Six investors in Lancelot Investors, a Cayman Islands hedge fund, were suckered by the operator of a billion-dollar Ponzi scheme. They sued Lancelot’s auditors in Cook County, where the offshore company is headquartered. The lawsuit alleged that fraudulent and negligent audit reports duped the six investors into pumping $79 million into Lancelot from 2004 to 2008, when the pyramid scheme was imploded, wiping out their investment.
However, the trial judge concluded that the internal-affairs doctrine required application of the United Kingdom’s “reflective loss” rule granted the defendants’’ motion to dismiss based on the investors’ lack of standing.
Applying Illinois law, the appellate court explained that there is “no meaningful difference” between “the shareholder standing rule followed in Illinois” and the U.K.’s reflective loss doctrine. And looking at the essence of the complaint, the Illinois Appellate Court for the First District reversed because “Lancelot’s conduct and the like have not been put at issue” and the plaintiffs were pursuing “a direct claim involving accounting fraud and misrepresentation that occurred in Illinois,” not “an indirect claim implicating the internal affairs of the Cayman Islands hedge fund.”
The shareholder-standing rule followed in the United States “is a long-standing equitable restriction that generally prohibits shareholders from initiating actions to enforce the rights of the corporation unless the corporation’s management has refused to pursue this same action for reasons other than good-faith business judgment.” Cashman v. Coopers & Lybrand, 251 Ill.App.3d 730 (1993).
Shareholders generally lack standing to bring indirect claims regarding a loss in the value of their company shares. When a shareholder directs a personal interest in a cause of action, he/she has standing to sue in Illinois in an individual capacity, even if the corporation’s rights are also implicated. “A suit brought by a stockholder upon a personal claim is by its nature distinguishable from a proceeding to recover damages or other relief for the corporation.” Zokoych v. Spaulding, 36 Ill.App.3d 654 (1976).
In order to proceed in any individual capacity, a shareholder “must allege something more than wrong to the corporate body” (Davis v. Dyson, 387 Ill.App.3d 676 (2008)), and this injury must be “separate and distinct from that suffered from other shareholders.” Stillyards v. Abboud, 278 Ill.App.3d 663 (1996).
In this case, the appellate court found that this lawsuit was fairly characterized as a direct action against Lancelot’s outside accountants regarding the financial losses that the individual shareholders suffered when they first invested in the fraudulent offshore fund. They also increased their shares and maintained their holdings. The court found the lawsuit was a direct action against the accountants rather than as a derivative action concerning the fund’s corporate government and conduct that subsequently diminished the value of their shares.
The appeals panel agreed with the plaintiffs’ characterization of their suit as a direct claim involving accountant fraud and misrepresentation that occurred in Illinois and rejected the defendants’ characterization of the suit as an indirect claim implicating the internal affairs of the Cayman Islands’ hedge fund.
Based upon the appellate court’s reading of the complaint in light of the concepts of the internal affairs doctrine and the standing rule that generally prevents shareholders from bringing claims that are merely indirect of the company’s own losses, the appeals panel found that the trial court erroneously concluded that the complaint presented “issues related to the corporate governance of Lancelot.”
The court in reversing the dismissal also defined a Ponzi scheme. The court stated that “A Ponzi scheme is a scheme whereby a corporation operates and continues to operate at a loss. The corporation gives the appearance of being profitable by obtaining new investors and using those investments to pay for the high premiums promised to earlier investors. The effect of such a scheme is to put the corporation farther and farther into debt by incurring more and more liability and to give the corporation the false appearance of profitability in order to obtain new investors” Hirsch v. Arthur Andersen & Co., 72 F.3d 1085 (2d Cir. 1995).
RS Investments, Ltd. v. RSM, LLP, 2019 IL App (1st) 172410 (Feb. 28, 2019).
Kreisman Law Offices has been handling corporation shareholder disputes, commercial litigation, business litigation and shareholder and partnership litigation for individuals, families and businesses for more than 40 years in and around Chicago, Cook County and its surrounding areas, including Bridgeview, Barrington, Schaumburg, Bolingbrook, Romeoville, Park Forest, Forest Park, Crestwood, Beecher, Crete, Matteson, Chicago (Kenwood, Garfield Park, Jefferson Park, Jackson Park, Washington Park, Roscoe Village, Beverly, Chinatown, Bronzeville, Oakland), Darien, Schiller Park, Rosemont, Mundelein, Palos Hills, River Forest, Kenilworth, Oak Park, Oak Lawn and Tinley Park, Ill.
Related blog posts:
Illinois Appellate Court Affirms Judgment Against Alter Ego Parties
U.S. Court of Appeals Ruled that Previous Business Owner Did Not Violate Non-compete Agreement