The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

In a March 12, 2010 order (here) in a Madoff-related derivative suit, the New York (Nassau County) Supreme Court, applying New York law, substantially denied defendants’ motion to dismiss, holding among other things that demand was excused. As far as I am aware, this is the first Madoff-related derivative suit to survive a motion to dismiss. It is also the first Madoff-related lawsuit dismissal motion denial by a New York court of which I am aware.

The derivative suit was filed on April 1, 2009 by non-managing member of Andover LLC, on behalf of Andover LLC, as nominal defendant. Among the defendants are Andover’s investment manager (Andover Management), general partner, and investment consultant (Ivy Asset Management) and Andover’s auditor. The complaint, which can be found here, alleged that Andover should recover damages for the defendants’ negligence, gross negligence, breach of fiduciary duty, and for aiding and abetting breach of fiduciary duty.

The complaint alleges that the defendants committed these wrongs by permitting Andover to invest "approximately a quarter of its assets under the personal control of [Bernard Madoff] through his investment firm." The complaint alleges that as of December 31, 2007, Andover had assets of $57.7 million. The complaint further alleges that Andover’s auditors were negligent in conducting annual audits by failing to plan and perform appropriate audits and appropriate tests that would have identified Madoff’s fraud.

The plaintiff alleged that serving a demand on Andover’s management to prosecute these claims would have been futile because Andover and its principles were involved in wrongdoing constituting the basis of the claims. The plaintiff also asserted that it would have been futile to demand that Andover pursue claims against Ivy because Ivy’s agreement with Andover required Andover to indemnify Ivy. The plaintiff alleged it would have been futile to demand that Andover suit the auditor because Andover’s misconduct was "inextricably interconnected" with that of management.

The defendants moved to dismiss, arguing the plaintiff’s lack of capacity to sue; that the plaintiff’s claims are barred by New York’s Martin Act; that his derivative claims were barred by failure to make a demand on the managing member of the limited liability company and by the business judgment rule, and numerous other grounds. The auditor moved on lack of capacity and lack of proximate causation since the investment has been made before the current auditor was retained and the loss therefore could not have been avoided.

In its March 12, 2010 order, the court substantially denied the defendants’ motions in all material respects.

First, the court ruled that the plaintiff’s failure to make a demand was excused. The court reasoned that Andover Management and general partner had an interest in not being sued and an interest in protecting its principals, Ivy and its auditor from being sued, as claims against those persons "would tend to establish that Andover Management negligently breached its own fiduciary duty."

Second, the court ruled that the plaintiff’s claims were not barred by the Martin Act because the plaintiff’s claims do "not arise from alleged securities fraud and is not simply a securities fraud claim."

Third, the court also denied the defendants’ motion to dismiss plaintiffs’ gross negligence claim against Andover Management because "it may be inferred" that Andover Management "failed to exercise even slight care in failing to detect" Madoff’s fraud. It may also" be inferred" that Andover Management "showed complete disregard for Andover associates’ right and the safety of its investment."

In addition to its several other holdings, the court also denied the auditor’s motion to dismiss as well, observing that "the court must assume that an audit … conducted pursuant to generally accepted accounting procedure would have uncovered Madoff’s fraud" and that "a proper audit would have provided Andover with an opportunity to liquidate its investment."

The Andover case is not the first Madoff lawsuit to survive a motion to dismiss (see, for example, my recent post here about a dismissal motion denial in a Madoff-related case). However, it is as far as I am aware, the first dismissal motion denial in a Madoff-related derivative case and it is as far as I am aware the first dismissal motion denial in a court in New York, many of the Madoff-related cases are pending.

If the March 12 order is in any way indicative of the likely course of Madoff investors’ claims against feeder funds and investment gatekeepers, the investors’ litigation outlook appears favorable, at least at the dismissal motion stage. Indeed, the March 12 order fairly bristles with incredulity that the various defendants failed to take steps that, the court assumes, would have detected Madoff’s fraud.

But while a similar judicial predisposition might allow other claimants, like the plaintiff in this case, to survive a dismissal motion, it remains to be seen whether the claimants ultimately will be able to recover their losses or any substantial part thereof.

Of course, to even have any hope of any recovery, the aggrieved investors’ claims must first survive a motion to dismiss. The March 12 order in this case should be of keen interest to other Madoff claimants.

Special thanks to Daniel Tepper, one of the plaintiff’s counsel in the Andover case, for providing a copy of the March 12 order.

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In an April 1, 2009 administrative complaint (here), Massachusetts Secretary of the Commonwealth William Francis Galvin accused Madoff feeder fund Fairfield Greenwich Advisors and its Bermuda affiliate of "complete disregard of its fiduciary duties to its investors" and of "flagrant recurring misrepresentations" that "rise to the level of fraud."

If you have not yet seen the complaint, you should take a look, because it contains some rather striking allegations, the most provocative of which are based on the transcript of a telephone conversation in which Bernard Madoff coaches senior Fairfield officials on how to respond to inquiries from the SEC.

At one time Fairfield has a much as $14 billion of assets under management, of which nearly $7 billion was invested with Madoff through its flagship funds. The firm earned hundreds of millions of dollars in fees from investors in connection with the Madoff related investments. (Detailed background regarding the Fairfield group can be found here.) UPDATE: Fairfield's principals were on track for payouts totalling over $117 million in 2008, before the scandal surfaced, as reflected in documents filed with complaint, according to the Dealbook blog (here).

The complaint alleges that Fairfield’s managers were "blinded by the fees they were earning" and "did not engage in meaningful due diligence" but instead "turned a blind eye to any fact that would have burst their lucrative bubble."

The complaint alleges that in contrast to the due diligence efforts Fairfield claimed in its marketing materials, the firm "neglected to do any meaningful check into whether Madoff was actually making trades he said he was making." The complaint further alleges that "the concept of due diligence was merely part of Fairfield’s marketing pitch, not an activity it meaningfully engaged in with respect to Madoff."

The centerpiece of the complaint is a transcript of a December 2005 telephone conversation between Madoff and several senior Fairfield officials. Fairfield apparently recorded the conversation then apparently unbeknownst to Madoff and produced the recording in connection with the Massachusetts investigation. The transcript of the call can be found here.

The SEC was about to interview the Fairfield officials in connection with the SEC’s investigation of allegations against Madoff by Harry Markopolos. The transcript shows that Madoff opened the call by stating "obviously, first of all, this conversation never took place, okay?"

Madoff then gave the Fairfield officials precise instructions on what to say in response to the SEC’s questions, noting at one point that "the secrecy as to information is the key issue for everybody," even going so far as to say to the Fairfield officials that "the less you know about how we execute… the better you are."

The complaint alleges with respect to this phone conversation that Madoff was "manipulating the flow of information to the SEC" and that as a result of its cooperation, Fairfield helped Madoff "evade SEC detection."

The complaint also alleges that Fairfield’s reliance on the outside audit firm’s audit of Madoff’s investment company was "absurd," and that Fairfield made "patently false representations" about the audit and the auditor even though Fairfield "did not know one thing about this one-person auditing firm."

The complaint also alleges that as 2008 progressed, client redemptions and larger problems in the financial marketplace began to trouble the Fairfield officials. They began to debate internally about "gaps" in their knowledge about Madoff. Their internal communications reflect liquidity concerns as well as concerns about Madoff’s counterparty exposures.

The complaint alleges that the officials did not follow up on these concerns. Instead, in response to Madoff’s anger about increasing fund redemption in the late fall 2008, they tried to support him by marketing against redemptions as well as by placing their own cash in new Madoff funds formed at the eleventh hour.

The complaint seeks a cease and desist order and restitution to all investors who invested in Madoff through Fairfield, as well as disgorgement of related fees and an administrative fine.

In response to the complaint, Fairfield issued an April 1, 2009 statement (here) in which it characterized the complaint as "false and misleading" and asserted that it "conducted vigorous and robust monitoring [of Madoff] on an ongoing basis." The complaint, according to the statement, is based on "nothing more than 20-20 hindsight that supposes that anyone familiar with Madoff’s operation should have determined that it was a Ponzi scheme." But, the statement notes, not one person detected the fraud.

Among the Fairfield officials mentioned by name in the complaint is Andres Piedrahita (a Fairfield partner and son-in-law of Fairfield founding partner Walter Noel), whom the complaint alleges in 2007 alone earned in excess of $45 million. The March 31, 2009 Wall Street Journal ran a fascinating front-page article about Piedrahita entitled "The Charming Mr. Piedrahita Finds Himself Caught in the Madoff Storm" (here), reporting among other things that Piedrahita had once told a friend that his "real job" was "to live better than any of my clients."

Piedrahita, trading on his "outstanding public relations skills," played a key role in "expanding the reach of the Madoff fraud by wooing wealthy Latin Americans and Europeans." Piedrahita is now under investigation with both Spanish and U.S. authorities, and is a defendant in numerous class action lawsuits, along with Fairfield and other Fairfield officials.

Meanwhile, the April 2009 issue of Vanity Fair has a lengthy article (here) about Fairfield founder Walter Noel and his family. The article features a particularly striking photgraph of Noel's five daughters, one of whom is the wife of Piedrahita. An October 2002 Vanity Fair article focused just on the five daughters can be found here. After awhile, trolling through the backstory on these sidelights to the Madoff scandal begins to create the same sensation as reading an overwritten novel.

A comprehensive list of the Madoff-related lawsuits, including the numerous lawsuit filed against Fairfield and related entities and individuals, can be accessed here. I have added the new Massachusetts complaint to the list.

Hat tip to the Wall Street Journal for the Fairfield Statement.

Other Stories We’re Following: According to news reports (here), a man in Newark, Ohio has been charged with drunk driving on a bar stool. The man apparently had built a motorized bar stool using a dismantled lawn mower. He managed to crash the stool, apparently as a result of the 15 beers he reportedly consumed prior to the accident. Readers interested in seeing this amazing (albeit unexpectedly dangerous) vehicle will want to refer here.

Meanwhile, on March 27, 2009, the Macomb (Ga.) Daily reported (here) that "a woman who sued a city of Warren police dog that she says bit her on the buttocks was ordered by a judge to pay $500 for frivolously naming the dog as a defendant." Frivolous? Has the judge ever been bitten on the butt by a police dog? Incidentally, the dog’s name is "Liberty" which is clearly what the dog took with the plaintiff’s behind

And in world news, Barrack Obama has apparently given Queen Elizabeth II an iPod as a gift in connection with his visit to Buckingham Palace today, as reported here. Alas, it is too late now, but had I been consulted in advance, I would have suggested loading the device with the music of this year’s inductees into the Rock and Roll Hall of Fame, in particular the songs of Run-D.M.C.

The Rock Hall induction, by the way, is this Saturday, April 4, 2009, in Cleveland, Ohio. (Cleveland Rocks, baby.)

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 When the Madoff scandal news first broke, I thought it would be like so many other fraud controversies, dominating the headlines briefly and then fading into the background – as seemingly has happened with the Marc Dreier debacle. But perhaps as a result of the scale and breadth of the harm caused, the Madoff scandal story just seems to keep escalating.

Today’s headline revelation is the widely reported news (refer here), that Ruth Madoff, Bernard Madoff’s wife, allegedly withdrew a total of $15.5 million from a brokerage account just prior to Mr. Madoff’s now-famous confession to his sons and subsequent arrest.

This allegation first arose in a footnote of a complaint filed on February 11, 2009 by Massachusetts Secretary of State William F. Galvin to revoke the broker-dealer registration of Cohmad Securities Corporation. The complaint and related exhibits can be found here.

The Enforcement Section of the Massachusetts Securities Division of the Officer of the Secretary of the Commonwealth had "sought to determine whether the businesses of Cohmad and Madoff Investments were so intertwined that they could be viewed as a common enterprise, and not as separate entities, for purposes of imputing liability and obtaining investor relief." The complaint alleges that Madoff was one of Cohmad’s co-founders and directors.

As detailed in the complaint, Galvan contends that Cohmad "categorically refuses to discuss its actions with regulators" and therefore "has no right to continue to engage in the securities business in the The Commonwealth of Massachusetts."

As part of the complaint’s contention that Cohmad and Madoff’s securities firm are "so intertwined that they could be viewed as a common enterprise," Galvin cites, among other things (in footnote 4, on page 25 of the complaint) wire transfer records showing the "flow of funds" between the two enterprises, referring specifically to documents showing that "Ruth Madoff withdrew [from Madoff-related accounts at Cohmad] $5,500,000 on November 25, 2008 and withdrew $10,000,0000 on December 10,2008." Madoff was arrested on December 11, 2008.

The documents reflecting these two wire transfers can be found on the last two pages of Exhibit 16 (refer to pages 51 and 52, here).

A news wire story (here) quotes a spokesman from Galvin's office as saying "We're not accusing her of anything wrong." The spokesman added "Now, what someone in New York or the feds may think of it may be entirely different."

A Painful Situation: And under the general heading of marital complications related to the Madoff scandal, I reference the difficulties facing Steven Simkin, formerly married to Laura Blank. On February 3, 2008, Simkin filed a complaint in New York State (New York County) Supreme Court (here) against his former wife in connection with the Madoff-related investment the couple had maintained prior to their divorce.

According to the complaint, the couple entered a June 27, 2006 agreement providing for the division of their marital assets. The couple "mistakenly believed" that their largest asset was their account with Madoff Investment Securities, which they believed to be valued at $5.4 million. As part of the agreement, Simkin agreed to pay Blank half of the assumed account value in cash. (Ouch.)

The account is now "worthless, literally not worth the paper on which the parties’ valuation rested." Simkin’s complaint alleges that

As a result of the parties’ clear mistake of fact, Steven paid Laura millions of dollars believing, as did Laura, that it represented her share in the "Account" (as the parties understood it to be) and retained the "Account" as a portion of his equitable share of the couple’s assets. As a result, Laura obtained a windfall and Steven did not receive an equitable share of the couple’s joint assets. Accordingly, by this action, Steven seeks to reform the Agreement, which is grounded upon a material and mutual mistake respecting the couple’s assets at the time …and recover from Laura so as to accomplish the goal the parties intended by executing the Agreement.

Mr. Simkin, you have my sympathy.

Special thanks to the several readers who send me links to the Massachusetts Secretary of State’s complaint and to Jon Jacobson for help in finding the Simkin complaint. I have added the two complaints to my register of Madoff-related litigation, which can be accessed here.

A Clawshank Redemption?: And under the general heading of trying to recover previously paid out amounts, one issue that has gained a great deal of attention is whether the trustee in the Madoff liquidation proceeding can recover ("clawback") amounts paid out to fund investors who cashed out before the scandal was revealed. The Securities Docket has a post on the topic (here), discussing efforts that some of the investors who redeemed their shares to change the claims bar date in the Madoff liquidation proceeding out of concern for anticipated clawback efforts. .

In a February 2009 memorandum entitled "How Long and Strong is Trustee Piccard’s Claw?" (here), the Seyfarth Shaw law firm takes a detailed look at the trustees’ powers, and reviews the similar clawback efforts undertake in the Bayou funds scandal.

The memo concludes that the trustee’s ability to clawback redemption payments is "not unbridled" and that there are "powerful defenses that can and will be advanced, including the good faith defense that protected many redeeming investors in the Bayou case." The memo also notes that "additional defenses also are likely to be developed as the facts surrounding what Madoff did come into sharper focus."

Meanwhile, in Europe:  According to press reports (here), European investor rights group Deminor has initiated a legal proceeding in a Luxembourg court in order to compel two Luxembourg units of UBS to provide informatoin and materials relating to the entities' role in steering clients to Madoff-related investmens.

The action, which Deminor initiated on February 11, 2009, is filed against UBS S.A. and UBS Fund Services, as well as against the Luxalpha SICAV Fund, Luxembourg Third Party Management Company SA and Access Management Luxembourg SA.

According to the news reports, the action seeks information regarding contracts between the UBS units, Madoff, and Luxalpha, an investment fund that UBS allegedly promoted. Regulators closed Luxalpha last week for not complying with regulatory requirements. The action also seeks to obtain audit reports of the fund, prepared by Ernst & Young.

Deminor claims that it represents individual and institutional investors that had lost over $1.3 billion as a result of the Madoff scheme.

I would be very grateful to any reader who might be able to provide me with a copy of the new Luxembourg complaint.

Gender Issues: A February 11, 2009 Washington Post article entitled "In Banking Crisis, Guys Get the Blame" (here) raises the question whether the current global economic crisis is a result of the fact that the financial industry and its regulators are "overwhelmingly male-dominated."

The article quotes one commentator as saying that "you can argue that the men have made a right mess of it, and now the ladies should have a go." Another commentator observes that "maybe if we had some more women in the boardrooms, we may not have seen as much risk-taking behavior."

Finally, one commentator with an odd notion of human anatomy, commenting on London’s top financial sector officials, observed that "there are quite a lot of alpha males with testosterone steaming out their ears."

At least when it comes to relying on women to clean things up, Iceland "is leading the way," having appointed a female prime minister as well as two women to lead two of its major banks. The prime minister’s spokesperson is quoted as saying "Men, especially young men, made a mess of things. There is a strong discussion that women would have taken a more cautious approach in the financial sector."

And Finally: I have added a Twitter button in the right hand column. Readers interested in receiving Twitter updates (or "tweets" as they are known) between blog posts will want to click on the Twitter button and register to become a "follower" of my Twitter site. I also add "tweets" when I have added new blog posts. I have come to appreciate that there are many web denizens who prefer to receive their information as "tweets", so that is why this blog now has a Twitter button.

The New York Times has a nice February 11, 2009 article (here) with a good overview of what Twitter is all about.

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If today’s filings are any indication, a huge wave of Madoff victim lawsuits could be coming. Madoff investors were quick to sue Madoff and his firm, with the first complaint filed last Friday (as noted here). But with Madoff’s firm in liquidation and the money likely long gone, investors who lost money as a result of Madoff’s scheme are casting around for other targets from whom to try to recover their losses. Early returns suggest that investment firms and Madoff "feeder funds" could find themselves facing substantial Madoff victim litigation.

UPDATE: Please note that a regularly updated table of Madoff investor litigation, including "feeder fund" litigation can be accessed  here.

First, as reflected in their December 16, 2008 press release (here), plaintiffs’ lawyers have filed a securities lawsuit in the Southern District of New York against investment partnership Ascot Partners L.P., its founder and general partner (Merkin), and its auditor, BDO Seidman. The class members are persons who purchased limited partnership interests in Ascot.

According to the press release, the complaint alleges that Ascot and Merkin

caused and permitted $1.8 billion -- virtually the entire investment capital of Ascot -- to be handed over to Madoff to be "invested" for the benefit of plaintiff and the other limited partners of Ascot. Plaintiff's investment in Ascot has been wiped out, as a direct result of: (a) defendant Merkin's abdication of his responsibilities and duties as General Partner and Manager of Ascot and its investment funds and; (b) the failure of Ascot's auditor Seidman, in light of "red flags" indicating a high risk to Ascot from concentrating its investment exposure in Madoff as sole third-party investment manager for all of the Partnership's assets, to perform its audits and provide its annual audit reports in conformance with generally accepted auditing standards.

The press release states that the complaint alleges ’34 Act violations as well as related statutory and common law breaches. A copy of the complaint can be found here.

UPDATE: On December 16, 2008, investors also filed a separate lawsuit against a different fund affiliated with Merkin, Gabriel Partners. A copy of the December 17, 2008 press release can be found here.  A copy of the complaint can be found here.  A WSJ.com Law Blog post about the Ascot and Gabriel lawsuits can be found here.

Second, and also on December 16, another plaintiffs’ firm initiated a separate securities lawsuit in the Central District of California. The lawsuit is filed against Madoff and his firm, but also names as defendants Brighton Company, a California limited partnership and a so-called "feeder fund," and its principal ( Stanley Chais). The firm’s press release (here) states that Brighton was "one of the many feeder funds that directed investor capital" to Madoff and his firm. The press release says that Chais "managed several investment groups [including Brighton], the monies for which were given to Madoff" and his firm.

The complaint (here) alleges that the plaintiff invested money through CMG Ltd., a California limited partnership. The complaint alleges that CMG provided all of its investment capital to Chais as general partner for Brighton, which in turn invested all of CMG’s money with Madoff. The complaint alleges that "all defendants contributed to the false, misleading, unlawful, unfair and fraudulent acts and practices associated with the Ponzi scheme."

The purported class consists of two groups; all persons who invested capital with Chais and Brighton, and all persons who invested with Madoff and his firm. The complaint alleges violations of the ’34 Act.

The press release also states that "the firm is investigating the actions of other feeder firms on behalf of investors." The December 17, 2008 Wall Street Journal has an article (here) discussing Stanley Chais and his investment funds'  (and charitable organizations') relation to Madoff
 

Given the magnitude and widespread dispersion of the Madoff losses, and given the fact that there appears to be little money left with Madoff and his fund, it seems highly likely that there will be other (perhaps many other) investment funds, "feeder funds," hedge funds, funds of funds, and other entitles, targeted by Madoff victims. The attention in the press (for example, here) to alleged failures of investment firms to catch supposed red flags or to conduct due diligence will only increase the likelihood of this kind of litigation. The inclusion of the auditor in the Ascot lawsuit suggests that some of these claims could range pretty far afield.

A December 16, 2008 Business Week article discussing the likelihood of Madoff investor claims against hedge funds and others, also discussing the Ascot lawsuit, can be found here.

The Wall Street Journal is helpfully collecting a list of Madoff’s victims here. It is a long list but it is also clearly incomplete; for example, Fairfield Greenwich Advisors may have been hit with $7.5 billion in losses, but those amounts in reality represent the losses of Fairfield’s own investors. The list would be substantially longer if all of these and other fund investors and customers were listed individually. The fund investors are the ones, like the plaintiffs in the cases described above, that will likely target the investment funds.A December 17, 2008 Wall Street Journal article entitled "Fairfiled Group Forced to Confront its Madoff Ties" (here) conveys some pretty strong suggestions along those lines.

In any event, going forward, the number one question D&O insurance underwriters will be asking financial institution applicants will be whether the applicant invested funds with Madoff.

Meanwhile, the Credit Crisis Litigation Wave Churns On: It seems as if the plaintiffs’ lawyers have kicked it into high gear as the year end approaches. There has been a flood of new securities lawsuit filings so far in December. By my informal count, there have already been at least 20 new securities lawsuit filings so far this month (if you count the two cases described above), an unusually high number for December, which historically is a quiet month for securities filings.

And though the filings have included a diversity of cases (as I discussed here), the filings have also included a number of new subprime and credit crisis related lawsuits, including at least four new cases that have been filed or become public this week.

For example, as reflected in their press release (here) on December 16, 2008, plaintiffs’ lawyers initiated a securities class action lawsuit in the Southern District of New York against investors in the C-Bass Trust Certificates backed by residential mortgage loans and issued by Credit-Based Asset Servicing and Securitization LLC. The defendants include C-Bass, the issuing trusts, and the offering underwriters. The complaint, which can be found here, asserts claims under the ’33 Act.

In addition, on December 4, 2008, plaintiffs’ initiated a securities class action on behalf of investors who purchased AIG shares in shelf offerings conducted during the period 2003 to 2007. The complaint (here) asserts claims against AIG, certain of its directors and officers, and its offering underwriters under the ’33 Act.

And on December 8, 2008, defendants removed to federal court a lawsuit that previously had been filed in New York County (New York) Supreme Court against Residential Asset Securitization Trust (which issued certain residential mortgage pass-through certificate), its offering underwriter, and two rating agencies. A copy of the removal petition, to which the original complaint is attached, can be found here.

Finally, plaintiff shareholders have initiated a securities class action lawsuit (here) against private equity firm American Capital Ltd. in the District Court of Maryland, alleging among other things that the firm failed to disclose its exposure to disruptions in the credit market.

I have added these new lawsuits to my running tally of subprime and credit-crisis related litigation, which can be accessed here. With the addition of these new lawsuits, the running tally of subprime and credit-crisis securities lawsuits now stands at 138, of which 98 have been filed during 2008.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing information and links about these new lawsuits.

And Finally: Before writing this post, I had no prior acquaintance with the phrases "Madoff victims" and "feeder funds." I guess I better get used to them.

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