In an April 11, 2014 decision the Second Circuit affirmed a ruling by the Southern District of New York, dismissing claims that certain Refco customers facilitated the wrongdoing of the now bankrupt financial services firm.
In Krys v. Pigott, 749 F.3d 117 (2d Cir. 2014), the plaintiffs were liquidators for a family of hedge funds that were customers of the financial services company Refco. The hedge funds had suffered significant losses in connection with Refco’s now infamous bankruptcy.
The liquidators filed suit against a group of customers of Refco alleging that the customers participated in a number of “round-trip” loan transactions with Refco and thereby aided and abetted Refco’s fraud and breach of fiduciary duty.
Under the “round trip” loan transactions, Refco would “loan” up to $720 million to some of its customers, including the defendants, who would then “loan” the same amount to RGHI, a Refco-related entity whose principal asset was shares of Refco. RGHI would then use the money it borrowed from the customers to pay down debt owed to Refco. By engaging in these circular loans at the end of every reporting and audit period, and then unwinding them by reversing the process after the start of each new reporting or audit period, Refco was able to conceal a large related-party receivable and the company’s overall insolvency.
In reviewing the claims against the customers, the Second Circuit agreed with the District Court ruling that under New York law, claims for aiding and abetting fraud and breach of fiduciary duty required the liquidators to establish that the alleged aider and abettor had actual knowledge of the underlying wrongful conduct.
The court emphasized that “constructive knowledge,” i.e. that the defendants should have known that they were aiding and abetting fraud or breach of fiduciary duty, was not enough to satisfy the scienter requirement for the allegations.
Although the liquidators alleged that the customers “knew and/or consciously avoided knowing” that the “round-trip” loans were created so that Refco could issue fraudulent financial statements and hide its insolvency, they failed to allege sufficient facts to “give rise to any reasonable inference that [the customers] knew or even suspected that Refco was insolvent” or that the loans were designed to hide that fact.
The court was not persuaded by arguments that the timing, specific amounts, or increasing size of the loans should have tipped the customers off about their fraudulent nature, and the court found it implausible that the customers knew about Refco’s insolvency because they continued to do business with the company, at times insisting on having the loans guaranteed by Refco.
In the absence of facts indicating that the customers had actual knowledge that Refco was engaged in fraud or breaching its fiduciary duties, the liquidators had failed to state a claim.
The Second Circuit decision demonstrates that future plaintiffs bringing similar claims will have to plead their cases with greater particularity, alleging facts sufficient to establish actual knowledge by those who they claim aided or abetted fraud or breach of fiduciary duty.