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Cannonball Fund, Ltd. v. Dutchess Capital Management, LLC

Superior Court of Massachusetts, Suffolk, Business Litigation Session

September 30, 2016

Cannonball Fund, LTD. et al. [1]
v.
Dutchess Capital Management, LLC et al. [2] and Dutchess Private Equities Fund, L.P. et al. [3] No. 135326

          Filed October 4, 2016

          MEMORANDUM OF DECISION AND ORDER ON DEFENDANT SULLIVAN BILLE PC'S MOTION FOR SUMMARY JUDGMENT

          Mitchell H. Kaplan, Justice

         This derivative action arises out of plaintiffs' investment in two feeder hedge funds, Dutchess Private Equities, L.P. (Dutchess LP), a Delaware limited partnership, and Dutchess Private Equities Cayman Fund, Ltd. (Dutchess Ltd.), a Cayman Islands exempt corporation. These feeder funds fed a master fund, Dutchess Private Equities Fund, Ltd. (Master Fund), also a Cayman Islands exempt corporation, which made all investments. Plaintiffs are certain of the limited partners of Dutchess LP and shareholders of Dutchess Ltd. They generally allege that the defendants, who controlled or were involved in the funds' operation, caused injury to the funds by causing the Master Fund to invest in companies that were financially at risk and did not meet the funds' stated investment strategy in order to enrich themselves through fees paid from the portfolio companies and the Master Fund to entities they owned and controlled. The limited partner plaintiffs of Dutchess LP (LP Plaintiffs) separately assert that Sullivan Bille negligently audited Dutchess LP's financial statements and issued unqualified audit reports certifying its financial statements, which prevented them from discovering and putting a stop to the improper investments. In the motion presently before the court, Sullivan Bille moves for summary judgment on the accounting malpractice claim brought against it. For the reasons that follow, the motion is DENIED .

         BACKGROUND

         The following facts are either undisputed for the purposes of this motion or viewed in the light most favorable to the LP Plaintiffs, as the non-moving party. It should be noted that Sullivan Bille does not concede its negligence, but only acknowledges that its purported malpractice is not an issue that can be resolved on the summary judgment record before the court.

         Dutchess LP is a limited partnership formed in 2000 and is the onshore feeder fund that solicited investments from investors located in the United States. In 2007, Dutchess Private Equities Fund II, L.P., a Delaware partnership formed in 2004, merged into Dutchess LP by contributing its net assets.

         LP Plaintiffs, Mark Wenzel, the Trustees of the Geraldine K. Schwab Revocable Trust, and the Carrswold Partnership, are limited partners of Dutchess LP. The General Partner and Investment Manager of Dutchess LP is defendant Dutchess Capital Management, LLC (DCM), an entity controlled by defendants Douglas Leighton and Michael Novielli. Leighton and Novielli are the only two members of DCM and hold equal interests in the company. Defendant Theodore Smith is DCM's Chief Operating Officer.

         At some point, Leighton, Novielli, and Smith (through DCM) began investing in financially distressed companies that did not meet Dutchess LP's stated investment profile and requiring these companies to place them on their boards of directors. They did this to enrich themselves through board member compensation and by causing the companies to enter into lucrative arrangements with businesses they owned. The fees for one of those businesses, defendant Dutchess Advisors, LLC, were ultimately paid for with the capital invested by DCM in these companies.

         In putting together the financial statements for Dutchess LP, DCM valued these investments at cost (i.e., the amounts paid for the interests) rather than at fair value as required under Generally Accepted Accounting Principles, resulting in inflated valuations. The inflated valuations enabled Leighton, Novielli, and Smith to conceal their improvident investments and DCM to charge higher management fees, which were based, in part, on the value of the Master Fund's holdings.

         In 2006 and 2007, Sullivan Bille audited Dutchess LP's financial statements for the years 2005 and 2006, respectively, and provided unqualified audit opinions for those periods. For purposes of this motion only, Sullivan Bille does not contest that its audits were not performed in accordance with Generally Accepted Auditing Standards and were otherwise negligently conducted.

         Beginning in 2007, Dutchess LP's reported financial performance declined, prompting significant redemption requests from investors. In response, DCM froze the investors' redemption rights in February 2008. This was followed a few months later by large write-downs for a number of Dutchess LP's investments, in particular the value of the investments made in the companies in question. Shortly thereafter, one of the companies in which the Master Fund had made its largest investment, Challenger Powerboats, Inc., filed a bankruptcy petition.

         DISCUSSION

         The LP Plaintiffs bring a single derivative claim for professional malpractice against Sullivan Bille in connection with its audits of Dutchess LP for years 2005 and 2006. They maintain that had Sullivan Bille issued qualified audit opinions, they would have discovered Leighton, Novielli, and Smith's misconduct and could have prevented some of the losses Dutchess LP sustained as a result of the improper investments. In the pending motion, Sullivan Bille argues that it is entitled to summary judgment because, even assuming that its audits were negligently performed and its unqualified opinions improperly issued, the LP Plaintiffs cannot prove two of the other essential elements of a professional malpractice claim, namely causation and damages.

         Sullivan Bille first contends that the LP Plaintiffs cannot establish that it caused Dutchess LP any injury because it is undisputed that DCM, the general partner, was aware of any misstatements in the financial reports and, therefore, clearly did not rely on the audits in making investment decisions. In similar vein, Sullivan Bille argues that the LP Plaintiffs' malpractice claim is barred by the in pari delicto doctrine because DCM prepared the financial statements upon which the audits were performed and was therefore at least as culpable as Sullivan Bille for the allegedly improper audits and audit opinions. Lastly, it asserts that the LP Plaintiffs have failed to provide competent evidence either that they could or would have taken action ...


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