Bayou Group LLC, a Stamford, Conn., hedge fund that collapsed in a $400 million fraud, asked a judge to order a Hawai'i man and other investors to return $88.9 million paid to them before the firm declared bankruptcy in May 2006.

Investor lawyers told U.S. District Judge Adlai Hardin that their clients had withdrawn the money in good faith and shouldn't be forced to give it back. Bayou claims the payouts constitute fraudulent transfers under federal bankruptcy law. Lawyers for both sides argued whether Hardin must hold a trial to determine whether investors were aware of "red flags" of the fraud and, if so, whether they took reasonable steps to investigate.

"How is Mrs. Sledge, who's wheelchair-bound in Tennessee, supposed to discover a fraud taking place in Connecticut?" lawyer William Munno asked at a hearing in White Plains, N.Y., yesterday, referring to his client, Mary Jane Sledge, a widow with multiple sclerosis who has $1.1 million Bayou wants.

Bayou is pursuing the money from 33 investors that include hedge funds and individuals. They range from a claim against investor Kevin Bass for $62,947 in phony Bayou profits to one for $28.6 million against Sterling Stamos Capital Management L.P.

Bayou declared bankruptcy after one of its founders, Samuel Israel, and its chief financial officer, Daniel Marino, pleaded guilty to fraud. Israel is in prison, serving a 20-year sentence after faking suicide and jumping bail last month.

Israel, who hid fund losses from his investors, himself was conned in his attempt to find an investment to help pay off his clients, a U.K. investigator claims. The U.S. has frozen $1 million in a U.K. account of a man who used a so-called prime bank scheme to cheat Israel, the investigator said.

LOSSES HIDDEN

Prosecutors in New York and Bayou's bankruptcy estate, seeking to recover funds for investors who lost $250 million, are targeting Robert Booth Nichols, a Hawai'i man to whom Israel gave $10 million in 2004.

Nichols cheated Israel by promising quick riches in secret markets, a commonly used con-artist scheme, according to the U.K. investigator, who is working with U.S. prosecutors. U.S. prosecutors in November persuaded a British judge to freeze $1 million Nichols held in the U.K. Prosecutors might be pursuing millions more in Singapore, said Joseph Bainton, Nichols' lawyer.

"Israel was defrauded," Stephen Annis, an investigator in the U.K.'s Assets Recovery Agency, wrote in a Nov. 13, 2007, statement filed last month in Bayou's U.S. lawsuit against Nichols in federal court in New York. Nichols, who he said he was then under investigation by U.S. prosecutors, "has benefited from his criminal conduct," Annis said.

NICHOLS SAYS HE HELPED

Nichols, 65, denies wrongdoing and seeks to retain the $1 million. He said in court papers that he helped Israel invest in a legitimate, though unspecified "project" involving U.S. government obligations. Nichols said he had no reason to believe Israel was engaged in fraud.

"He was asked to find something, and he found it," Bainton said in an interview, declining to elaborate. "There are very few people capable of performing this service, for which he was paid a lump sum of $10 million."

More than $79 million of the Bayou estate claim discussed today at the hearing is for principal returned to the investors. The rest is for illusory profits paid from the fund, which creditors claim operated as a huge, fraudulent "Ponzi scheme." Bayou has already collected $30 million, which it will use to repay creditors.

Hardin will decide whether to grant Bayou's request that he order the money returned. He didn't say when he will issue a decision.

The criminal case is U.S. v. Israel, 05cr1039, U.S. District Court, Southern District of New York (Manhattan).

The bankruptcy case is In re Bayou Group LLC, 06-22306, U.S. Bankruptcy Court, Southern District of New York (White Plains).