By Jonathan Stempel
NEW YORK (Reuters) - A federal appeals court on Friday said PricewaterhouseCoopers LLP must face a securities fraud lawsuit by investors who accuse it of missing red flags when it audited a hedge fund whose portfolio manager eventually went to prison.
The 2nd U.S. Circuit Court of Appeals in New York said a trial judge erred in dismissing a claim that PwC's auditor opinion letters fraudulently induced the plaintiffs to invest in Lipper Convertibles LP.
Lipper Convertibles was liquidated in 2002 after having overstated its assets by hundreds of millions of dollars. PwC audited the fund's financial statements from 1996 to 2000 and issued letters generally affirming their accuracy.
After portfolio manager Edward Strafaci, who was director of fixed income money management at the fund's parent, Lipper Holdings LLC, abruptly left in January 2002, the fund decided to review its portfolio.
It was revealed that the fund was worth just $365 million, 49 percent less than the $722 million it had reported before Strafaci's departure.
Strafaci pleaded guilty in August 2004 to securities fraud and was sentenced the following May to serve six years in prison and pay $89.3 million in restitution.
In their lawsuit, the investors said PwC missed "significant red flag(s)" in auditing the Lipper fund, whether knowingly or recklessly.
In November 2010, one month after Strafaci was released from custody, U.S. District Judge Richard Berman in Manhattan dismissed the investors' lawsuit.
He said the investors lacked standing to sue because they had shown no injuries separate from harm to the fund itself.
But Circuit Judge Raymond Lohier, writing for the appeals court, said it was an open question whether the investors suffered direct injuries.
Lohier said Berman had put too much emphasis on a disclaimer in BDO Seidman LLP reports, prepared for the fund's liquidation, that BDO was not asked to pinpoint what the investors' interests were worth at any given point in time.
"The BDO reports, at least in combination with Strafaci's admission of overvaluation, sufficed to create a triable issue of fact," Lohier wrote for a three-judge 2nd Circuit panel.
"A reasonable jury could infer that the reports contained the more accurate prices of the relevant securities and that plaintiffs had purchased at least some of their limited partnership interests at prices that exceeded the prices listed in the reports," he added.
Daniel Krasner, a partner at Wolf Haldenstein Adler Freeman & Herz representing the investors, said his clients are pleased with Friday's decision.
He said PwC "had all the indicators that the fund was overstating (assets) and that Strafaci was giving it numbers that were not supported by independent reports that it had."
PwC spokeswoman Caroline Nolan said the auditor is reviewing the decision.
The 2nd Circuit upheld Berman's dismissal of the investors' state law claims, which both sides agreed was proper.
Lipper Convertibles and Lipper Holdings are not related to Lipper, a mutual fund research unit of Thomson Reuters Corp.
The case is CILP Associates LP et al v. PricewaterhouseCoopers LLP, 2nd U.S. Circuit Court of Appeals, Nos. 11-4904, 11-4905, 11-5104 and 11-5106.
(Reporting by Jonathan Stempel in New York; Editing by John Wallace)