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Publications
Credit Crunch Digest
February 2009
The subprime lending crisis and ensuing credit crunch have resulted in significant losses and numerous lawsuits and regulatory investigations involving parties to the mortgage lending and securitization process. This digest collects and summarizes recent media reports and announcements regarding potential liability, litigation and regulatory actions arising from the subprime mortgage crisis and credit crunch.
This issue focuses continuing government efforts to ease the economic impact of the subprime crisis and credit crunch, including oversight of the remaining bailout funds and the potential need for additional government rescue measures, and recent developments in related litigation.
Madoff Supplement
As the economic slump caused by the subprime and credit crunch crisis intensifies, reported cases of financial fraud have increased significantly. In particular, a number of large Ponzi schemes have been uncovered as heavy investment losses and a high number of investor redemption demands have made it difficult for con artists to maintain such schemes.
In mid-December 2008, authorities revealed that Bernard L. Madoff had perpetrated the largest and possibly the longest-running Ponzi scheme in U.S. history. Investors around the world have sought to recover estimated losses of up to $30 billion from Madoff, his investment funds and advisory business, so-called feeder funds, and other parties that were involved with the Madoff entities.
The summary below provides background on the Madoff Ponzi scheme, and discusses the current and potential related civil litigation and criminal and regulatory actions.
The Alleged Ponzi Scheme
In 1960, Madoff formed Bernard L. Madoff Investment Securities LLC (Madoff Investment), reportedly with money he earned from working as a lifeguard and sprinkler installer. Madoff eventually became a prominent member of the securities industry, serving as vice chair of the National Association of Securities Dealers and a member of the Nasdaq board of governors and chair of its trading committee.
Madoff Investment operated as a market maker as well as an investment advisory business, and at one time was the largest market maker on Nasdaq. Further, Madoff’s firm reportedly developed innovative computer information technology used to disseminate quotes on Nasdaq and was one of the most active in the development of Nasdaq. By the time of the 2000 Internet bubble, Madoff Investments was one of the top traders of securities in the United States. In addition to Madoff Investment, Madoff owned and operated an investment firm based in the United Kingdom that bought and sold European stocks, Madoff Securities International (Madoff International).
As early as the 1970s, Madoff allegedly began operating a Ponzi scheme in which existing investors were paid with money received from new investors. His scheme has been described as an “affinity Ponzi” as it often targeted individuals and charities in the Jewish community. In addition to high worth individual and institutional clients, Madoff also received investments through so-called “feeder funds.” Feeder funds accepted money from investors, then turned over those funds to Madoff for investment. Madoff also sought investors from Europe and other parts of the world.
Madoff reportedly represented that he used an options-trading investment strategy involving the purchase of shares of blue chip securities along with options, or rights to buy or sell shares of the same security at a fixed price. Such a strategy is commonly used by investors seeking to achieve steady returns over a period of time. Instead of investing his clients’ money according to the options-trading strategy, however, Madoff simply paid prior investors with funds that he obtained from new investors. Over the course of the scheme, Madoff misrepresented to investors that their investments were consistently earning approximately 10 percent returns annually.
So long as Madoff was able to solicit new investors, who provided enough cash to pay existing investors who sought to redeem their investments, his Ponzi scheme was successful. Madoff has been described as a “master marketer” and “the most sophisticated and charming huckster of all time.” He created an aura of exclusivity for his firm and funds, and many investors trusted him completely and begged to be allowed to invest in his funds. Further, Madoff was apparently able to conceal his scheme by offering relatively modest (in comparison to other Ponzi schemes) but steady returns, and by being cryptic about his firm’s business. (“Q&A on the Madoff Case,” The Wall Street Journal, January 12, 2009; “Madoff Created Air of Mystery,” The Wall Street Journal, December 20, 2008)
Early Investigations and ‘Red Flags’
Despite numerous investigations of Madoff and his entities by regulators and investors and a number of red flags indicating fraud, Madoff was able to conceal and maintain his Ponzi scheme for an unprecedented length of time.
The Securities and Exchange Commission (SEC) or other regulatory authorities apparently investigated Madoff Investments at least eight times in 16 years but were unable to uncover the fraud. In 1999 and 2000, the SEC investigated concerns that Madoff Investments was hiding its customers’ orders from other traders. At that time, financial analyst Harry Markopolos reportedly told the SEC that it should investigate Madoff because it was impossible to legally make the profits he claimed through his reported investment strategy. After Madoff took corrective measures, however, the SEC ended its investigation. (“Madoff Chasers Dug for Years, to No Avail,” The Wall Street Journal, January 5, 2009)
In 2004, the SEC investigated whether Madoff Investments was engaging in the illegal practice of front running (placing favored customer orders before others) but eventually cleared Madoff and his firm. In 2005, the SEC found three rule violations but no evidence of fraud.
In 2005, Markopolos sent a 17-page memo to the SEC titled “The World’s Largest Hedge Fund Is a Fraud.” Markopolos identified 29 red flags and concluded that Madoff’s “unsophisticated portfolio management was either a Ponzi scheme or front running, but that it was most likely a Ponzi scheme. In 2007, the SEC reportedly completed an investigation of whether Madoff was running a Ponzi scheme and again found no evidence of fraud. As a result, the SEC has been accused of missing numerous opportunities to end the Madoff Ponzi scheme, and is being investigated itself with regard to its handling of its earlier investigations and oversight of Madoff Investments. (“The World’s Largest Hedge Fund Is a Fraud,” ProPublica, December 18, 2008)
According to plaintiffs and commentators, several suspicious circumstances suggested at an early date that Madoff was engaging in a fraudulent scheme, including: (i) hedge funds that invested with Madoff were not allowed to use his name in marketing materials; (ii) Madoff’s firm processed its own trades while hedge funds usually hold their portfolio at a securities firm that acts as their prime broker, which would allow an outside investigator to verify the holdings; (iii) although Madoff’s firm was a pioneer in electronic trading, it did not allow clients online access to their accounts; (iv) Madoff Investments avoided filing disclosures of its holdings with the SEC by selling its holdings for cash at the end of each period; (v) Madoff Investments used a three-person accounting firm to conduct audits that had only one active accountant; and (vi) Madoff reported high steady investment returns despite volatile markets. It appears that certain hedge funds and other institutional investors suspected the fraud at an early date, and cautioned their clients not to invest with Madoff. (“All Just One Big Lie,” The Washington Post, December 13, 2008)
The Ponzi Scheme Revealed
In late 2008, the general market downturn accelerated and investors in need of cash sought to redeem their investments with Madoff. The Ponzi scheme faced collapse because Madoff was unable to solicit enough new investors to pay off redeeming investors.
On December 10, 2008, Madoff reportedly confessed to his sons, who worked for his investment advisory firm, that his business was a “big lie” and “a giant Ponzi scheme.” He also indicated that investors had collectively asked for $7 billion in redemptions, but there was only $200 million to $300 million left at the firm. Madoff allegedly stated that the cost of the fraud to his clients is at least $50 billion. Later that day, his sons notified the authorities of the fraud.
On December 11, 2008, Madoff was arrested and charged with one count of securities fraud in relation to the activities of Madoff Investment in a criminal complaint filed in the U.S. District Court for the Southern District of New York (SDNY). Madoff reportedly confessed his scheme to the FBI agent who took him into custody. (“Q&A on the Madoff Case,” The Wall Street Journal, January 12, 2009)
Although Madoff stated at the time of his arrest that the cost to his clients is at least $50 billion, it appears that total investor losses are closer to $30 billion.
Bankruptcy and Liquidation of Madoff Investment
On December 15, 2008, the Securities Investor Protection Corporation (SIPC), which maintains a special reserve fund authorized by Congress to help investors at failed brokerage firms, announced its intent to liquidate Madoff Investment under the Securities Investor Protection Act (SIPA). (“Q&A on the Madoff Case,” The Wall Street Journal, January 12, 2009)
That same day, the SIPC filed and the SDNY granted an application for a declaration that the customers of Madoff Investment are in need of the protections available under the SIPA. The SDNY also appointed Irving Picard, a partner in the New York office of Baker Hostetler, as trustee for the liquidation of the firm. The trustee has engaged Lazard Frères & Co. LLC to assist in the sale of the market making and proprietary trading operations of Madoff Investment. (www.madofftrustee.com)
Under the statute that created SIPC, customers of a failed brokerage firm receive all nonnegotiable securities (e.g., stocks or bonds) that are already registered in their names or in the process of being registered. At the same time, funds from the SIPC reserve are available to satisfy the remaining claims of each customer up to a maximum of $500,000. This figure includes a maximum of $100,000 on claims for cash.
The SIPC president and CEO cautioned that “the scope of the misappropriation and the state of the defunct firm’s records will make this more difficult than in most prior brokerage firm insolvencies.” Commentators have noted that investors may be limited to the $100,000 limit for lost cash because it presently appears that Madoff simply shifted cash between investors without actually purchasing securities. In addition, legal experts expect that clients who invested through intermediaries (i.e., feeder funds) will be ineligible to qualify for SIPC relief. (www.madofftrustee.com; “Madoff Firm Trustee Seeks $28 Million for Liquidation (Update 2),” Bloomberg.com, December 29, 2008; “Q&A on the Madoff Case,” The Wall Street Journal, January 12, 2009; “A New Legal Industry: Madoff,” The National Law Journal, January 26, 2009)
On January 2, 2009, the trustee mailed more than 8,000 customer claim forms, with detailed instructions for the completion and filing of the forms. (www.madofftrustee.com) On February 4, 2009, a list of nearly 14,000 clients who invested with Madoff was released to the public. In addition to institutional investors, the list included professional athletes, celebrities and well-known business persons. Although the list did not detail the amount of money each victim lost, it revealed that many of Madoff's victims were charities and retirement funds. (“More Names of Note Appear on Madoff List,” New York Times, February 6, 2009)
To date, approximately $950 million has been recovered for investors. On December 30, 2008, the U.S. Bankruptcy Court for the SDNY approved the transfer of $29 million in funds held by Madoff Investment by the Bank of New York (BONY). The trustee reportedly has located an additional $830 million in liquid assets at the firm. In late January, J.P. Morgan and BONY agreed to transfer roughly $535 million in accounts of Madoff Investments to the trustee. During a hearing on February 4, 2009, the trustee advised the bankruptcy court that he had recovered an additional $111.4 million in cash from financial institutions and identified approximately $300 million in securities. (www.madofftrustee.com; “Madoff Firm Trustee Seeks $28 Million for Liquidation (Update 2),” Bloomberg.com, December 29, 2008; “Aggrieved Investors Turn Sights to Banks,” Wall Street Journal, February 3, 2009; “Madoff Trustee: About $950 Million Recovered, Associated Press, February 4, 2009)
A meeting of the creditors is scheduled for February 20, 2009.
The Criminal and Regulatory Investigations
A number of criminal and regulatory investigations into the Madoff Ponzi scheme are pending, and despite Madoff’s statement that he acted alone, authorities are seeking to determine whether Madoff’s family members and others were involved.
Madoff
Since his arrest, Madoff has been free on $10 million bail, but is confined to his Manhattan penthouse apartment under constant surveillance.
The Federal Bureau of Investigation (FBI), the SEC, the Financial Industry Regulatory Authority and the U.S. Attorney’s office for the SDNY are currently investigating the Madoff scheme.
On February 9, 2009, two days before the federal prosecutors’ deadline to file a formal indictment, Madoff agreed to a partial settlement of the SEC’s civil investigation. The limited settlement with the SEC, which is subject to court approval, does not affect the criminal securities fraud charges filed against Madoff. Further, the settlement does not establish an amount of civil penalties or restitution for defrauded investors, but it does continue the asset freeze imposed in December 2008.
According to commentators, the SEC settlement suggests that attorneys for Madoff are negotiating a plea deal with federal prosecutors. Under the terms of the settlement, Madoff neither admitted nor denied the charges in the civil case, but he cannot dispute the accuracy of the charges against him for the purpose of determining his obligations to repay ill-gotten gains, interest and civil penalties. This provision will pose a serious hurdle if Madoff later tries to protest his innocence. (“Madoff in Partial Settlement With S.E.C.,” New York Times, February 10, 2009)
On February 11, 2009, federal prosecutors received a 30-day extension to file an indictment against Madoff. Under the extension, prosecutors have until March 13, 2009 to bring a grand jury indictment. (“Madoff Indictment Deadline Delayed for Month,” Associated Press, February 11, 2009)
Other Parties
Federal and state regulators have launched numerous investigations into the activities of auditors, brokerage firms and investment funds with close ties to Madoff and his firm.
As part of a probe into fraud perpetrated on nonprofit organizations that invested with Madoff, the Office of the New York State Attorney General (NYAG) has issued subpoenas to J. Ezra Merkin and three of his investment funds that were partially or completely invested with Madoff. Several nonprofit organizations with ties to Merkin have also been subpoenaed by the NYAG in connection with the investigation into “whether other individuals helped … Madoff carry out the alleged fraud scheme and on recovering assets for burned investors.” (“Cuomo Subpoenas Madoff Investor,” The Wall Street Journal, January 16, 2009)
In addition, the Securities Division of the Massachusetts Secretary of the Commonwealth is investigating Cohmad Securities, a small brokerage firm that served as a feeder fund for Madoff’s stock-trading operation. Cohmad was formed in 1985 by Madoff and his close friend, Maurice Cohn. Madoff holds a 5 percent ownership stake in Cohmad. Cohmad operated its business in the same building where Madoff housed his stock-trading and investment advisory businesses, and many Cohmad employees had “long-term relationships with the Madoffs.” According to investors, Cohmad began soliciting clients for Madoff during the early 1990s and continued to act as a “go-between” for investors to Madoff throughout the 1990s. The Massachusetts regulators reportedly are focusing their investigation on the activities of Robert Jaffe, an official at Cohmad who allegedly solicited investors for Madoff from Palm Beach, Florida. Cohn and Jaffe both allege that they were victims of Madoff’s fraud. (“Cohmad, Jaffe Draw Closer Look,” The Wall Street Journal, January 14, 2009)
Civil Litigation
Commentators expect that civil litigation arising from the Madoff scheme will be widespread and will likely lead to developments in case law regarding jurisdictional disputes, bankruptcy law, international finance and insurance. For example, international investors who file claims with the SIPC may expose themselves to U.S. jurisdiction and the trustee’s attempts to reclaim or “claw back” improper payments made by Madoff to earlier investors in the Ponzi scheme. (“A New Legal Industry: Madoff,” The National Law Journal, January 26, 2009)
Feeder Funds
In the wake of revelations about the Madoff investment scheme, plaintiffs have filed class action complaints throughout the country against feeder funds that redirected client investments to Madoff. Those lawsuits generally allege that the fund managers ignored numerous red flags, acted negligently and failed to perform any due diligence regarding Madoff’s investment activities. The plaintiffs state causes of action for breach of fiduciary duty, negligence and unjust enrichment. Some lawsuits allege that the defendants violated §§ 10(b) and 20(a) of the Securities Exchange Act “by issuing false and misleading statements about their due diligence and oversight of Madoff.” (“Noel’s Fairfield Greenwich Sued Over $7.5 Billion Madoff Money,” Bloomberg.com, December 23, 2008; “Fairfield Greenwich Fund Sued by Investors Over Madoff Losses,” Bloomberg.com, January 9, 2009); “Labaton Sucharow and Cremades & Calvo-Sotelo File Class Action Lawsuit Against Santander and Optimal in Connection With Losses Caused by the Madoff Ponzi Scheme,” Labaton Sucharow Press Release, January 27, 2009; “A Spanish Bank’s Madoff Redress,” The Wall Street Journal, January 28, 2009; “Banco Santander Offers Madoff Victims Compensation, While Investors File Suit,” D&O Diary, January 27, 2009)
Commentators believe that indirect investors who held accounts with feeder funds that turned over their investments to Madoff may be in the best position to recover because the feeder funds owed an obligation of due diligence to investigate Madoff Investments and may have insurance to cover such claims of negligence. Observers caution, however, that litigation against feeder funds will be prolonged and costly, and feeder funds without sufficient cash or insurance may be forced to default in the litigation and liquidate their assets. (“A New Legal Industry: Madoff,” The National Law Journal, January 26, 2009;“Madoff Suits Pile Up, But Will They Fly?”, The National Law Journal, January 19, 2009)
Custodian Banks
Banks that served as custodians of investor accounts may face liability for investor losses caused by the Madoff scheme. For example, a Luxembourg court has ordered UBS A.G. to reimburse French investor group Oddo & Cie $39 million from a fund invested with Madoff after finding that UBS, as custodian of the money, delayed liquidating the holdings despite the investor’s demand to withdraw the money a month before Madoff’s arrest. UBS has stated its intent to comply with the order.
In addition, HSBC Holdings PLC faces potential exposure from its role as a custodian bank for Madoff Investments. A recent lawsuit filed in Florida federal court accuses the bank of a “lack of scrutiny” that “falls far short of the legal duties owed and representations made.” HSBC asserts that its role was strictly passive and administrative. (“Aggrieved Investors Turn Sights to Banks,” Wall Street Journal, February 3, 2009; “Two Federal Suits Highlight Retail Banks' Potential Liability in Ponzi Schemes,” The National Law Journal, February 6, 2009)
Accounting Firms
Large and small accounting firms are facing litigation arising out of the Madoff scheme. For example, a Minnesota accounting firm with 100 offices nationwide has been named in lawsuits alleging that it failed to detect the Madoff Ponzi scheme. Similar actions have been brought against national accounting firms PricewaterhouseCoopers, KPMG, Ernst & Young and BDO Seidman, which audited feeder funds that invested with Madoff. None of these firms directly audited Madoff Investments.
Madoff used Friehling & Horowitz, a three-man firm located north of New York City, to audit the firm. Only one of the individuals in that firm was an active accountant and for 15 years it apparently advised the American Institute of Certified Public Accountants that it did not conduct audits. The U.S. Attorney’s office in Manhattan is reportedly investigating the firm’s involvement in the scheme. Nevertheless, investors argue that the feeder funds’ level of investment with Madoff coupled with the unusual nature of his business – it served as both custodian and money manager – created a special duty on the part of their auditors to examine Madoff’s books as well as those of the feeder funds. (“Ponzi Scheme Litigation Continues Its Spread Through Accounting Firms,” The National Law Journal, February 5, 2009; “Plaintiffs Take Aim at Madoff’s Auditors,” Financial Times, February 5, 2009)
Investors
The trustee may attempt to claw back payments made by Madoff to earlier investors, and this is likely to be a hotly contested issue in the bankruptcy proceeding. What law governs how far back the trustee may go to recover illegal Madoff payouts will be a significant issue in those proceedings. Under federal law, there is a two-year limit for investors seeking past payouts to early investors (i.e., “priority payments”). In New York, however, the trustee can go back as far as six years to recover fraudulent conveyances. Non-New York investors who received payments may assert home-state laws with shorter claw back periods to avoid such claims. Some commentators believe, however, that the trustee will prevail in arguing that New York law applies to the claw backs because the improper payments were made out of Madoff’s offices in New York. (“A New Legal Industry: Madoff,” The National Law Journal, January 26, 2009)
In pursuit of fraudulent conveyances, the trustee will likely file international litigation to recover funds Madoff paid to overseas investors. (“A New Legal Industry: Madoff,” The National Law Journal, January 26, 2009)
The Congressional Hearings
On January 27, 2009, the Senate Banking Committee held a hearing to examine the SEC’s failure to identify and investigate the Ponzi scheme operated by Madoff despite numerous “red flags.” The House of Representatives Financial Services Committee conducted a similar hearing on January 5, 2009. During the hearings, lawmakers raised questions about “red flags” that the SEC apparently ignored. Specifically, senators noted that Madoff’s fund was audited by a small firm and it “did not employ a reputable outside custodian” to hold the assets of the fund. Lawmakers concluded that the SEC should reevaluate its “model for examining fund managers” and increase its oversight of hedge funds and institutional investors. Senate Banking Committee members stated that they will examine whether legislation is necessary to reform the SEC. (“SEC Must Watch Fund Managers, Lawmakers Say; After Madoff, Senators Want More Attention Paid to Possible Fraud,” MarketWatch, January 27, 2009)
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