Colorado Business Litigation Lawyer Blog

About a week ago, in a post titled Colorado Business Litigation: Does Colorado Recognize a “Declaimer Defense” for Feeder Funds? I reported that sophisticated auditors for feeder funds sometimes rely upon disclaimers as a “pretend justification” for ignoring their due diligence responsibilities to their feeder fund clients. For example, the national accounting firm of BDO Seidman knew that its client Ascot Partners had invested $1.8 billion with Bernie Madoff. When Madoff’s Ponzi scheme fell apart, Ascot’s investors lost the entire $1.8 billion.

One of Ascot’s investors was New York Law School which lost $3 million of its endowment funds when Ascot placed that investment with Madoff. The law school sued Ascot’s national accounting firm BDO Seidman claiming that BDO should have alerted Ascot to Madoff’s palpable fraud. BDO knew its feeder fund clients were relying upon the auditor to inform them of risks associated with investing in Madoff. The auditors were being paid enormous annual fees for helping safeguard investments. BDO, along with auditors for the other feeder funds, were periodically providing their clients self-serving and dishonest statements from Madoff claiming his investments were worth millions and his track record always on the upswing even during times when the equity markets were experiencing downturns.

It appears the auditors did little, if anything, to verify the financial stability of the Madoff investment machine. Of course, that would have required that they do some actual work.

The auditors also knew that Madoff was not a registered investment firm and thus was not being audited by an accounting firm registered under the Public Company Accounting Oversight Board. For privately-held brokerage firms like Madoff, there was no requirement for auditor registration.

Knowing all of this, one asks why BDO made no effort to communicate with Madoff’s auditor. A simple phone call to Madoff would have uncovered the fact that his auditor was located in a strip mall and consisted of three persons: a secretary, one partner and a gentleman in his 70’s living in Florida. About a month ago the SEC charged Madoff’s strip mall auditing firm with securities fraud. SEC chairman Mary Schapiro announced that the SEC will “continue this investigation (of the auditors) and hold accountable all those who helped facilitate this massive fraud.” Small comfort, isn’t it?

A trial against these auditors could sink into a huge black hole of competing and complex accounting rules. I have been asked by a number of clients how I would simplify the issues for a jury. The first thing I would do is blow up a photograph of the strip mall office of Madoff’s three person auditing firm. The courtroom exhibit would look something like:

SHOULD BDO HAVE TOLD ITS CLIENTS THIS?

Madoff auditor’s strip mall office.

A Colorado business will lose its case if the case bogs down into technicalities. But, your contingent fee lawyer can help you win your case by keeping it simple and motivating the jury. I have dedicated my career to winning high risk and complex litigation based on this tactic. I would enjoy the opportunity to discuss with you how I can work with you on these types of colorado business litigation claims.

Ina previous blog post, Madoff’s Ponzi Scheme: Feeder Fund Liability, I discussed a Denver based investment firm who, as a feeder fund, found themselves tangled up in Madoff’s Ponzi Scheme. I would now like to look at some of the challenges of litigating these types of cases.

Colorado business litigation suits against feeder funds include claims for fraud, negligence, and breach of fiduciary duty. But what are the legal roadblocks?

The biggest obstacle to claims against the feeder fund may be the protection Congress bestowed upon investment funds more than a decade ago. In the Private Securities Litigation Reform Act (PSLRA) of 1995, Congress determined that the investor must not only prove negligent failure of the feeder funds to investigate the Ponzi schemer, but also must prove that any feeder fund advice bordered on intentional fraud. And for the most part, those claims must be filed in a federal courthouse.

The typical investor is unaware of the detailed relationship between the feeder fund and the Ponzi scammer, such as Bernie Madoff. As in other technical cases where the factual basis of the misconduct is often known only to the defendant, such as a medical negligence case, the investor seeks to learn about the relationship between the feeder fund and the Ponzi schemer through discovery rules. Investors begin taking depositions of people with knowledge and use those depositions to establish the basis of the wrongdoing.

Under the PSLRA, however, Colorado federal courts, including Denver, may require detailed factual allegations against the feeder fund without the benefit of discovery depositions. Congress essentially requires fraud victims to “shoot in the dark.”.

However, while fraud claims in the federal courts may be difficult under the PSLRA, breach of fiduciary duty claims can be filed in state courts. Whether it stays there, though, without a transfer to the federal court depends on complex procedural rules. A Washington Post article earlier this year (“Madoff Investors Face Dim Prospects in Court”, February 22, 2009, by Quinn) describes the difficulties in making claims against feeder funds. Quinn acknowledges that these cases may “sound like slam dunks” but:

“They are 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.”

One final disappointment to an investor in a feeder fund is that its loss may not be insured. Bank accounts are insured by the FDIC up to $250,000. Investment accounts in a feeder fund that is registered under security regulations are insured by the Securities Investors Protection Corp (SIPC) up to $500,000. However, if the fraud or other misconduct was not perpetrated by a licensed fund/broker, there is no coverage at all. Once again, this gap in protection is a by-product of the anti-regulatory attitude part of Congress.

For more information on litigating these types of claims, contact a Colorado Business Litigation attorney.

Jim Gilbert

One of Madoff’s victims was a feeder fund named Ascot Partners. New York Law School invested $3,000,000 of its endowment funds in Ascot. When Madoff’s scheme fell apart, Ascot was unable to repay New York Law School its $3,000,000 investment.

In recognition of the substantial legal and practical roadblocks to a lawsuit against Madoff and the feeder fund Ascot, New York Law School instead sued BDO Seidman, the auditor for Ascot claiming that Ascot failed to adequately audit and assess the risk of Ascot’s investments with Madoff.

The law school argued that even a minimal investigation by its auditor BDO would have triggered a full-throated warning to Ascot’s investors: “Be careful. This Madoff investment is risky!” Instead, BDO, a large sophisticated national accounting firm sought to justify its lack of due diligence and failure to investigate Madoff by hiding behind the fine print of a disclaimer that said, “We conducted no independent review of Madoff.”

How much effort would it have taken for someone at BDO to pick up the phone, call Madoff and ask for the name, address, and phone number of Madoff’s auditor/accounting firm? You know what that five minute call would have uncovered? The feeder funds’ auditor BDO would have learned that the Madoff auditor was housed in a local strip mall and had three employee: a secretary, accountant and partner in his 70’s who lived in Florida.

Imagine the courtroom impact of Exhibit A, a photograph of the Madoff auditor’s strip mall office! For one hundred bucks the feeder fund auditor could have taken such a photograph years before and would have prevented a loss of millions to the feeder funds’ investors. Instead, the auditor crafted a pretend justification for sitting on its hands by “disclaiming” any responsibility to investigate.

A disclaimer defense by a sophisticated auditor reminds us of the “Three Wise Monkeys” from Japanese lore who “hear no evil, speak no evil, see no evil.” The BDO auditors, being the wise monkeys they were, elected to turn a blind eye to Madoff’s scam. Madoff’s scam was no less consequential merely because BDO ignored it.

Jim Gilbert

The simple Ponzi scheme, as drawn up by Charles Ponzi himself in the early 1900’s, involved one schemer recruiting suckers one by one. While this is effective, it is not nearly as efficient in an “earnings by the hour” analysis. To increase the scam’s efficiency, it requires big suckers, not little ones.

Bernie Madoff wanted to earn the big bucks. In order to do that, Madoff knew he would have to steal large sums of money from each victim. Using his sophisticated financial networking skills, he decided to go after large investment funds. With his background as an investment advisor and former president of NASDAQ he reviewed his old rolodex cards and began soliciting monies from familiar investment funds. Although he knew he could steal from his neighbor, why not steal from the whole neighborhood?

Individual investors in the funds funneled to Madoff lost tens of billions of dollars when Madoff’s scheme collapsed. Most of these investment funds were unable to repay their investors. These funds were the “feeder funds” that allowed Madoff to accumulate a dishonest personal wealth of billions of dollars.

One of the largest of these feeder funds was a custodian for IRA investments located in Denver, Colorado. NTC and Co. served as an investment depository for wealthy investors who preferred to self-direct their IRA investments. While traditional IRA’s invest in mutual funds, stocks or bonds, the self-directed IRA’s invest in riskier ventures such as hedge funds, limited partnerships and the like. Some of the NTC investors probably directed investments to Madoff. However, many others did so upon advice of NTC and financial consultants. Some of these feeder fund were licensed under security regulations but many others were not. And pity the investor seeking recovery against the unlicensed feeder fund.

There are many important ideas to keep in mind when litigating these types of claims. In a future post, I will discuss the legal roadblocks to claims against feeder funds.

~Jim Gilbert~