The securities laws may be your worst enemy if you lost money in the Madoff scam. Investors are suing the feeder funds that channeled their money to Bernard Madoff, charging the feeders with fraud, negligence or breach of fiduciary duty. On the surface, the cases sound like slam dunks.
They're not. Congress and the courts have spent more than a decade writing and affirming laws that protect companies from irate investors. Those laws may turn out to be feeder fund protection acts.
For bilked investors, the problems begin with the federal Private Securities Litigation Reform Act (PSLRA), passed in 1995. It was designed to reduce the number of “frivolous” securities lawsuits filed in federal courts. In essence, it says that investors can't proceed with a case unless they already have facts in hand that strongly suggest a deliberate fraud.
By this standard, it's not enough to claim that the feeders failed to investigate Madoff or issued financial statements later found to be false.
You have to show that the feeder probably knew about the fraudulent scheme, or recklessly disregarded evidence of it, or that the fund violated a written commitment -- say, by investing all of your money with a single manager when it specifically promised not to. You need documentary evidence showing that your claim is strong.
Stupid, not criminal
The feeders will argue that they didn't know what Madoff was up to, that they vetted him along with other managers and that everyone was fooled. They have a good chance of getting your case dismissed. “Stupid” isn’t a triable offense.
Prior to the PSLRA, you could start your case with minimal evidence and use pre-trial discovery to search for more. The feeder would have to turn over e-mails and other documents that might show it had doubts about the Madoff accounts. Today, however, you need such evidence just to begin, and it's tough to get.
You also can't argue that the feeders are liable because their actions made the fraud possible. In 1994, the Supreme Court ruled that investors may not sue advisers -- investment banks, lawyers, accountants -- that aid and abet a securities fraud (the case was Central Bank of Denver vs. First Interstate Bank of Denver). Abetters have get-out-of-jail-free cards.
You might get a break if Madoff made secret kickbacks to one or more feeder funds, to bring in more cash. No one knows if that happened. If it did and Madoff confesses to it, that could be enough evidence of fraud to get you into court, says John C. Coffee, a professor of law at Columbia University in New York.
Seeking friendlier courts
Most securities fraud cases have to be brought in federal court, but there's potentially a second road to justice. Instead of claiming fraud, investors can claim that the feeders breached their fiduciary duty -- a charge that’s tried in state courts. It doesn’t require proof of fraudulent intent.
“Getting these cases into state courts is crucial for the litigation, because success will depend heavily on getting access to the feeder funds' records,” says James Cox, professor of law at Duke University in Durham, N.C.
There's a hitch. Class actions involving the securities laws and covering more than 50 people can easily be moved by the defendant to the inhospitable federal courts. A case can also be moved for other reasons -- for example, if it was filed in a different state from the one where the feeder has its main office.
Many of these cases will wind up in New York, where some of the principal feeders are located. That creates yet another problem. A state law called the Martin Act prevents individuals from filing claims under New York securities laws. Only the attorney general can pursue an action.
You can't even pursue a breach-of-fiduciary-duty claim in New York’s courts, if the breach involves a securities case. It has to go to the federal courts -- a finding affirmed as recently as July 2007.
In that case, South Cherry Street LLC, an investment group, sued Hennessee Group LLC, a consultant, for recommending the Bayou Group, a hedge-fund Ponzi that blew up in 2005. The judge, Colleen McMahon, also found that, even if Hennessee's principals had egregiously failed to investigate Bayou, they weren’t liable for South Cherry’s losses as long as they didn’t deliberately shut their eyes to what was going on.
Pursuing deep pockets
Her decision is on appeal and lawyers are watching it closely. “It's a stark example of how many barriers there are now to private investors seeking to recover,” says attorney Joel Laitman of Schoengold Sporn Laitman & Lometti in New York.
Investors are pursuing one other set of deep pockets: The institutions chosen by the feeder funds to be custodians of the assets. Custodians are supposed to hold your investments and account for them. Their presence made people feel secure.
Most custodial contracts, however, permit the appointment of subcustodians, says Dominic Hobson, editor-in-chief of London-based GlobalCustodian, which covers the field. Ideally, the sub should be independent but the contract may not require it. In this case, the institutions handed off to Madoff, acting as his own custodian.
Custodial contracts typically require that subs be chosen carefully and monitored, Hobson says. An institution might argue, successfully, that it did indeed monitor Madoff but was craftily misled.
This isnít to say that the feeder funds are safe, only that lawsuits face surprising hurdles. Investors whose contracts include an arbitration clause might do better. Arbitrations don’t follow the securities laws. At the very least, you’ll have a chance to make your case.
Bryant Quinn, a leading personal finance writer, is a Bloomberg News columnist. She is a director of Bloomberg LP, parent of Bloomberg News.