The U.S. Court of Appeals for the Second Circuit has affirmed a ruling by Southern District Judge Jed Rakoff (See Profile) upholding a $20.6 million arbitration award against Goldman Sachs for clearing trades for a fraud-riddled hedge fund.

The award was won by the unsecured creditors’ committee of the bankrupt Bayou Group of hedge funds in June 2010 following an arbitration before the Financial Industry Regulatory Authority.

Bayou collapsed in 2005 in the wake of of a $400 million Ponzi scheme orchestrated by the fund’s former CEO, Samuel Israel III.

The FINRA arbitrators agreed with the committee’s lawyers at Rich, Intelisano & Katz that Goldman had fraudulently allowed millions to be transferred into four Bayou funds at the heart of the Ponzi scheme.

Goldman’s lawyers at Schulte, Roth & Zabel sued to vacate the award, arguing that the FINRA panel’s decision stood in “manifest disregard of the law.” Among other things, Goldman argued that it had acted as a conduit for the transfers, not as an “initial transferee,” and had no duty to police the Bayou funds for fraud. Rakoff disagreed, ruling in November 2010 that the award must stand, despite his misgivings about the merits of arbitration over litigation.

Rakoff’s ruling rattled clearing firms, which do not want to be forced to monitor every trade for signs of fraud. The Securities Industry and Financial Markets Association, represented by Sidley Austin, was an amicus for Goldman both at the district court and on appeal.

In an unsigned summary order, the Second Circuit in Goldman Sachs v. Official Unsecured Creditors Committee, 10-5049-cv, upheld Rakoff’s ruling in its entirety on July 3, finding that it must be “highly deferential” to the FINRA panel’s findings. The appellate court made it clear that it didn’t necessarily agree with the arbitrators’ reasoning, but nevertheless rejected Goldman’s contention that the award manifestly disregarded the law.

The panel included Second Circuit judges Joseph McLaughlin (See Profile), Robert Sack (See Profile) and Gerard Lynch (See Profile).

John Rich of Rich Intelisano, who argued for the Bayou unsecured creditors’ committee before the Second Circuit in May, said, “The investors are very pleased that hopefully they are one step closer to having a good portion of their losses covered by this award.”

Rich added, “It’s also important that the court reaffirmed the extreme deference under the law that’s supposed to be given to these arbitration awards.”

Howard Schiffman of Schulte Roth, counsel to Goldman, did not return a request for comment.