Judge Revives Some Fraud Claims In Refco MDL

Law360–Law360, New York (May 5, 2011) — A New York federal judge revived some fraud claims Wednesday in the Refco Inc. multidistrict securities litigation after rejecting a special master’s recommendation that he dismiss the allegations with prejudice.

U.S. District Judge Jed S. Rakoff disagreed with the special master’s finding that fraud claims brought on behalf of a group of hedge funds were barred because the plaintiffs were partially to blame for some of the alleged wrongdoing at issue. Judge Rakoff said only a few lines out of the 300-page amended complaint support such a reading.

In December, Special Master Daniel J. Capra recommended the court nix the claims permanently – they were dismissed without prejudice in March 2010 – because they were barred by the Wagoner rule, also known as the in pari delicto doctrine. The alleged wrongdoing of four individual defendants must be imputed to Sphinx and PlusFunds, and that imputation applies to both the Sphinx fraud and the larger Refco fraud, according to Capra.

“This court, however, subsequently overruled the special master on this issue,” Judge Rakoff said in his order Wednesday. “Thus, there now appears to be no reason why the Refco fraud claims…should not be revived.”

The plaintiffs brought their actions, now consolidated into the MDL, seeking to recover $263 million plus interest in damages suffered by the Sphinx family of hedge funds, the lost business enterprise value and deepening insolvency damages inflicted on Sphinx investment manager PlusFunds Group Inc. and damages to a group of Sphinx investors.

The complaint alleges that excess cash in segregated accounts at Refco was swept into commingled accounts at Refco Capital Management and was ultimately lost in the Refco scandal because it was not protected from RCM’s insolvency.

While the special master found that the claims were barred by the Wagoner rule, Judge Rakoff said Capra had failed to consider the adverse interest exception, which applies when an agent totally abandons his principal’s interests and acts entirely out of his own purposes.

Judge Rakoff said the plaintiffs alleged exactly that – the individual defendants acted in their self-interest to the detriment of the funds.

“The special master, however, reads various allegations of the amended complaint as belying these assertions,” Judge Rakoff said. “Reading the amended complaint most favorably to the plaintiffs, however, the court finds itself in disagreement with the special master’s interpretation.”

Refco filed for bankruptcy in October 2005 after losing its New York Stock Exchange listing as a result of an announcement that it was owed $430 million by an entity controlled by former directors.

The filing came two months after Refco raised $583 million in an initial public offering and about a year after it was purchased for $1.9 billion in a leveraged buyout by Thomas H. Lee Partners.

Investigators found that the company had been covering up customer trading losses by transferring securities to appear as debts owed by Refco Group Holdings Inc., a holding company controlled’by former directors, according to federal prosecutors.

The Sphinx entities are represented by Brown Rudnick LLP.

The defendants are represented by Alston & Bird LLP, Baker Botts LLP, Hartman & Carven LLP, Seward & Kissel LLP, Vedder Price PC, Winston & Strawn LLP, Lowenstein Sandler PC, Arnold & Porter LLP, Mccarter & English LLP and King & Spalding LLP, among others.

The MDL is In re: Refco Securities Litigation, case number 07-md-01902, in the U.S. District Court for the Southern District of New York.