The Legal 500

Publishing firms

Legal Developments worldwide

Madoff investor claims: US proceedings and possible UK approaches

May 2009 - Banking and Finance. Legal Developments by Fountain Court Chambers.

More articles by this firm.

The credit crunch of 2008 and the recession of 2009 have already thrown up some politically significant, legally interesting and hard-fought court proceedings.

First, we have had the strongly contested judicial review of the government’s decision to nationalise Northern Rock. The proceedings have pitted Lord Pannick (for the hedge fund investors) and Lord Grabiner (for the government) against one another. In February the Administrative Court ruled in the government’s favour, saying that the nationalising legislation was not incompatible with the principle (enshrined in Article 1 of Protocol 1 to the European Court of Human Rights (ECHR)) that there should be fair compensation for expropriated property. Even more recently than the Northern Rock claim, but of equal (if not greater) political importance, has been the class action issued in New York against RBS and (among others) its embattled former chairman, Sir Fred Goodwin. Court papers allege that the company and its board gave false reassurances about the bank’s financial strength to investors, leading to massive losses being suffered by all investors who bought or retained significant holdings in the bank once the share price adjusted downwards to reflect the actual state of the bank. It has been reported that Cherie Booth QC has been instructed for two UK local authorities’ pension funds that have joined the class action. No doubt further investors will follow suit in the near future.

Madoff

Background

Notwithstanding the significance of each of these two cases, without question, the most dispute-productive occurrence of the recession began in December, when two senior employees of a well-respected investment firm in New York asked to speak to their boss as they had noticed that he had been showing signs of being under great stress in the prior days and weeks. Requesting a private discussion at his Manhattan apartment as he ‘wasn’t sure he could hold it together in the office’, the boss confessed to his concerned colleagues that he was ‘finished’ and that the firm was ‘all just one big lie’. This was the moment that Bernard L Madoff, the former chairman of the NASDAQ (later to be known as Inmate #61727-054), revealed that Bernard L Madoff Investment Securities LLC (BMIS) was the world’s largest Ponzi scheme, with total investor losses estimated at circa $50bn.

Who was affected?

The range of affected investors makes for staggering reading and gives a flavour of how extensive the disputes caused by this massive fraud will undoubtedly be. British financial institutions that have been affected include HSBC, RBS and Man Group plc. After the financial institutions, however, the list becomes more and more bizarre. Caught up in Madoff’s mess are various universities (New York University (NYU) allegedly having invested circa $24m), pension funds (including Royal Dutch Shell plc), charities (including that of Nobel Laureate Elie Wiesel), celebrities (including Kevin Bacon, John Malkovich, Larry King and Zsa Zsa Gabor) and even the International Olympic Committee.

Consequences in the US

These events have already given rise to various sets of legal proceedings in different jurisdictions. According to press reports, thus far in the US there have been:

  1. criminal proceedings for securities fraud against Madoff (in which he has entered a guilty plea and awaits sentencing);
  2. civil proceedings brought by the US Securities and Exchange Commission (SEC) for fraud and breach of fiduciary duty against Madoff and BMIS;
  3. civil proceedings brought by the Attorney General of New York, Andrew Cuomo, against a hedge fund run by Madoff’s associate, Ezra Merkin, which acted as a ‘feeder fund’ to BMIS;
  4. civil proceedings brought by NYU against Ezra Merkin’s hedge fund;
  5. civil proceedings brought by the Massachusetts regulator against the feeder fund Fairfield Greenwich Group, based on ongoing failure to conduct adequate due diligence or monitoring (in particular by failing to do the monitoring they said they were doing);
  6. civil proceedings brought by private investors in Connecticut against a feeder fund;
  7. involuntary insolvency proceedings against Madoff brought by a group of aggrieved investors;
  8. insolvency proceedings for BMIS in which the court appointed a trustee, Irving Picard, is clawing back money paid away within 90 days of Madoff’s arrest; and
  9. civil proceedings brought by a 61-year-old retiree, Phyllis Molchatsky, against the SEC for negligently failing to detect the fraud.
Consequences in Europe

The US civil proceedings have, therefore, thus far focused (apart from claims against Madoff and his companies directly) on claims against feeder funds and claims against the regulators. In Europe there are major criminal investigations underway. In the UK the Serious Fraud Office (SFO) has mainly been focusing on the sister company to BMIS, Madoff Securities International Ltd (MSIL), which was allegedly used as a money-laundering vehicle to give the appearance of genuine investments being made. In Austria the focus is on Sonja Kohn and the Bank Medici, of which Kohn is president. As for civil claims, according to press reports, David Greene at Edwin Coe LLP has been instructed by aggrieved UK investors to bring claims against banks that may have given negligent advice or otherwise misrepresented the nature of any investment in BMIS. The unease that will be felt by banks caught out by the fraud is aptly demonstrated by the fact that both the Swiss bank UBP and the Brazilian Safra Group are reported to have been settling potential claims by investors that they did not carry out adequate due diligence on BMIS and Madoff himself.

Warning signs and an analogy

One tricky fact for banks who may have advised on investment in BMIS or its feeder funds is that, as early as 2001, analysts were sounding the alarm about the curiously steady and reliable profits being earned month-on-month by BMIS. The leading article written in May 2001 by Michael Ocrant, following interviews with Madoff and other hedge-fund specialists (who asked to remain anonymous), was entitled ‘Madoff tops charts, sceptics ask how’. The anonymous parties doubted that the strategy Madoff stated he was using to generate the steady returns (which he called his ‘split-strike conversion strategy’) could in fact do so.

A case that may prove to be a helpful analogy on this kind of failure to adequately monitor market information is Voisin v Matheson Securities [2001], a case heard in the Jersey courts. In Voisin investors had been sold bonds by the defendant in the mutual insurer, Confederation Life Insurance Company. Although seemingly a sound investment when bought, the rating of the bonds was subsequently downgraded. This was not picked up immediately by the defendant firm as it relied on informal reports of market news rather than a systematic, formal reporting system. By the time the firm did discover the downgrade, there was no market for the bonds at all. Although at first instance Jersey’s Royal Court found that the market monitoring used by the firm was adequate, this was overturned on appeal. Voison is therefore an example where the advisor’s due diligence as to the quantity of the investment was found to be inadequate.

Comment

It may be that many of the banks and feeder funds investing in (or advising investment in) BMIS were not aware of the adverse views on Madoff that were being voiced by some in the market, such as the Ocrant article. The question then becomes whether they should have been aware of these views and whether enough was done to investigate and corroborate Madoff’s explanations as to how his returns were being generated. The level of information made available by Madoff as to the workings of his ‘black box’ investment seems to have been minimal by comparison with the sort of detailed reporting that fund managers are typically required to produce to their clients.

On the other hand, in any professional negligence context, but above all when dealing with investments, one has to be careful to strip out hindsight. It’s all too easy now to say everyone should have subscribed to the Ocrant school of though about Madoff but the issue, of course, is whether other views were tenable at the time, albeit we can all now see Ocrant was right.

Causation and quantum in such claims will also undoubtedly throw up some tricky points. For example, if the feeder fund or BMIS has not invested in Madoff, what investments would have been made instead and with what result? Against the background of a global stock market correction, it may well be the case that the hypothetical non-negligent alternative investment would also have suffered very significant losses. The question of what measure to adopt for quantifying loss in claims for negligent fund management is fraught with difficulty and, as yet, bereft of authority (given that, to date, claims have invariably settled).

By Patricia Robertson QC and Sebastian Said, barrister, Fountain Court Chambers.

E-mail: pr@fountaincourt.co.uk; ss@fountaincourt.co.uk.