Madoff and fraud claims against third parties

By Steven E. Cole The Daily Record Newswire By now, everyone has heard of Bernard Madoff, the investment fund manager who managed to operate a massive Ponzi scheme for more than 20 years without detection. It is alleged that for years, Madoff engaged in virtually no trading for his investment clients, and kept entirely fictitious records of investments, profits and losses. What makes the Madoff scheme different, beyond the sheer amount of money involved, is that Madoff was able to use a highly regulated brokerage firm and investment advisory firm to shield the wrongdoing. According to the various complaints filed by the New York state attorney general, his investors and others, Madoff reported achieving consistently high investment returns under all market conditions using a fictional trading strategy. Madoff and his family were well-known, well respected in the industry, and served in official capacities for the National Association of Securities Dealers (the self-regulating body that oversaw broker dealers during the period in question). Madoff's consistent high returns generated demand, which resulted in the creation of several "feeder funds" that served to place investor's money with Madoff. However, the bona fides of Madoff's investment strategy, and the veracity of the investment returns it allegedly generated, were questioned for years by other investment firms and professionals who did business with Madoff. When the Ponzi scheme collapsed, the SEC and investors learned that the funds were gone, and that none of the transactions reported had actually occurred. Since Madoff himself and his firms had insufficient resources to satisfy the various claims by a wide margin, litigation ensued and has continued unabated over the past three years. Madoff received substantial funds for investments through other, independent, investment advisors and "feeder funds." One of the feeder funds, Beacon Asset Management, was formed by an independent investment advisor, Ivy Asset Management. In this article, I discuss a decision by Judge Sand of the U.S. District Court for the Southern District of New York. Judge Sand reviewed the viability of securities fraud claims brought against the feeder fund and the investment advisory firm that had formed the feeder fund and advised its clients to make investments with Madoff. To state a securities fraud claim, a plaintiff must establish that the defendant, in connection with the purchase or sale of securities, made a materially false statement or omitted a material fact, with scienter, and that the plaintiff's reliance on the defendant's action caused injury to the plaintiff. Further, securities fraud claims are subject to the heightened pleading standards of Federal Rule of Civil Procedure 9(b) and the Private Securities Litigation Reform Act (PSLRA). Under the PSLRA, the complaint must specify each statement alleged to have been misleading and state with particularity facts giving rise to a strong inference that the defendant acted with intent to deceive, manipulate or defraud. Based upon the facts alleged, both the feeder fund and the investment advisory firm were found to be potentially liable for securities fraud. The plaintiffs alleged that Ivy became suspicious of Madoff as early as 1997, and completely withdrew its own investments from Madoff in 2000. However, Ivy failed to disclose the basis for its concerns about Madoff to its own clients. Ivy was also found to have a duty to correct prior misstatements to its clients. The court ruled that the plaintiffs had successfully alleged that Ivy acted with scienter in failing to disclose its true concerns about Madoff to its clients. The plaintiffs asserted that Ivy benefitted in a "concrete and personal way" from the alleged fraud, as Ivy was concerned that it would lose those clients if its suspicions were revealed. Beacon, the feeder fund, was also found to be potentially liable for securities fraud. Beacon promised to conduct due diligence on Madoff and other investment managers who received investments through Beacon. The court held that a securities fraud claim lies when a defendant knows that it cannot perform due diligence or does not intend to fulfill its promise. Beacon had allegedly expressly decided to end all due diligence of Madoff in 2006, and failed to inform plaintiffs of its action. This express decision, along with an agreement executed by Beacon memorializing its intention to perform no further due diligence of Madoff, supported an inference that Beacon had acted with scienter. Not all of the claims against Beacon survived, however. The plaintiffs had also attempted to state a securities fraud claim based on Beacon's failure to discover that Madoff was operating a Ponzi scheme. However, the plaintiffs alleged that Beacon should have discovered certain "red flags" concerning Madoff during the course of due diligence; not that Beacon did actually discover them. Unless Beacon was alleged to have actually uncovered the "red flags," the plaintiffs could not state a claim for securities fraud. The plaintiffs also failed to state securities fraud claims against Beacon's auditors, again because the auditors were not alleged to have actually uncovered any facts that alerted the auditors to the possibility of Madoff's fraud. Judge Sand's opinion goes on to address other defendants' liability under ERISA in connection with the Madoff case. The recitation of facts in the opinion provides an interesting perspective into one aspect of the Madoff scheme, as it relates to some of the firms who allegedly turned a blind eye to Madoff's fraud because it was profitable to do so. The decision also serves as a reminder of the wide net that may be cast under the federal securities statutes. ---------- Steven E. Cole is a partner in the law firm of Leclair Korona Giordano Cole LLP, and concentrates his practice in the area of commercial and securities litigation. Published: Mon, Oct 24, 2011