said the next battleground will be in breach of contract cases tried at the state level. These require a lower standard of proof. Many investment advisers obtain waivers that they cannot be held liable except for gross negligence. But representations they offer to clients, such as promises to conduct due diligence, are considered part of a contract, says Richard Jarashow, a partner at McGuireWoods.

“If I were an aggressive plaintiffs lawyer, I would say putting your head in the sand is not enough,” Jarashow says.

Falling Short

In its sales pitch, Hennessee touted a detailed process for evaluating hedge funds based on personal and professional relationships, a proprietary database and analytics, along with a five-step due diligence process. It said Bayou Funds was a good investment because it was headed by a seasoned trader and was delivering a 19 percent annualized return.

But a 2005 Securities and Exchange Commission report found Bayou to be a Ponzi scheme. Its principals pleaded guilty and were eventually convicted of securities fraud. South Cherry alleged in its complaint that Hennessee could not have performed any real due diligence beginning in 2003. If it had, it would have learned that Bayou’s principal trader, Samuel Israel, wasn’t so seasoned after all. Moreover, in 1998 Bayou replaced its independent auditor with Richmond Fairfield, a firm that turned out to be owned by another Bayou principal. Thus, South Cherry charged, Hennessee was grossly negligent or reckless in passing along Bayou’s doctored financial figures.

But the 2nd Circuit panel found that Hennessee fell short of the scienter requirement. Nowhere is there any allegation that the adviser had knowledge its representations were untrue, the court held. Instead, the complaint alleges that Hennessee “would have learned the truth” if it had performed the due diligence that it promised. Those allegations “do not give rise to a strong inference that the alleged failure to conduct due diligence was indicative of an intent to defraud,” the court found.

Next Battleground

Attorneys who advise investment advisers caught in the Madoff scandal said the decision offers clarity.

“To show recklessness, you must know and disregard a clear indication of fraud,” says Seth Schwartz, a partner at Skadden, Arps, Slate, Meagher & Flom, which represents Tremont Group Holdings, a hedge fund that clients are suing for investing with Madoff. “Anything short of that is negligence at best.”

Schwartz maintains that even if plaintiffs pursue a breach of contract or negligence claim in state court, few will be successful because they will bump into the standard exculpation clauses typical in the hedge fund industry.

But others may be able to demonstrate that their adviser failed to conduct the promised due diligence.

The advisers make promises to monitor the investment, and there is inevitable tension between those representations and the exculpation clauses meant to insulate them from liability, says Jarashow, who represents funds that may have exposure but which haven’t been sued.

In South Cherry, the change of auditors might have raised a red flag and begged for a closer look. Was there a duty to investigate?

South Cherry set a high standard for scienter,” Jarashow says. “But what it didn’t touch is breach of contract.”