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November 5, 2009 |
Schiff Hardin has received numerous inquiries related to events following the arrest of Bernard L. Madoff. The content presented here does not include or reveal any information obtained from such consultations or representations; our aim is to present a quick summary of the situation, followed by a short listing of some of the legal questions being raised most often. This information will be updated from time to time on our Web site; please visit us at www.schiffhardin.com for the latest developments.
Follow the Money Despite some of the more dramatic and salacious factual allegations which came to light in recent weeks about work life at the Madoff firm, it probably still makes sense to heed advice given during another national scandal, Watergate — "Follow the money." In that context, it was fascinating to see federal prosecutors assert that about half the people who invested with Madoff had come out ahead, even allowing for the profits that never were — they had received more money over time than they had invested. This, of course, dovetails with the trustee's assertion that following any course other than the cash in/cash out approach would favor one set of defrauded investors over another, paying them with someone else's losses. As of mid-day, October 29, the trustee said 2,871 claims had been determined (of which 1,562 had been allowed). Those claimants had lost approximately $4.438 billion at Bernard L. Madoff Investment Services (BLMIS), and SIPC payments to them of a little more than $535 million had been approved. (The other $3.9 billion constitutes excess claims.) All told, the trustee now thinks Madoff cost investors $21 billion in losses. The trustee and the SIPC took advantage of the occasion to stage a "media event" to announce that the amount committed to defrauded Madoff investors was now more than all the amounts ever before paid out by SIPC. No doubt that fact was perceived as a useful backdrop to have in place for the scheduled February 10, 2010 hearing on how the trustee has calculated net equity. He and the SIPC filed papers on that issue on October 16. The trustee's brief described how a very small number of Madoff accounts (about 245, or five percent) were faked individually rather than en masse through the supposed split-strike conversion investment strategy. The trustee said these VIP accounts belonged to long-time investors Stanley Chais, Jeffry Picower (recently deceased), and Madoff family members and employees. The transactions were equally fictive, but earned even higher non-existent profits. (An article in a securities industry IT publication points out that, while the Madoff market-making operation had customized, state-of-the-art information technology on its "House 5" system, the "House 17" system — 17 for the 17th floor — was an antique, a situation that puzzled techies working there. We note as well that one of the obligations of an auditor is to note possible data systems weaknesses, but the auditor here didn't — see below for more on his status.) Despite supposed investments in excess of $73.1 billion, BLMIS' "special reserve bank account for the exclusive benefit of customers" contained just $20,000. Through all the years and for all the customers, BLMIS executed purchases and sales of securities for just one customer. When BLMIS cashed out periodically and placed its investors' supposed proceeds into Treasuries or money market funds, one of the funds which 2008 statements said received customer funds was Fidelity Spartan U.S. Treasury Money Market Fund — even though Fidelity had stopped offering that fund in 2005. The brief traces the history of the law on stockbroker customer accounts, starting with the Chandler Act in 1938, and distinguished the Second Circuit's holding in New Times Securities I, 371 F.3d 68, that investments in fictive money market funds should be treated as securities rather than cash holdings, so as to take advantage of the higher SIPC advance limit for securities, because this vindicated customer expectations created by periodic statements. But, the trustee argues, the Second Circuit still employed net cash invested, not statement values, to determine recoveries. Interestingly, the last paragraph of the brief seems to leave open the possibility of applying some interest calculation to funds on deposit; the trustee simply notes that question is not now before the court. Opposing papers are due November 13. New suits, new claims Early in October, the trustee sued Peter Madoff (brother and BLMIS Chief Compliance Officer), Andrew and Mark Madoff (sons and Co-Directors of Trading at BLMIS) and Shana Madoff (niece and BLMIS Compliance Director, in-house counsel) for just over $198 million. Asserting that the company was operated "as if it were the family piggy bank," the suit asserts the four diverted funds through hundreds of fraudulent conveyances, generating funds to invest in personal businesses or to spend on personal expenses. Joseph Cotchett added some new, high-profile defendants, including accounting firm KPMG and JPMorgan Chase and Bank of New York Mellon, among others. An amended pleading in Supreme Court, New York County accuses JPMorgan Chase of helping Madoff "launder" nearly $6 billion of investors' money between the United States and London. Two plaintiffs sued the SEC under the Federal Tort Claims Act for "serial, gross negligence" in connection with Madoff. They previously had asserted an administrative claim against the agency, an FTCA prerequisite, Molchatsky v. United States; Schneider v. United States. The actions, pending in the Southern District of New York, will have to overcome a likely sovereign immunity defense. The California Attorney General brought suit against Stanley Chais in California state court, asserting securities fraud and unfair competition, among other things, and seeking fines, restitution and injunctive relief, among other things. The California Attorney General thus piles on to an SEC civil fraud claim, a billion-dollar claim by the BLMIS trustee, and various investor suits. Chais, through counsel, denies wrongdoing. Indeed, he answered the SEC's suit by saying it should be barred owing to the Commission's "own conduct, which provided credibility to Madoff." The trustee boosted the amount of his claim against Cohmad Securities to $245 million from $213 million. Plaintiffs suing Banco Santander in a putative class action pending in Miami federal court over two Optimal funds amended their complaint to assert that the bank had revised the funds' prospectuses to allude to the "possibility" Madoff could abscond with funds after its requests to Madoff to use an external custodian were rebuffed. Jeffry Picower's death may raise new problems both in trying to secure information and in seeking recovery of funds. Guilty Plea No. 3 David Friehling, the one active accountant at the firm which audited BLMIS, entered a guilty plea November 2 before U.S. District Judge Alvin K. Hellerstein in the Southern District of New York. Sentencing tentatively was set for February 26, 2010. Mr. Friehling told the court he accepted the records he was given by Madoff "at face value," but denied knowing of the Ponzi scheme, pointing to his own family's losses from Madoff accounts. More On Net Equity In a September 16, 2009 Order, the Bankruptcy Court adopted the trustee's proposed schedule for briefing and hearing on the question of how to determine net equity for purposes of calculating investor losses. The deadlines essentially track those in the trustee's motion (see September 15, 2009 update), with a hearing set for February 2, 2010 at 10:00 a.m. The "net equity" issue is framed for resolution as follows: ORDERED, that, consistent with the record of the hearing held on September 9, 2009, the briefing to be submitted to the Court pursuant to this Order shall be limited to discussing the proper interpretation of "net equity," specifically the following two issues:Notice will be sent to all who filed customer claims and also posted on the trustee's website. Bankruptcy Judge Burton R. Lifland dismissed claims brought as an adversary proceeding by certain plaintiffs (Diane Peskin, Roger Peskin and Maureen Ebel - see July 1, 2009 update), which also sought a determination of the net equity calculation issue. Judge Lifland's September 10 opinion found the adversary proceeding violated the Claims Procedure Order adopted by the court on December 23, 2008, under which BLMIS customers must make claims to the trustee, obtain a determination, and file an objection if they disagree with the determination. Accordingly, the court dismisses the first claim, for declaratory relief as to the net equity issue, stating, "Plaintiffs' failure to follow the procedures is fundamentally unfair to other objecting customers and allowing such conduct to proceed would wreak havoc on the claims adjudication process." Elsewhere, the court terms the claim "unjust as it appears to be Plaintiffs' way to jump the line and obtain priority of their claims over the claims of other customers." The Bankruptcy Court also dismissed the two other claims by plaintiffs in the adversary proceeding. The court found the claim regarding preferences originally asserted by the trustee based on withdrawals from accounts to be unripe. It appears the trustee now has acknowledged that the Peskins should not be charged with a preference, as they had invested more than they had withdrawn during the preference period; accordingly, they had been paid the $500,000 SIPC advance limit. As to Ms. Ebel, the trustee claimed she, too, had been paid the $500,000 ceiling. The court allowed the Ebel claim in the adversary proceeding to be converted into an objection to the trustee's determination. As to the third claim, which accused the trustee of breach of fiduciary duty, the court found it, too, was unripe. Whether there had been a breach of duty necessarily turned on whether the trustee had calculated net equity properly, and there was little point in trying to reach the breach claim before the underlying issue has been resolved. Accordingly, this claim was dismissed without prejudice to its renewal, depending on the net equity decision. Finally, although the trustee had urged that counsel for the Peskins and Ebel had a conflict of interest because she also was a Madoff customer with losses, and the SIPC (but not the trustee) had urged that the filing of the adversary proceeding violated the automatic bankruptcy stay, the court did not reach either issue. Bernie, We Hardly Probed You The appearance of the report by SEC Inspector General David Kotz on the agency's efforts from 1992 on to probe Bernard L. Madoff and Bernard L. Madoff Investment Securities (BLMIS) made for unsettling reading. Indeed, the IG concludes that Madoff used the agency's investigations as a clean bill of health to promote his intake of funds from investors. On the brief bright side, the report found no basis to think the personal relationship between Madoff's niece (and for a time BLMIS' compliance officer) and an SEC staffer led to any impropriety, or that anyone at the Commission tried to influence the agency's investigations or examinations or to interfere with staff's conduct of them. But the list on the negative side was, in the word used by Senate Banking Committee Chairman Christopher Dodd, D-Conn., "ugly," and much, much longer. Six "substantive complaints that raised significant red flags" and two published articles raising questions about BLMIS over 16 years, and three SEC examinations and two investigations, led to no meaningful regulatory action. "[A] thorough and competent investigation or examination was never performed." Although SEC staff "almost immediately caught [Madoff] in lies and misrepresentations," they failed to follow up. At one point, while a Madoff employee was speaking with SEC examiners, another Madoff employee rushed in to pull her out of the meeting, claiming she was needed urgently. When Bernard Madoff later was asked what the urgency had been, he said her lunch had just arrived - at 3:00 p.m. The report says many of the SEC staff members who conducted the probes were "inexperienced." "Each member of the Enforcement staff accepted as plausible Madoff's claim that his returns were due to his perfect 'gut feel' for when the market would go up or down." Agency probers seeking to verify BLMIS' claims sometimes did not seek confirming records from independent sources. Instead, they relied on records furnished by Madoff or statements by attorneys for him. In one instance, where an independent source denied trading activity Madoff claimed had occurred, an SEC assistant director did not follow up and did not inform the examiners. In another instance, options trading positions claimed by Madoff to exist were checked with and denied by the NASD - but nothing was done about it. Madoff himself later told the agency he thought the jig was up when SEC personnel asked for his Depository Trading Corporation account number, and he expected that DTC would reveal there were no trades - but the agency never went to DTC for records. At one point the SEC was conducting two probes of Madoff out of different offices; neither was aware of the other until one investigating group found out about the other - from Madoff. Both probes experienced significant delays in getting under way. Both were faulted as insufficiently planned and too narrowly focused on possible front-running by BLMIS. A later investigation focused on whether Madoff should register as an investment advisor and whether he had made adequate disclosures, rather than on whether he was running a Ponzi scheme. A 1992 investigation of what was feared to be a Florida-based Ponzi scheme led to Madoff, who turned out to have control of all investments for the Florida investment firm. The SEC made sure all of the firm's clients' funds were returned, but did not consider whether the funds provided by BLMIS to make the Florida firm's investors whole were in turn the product of a bigger Ponzi scheme by Madoff. Madoff threw his reputation around in an attempt to impress and intimidate SEC staff, dropping prominent names and hinting he himself might be the next chairman of the Commission. The SEC failed to connect the dots even though private entities that did due diligence about Madoff had concluded investing with him would be "unwise" - and the SEC knew some of the conclusions that had been drawn. Adding insult to injury, agency staffers won praise and promotion for their efforts in the Madoff investigations. All told, Madoff's own coaching of an individual at Fairfield Greenwich in advance of an SEC interview, captured on tape, seems to have been all too shrewd:
BLMIS Trustee Asks Bankruptcy Court to Decide How to Calculate Investors' "Net Equity" As noted previously, one of the potentially most significant legal issues surrounding the Madoff losses is how to calculate them. The trustee has used what he calls the "money in-money out" approach, subtracting the amounts investors withdrew from their accounts from the amounts they invested to derive their losses. Some investors have argued the figure that should be used as the starting point is the amount shown on their last statements as their fund balance, i.e., that the investor's loss should include the fictitious income BLMIS claimed to have earned. On September 2, the trustee asked the Bankruptcy Court to say whether he is right. The request to set a briefing and hearing date schedule would limit the parties who can file papers, unless the court otherwise grants leave, to those who have filed claims with the trustee, as well as government agencies. Under the proposed procedure, the trustee would move by October 16 to confirm certain customer claims where net equity calculation is an issue. Claimants who object, and any movants given leave, would have to file opposition papers by November 13. Claimants or governmental units who oppose the trustee's motion could file replies until December 21, with the trustee and SIPC having until January 15 to file any replies. The motions would be heard on February 2, 2010. The trustee's proposed scheduling suggests he intends to have resolved the great bulk of claims by the time the motion is heard, if not earlier. Some investors objected that a similar procedure should be used to resolve other common issues, such as whether investors whom Madoff caused to consolidate their funds into a single aggregate account should be treated as holders of one or multiple accounts for purposes of SIPC loss coverage ceilings. Other investors worried that resolution of the net equity issue would be confused by the introduction of other issues, and asked the court to exclude them. Good News for Fairfield Greenwich Investors - If They're in Massachusetts Feeder fund Fairfield Greenwich reached a settlement with the Massachusetts Secretary of the Commonwealth in which the firm agreed to pay back all losses suffered by Madoff-related investors - as long as they were from Massachusetts. Only about 15 were. The total payment, including interest at six percent and a $500,000 fine payable to Massachusetts, is only $8 million. Interestingly, the formula for losses relies on the total of funds invested less withdrawals - seemingly the same money in-money out approach the BLMIS trustee has been using to determine SIPC claims. Argus Settlement Argus Group Holdings, Ltd. reached a proposed settlement of claims by Madoff investors who had purchased variable universal life or deferred variable annuities from Argus or Tremont International Insurance Ltd. between May 10, 1994 and December 11, 2008, according to The Wall Street Journal. Among other things, the plaintiffs would receive loans should their policies be threatened with lapsing as the result of losses in certain Rye Investment Funds. The agreement is subject to court approval and does not resolve claims against Tremont Group or the Rye funds. Just Out In The Financial Fraud Law Review "Madoff: The Second Act" by our colleague David Jacoby, an overview of Madoff fraud developments so far and a preview of what's next, was just published in The Financial Fraud Law Review. SIPC Claims Processing As of August 25, 2009, the trustee reported having allowed 974 claims. Out of a total of over $3.519 billion in claimed amounts, about $358.8 million was approved. Earlier in August, the trustee agreed to stop requiring Claimants to agree to waive portions of SIPC claims he disputed before paying the undisputed portions. More Criminal Charge and Investigation Developments David Friehling, the former auditor of Bernard L. Madoff Investment Securities (BLMIS), waived indictment and entered a guilty plea in July to charges of securities fraud, aiding and abetting investment advisor fraud and filing false audit reports with the SEC. A further hearing was set for October 1. More recently, and probably more significantly, a key Madoff assistant, Frank DiPascali Jr., pled guilty to 10 criminal counts. DiPascali was the point man for many investors' dealings with BLMIS. Although prosecutors were willing to agree to DiPascali's release on bail, U.S. District Judge Richard Sullivan sent him to jail nevertheless. The criminal complaint refers to unnamed co-conspirators with DiPascali, in addition to Bernard Madoff, fueling speculation he may shed light on the roles of others. DiPascali already has parted company with Madoff's own plea allocution to some extent by stating he learned in the early 1990s or late 1980s that BLMIS in fact was conducting no trading. Madoff's admission did not reach back as far as the 1980s. Other revelations include elaborate efforts to create counterfeit records resembling Depository Trust Corp. records; using software to generate random numbers to make phony trades look as though they had been placed at variable intervals and in different amounts; and having a stand-by plan to show investors trading being conducted electronically, should they insist on seeing it, by having one employee enter a purported trade while another employee in a separate room of the BLMIS Lipstick Building office responded on-line, pretending to be a European trader. Austrian, British and U.S. prosecutors were examining whether Sonja Kohn, 75 percent owner of Austrian Medici Bank, where feeder funds were the source of some $3.5 billion for BLMIS, had received $40 million in kickbacks. On the other side of the ledger, federal prosecutors reported they had found no physical evidence so far to link Ruth Madoff to wrongdoing at BLMIS. Trustee Sues Ruth Madoff But it wasn't all good news for Mrs. Madoff. Despite her agreement to surrender $80 million in assets to the government, BLMIS trustee Irving Picard sought to recover $45 million more from her in an adversary proceeding in the Bankruptcy Court. The suit argues that she had lived "a life of splendor" using funds drawn from the entity, "[r]egardless of whether or not Mrs. Madoff knew of the fraud her husband perpetrated." The 32-page complaint, dated July 29, asserts 14 causes of action. It seeks about $23.76 million Mrs. Madoff received in the two years before the collapse, and another $21,116,820 received in the four years before that, through a total of 111 transfers, which are described in considerable detail. Shortly after the complaint was filed, the trustee and Mrs. Madoff agreed that she will provide him with monthly reports of her income and payments, including reports of all expenses exceeding $100. Homeowner Insureds' Class Action A group of Madoff victims who sought coverage for their losses under "Fraud SafeGuard Events" coverage of their homeowners' insurance issued by American International Group started a class action against the insurer on August 19, claiming AIG wrongfully had denied them coverage. SEC Inspector General Report A report by the SEC Inspector General on the agency's examinations and investigations of Madoff, stretching back to 1992, is supposed to be issued by month's end. JULY 2, 2009 DEADLINE FOR SIPC CLAIMS REMAINS IN FORCE July 2 remains the deadline for filing SIPC claims. An attempt to obtain an emergency hearing to allow SIPC claims of a putative class to be deemed filed even if individuals had not filed claims was rejected by the Bankruptcy Court on June 24. Claim form packages are available on the SIPC trustee's Web site, www.madofftrustee.com. 150 Years It probably should not have come as a big surprise that District Judge Denny Chin sentenced Bernard Madoff to the maximum jail time he could, 150 years, on June 29. The scope of Madoff's admitted fraud was without precedent and the amount his victims are likely to recover, even with his agreements to date and the last-minute agreement by Mrs. Madoff to surrender $80 million, remained modest. The handwriting probably was on the wall by the preceding Friday, when Judge Chin granted the United States' application to forfeit almost $171 billion in assets Madoff doesn't and never did have. Prosecutors had sought the maximum sentence. Madoff's defense counsel, Ira Lee Sorkin, had urged the court to impose a sentence one year shorter than his client's 13-year actuarial life expectancy, or, in the alternative, one of 15 to 20 years. "We seek neither mercy nor sympathy," Mr. Sorkin wrote, and it was a wish the court accommodated. The foundation for the shorter sentence argument had seemed weak. According to the June 22 letter to Judge Chin, a study of ten years of federal sentencing data by the chief executive officer of the National Center on Institutions and Alternatives revealed that, of just under 50,000 cases with full relevant data where the defendant pled guilty, only about half had been sentenced to jail time. Of those whose sentence range under the guidelines was life imprisonment, who had pled guilty, and who did not receive a downward adjustment under Guideline Section 5k1.1, the average jail sentence was 184 months. But apparently it was more compelling to the court that, of the roughly 42,000 cases with no downward adjustment and a guilty plea, only 15 involved loss amounts exceeding $400 million. Nine Madoff victims spoke at the sentencing. Observers said Judge Chin seemed to have been affected in particular by the statements submitted by victims, to which he referred.1 Madoff himself mustered little to evoke sympathy. He said the words, "I am sorry for everything that I've done," but the statement that probably most vexed his listeners was, "[T]here is nothing that I can do that will make your lives better." Many observers doubtless thought that statement was false, believing that Madoff could reveal more about assets and accomplices if he chose to do so. The government told the court Madoff had not provided "meaningful cooperation or assistance." Meantime, reports indicated prosecutors continued to probe possible criminal charges against Madoff family members, former Madoff employees and individuals associated with entities which invested funds with Madoff. Mrs. Madoff Chips In Also on the Friday before the sentencing, Ruth Madoff reached an agreement with the U.S. Attorney for the Southern District of New York to yield claims to some $80 million worth of property, keeping $2.5 million in cash. More Claims The SEC brought suit against Stanley Chais on June 22, who already had been sued by SIPC trustee Picard for $1 billion, alleging, among other things, that he had insisted that Madoff never show losses in the Chais accounts. Chais' lawyer denied the allegations. Both the trustee and the SEC sued Cohmad Securities Corporation; its co-founder and chairman, Maurice J. Cohn; its president and chief operating officer (and Maurice's daughter) Marcia Beth Cohn; and its vice president, Robert M. Jaffe, who is also the son-in-law of Carl Shapiro, whose family is said to have lost substantial sums to Madoff. Maurice Cohn was the "Coh" in the firm's name; Bernard Madoff was the "mad," and still owned an equity interest in the firm. The suits asserted that Cohmad executives were paid fees by Madoff based on the net amount of cash they brought into the Madoff funds — about $1 billion, in Jaffe's case. Not included in the calculation were the profits Madoff investors supposedly were accruing in their accounts; and subtracted were withdrawals, which, it is urged, shows Cohmad knew the purported investor returns were bogus. Lawyers for the defendants denied the charges. SIPC Claims Processing Through June 23, the trustee said claims from 441 account holders had been processed. Their claims totaled about $1.16 billion; SIPC had decided to pay them a total of $188 million. If the latest information on number of actual accounts (1,341 against over 10,000 filed claims) is correct, only about 800 claims remain that could be granted. Presumably, that includes the roughly 230 claims as to which the trustee suggested there might be clawback liability (see April 27, 2009 update). It also implies that something over 8,500 other claims, perhaps principally from indirect investors, will be rejected. The Trustee's Arithmetic Two adversary proceedings brought in the Madoff bankruptcy in June challenged the trustee's calculation of director investor "net equity," the basis for determining the amount of SIPC payments.2 Both claims urge that it is consistent with the goal of the Security Investor Protection Act to use the values shown on statements given to defrauded Ponzi scheme victims, at least where publicly traded securities are involved, rather than the amount they actually invested and not including fictive interest or dividends. The Peskin complaint advances another argument that could have wide-ranging impact. It contends that the trustee is acting in bad faith by offsetting withdrawals directly against the SIPC's obligation to pay up to $500,000, thereby minimizing what SIPC has to advance. This affects only claims above $500,000. In practical effect, the question boils down to whether an offset for withdrawals is applied to the gross claim of a victim or to the amount recoverable from SIPC. To illustrate: suppose a million-dollar Madoff investor made only one withdrawal, of $400,000, on December 1, 2008. Under the trustee's approach, the investor receives only $100,000 from SIPC. Under the approach urged in the Peskin complaint, the withdrawal, if it were deducted at all, would be deducted from the gross claim, meaning the victim receives the full $500,000 from SIPC. This approach could make it much easier to calculate SIPC payments in many cases; it also could increase SIPC's tab substantially. But if only 800 claims with a maximum SIPC exposure of $500,000 are left, the grand total of SIPC's tab for advances may not reach $600 million, apparently less than five percent of the total losses as the government now calculates them. 1 In an opinion handed down on June 17, Judge Chin decided news media applications to obtain unredacted copies of 188 e-mail statements submitted by victims prior to Madoff's guilty plea. The court ordered redaction of identifying data from e-mails from 41 individuals who objected to their public disclosure. The court kept under seal portions of a March 6, 2009 letter from prosecutors because they described efforts to obtain evidence from foreign countries, efforts to obtain seizure of Madoff assets and voluntary restraint agreements between the U.S. Attorney's Office and various individuals. 2 Albanese v. Picard (purported class action), Adv. Pro. No. 09-01265 (Bkr. S.D.N.Y.); Peskin v. Picard, Adv. Pro. No. 09-01272 (Bkr. S.D.N.Y.). The putative class alleged consists of all those adversely affected by the trustee's definition of net equity, excluding the trustee or related parties and excluding Bernard Madoff or related parties. Because it is averred that the trustee's interpretation has scared off some victims who otherwise would have filed SIPC claims, which now may be barred after July 2, 2009, the complaint asks that the class members be deemed to have filed SIPC claims as of the filing of the complaint. The Bankruptcy Court denied an application for an exigent hearing to determine the class and grant this relief on June 24, reiterating that anyone with a claim to SIPC must file it by July 2. Show Me The Money The BLMIS trustee put some big numbers on the board in recent weeks, most notably announcing a settlement for $235 million with Banco Santander, parent company of Optimal Investment Services, a Madoff feeder fund, reflecting, according to the trustee, roughly 85 percent of the amount which could have been sought. That means about $1.25 billion is now in the trustee's kitty. The trustee also lifted the veil a little on the status of SIPC claims, telling The New York Times that 251 (of about 8,800) claims had been processed by May 28. Verified customer loss claims at the same date totaled $759.5 million, and $122.1 million in payouts had been approved, mostly for the maximum amount SIPC can pay, $500,000. The trustee also disclosed that, of 144 hardship requests received in the first two weeks after the program's May 8 start, 59 were approved. Meanwhile, the head of the SIPC, which is footing the bill for trustee Picard's work as well as for the payouts to covered customers of BLMIS, warned that reeling in all the assets for which claims could be made might take up to 10 years. The absolute deadline for filing SIPC claims is July 2. Trustee Sues Fairfield Greenwich Funds and One Fund Sues Fairfield Greenwich Not that this was a particularly daring prediction on our part, but it has come to pass: the trustee sued three Fairfield Greenwich feeder funds in mid-May (Fairfield Sentry Ltd., Greenwich Sentry LP and Greenwich Sentry Partners LP). All told, the three funds withdrew $1.2 billion in the 90 days before BLMIS collapsed; for the six-year clawback period, the total was $3.2 billion. Meanwhile, the Fairfield Sentry fund sued a flock of Fairfield Greenwich-related entities and partners in Supreme Court, New York County on June 1 for $919 million. Among other things, the 29-page complaint alleges that BLMIS never made a single trade over 18 years with the sums invested by Fairfield Sentry, which tops the charts with a loss of $7 billion in the Madoff fraud. In the last six years alone, it avers, the Fairfield Greenwich entities charged management fees of over $265 million and "performance fees" — typically 20 percent of purported value appreciation — exceeding $654 million, or more than $919 million in all. The complaint asserts seven claims against some or all defendants: breach of fiduciary duty; breach of a specific contractual duty to use "best efforts" with regard to the Fund's investment activities; unjust enrichment; constructive trust; rescission of various investment management agreements based on mutual mistake (the mistake essentially being that the investments with Madoff were legitimate and followed a split strike conversion strategy); an accounting; and a declaratory judgment that Fairfield Sentry does not owe $26 million in deferred fees. The complaint also notes that Fairfield Sentry fired the Fairfield Greenwich entities on May 29, the date of the complaint. Although the suit asserts that the Fairfield Greenwich entities' fees were based on inflated net asset value figures, it carefully avoids asserting that anyone associated with Fairfield Greenwich knew what Madoff was up to. SIPC Hardship Program for Individuals The trustee for Bernard L. Madoff Investment Securities ("BLMIS") instituted a special program geared to providing faster SIPC payouts to individual, direct investor victims who are in dire circumstances. Hardship applicants must submit an SIPC claim by July 2, 2009, as well as file a separate hardship application. Full details and the hardship application are available on the trustee's website, www.madofftrustee.com, but the criteria target those most severely affected by their losses. The six factors to be considered are:
The trustee promises a decision (or request for more information) on hardship applications within 20 days. Qualifying applicants will have consideration of their SIPC insurance claims expedited. Acknowledging that BLMIS records "are currently incomplete," the trustee makes no promises but says he will try to determine claims on accounts opened after 1995 within 20 days of qualifying as a hardship case. Evidently the pre-1996 records are in the worst shape, because for those claims, the trustee says, even hardship applicants will have to wait "until full information is available," and he urges them to provide whatever information they can to reconstruct the records. The SIPC claims are limited to $500,000 per account. Feedback Claims Two lawsuits brought by the trustee recently continue the pattern of looking beyond BLMIS and directly controlled entities to augment available funds. The trustee sued West Coast investment advisor Stanley Chais, who funneled many entertainment industry investors into Madoff, and J. Ezra Merkin, whose three funds (Ariel, Ascot and Gabriel) were multi-billion dollar feeders of funds to Madoff. If Merkin is in the mix, can claims against Fairfield Greenwich be far behind? In both cases, the trustee alleges Chais and Merkin knew or should have known something was amiss. He seeks to recover $1 billion from Chais and almost $558 million from Merkin. In both cases, there is also a 1995 cut-off, further suggesting the nature of problems with records so far available. The trustee likely will continue to pursue such claims, including against foreign funds that fed investors' money to Madoff. Indeed, it was reported May 7 that Switzerland's UBS AG had been subpoenaed (back in March) for information not only about Madoff accounts with it, but about accounts of feeder funds and banks. A Twofer Also this week, the trustee filed papers urging the U.S. District Court for the Southern District of New York to let him fold Bernard Madoff's personal bankruptcy into the administration of the BLMIS estate, arguing the two effectively were one. Bankruptcy Judge Lifland earlier had allowed victims to force Madoff into personal bankruptcy and the U.S. trustee appointed a receiver in the personal bankruptcy. Bad move, the trustee argues, which only will increase costs and lessen recoveries. There's nothing particularly new in the legal arguments, but the affidavit submitted by investigator Michael Slattery, Jr. contained some juicy factual tidbits, including the following assertions:
The Other Shoe Drops... or Does It? As we noted in our last update, the trustee for Bernard L. Madoff Investment Securities ("BLMIS") began the clawback dance by going after a fund that had made withdrawals during the 90-day preference period. On April 20, he sought $255 million from two other British Virgin Island-based funds, Kingate Global Fund, Inc. and Kingate Euro Fund Ltd., on a similar theory. But then came word that the trustee had written to about 223 Madoff victims - including individuals, Madoff employees and institutional investors - who made withdrawals during the six years preceding the Madoff's firm's collapse, seeking recovery of about $735 million in sums withdrawn. Initial reports made it seem the trustee was taking a hard line, demanding funds back even from investors whose investments exceeded their withdrawals - an unfair double whammy, many said. But later reports indicated the trustee would not go after such investors. After word of the letters got out, the trustee issued a statement, which said in part:
So what's up? Both more and less than meets the eye, in all likelihood. More, because there is no way to know how the 233 letter recipients were selected. There is ample reason to think BLMIS records are incomplete or inaccurate. Perhaps the 223 are only those identified so far. The trustee initially sent claim forms to 8,000 BLMIS clients; does it seem probable that, of that universe, only three percent made withdrawals in the last half-dozen years? So this may be just another in an unknown number of rounds of demands. Less, because it appears the letters are really just invitations for negotiation, even though they make noises about legal action and interest being charged on unreturned amounts. In particular, they invite addressees to come forward with information, including detailed explanations of why they believe they received funds "for value and in good faith." Institutional investors (who may have clients of their own) and Madoff employees may be folks from whom the trustee particularly would like to hear on those topics. Also, remember that Madoff's guilty plea allocution put the date for the inception of the Ponzi scheme later than the government alleged. If there's any truth to that, and if record-keeping practices changed at that point, there may be enormous difficulty in determining the relative amounts of original investments and total withdrawals. The letters seem to raise another troubling issue. If the trustee has a standard in mind for guiding the negotiations with the letter recipients, it has not been disclosed. One readily can imagine circumstances where equity and decency would counsel against seeking recovery. But how will anyone know if like situations are being treated in like fashion? If, as both the government and Madoff stated, the Ponzi scheme goes back more than six years, should someone who made substantial withdrawals before late 2002 and none thereafter be allowed to keep everything, when those earlier withdrawals also were of "other peoples' money"? In the absence of uniform standards, those investors who can afford to hire counsel to make a more compelling case, whether or not they have more compelling facts, may do better than those who don't. Dueling Courts Within a week of the way being cleared for Madoff victims to force his personal bankruptcy by one federal judge, another federal judge rolled a large boulder across the path. U.S. District Judge Denny Chin, before whom Madoff entered his guilty plea and who is scheduled to sentence him in June, entered an order freezing Madoff's and his wife Ruth's assets. All the same, Bankruptcy Judge Burton Lifland, expressing the hope that a "turf war" wouldn't erupt, appointed Alan Nisselson as interim trustee for the Bernard Madoff personal estate. The Circle Widens Recent weeks have seen an acceleration of a trend previously anticipated on this site: multiple efforts to widen the circle of parties - and assets - available to victims of Madoff fraud. With readily available Bernard L. Madoff Investment Securities (BLMIS) assets seemingly plateauing just above $1 billion, the firm's trustee sought a $150 million recovery from a British West Indies-based firm, Vizcaya Partners Ltd. Vizcaya allegedly drew that sum out from Madoff on October 31, 2008, within the 90-day bankruptcy preference period. This alone does not reveal much about the trustee's plans, particularly with regard to clawback claims outside the 90-day (one year for insiders) preference period. Many victims are still holding their breath to see what the trustee will do about (or to) victims who withdrew what they thought were profits, that is, sums in excess of the original sums invested with Madoff. At almost the same time he sued Vizcaya, the trustee told another party trying to reach beyond Bernard Madoff and his firm that anything that claimant recovers also might have to go into the collective BLMIS pot. In this instance, the claimant was law student Andrew Samuels, who had sued Peter Madoff in his capacity as the sole trustee of a fund set up to benefit Samuels and his sister - and, ironically, initially largely funded by Bernard and Ruth Madoff. Peter invested the trust fund with BLMIS. Samuels' suit in Supreme Court, Nassau County, Commercial Division, earlier had led Justice Stephen A. Bucaria to impose a freeze on Peter Madoff's assets. This order was modified on April 3 so that it tracked a previously unknown voluntary asset-freezing agreement Peter Madoff had made with the federal government in December. In Connecticut, the Town of Fairfield won state court attachments totaling $25 million against both Madoff brothers, Bernard Madoff's sons Mark and Andrew, and Walter Noel of Fairfield Greenwich Group. In Massachusetts, the Secretary of State sued Greenwich Fairfield for civil fraud. In New York, Attorney General Andrew Cuomo charged J. Ezra Merkin with civil fraud in connection with three funds he ran which invested $2.4 billion with Madoff (Ascot Fund Ltd., Gabriel Capital Corp. and Ariel Fund Ltd.) Among the allegations of the complaint was that although Merkin took $169 million in management fees for the Ascot Fund from 1995 to 2007, he and family trusts and foundations never had more than $7 million in the fund, and for a decade had less than $2 million. The same day Cuomo filed his claim, Mortimer Zuckerman, whose family foundation suffered a $40 million Madoff loss, also sued Merkin and Gabriel Capital. Still other suits too numerous to catalogue here have been filed by victims against various financial institutions which owned funds which had made or permitted customers to make Madoff investments. Farther afield, the BLMIS trustee geared up to litigate in Bermuda, the Cayman Islands, Gibraltar and Luxembourg to try to recover assets. A Luxembourg court ordered HSBC Holdings plc and Bank Medici AG of Austria to turn over documents related to Madoff investments made with Madoff through a Luxembourg-based fund, Herald Lux. (HSBC was its custodian; Medici acted as an intermediary.) Court Lets Victims Force Bernard Madoff into Personal Bankruptcy U.S. District Judge Louis Stanton rejected the positions of the SEC, the U.S. Attorney for the Southern District of New York and the BLMIS trustee on April 10 and allowed a group of victims to file an involuntary bankruptcy petition against Bernard Madoff personally. The court noted that the trustee's mandate is to recover funds only for broker-dealer customers, and not for other victims, for example, those who invested through intermediaries. Moreover, the bankruptcy claim lets victims reach all of Madoff's personal assets, without having to show they were criminal proceeds from BLMIS. Given the green light, the victims filed the petition in U.S. Bankruptcy Court in Manhattan on April 13. Tax Guidance In Revenue Ruling 2009-9 and Revenue Procedure 2009-2, the Internal Revenue Service recently issued guidance to individual investors who suffered losses from schemes such as Madoff's. What follows is only a summary and it is important to consult your tax advisor before making any decision on how to proceed. As IRS Commissioner Doug Shulman testified before the Senate Finance Committee on March 17, the rules go beyond Madoff victims and include victims of other Ponzi schemes discovered after December 31, 2007. An individual who invested either in connection with a trade or business or for investment purposes is entitled to claim a theft loss in the year the fraud is discovered, except to the extent there is a reasonable prospect of recovery. Theft losses of this type generally constitute itemized deductions for individuals and they are not subject to various limitations that apply to many other types of itemized deductions. Such losses are not capital losses. Theft losses of a magnitude that create net operating losses can, in turn, be carried back three years and carried forward 20 years. In some circumstances, these theft losses may be subject to four or five year carry backs under the recently-enacted American Recovery and Reinvestment Act of 2009. The amount of the loss includes not only the original amount invested, but also any income or gain from the investment that the taxpayer reported on prior returns and "reinvested." If the taxpayer qualifies for the safe harbor treatment set forth in Revenue Procedure 2009-20, the loss is allowable in the taxable year of the investor in which the indictment, information, or complaint is filed against the promoter. In Madoff's case, this occurred in 2008. This is significant since the IRS traditionally took a conservative view when fixing the taxable year in which a theft loss occurred. Among the requirements for qualifying for safe harbor treatment is that the taxpayer cannot amend prior year returns that are affected by the scheme (other than for purposes of carrying back net operating losses as mentioned above). The Revenue Procedure sets forth the following two-part test for determining whether the loss is a result of a qualifying theft: (1) the promoter has been charged under state or federal law with commission of fraud, embezzlement or a similar crime which would constitute a theft; or both a state or federal criminal complaint alleging such a crime has been filed and that there either (a) is some evidence of an admission of guilt by the promoter or (b) a trustee was appointed to freeze the assets of the scheme. Another difficult issue when claiming a theft loss is determining what might be recovered ultimately from litigation or insurance. The Revenue Procedure provides safe harbor guidance regarding this issue as well. Qualified investors who will not sue parties or pursue claims (other than SIPC claims or claims against an insurance policy in the name of the promoter), generally may deduct 95 percent of their loss in the year of discovery, less the total of any actual recovery in that year and any expected recovery from SIPC or private insurance. Qualified investors who have sued or will sue parties other than the promoter (excluding the SIPC or any insurance company that insured the promoter) are limited to 75 percent (less any actual recovery in year of discovery and any expected SIPC or other insurance coverage). To illustrate all this in an example: Suppose an individual had deposited $1 million in a single Madoff account in 2000, earned a total of $1 million in income during the years 2000 through 2007 on which tax was paid, and withdrew a total of $400,000 from the account. The year of discovery is 2008 and the likely SIPC recovery and/or promoter insurance recovery is $500,000. The individual's deductible theft loss under the new ruling and safe harbor of the Revenue Procedure would be $2 million less the $400,000 withdrawn, less the $500,000 likely recovery from SIPC, or $1.1 million, multiplied by .95, or $1,045,000. However, if the same individual commenced a suit against, say, a Madoff feeder fund, his or her theft loss under the safe harbor procedure would be only $1.1 million multiplied by .75 or $825,000. Presumably, putative class members who opt out of any class actions against feeder funds or other non-promoter parties, should any be certified, could use the higher 95 percent figure. Those new rules regarding deductibility of theft losses in connection with Ponzi schemes are highly complex, and we urge you to consult with a skilled tax advisor prior to deducting my theft losses on your tax return. Treasury Circular 230 Notice Private Foundations as Madoff Investor Victims During testimony before the Senate Finance Committee on March 17, IRS Commissioner Doug Shulman said the IRS would consider levying taxes on board members of charities that lost money to Madoff. Senator Charles Grassley (R-IA), the ranking minority member of the committee, had a clear-cut viewpoint: "Some of the charities that invested with Bernie Madoff, including universities and those funded by Hollywood big shots, would presumably have sophisticated advisers. This raises issues for me about whether the board members of those organizations were more interested in helping their friend than furthering their charitable work." Private foundations, their trustees, directors and officers, can face a 10 percent penalty tax, up to $10,000, for failing to exercise due diligence or properly monitor an investment, plus an additional 25 percent penalty, up to $20,000, if they fail to recover the funds during the tax year. Casting a Wider Net In an action filed on March 17, federal prosecutors sought the forfeiture of assets belonging to Bernard Madoff and Madoff family members. Among other things, they identified interests Bernard and Ruth Madoff have in a score of businesses, including a restaurant, real estate investments, more than $2.5 million in jewelry owned by Ruth Madoff and proceeds of promissory notes totaling more than $31 million for loans Bernard Madoff made to his sons, Andrew and Mark. Madoff Firm's Accountant Charged Accountant David G. Friehling surrendered to federal authorities March 18 after a criminal complaint and an SEC civil complaint were filed against him. He was the sole active practitioner at Friehling & Horowitz, P.C., the firm that audited Bernard l. Madoff Investment Securities, LLC from 1991 to 2008. The criminal charges include securities fraud, aiding and abetting investment advisor fraud and four counts of filing false audit reports with the SEC. The SEC complaint also names Friehling & Horowitz as a defendant, and seeks injunctions against further violation of law, disgorgement and civil penalties. The allegations of the SEC complaint are nothing short of remarkable, even though authorities did not accuse Friehling. For example, the 2007 Madoff statements, which the accountant said fairly presented the entity's financial situation in accordance with generally accepted accounting principles, showed assets of $1.093 billion and liabilities of $425 million. This is a fraction of the figures shown on Madoff's statements to customers, and probably less even than some individual funds or entities had invested. Put differently, as the complaint states, "BMIS owed tens of billions of dollars in unreported liabilities to its customers and thus was insolvent." The SEC alleges that, although the accountant opined on the absence of any internal control matters that would be material weaknesses, in fact, he did no testing. He performed no checks on securities purportedly held by depositories or clearing institutions and made no reconciliation to Madoff's records. Moreover, particular customers hired Friehling to do work regarding their Madoff accounts, including to confirm that assets were held in a segregated account; Friehling told these customers he had performed tests to confirm that the securities shown in their accounts existed when, in fact, he had not. Friehling also failed to seek account confirmations from a bank through which billions of dollars flowed between the Madoff entity and its investors. The complaint also asserts that the accountant let Madoff pick which customers would be sent confirmation statements; identified himself as independent when Friehling and his wife had as much as $14 million in accounts of the entity he purportedly audited; kept no audit workpapers; lied to the American Institute of Certified Public Accountants, saying he did no audit work, to avoid a peer review of his Madoff work; and signed off on a report on internal controls that had been drafted by Madoff management after making no inquiry of his own. No Get Out of Jail Card The U.S. Court of Appeals for the Second Circuit issued a summary order affirming Bernard Madoff's remand to jail pending sentencing in June. The four-page order issued about 24 hours after argument on the appeal from Judge Chin's order relied on the risk of flight, and did not reach the question of whether risk of further endangerment would have been another basis for revoking bail. Jail — While there was some jubilation that U.S. District Judge Denny Chin revoked Bernard Madoff's bail when Madoff entered a guilty plea March 12, there was little in Madoff's allocution statement to give cheer to his investor victims. Not only did the prosecutors confirm there had been no deal involving Madoff's cooperation; the carefully crafted statement Madoff read was at pains to preserve the major points of his "just me" claims. Thus, Madoff's statement claims the fraud began in the 1990s as the result of the recession and not in the 1980s, as the government's information had alleged, and asserts that no one ever had been promised fixed rates of return. No new hidden assets were revealed; most importantly, Madoff strove to maintain the position that only he had been involved. The allocution insisted that the "legitimate" parts of Bernard L. Madoff Investment Securities (market making and proprietary trading, as well as its London affiliate) and the fraudulent investment advisory operation were neatly and completely separated from each other. Although Madoff admitted government allegations that investor victims' funds had been transferred to the "legitimate" operation, he claimed to have done this "as a way of ensuring that the expenses associated with the operation of the fraudulent investment advisory business would not be paid from the operations" of the legitimate businesses. This is prize-winning pretzel logic. For investor victims, the real significance of the allocution may be that either there are no more assets to go after (if Madoff was telling the truth) or at least that the government and the trustee have not yet opened an easy path to finding them. That means the trustee likely will redouble efforts to identify investor victims who made substantial withdrawals to add those sums to the assets he garners. The Wall Street Journal (March 11) quoted SIPC President Steve Harbeck as reminding everyone that the trustee "has an obligation to all investors to maximize the common pool of assets," and saying the trustee likely would work on clawing back some investors' gains "because otherwise you'd let the thief determine who wins and who loses." Madoff's attorneys filed an appeal to the Second Circuit, seeking to overturn Judge Chin's revocation of bail. On a brighter but narrow note, SIPC mailed out $500,000 checks to investor victims this week — but only to a dozen of them. Taxes — Rep. Gary Ackerman (D.-N.Y.) introduced a bill in the House of Representatives (H.R. 1389) this week which would let Madoff investor victims reach back 13 years to claim refunds of federal tax paid on what has proven to be phantom income. U.S. v. Bernard L. Madoff Bernard Madoff waived indictment in a signal widely read to mean he will plead guilty at an arraignment scheduled for March 12. If so, the plea will be a to an 11-count criminal information filed by the Acting U.S. Attorney for the Southern District of New York on March 10. The 25-page document alleges securities fraud, investment advisor fraud, mail and wire fraud, several varieties of money laundering, the making of false statements to federal authorities and particularly the SEC, perjury and theft from employee benefit plans. Conviction on all counts would lead to potential jail time well in excess of a lifetime even if Madoff weren't 70. The criminal information also seeks forfeiture of assets, either the actual proceeds traceable to the crimes, or, if those are unavailable, any other assets the defendant has. Prosecutors pegged the sum sought as $170 billion, thought to be the total transactional volume in the Madoff accounts. The government emphasized that its investigation is continuing. It has been reported that the scrutiny extends to as many as a score of potential co-conspirators. The allegations of the information contain some new factual assertions, including:
Madoff Waives Conflict of Interest Issues Also on March 10, a hearing took place before U.S. District Judge Denny Chin in the Southern District of New York on whether Bernard Madoff's counsel, Ira Lee Sorkin, faced any conflicts of interest. The government had noted that Mr. Sorkin once had had a small retirement account investment with Madoff, that his family members also had had accounts, and that in the 1990s he had represented two accountants accused in an SEC case who had funneled funds to Madoff. The issue was mooted by Madoff's waiver of any potential claim based on a conflict. Mrs. Madoff It also was announced that Ruth Madoff, Madoff's spouse, would be hiring her own counsel. Mrs. Madoff has not been the subject of any criminal charges, although she has been named as a defendant in some civil suits. Victims were infuriated by a court filing by Bernard Madoff earlier in March asserting that the Madoffs' $7 million Manhattan apartment and some $62 million in bonds and bank accounts were Mrs. Madoff's, and not subject to seizure in connection with the prosecution of Bernard Madoff.
Meanwhile, U.S. District Judge Louis Stanton approved a partial judgment on consent between the SEC, and Madoff and Bernard L. Madoff Investment Securities LLC. The partial judgment continues the asset freeze already in force and requires Madoff to pay disgorgement yet to be determined. Madoff agrees not to commit certain frauds and not violate certain federal securities laws in the future; interestingly, the judgment extends those prohibitions to his "partners, agents, servants, employees, and attorneys, and those persons in active concert or participation with them" who receive actual notice of the Order in specified ways. Evidence-gathering efforts related to the Madoff scandal picked up speed, as the Madoff trustee filed roughly a score of subpoenas on President's Day (Feb. 16) and then again on February 18. Recipients included brokerage firms, clearing houses, law firms and accounting firms. Banco Santander reportedly improved its settlement offer to some of its most important clients. Supposedly among the sweeteners: allowing recipients of preferred shares offered in the settlement to use them to collateralize low-interest loans from the bank; and freeing those clients from the previously sought commitment to maintain all existing accounts at the bank. A complaint filed by the Massachusetts Secretary of the Commonwealth asserted that Ruth Madoff, Bernard Madoff's wife, withdrew more than $15 million from Cohmad Securities in the 16 days before his arrest. A list of Madoff "customers" became available on Wednesday, February 4, but it was both more and less than it seemed. More, because the 162-page list included names, famous and ordinary, not previously identified as having been involved. The list had something over 13,500 entries in all. Less, because it was not clear that all those listed in fact had suffered losses.The list consisted of those identified as having accounts with the Madoff broker-dealer in the one year preceding the collapse, and those who had identified themselves to the trustee as having losses. But according to one report, one New York law firm which was listed is actually adverse to the Madoff entities on behalf of clients who suffered losses. The list was less, too, in its organization, with an idiosyncratic alphabetizing system. If John Doe suffered a loss, he might appear under "J," for John Doe, or "M," for Mr. John Doe, or under "T," for "Trust for benefit of John Doe, or under "F," "For Account of John Doe." But a quick-witted entrepreneur set up a Web site (www.madoffsearch.com) for those who want to perform searches. The list doesn't show amounts of losses, but it does show addresses, something which those on it probably wish were not so public. Agents from the Federal Bureau of Investigation arrested Bernard L. Madoff on December 11, 2008 on a single charge of federal securities fraud: that his investment advisory business was nothing more than a global Ponzi scheme. Madoff allegedly had said that, against as much as US$50 billion in supposed deposits and earnings over decades, there was perhaps only US$200 to 300 million in assets. The stock market collapse following the bankruptcy of Lehman Brothers in September confronted Madoff with demands to redeem some US$7 billion against some US$17 billion in supposed sums on deposit, which couldn't be met. In addition to the criminal charges, Madoff is a defendant in a civil suit by the U.S. Securities and Exchange Commission (SEC), which secured an order on consent freezing his assets. The U.K. Serious Fraud Office has opened an investigation in connection with the liquidation of Madoff's British operations. Purported class action lawsuits have been commenced against Madoff and some funds of funds that invested with him, primarily in Manhattan federal court. Other, more unusual claims have been filed, including one by a latecomer seeking return of his funds because Madoff never "invested" them, and one against the SEC for negligence. A Luxembourg trial court ordered a bank to honor a November redemption demand by a French investor in a fund that had invested with Madoff and for which the bank was the custodian. The Securities Investor Protection Corporation (SIPC), a private entity which provides limited insurance to brokerage clients, obtained the appointment of a trustee for the Madoff broker-dealer firm, Bernard L. Madoff Investment Securities, LLC. Early in January, the trustee sent claim forms to approximately 8,000 known Madoff broker-dealer clients with accounts open during the preceding year, asking for documentation of claims by March 4, 2009. Those and other claims will be accepted until July 2, 2009. Much about the extent and distribution of losses remains unclear. For example, it remains unclear which, if any, of the invested funds may been used for broker-dealer transactions at all. Insurance — A direct investor with Bernard L. Madoff Investment Securities, LLC, who withdrew nothing and lost an original investment and all purported income, may benefit from SIPC coverage, and should preserve and gather relevant documents immediately. The coverage is limited, to US$500,000 per account, including $100,000 for cash, for brokerage losses. Coverage for losses also may exist under typical homeowner or umbrella liability policies issued in the United States. Prompt notice to the carrier may be critical. Claims and restitution — The direct investor may have claims to pursue, individually or in a group. (See more on class actions below.) The SIPC trustee will round up Madoff assets; so far, the trustee has identified just under $950 million. Investors also could receive restitution as a result of the criminal and SEC prosecutions — if meaningful assets can be found. "Clawback" issues — Direct investors who withdrew principal or purported earnings from Madoff investments may face clawback claims. Under U.S. bankruptcy law, withdrawals made in the 90 days preceding the December 11 complaint (one year if by insiders) are subject to recapture as preferences. Moreover, if withdrawals are deemed to be withdrawals of other investors' funds, not the investor's own funds or earnings, they may be subject to recapture going back as far as six years (to roughly December 2002) as fraudulent transfers under New York's Debtor-Creditor Law. Investment Through Intermediaries Many investments came to Madoff through other entities, such as funds of funds. Any SIPC coverage may be meaningless if the investments were held in the funds' names. Funds of funds may face claims from such indirect investors, likely focusing on whether the funds took sufficient steps to investigate or adequately disclosed the nature (or fact) of the Madoff investments. The funds' errors and omissions insurance may be implicated. Some would-be claimants may have signed investment advisory agreements with provisions calling for them to pursue any claims through arbitration and not in court. Courts have applied a test which requires investors who profited in Ponzi schemes to share ratably in the losses. See, e.g., SEC v. Credit Bancorp, Ltd., 290 F.3d 80 (2d Cir. 2002). To the extent assets were in trust accounts or were not under Madoff's control, claimants may be able to "trace" their particular assets. Sums deemed to be a return of capital also may escape such sharing, unless the investor acted in bad faith — such as being aware of the fraud or having knowledge of it imputed to the investor. Some Madoff investors may have heard rumors that he generated his steady returns from "front-running" — using "inside" trading information from the affiliated broker-dealer to benefit Madoff investors. Those investors may confront a fact issue as to bad faith. Some of the funds that invested in Madoff may themselves end up bankrupt. If there are claims that such funds knew of fraud, they (or their principals) may find claims against them non-dischargeable. In the absence of direct knowledge, one can imagine arguments both ways. Although some investment advisors warned clients against Madoff, numerous regulatory investigations did not reveal the scheme. A class action suit was commenced in Florida federal court over losses claimed by investors in Optimal Strategic U.S. Equity Fund. Reports say clients of Spanish bank Santander and its Swiss private banking business Optimal, many from Latin America, lost over $3 billion in connection with Madoff. Defendants included an HSBC unit which acted as custodian and accounting firm PriceWaterhouse Coopers. Within days of the filing, Santander reportedly had offered non-institutional private clients a deal: preferred stock in the bank worth over $1.8 billion in settlement, based on client sums invested without purported profits. The preferred stock would have a two percent per year yield, trade on an exchange and be callable in ten years. Participants would have to agree not to sue and to maintain all current business and deposits with the bank. Investors who wished to liquidate the preferred stock now likely would be able to do so only at a steep discount. Investors who lost funds are likely to reach beyond Madoff and intermediary funds in seeking relief. Professional firms, such as lawyers and accountants, are obvious targets, made particularly attractive because they are likely to have insurance. Generally speaking, errors and omissions coverage will not cover fraud, but it may be available to answer for claims of negligence or malpractice. Defendants, however, may be entitled to defense costs under policies. Friends, family or fellow club members seem to have attracted many of Madoff's investors. They also may face claims. The Madoff losses seem unlikely to lend themselves to treatment as class actions, on an overall basis, owing in large measure to the wide variation in investment circumstances and vehicles. The size and number of claims point strongly toward any class action attempt proceeding in federal court. The Federal Rules of Civil Procedure set out four criteria for class action certification:
The trustee's marshalling of assets may take the place of many of the procedural functions a class action ordinarily might perform. Foreign claimants seeking to make claims against foreign funds of funds will have to consider the recent "foreign-cubed" decision of the Second Circuit in Morrison v. National Australia Bank, Ltd., 547 F.3d 167 (2d Cir. 2008), which suggests there will be fact-driven litigation over whether the "heart of the fraud" occurred in the United States. Criminal and Regulatory Issues The Madoff arrest and prosecution is unlikely to be the last domino to fall. Prosecutors and regulators in the U.S. and abroad will want to learn whether Bernard Madoff acted alone or, if not, who else was involved with the purported Ponzi scheme. Whether or not there were co-conspirators, hundreds of individuals and entities can expect to face subpoenas for documents and electronic data going back many years, as well as requests for interviews, grand jury testimony, depositions and trial testimony. The trustee has been granted subpoena power and law enforcement agencies in both Massachusetts and New York have issued subpoenas. The Financial Industry Regulatory Authority has directed some brokerage firms to disclose to investigators whether their employees referred clients to Madoff, investment vehicles managed by the Madoff broker-dealer, or investment funds that invested wholly or in part with Madoff during the period 2006 to 2008. The January 15 letter sought identification of the employees and a list of any other investment advisory firms to which customers were referred. One possible focus of the inquiry is whether the referring brokers received commissions or fees. Broker-dealers responding to the request, which may require them to create new documents, should talk with counsel about possible evidentiary traps to avoid. Entities from Austria, France, Israel, Italy, Japan, Korea, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom already have appeared on lists of investors with multimillion-dollar direct Madoff losses. The liquidation proceedings will require an unusual degree of cross-border judicial cooperation. There are likely to be many applications in U.S. federal courts for evidence to aid foreign litigations or arbitrations over Madoff losses. The existence of criminal charges may promote cooperation by off-shore jurisdictions in identifying proceeds. Madoff litigation discovery will be massive. There are likely to be multiple proceedings going ahead simultaneously, such as individual lawsuits, purported class action claims, the trustee's proceedings in the Bankruptcy Court, the SEC's lawsuit and criminal and regulatory investigations. The related discovery is likely to push the outer boundaries of scope, particularly because many involved parties keep sophisticated electronic and other records. Given the magnitude of losses, it will be harder than usual to argue that the need to obtain relevant data is outweighed by the cost to recover it. Moreover, the decades-long time frame of the alleged fraud will make discovery resemble that in litigations over giant anti-trust conspiracy claims or over "long-tail" environmental and toxic tort insurance coverage claims. The trustee's work in marshalling assets and pursuing claims may help to provide a central focus. Clearinghouse arrangements for discovery may help avoid the need to reinvent the discovery wheel in each case. Madoff investors face several tax issues. First, they may be able to deduct their losses for federal, state and local income tax purposes in the U.S. Federal tax casualty losses are subject to a "deductible" amount ($100) and then are deductible only to the extent they exceed 10 percent of adjusted gross income. Losses from transactions entered into for profit, as Madoff investments arguably were, are fully deductible, but it may be too early for investors to quantify their post-recovery net losses. Investors also presumably declared and paid taxes on their past Madoff "income." They should consider whether to amend earlier returns to seek refunds. Federal amendments can be made by the later of three years after filing or two years after payment. Apart from just trying to recover their sometimes substantial losses, charitable entities may confront other, unique issues. In the U.S., most are regulated at the state level. The New York attorney general has issued subpoenas to a number of charities with Madoff losses. But not-for-profits should be alert that they may face inquiries from regulators about the investment decision-making process they followed. This is particularly the case if members of the charity's investment committees brought the charity to Madoff or realized gains from the charity's Madoff investments. It is possible that Congress may take steps to create a special compensation mechanism for the Madoff loss claims, as it did with certain September 11, 2001 claims. For example, a special panel might be established to award compensation, not necessarily on a pro rata basis, in exchange for litigation waivers. Contact Schiff Hardin for more information Schiff Hardin attorneys have extensive experience with the myriad issues following from the alleged Bernard Madoff scheme. For more information on the following legal issues, contact the attorney listed.
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