In U.S. v. Lay, No. 08-3893 (6th Cir. July 14, 2010), the court upheld an instruction that permitted the jury to find that a hedge fund adviser had a fiduciary relationship with a client. Defendant Mark Lay began serving as an investment adviser to the Ohio Bureau of Workers’ Compensation when his company, Capital Management, Inc. started to manage the Bureau’s investment in a long-term bond fund, the Long Fund.

Subsequently, in 1998 Mr. Lay started a hedge fund, the Active Duration Fund. The Bureau moved $100 million of its investment from the Long Fund to the Active Duration Fund. The agreement set a non-binding 150% leveraging guidelines which Mr. Lay exceeded. By March 2004, the Active Duration Fund had lost $7 million. In May 2004, the Bureau added $100 million to its hedge fund investment. In September of 2004, the Bureau invested an additional $25 million in the fund. The losses continued.

The Bureau ultimately recovered $9 million of the $225 million that was invested in the hedge fund. Most of the loss involved leveraging over the 150% guidelines. In fact, about one fifth of the trades involved leveraging over 1000% with some trades involving leveraging over 10,000%.

The jury was given an instruction which provided that, to find Mr. Lay guilty of investment adviser fraud, the government had to prove each element contained in either Adviser Section 80b-6-(1) or 80b-2(2) or 80b-6(4). With respect to Section 80-6(1)&(2) the court informed the jury that “it is for you to determine as a matter of fact whether Mark Lay had an investment adviser-client relationship with the [Bureau] with respect to its investment in the . . . Active Duration Fund . . .” With respect to Section 80b-6(4), the jury was told that if it concluded the Bureau was not Mr. Lay’s client with respect to the hedge fund then it should determine as a matter of fact whether he had a fiduciary duty with respect to the hedge fund. The jury returned a verdict of guilty

The Sixth Circuit affirmed, concluding that the jury instructions were correct in the context of this case. Mr. Lay never disputed the fact that he had an investment adviser-client relationship and thus a fiduciary relationship with the Bureau as to its Long Fund investment. Mr. Lay claims however that he did not have such a relationship with the Bureau with respect to the hedge fund based on the decision in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). There, the Court rejected a rule issued by the SEC requiring hedge funds to register based on the number of its clients as discussed here. Previously, the SEC had viewed the fund as the client. In rejecting the rule, the D.C. Circuit concluded that the hedge fund adviser does not tell the individual investor how to spend his or her money. That decision is made when it is put into the fund.

Goldstein did not hold that “no hedge fund adviser could create a client relationship with an investor, but rather held only that the SEC had ‘not justified treating all investors in hedge funds as clients,’” the Sixth Circuit concluded. Indeed, hedge funds have different classes of investors with different rights or privileges with respect to their investments. Accordingly, it was entirely proper for the district court to submit the question to the jury as an issue of fact.