The previous article asked whether a company that clears trades for a fraudulent hedge fund has a responsibility to notice that the hedge fund is perpetrating a fraud. This article asks whether a company that rates hedge funds is liable for failing to discover a Ponzi scheme by a hedge fund that the rating company has rated.

     Morningstar is a well-regarded Chicago company that rates mutual funds and hedge funds for investors. It gave its highest rating of five stars to the hedge fund Life’s Good Stabl Mortgage Fund, but the fund turned out to be a Ponzi scheme, according to the Securities and Exchange Commission. Three investors who each lost $75,000 or more by investing in Life’s Good have sued Morningstar in Pennsylvania federal court.

     Morningstar’s defense is that hedge funds are not required to disclose data about themselves the way that mutual funds are, so in evaluating a hedge fund Morningstar must rely on the fund’s self-reported data. And Morningstar openly admits that its hedge-fund evaluations have that limitation.

     The Life’s Good hedge fund was founded in 2006, and it raised $16 million from 140 investors by claiming that it was investing in short-term commercial mortgages. It promised 10% to 16% annual returns. In fact, the fund used investors’ money to pay the fund managers’ personal expenses, including the expense of a luxury yacht rental, the SEC’s complaint against Life’s Good alleges.

     Mercer Bullard, associate professor of the University of Mississippi, says that if the investors who have sued Morningstar can prove that the company knowingly provided false information about Life’s Good, Morningstar should be liable to the investors. But if Morningstar was merely negligent in the way it evaluated Life’s Good, then it should not be liable. (See “Fund Ratings Under Scrutiny,” Wall St. J. at page B9 (8–9-OCT-2011)).

     This story’s significance is the same as that of the previous story: this story shows yet another way that an investor who has been defrauded by a Ponzi scheme may be able to recover some of her losses—here, by suing a rating company.

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