Key Factors Facing Indirect Investors in Madoff-Style Schemes

By Teresa Zink for HB Litigation Conferences LLC

Indirect investors looking to recover losses in the Madoff and other Ponzi schemes should consider liability and collectability in deciding who to sue, a panel of experienced plaintiff and defense attorneys told participants in HB Litigation Conference’s “Madoff & Ponzi Scheme Litigation Conference” June 3, 2009.  (The complete recording of the program is available from HB).

Madoff feeder fund investors need to first consider whether they have a good chance of obtaining a judgment against a given defendant, panel moderator Philip Bentley of Kramer Levin Naftalis & Frankel in New York explained. However, he added “If you get a judgment against a defendant who doesn’t have a deep pocket, it may not do you much good.”

Potential Defendants

Who are the potential defendants for Madoff investors seeking to be made whole? Panel member Harry Susman of Susman Godfrey in New York said in the case of direct investors “unfortunately it is a short and sad tale.”

However, indirect investors, like investors in feeder funds have more to be hopeful about, said panel member Scott Berman of Friedman Kaplan Seiler & Adelman in New York. He said investors in the feeder funds have some of the best claims because those investors have claims against both the feeders, including the management companies, and against service providers like auditors, administrators and consultants. Berman said that, according to the evidence he has seen, the feeders were in the position of “gatekeepers” and their service providers “were providing, or supposed to be providing, a level of comfort to the investors in the feeders that things were as represented.”

Berman noted that there is also a third tier of potential claims, brought against the investors who invested in the feeder funds – for example pensioners suing the pension fund that invested in a feeder fund – however these claims are much more difficult because there was never a representation that that tier was providing the same sort of gatekeeper function that the feeders were providing. Having said that, he added, “there has been a litigation feeding frenzy, everybody is trying to sue anybody that they can to try to get a seat at the table.”

Hedge Fund Managers and Auditors

What are the differences in bringing claims against hedge fund managers versus auditors?

Turning first to claims against fund managers, Susman said the best claims are claims for fraud, especially if brought under state law. Why? Fraud claims are not subject to the Private Securities Litigation Reform Act (PSLRA) requirements that are in play when a plaintiff brings a class action under federal law, and with a fraud claim, plaintiffs don’t run into the issue of New York Martin Act preemption. According to Susman, with any other claim, such as negligent misrepresentation or breach of fiduciary duty, if there is some nexus to New York the defendant is going to claim it is all preempted by the Martin Act. In addition, according to Susman, plaintiffs could have trouble with any claim that doesn’t sound in fraud against a fund manager because there are provisions in most of these limited partnership agreements that will exculpate the defendant from anything but fraud or gross negligence.

So fraud is where you have to start but it can get complicated in cases where the fraud claim isn’t a straight misrepresentation claim, Susman said. In many of the Madoff cases, the claim isn’t that the defendant didn’t tell the plaintiff the investment was a feeder into Madoff, the claim is that the investor was not informed of the lack of due diligence being performed or the lack of information the fund manager had, “that is a much harder fraud claim to make out,” said Susman.

“No problem,” Berman retorted. However, he conceded that the Madoff cases against feeder funds do bring up novel and interesting theories that haven’t been litigated nearly as much in the past. “In typical hedge fund blow up cases it’s almost a layup to show fraud against the manager but there is no money so you want to sue the services providers for aiding and abetting the fraud,” says Berman. The feeder fund cases are a little bit different, he said, because the fraud claim is a different species of fraud.

What Defenses Are Available?

Looking to the defense side, Howard Suskin of Jenner & Block in Chicago explained some of the defenses available to hedge fund managers accused of fraudulently representing the due diligence they have been performing. He noted that the defense is very dependent on the claim and the cause of action that has been framed, and whether the action is in state or federal court.

He noted that, since the enactment of the PSLRA, it is very difficult to bring a Section 10B general fraud claim under the Securities Act of 1934. These claims are relatively good to defend he said, adding that since the U.S. Supreme Court ruled nearly 20 years ago that there wasn’t any aider or abettor liability under 10B, it is very difficult to get secondary liability.

Berman noted that plaintiffs can still plead aider and abettor theories under state law and Suskin agreed that defending state court actions is more difficult. “First, I understand if you sue in New York, you will probably have to deal with the Martin Act and all of us in other jurisdictions shake our heads and wonder how defendants in New York were so lucky as to get that on the books,” Suskin said. However, in other states consumer fraud acts will apply to the cases. “Scott is absolutely right, in some of the state court forums it is very difficult, but not impossible, to launch a very tough defense, depending on the nature of the claim.”

“If you don’t have to sue in New York, you would be silly to sue in New York state court,” Susman added. However, if you can sue in state court, “the smart thing to do is to avail yourself of the blue sky law in your state,” he said. Under state blue sky laws, which are strict liability statutes, plaintiffs only have to prove that there was some misstatement, then the burden shifts to the defendant to show he didn’t know. There are some preemption questions that may be argued, but if a plaintiff can use a blue sky law, “you have a heck of a case to file, they are home run cases.”

What About the Auditors?

Turning to the issue of what claims might be brought against the auditors, Susman pointed out that these cases come down to a legal question of duty, not whether the auditors breached their duties. He noted that, as far as he is aware, very few people were shown audited financials to induce them to invest originally, so the claim is that the investor held onto the investment after seeing the audits. That leads to a damages question, “If the theory is that the auditor should have revealed the Ponzi scheme while you were already an investor in the Ponzi scheme, how are you damaged? The thing would have collapsed anyway and you would have had your loss earlier? That is going to be the tension there,” Susman predicts.

Berman added that he has successfully argued that audits of hedge funds are typically addressed to both the board of directors of the fund as well as the investors of the funds, and that there is an expectation that those audits would be received and relied upon by both investors and potential investors.

Suskin added that it is too big a leap to try to claim that an auditor for a feeder fund had the additional duty to audit Madoff. Susman agreed, “I don’t think the nature of the claim is the auditor had to audit Madoff,” however, the auditor had to do something. The question is “given the way Madoff operated, what else could that something have been?” According to Susman, Madoff wouldn’t answer questions or provide names of counterparties, so how did the auditors confirm that Madoff was legitimate and had legitimate internal controls? “I think there is a heck of a good claim, not that you were supposed to audit them but that you were supposed to get answers to some pretty basic questions and it is a mystery how they could have gotten those answers.”

Teresa Zink is a freelancer writer and former editor of litigation news reports living near Philadelphia. She wrote this article based on recordings from HB Litigation Conferences’ Madoff & Ponzi Scheme Litigation Conference held June 3, 2009.