Tuesday, August 23, 2011

Comments on the Second Circuit's Decision on Net Equity


August 23, 2011

I have been asked to state my views on the Second Circuit’s decision on net equity in the Madoff case. Some of the matters I shall discuss are relevant to a request for rehearing en banc to the Second Circuit and/or a subsequent petition for certiorari to the Supreme Court.

1. The Court’s decision is based on its acceptance of the statutory language relied on by the Trustee rather than the language relied on by the victims. The victims said they had a right to their “securities positions” as reflected in their final statements. The Trustee said he had to and should give them only what the “books and records” showed they had put in and taken out, so that a person who took out more than he put in had no net equity. In these regards (and others), the Court, like the Trustee as well as many people not connected with the Madoff affair, thought it overriding that everything Madoff did was a fake and the final account statements represented fakery, so it was better, and necessary, to look at the books and records rather than rely on the phony securities positions set forth in the final statements.

To me it seems self evident that, in a case where things were faked, and there is rival statutory language for the Court to choose from in determining net equity, it is essential to present a court with strong and repeated policy statements as to why it should choose the counter intuitive position of using the faked statements to determine net equity rather than the reality reflected in the books and records. Those policy reasons are found in the intent of Congress repeatedly stated in the legislative history. This author vigorously and repeatedly urged upon the New York lawyers who controlled the case for the victims’ side that the policy arguments, found in the intent of Congress expressed in the legislative debates on the floor of the Senate and House at the beginning and near the end of the ’70s, should be the linchpin of the case. For (with some relatively minor exceptions we can overlook here) true securities positions were zero, since Madoff did not buy or sell stocks for the victims.

This author’s urgings were unsuccessful. It was decided early-on in New York that the dispositive point was that the statute said net equity was the securities positions reflected in statements from Madoff (less indebtedness to him). This writer disagreed, saying, as did judges at oral argument, that “securities positions” were zero because the whole deal was a fake in which securities were not purchased. This view was unpersuasive to the lawyers on our side, who said victims’ securities positions were what was shown on the final statements: Such was required by state law, it was said, is admittedly what Madoff would have been obligated to pay victims had they sued him before December 11, 2008, and for all these reasons is the measure of net equity under the statute.

The foregoing argument about securities positions, an argument about which our side was warned, was, and proved, a loser because, as said, in reality the victims’ securities positions were zero.

2. It was, as said, this writer’s view, unsuccessfully pressed on the New York lawyers orally and in writing, that the only way to persuade a court to rule that the final statements should be the measure of net equity though they were faked was to rely extensively and repeatedly on the intent of Congress as reflected in floor statements, many of them made by the leading Senators and Congressmen of the 1970s. (President Nixon and Treasury Secretary Kennedy also weighed in.) Those extensive and repeated statements made plain that the Congressional intent would be vitiated if CICO were used instead of the FSM. It is not that the legislative history ever discussed net equity explicitly. It did not. It is, rather, that the floor statements repeatedly stated Congressional goals that will be vitiated by the use of CICO, goals such as protecting small investors, giving them confidence in markets, paying investors promptly, and protecting them against non purchase and/or theft of securities. And not to be forgotten is that it was known that investors would have to rely on their statements because the securities industry was switching, and SIPA was part of the switch, from giving physical securities to investors to holding securities in street name. (The Madoff scam could not have been done if Madoff had had to give physical securities to investors.)

As readers will know very well, and for reasons most readers will likewise know very well, the goals sought by Congress are stymied by CICO. The Second Circuit discussed Congress’ goals only very scantily and paid no heed whatever to the abundant floor statements setting them forth. Fundamentally, the Circuit relied instead on what it thought the best reconciliation of the statutory provisions, with little regard to the goals shown on the floors of Congress. In this regard, it adopted the Trustee’s position.

Was the Circuit told of Congress’ goals and was it given the floor statements reflecting them? Yes. But only by one lawyer. What was said by an unknown lawyer from the New Hampshire/Massachusetts border, far from the Court’s location in New York City, did not move the Court. Would the Court have been moved by the legislative history had it been the linchpin argument, or even a major argument, of the Wall Street firms -- firms well known to the Circuit and doubtlessly respected by it? One cannot know for certain, but one might consider it common sense to think it might have made a big difference to the Circuit if the legislative history argument had been pushed by prominent Wall Street firms whom the Court knows very well rather than solely by an unknown lawyer living far from New York City.(1)

When one considers that the Court has chosen to ignore the legislative intent -- has chosen to ignore Congress’ intent for prompt payment, has overridden Congress’ desire to protect small investors, has paid virtually no mind to the legislative desire to build confidence in markets -- the question arises of whether the Trustee and the judiciary have violated separation of powers and engaged in judicial legislation by doing what they think most appropriate while not even considering the Congressional purpose underlying the statute. This question comes up in regard to other matters too, as discussed below.

2. Relying solely on the statutory wording -- i.e., relying on the statute’s books and records clause -- the Circuit gave Trustees wide discretion to use whatever method of calculating net equity they deemed best in the circumstances of their cases. The Court appears to believe that there can be several ways of calculating net equity, depending on the particular facts of cases, and only if a Trustee chooses a method “clearly inferior” to some other method will the Court strike down a Trustee’s choice.

Paradoxically, while giving the Trustee wide discretion, the Court likewise said that as a matter of law CICO had to be used here. So I guess Trustees have wide discretion except when they don’t have wide discretion -- as here apparently, because the Court seemed to feel that the FSM method was “clearly inferior” to CICO on the facts of this case.

The grant of wide discretion to a Trustee in measuring net equity (unless and until a court rules there was no discretion in a case and only one method was permissible) will result in Trustees choosing measures that will save the most money for SIPC. Trustees, after all, make good livings by being SIPC trustees, and want to continue to get such assignments. So of course they will measure net equity in ways that save money for SIPC. Their likely varying choices of measurements of net equity will at times cause extended, long litigations on the subject, thereby insuring there will not be the prompt payments desired by Congress. The Trustees’ efforts likewise will mean there will be no confidence built up on the part of investors, and far less protection given them. Investors will again take it in the ear because of the Circuit’s decision.

There is also another crucial aspect to the ruling that Trustees are pretty much free to define net equity in any way they choose. The statute defines net equity essentially as meaning one’s securities positions minus one’s obligation to the broker. The statute also provides, in the section defining SIPC’s powers, that SIPC cannot change the statutory definition of net equity. Yet if SIPC and its Trustees can pick whatever definition of “securities positions” that suits them in the circumstances, for practical purposes is this not changing the definition of net equity? When you change the definition of a critical phrase in the definition of net equity, are you not thereby changing the definition of net equity itself for practical purposes? I would think you are, and that the Circuit’s decision is a plain violation of separation of powers and is judicial legislation overturning the explicitly expressed will of Congress.

Perhaps the Circuit felt it had to say there could be lots of definitions of net equity, depending on the circumstances. For if there could be only one definition of it, how to explain approving CICO now after the final statement method previously was used in something like 319½ out of 321 prior cases and, as the Court itself recognized, necessarily will be used in a host of future cases where CICO would be absurd? So, having to say there can be many definitions of net equity, the Court did say it. But what it said seems to me, as said above, a plain violation of separation of powers and a piece of judicial legislation, because it provides for SIPC and its trustees changing the definition of net equity to suit their purposes although Congress said the definition is not to be changed by SIPC.

3. The Circuit fully accepted the Trustee’s position that CICO was the only way to achieve fairness. Since there were those who took out more than they put in (net winners) and those who didn’t (net losers), the former would be unfairly advantaged if they received more (from the Trustee) while the latter have not yet fully recouped. Furthermore, the Court claimed, every dollar given by the Trustee to a person who had taken out more than he put in is a dollar made unavailable to one who has not gotten out all that he put in.

In terms of general fairness, the Court’s view -- its echoing of Picard -- is dubious. If one says that fairness is controlled solely by dollar figures (a very simpleminded view), than I suppose it makes sense to say that it is fair to insure that those who took out more than they put in (the net winners) should get nothing more unless and until there is complete recoupment by the others (the net losers). But is this fair if one considers more than just dollar figures, if one considers the complete situation? Those who took out more than they put in are, by and large I would think (pace Wilpons), the small people, the people who often are now remitted to poverty or something close to it. Those who didn’t take out more than they put in are, by contrast, usually huge and wealthy institutions such as hedge funds (or wealthy individuals). They are, moreover, the particular institutions, and the kinds of institutions, whom the Trustee himself has said enabled Madoff to maintain his fraud for years longer than it otherwise would have lasted. They did this by investing many, many billions of dollars without which the scam would have collapsed -- and without doing the due diligence of which they were financially and professionally capable and which would have caused the whistle to be blown on the fraud. And, by keeping the scam going, these institutions caused the losses of the small people to continue and to increase as the small investors put in more money year after year, took out more year after year in order to live, and thereby increased their losses and the potential clawbacks against them year after year.

Now, when one considers the complete situation, does it still look like using CICO rather than the FSM is the fair method? Not to me it doesn’t. I think it is no surprise that, unless he has sued them or entered a settlement with them which the Bankruptcy Court must approve, the Trustee has never been willing to identify the institutions (or very wealthy individuals) who have not taken out more than they put in, therefore have positive net equity under CICO, and will get SIPC advances and customer property. To reveal the identity of these institutions would be to disclose how unfair is the Trustee’s method of determining net equity, now approved by the Second Circuit.

There is another and extraordinarily fundamental matter pertaining to the Court’s claim that fairness requires use of CICO lest money given to net winners reduce, dollar for dollar, the funds available to net losers. The case in the Second Circuit involved two separate funds -- as the Court was aware because the matter of there being two separate funds was not only mentioned in briefs, but was discussed several times in the oral argument. One fund is the SIPC fund. That fund is created by contributions from the securities industry, and can be augmented by lines of credit obtained by SIPC and by requested appropriations from Congress. This fund is used to pay a customer up to $500,000, depending on her net equity, if a bankrupt broker’s coffers, as is usually the case, are insufficient to pay off. The amount of up to $500,000 is an advance against the customer’s share of the second fund, the customer property fund, but must be paid even if not one dollar of customer property is recovered. This further shows that, as I say, the SIPC fund is separate from the customer property fund, as Congress made clear -- though the Trustee and his counsel have tried, and in the Second Circuit have succeeded, in tricking this all up by their apparent claim that the SIPC fund is only a part of the customer property fund – and that the SIPC fund must be used to pay up to $500,000 of net equity even if there is no fund of customer property because no such property is recovered.

As I say, the Court was aware that there were two funds. From reading the oral argument several times, I think the Court also knew that payments to victims from the SIPC fund did not subtract one dollar from payments that other victims would get from either the SIPC fund or the fund of customer property. Yet though there were two funds, the Court appears to have deliberately treated the case almost exclusively as if there were only one fund, the customer property fund, and as if the SIPC fund were nothing but a specific branch of customer property, since payments from the SIPC fund are advances against customer property.

The nearly exclusive treatment of the case as involving only one fund, a customer property fund, is inherent in a number of the Court’s statements. Strikingly in this regard, the Court said that a dollar going to a net winner was a dollar denied to a net loser. That is simply untrue with regard to the SIPC fund, and I do not grasp how the Court could not have known it was untrue in regard to that fund. Yet the Court said it. I find this incomprehensible.

Maybe the Court thought the following, although it gave no indication of it. If net equity is measured by the Final Statement Method, then net winners will receive money from the SIPC fund and, having a positive net equity, will also be eligible for money from the customer property fund. Their eligibility for money from the customer property fund will take money that net losers would otherwise get from this fund, i.e., will take money from those who haven’t yet recouped all the money they put in.

But if this is what the Court thought, it told nobody about it in its opinion and was mistaken. For money from the customer property fund must be distributed “ratably” in accordance with respective net equities. Though the word “ratably” may sound like it means proportionally, and can mean proportionally, it doesn’t have to and doesn’t always mean that. It can mean merely that something can be rated or appraised or estimated. So . . . . . . if the FSM were used, it would be consonant with ratability to deny net winners any share of money from the customer property fund until net losers have received back all the money that they put in. This would allow net winners, who, as I say, often had to take out money to live and are now often impoverished, to receive advances from the SIPC fund in order to live, and would insure that they thereafter get nothing more -- get nothing from the customer property fund -- until all -- even the wealthy banks and hedge funds -- get back all the money that they put in.

It is noteworthy, in regard to finding some way to get money to the small investors whom Picard and the courts ironically call net winners (though they are often impoverished while hedge funds with scores of billions of dollars and near-trillion-dollar banks are called the net losers), that in hundreds and hundreds of pages of legislative history, Congress almost never discussed customer property. Congress was deeply concerned, rather, with the SIPC fund. It was the SIPC fund that was to provide the protection small investors needed, not the customer property fund. Yet Picard and the courts have focused entirely on the customer property fund, and to insure that so-called net winners get none of that fund, which Congress cared little about, have defined net equity in a way that insures that many small investors, so-called net winners, will get nothing from the SIPC fund, which Congress cared everything about because it was the SIPC fund that was considered the main protection for investors. To say that this is a distortion of priorities by Picard and the courts is mild. It is a point which should be one of the foci for petitions for rehearing or certiorari, I think. And while I myself, being a lawyer, would feel constrained from putting the whole matter the way it was recently put by a woman whom I believe is a leading member of the victims’ community, I think it is fair to quote to you what she recently wrote: “The court just rescued SIPC and Wall Street but condemned thousands of victims to poverty. You call that justice? These judges had the opportunity to come up with a little more creative solution to this problem but they chose the easy way out by regurgitating Picard’s lies. They had an agenda and it’s clear.” The statement about an agenda may be might be right or wrong, but it is, I think, the way lots of people feel, and the rest of the quote strikes me as right even if a lawyer would feel constrained from using some of its language.

4. Though Congress wanted SIPA to give confidence to investors, and to stimulate investment in the market, the Second Circuit’s opinion can only have the opposite effect. For now no investor can rely on his statement to know what he owns and to receive money from the SIPC fund accordingly. One cannot know in advance, of course, whether one is being victimized by a fraud -- if one knew there was a fraud it would be the rare case in which one would invest anyway.(2) And now the investor, who cannot know whether she is being subjected to a fraud, cannot depend on her brokerage statement to tell her what she has at her broker’s, cannot know whether she will receive up to $500,000 from SIPC, and has to reckon with the fact that a Trustee, on SIPC’s behalf, could (and will) deliberately choose a method of measuring net equity that may result in her getting nothing from SIPC. For the small investor this is entirely a disaster. One could just imagine what the situation would be if the FDIC were to tell depositors that it will not honor their bank statements because there was embezzlement which caused the bankrupt bank not to have the money shown on their statements. The situation here is no different.

In this regard, there are people who say that what Picard and the court have done is okay because investors, by definition, take risks. Of course, they take risks. That is inherent in investing. But the risk is of a decline in the market, a decline in the price of the securities one owns. The risk is (called) market risk. It is not risk of fraud. Fraud happens -- both in securities houses and banks. But both the FDIC and SIPA are supposed to protect against the fraud risk, albeit not against market risk.

5. There are many of us who believe that SIPC and Picard chose to use CICO because SIPC thought it did not have enough money in its SIPC fund to handle the Madoff problem if it used the FSM. The Trustee and SIPC have always resisted providing any information about the deliberations which led them to choose CICO. Defacto their position has been -- although they of course would never put it this way -- that no information need be given about such deliberations, and there can be no discovery into the deliberations, even if CICO thwarts the intent of Congress to protect investors. In taking this position defacto, they have violated separation of powers and have engaged in judicial legislation.

The Second Circuit has now done the same by ignoring the will of Congress, upholding positions which it deems fair in the circumstances regardless of what Congress wanted, and declining to address the fact that one party asked it to order the discovery necessary to learn why SIPC and Picard chose CICO. It has thereby eliminated the possibility of learning, through the judicial process, why CICO was chosen. Such elimination will also be the consequence of the Circuit’s (contradictory) statements that, even though trustees have discretion in selecting the method for measuring net equity, CICO is the only proper method here. The Trustee will quote the latter half of the contradictory statements to argue, yet again, that discovery of the real reasons why CICO was chosen -- discovery of whether it was chosen because of SIPC’s lack of funds even though it thwarts Congressional intent -- is improper because, after all, the Second Circuit said CICO is the only proper method for determining net equity here.

There may, however, be non judicial ways of determining what many of us think are the real reasons CICO was chosen. Congress could find out through legislative subpoenas and investigation or through the inquiries that now have been undertaken by the GAO. And what would happen if Congress were to learn that a concern over lack of sufficient monies in the SIPC fund was the reason, or an important reason, that caused CICO to be used instead of the FSM? Would the Second Circuit’s decision still stand because it said CICO is the only proper method here and this remains true regardless of the reason CICO was used? Or, contrariwise, would the Circuit’s opinion have to fall because it is the product of a bill of goods sold to the Court as the reasons for using CICO and because the Court focused entirely on the effect of net equity on the customer property fund while entirely ignoring its effect on the SIPC fund, about which Congress was far more concerned? My own view would be the latter, but there will be others who feel differently.

I should add that this problem is another one that stems from the basic nature of the procedure that was used here. Lawyers will immediately grasp my meaning when I say that this case, from the Bankruptcy Court through the Second Circuit, was a summary judgment without any opportunity for discovery, a procedure I believe very rare if known at all. So called summary judgments, which end a case before trial, are given only when each side has had discovery to learn the facts supporting and opposing it. But here no discovery was allowed or had on crucial matters such as the underlying reasons of SIPC and the Trustee for using CICO, the extent to which huge banks and hedge funds are helped and small victims are hurt by using CICO rather than the FSM, and other matters. The judiciary denied discovery, simply took one side’s (the Trustee’s) word for things, and then ruled against the victims who were not permitted discovery. This is, I think, a pretty astonishing method of proceeding where anybody on the losing side has sought discovery, and in this case one victim did. Guess who that was. His requests for discovery were rejected in the Bankruptcy Court and ignored in the appellate court. And again, common sense causes one to believe the requests for discovery might have received more respect from the courts had they been made by the large Wall Street firms the Circuit knows and respects -- but who were so convinced of the infallibility of their argument from the words of the statute that they thought discovery irrelevant -- instead of by an unknown guy from the far-off New Hampshire/Massachusetts border.

6. There are three points, which I shall very briefly allude to, that caught my eye in studying the opinion.

One is that the Circuit accepted the idea that, though no securities were bought or sold (with minor exceptions), still the victims had a claim for securities, as reflected in their final statements, because they gave Madoff money to purchase securities. Yet, though victims had a claim for the securities shown in their final statements, the value of those securities was not the value for them shown in the final statements. This has always been Picard’s position, and has always struck me as bizarre. After all, have you ever heard of a person who thought he owned securities because they were shown on his statement but (barring a mistake) has not thought the value of the securities was what was shown on the same statement? As I say, bizarre.

A second point is the alleged concern -- the bill of goods sold to the Second Circuit by the SEC and SIPC in New Times and repeated in Madoff -- that, unless CICO is used, the fraudster will dictate who gets what; in particular he will dictate huge sums for his cronies and will break the SIPC fund. The Madoff case is in itself proof that this is untrue. Madoff’s cronies -- e.g., Levy, Picower, Chais -- have been caught and have been forced already to disgorge huge sums or have been sued for huge sums. Moreover, as I’ve said many times before (but as the Circuit did not care), it has been customary in the financial world for decades to use surrogate measurements to determine what would have been or will be made -- here what would have been made if the deal had been honest.

7. Finally, it must be noted that the Trustee is seeking huge sums from large institutions that should have known Madoff was a fraud because they knew of serious red flags but ignored them in order to reap profits from the Madoff fraud. If the courts allow the Trustee to sue for those sums, and if he wins them at trial or by settlement, then the victims will ultimately be made whole because they will recoup fraud damages from the general estate. The Trustee’s and the Circuit’s denial of net equity, and therefore of a share of customer property, to small victims who have a negative net equity under CICO, will ultimately not deny full recovery to the victims. But, and it is a very big but, for this to occur the courts will have to allow the Trustee to sue the huge institutions for the damages they caused, which at least currently is not looking all that likely after Judge Rakoff’s recent decision on the matter in the HSBC case. Also, the courts would have to agree that the huge banks will be liable if they, as charged, knew of but ignored red flags in service of making profits. How the courts will rule on this question is unknown. And finally, ultimately might be a long time -- it could possibly be years before the Trustee defeats or settles with the large banks (though one hopes for faster results).

(1) At an early point, before the legislative history had been researched, one of the major New York City lawyers told me definitively that it contained nothing helpful. The subsequent research showed the contrary to be true, but the New York lawyers stuck with the doomed statutory argument they had selected early on.

(2) Some such possibly rare cases are currently in litigation.

Thursday, August 18, 2011

Amicus Curiae Brief of the Network For Investor Action and Protection



The Network For Investor Action And Protection (“NIAP”) is a two year old organization with about 1,200 members which arose because of the Madoff debacle and seeks to protect against frauds that victimize investors. It especially seeks to protect small investors, who comprise almost its entire membership.

During the course of its existence, NIAP has been active in both legislative and judicial matters, and was allowed to file amicus curiae briefs in the Second Circuit on the question of net equity. NIAP has had the benefit of study of extensive writings on the economic, financial, legal and political aspects of the Madoff fraud, including the role played by large financial institutions in enabling that fraud.

In this amicus brief NIAP seeks to present its views regarding the question of red flags known to large financial institutions that facilitated Madoff’s Ponzi scheme. The question of red flags is before the Court in this case, and NIAP has a deep interest in the question because, if the Court decides the question, as it may, the decision could have a major impact on cases that will be brought by members of NIAP.


Large Financial Institutions, Like JPMC, Which Knew Of Red Flags But Ignored Them In Service Of Reaping Large Profits, Should Not Be Permitted To Escape Liability.

It has long been understood that the Congressional purpose underlying the Securities Investor Protection Act is to protect the small investor and thereby build his confidence in markets. The protection of investors and of the integrity of securities markets was likewise the goal of the 1933 Securities Act and of the 1934 Securities Exchange Act. Congress’ repeated purpose of protecting investors and markets requires that frauds, including Ponzi schemes, be detected and stopped as early as possible, thereby lessening and at times even perhaps eliminating the losses caused by the frauds.

As the Madoff and Stanford cases have taught yet again, we cannot rely solely on governmental and quasi-governmental agencies to detect fraud early-on. The failure of the SEC (once a premier governmental body) and FINRA to detect Madoff’s Ponzi scheme while it grew to be the largest fraud in financial history is proof enough that we cannot rely on government or quasi-government alone. The same is true with regard to the huge Stanford fraud. To stop fraud as early as possible, and thereby protect investors, we must, rather, as in so many other areas of economic and social life, enlist the cooperation and assistance of knowledgeable private professionals who discover the existence or possibility of fraud during the course of their professional work. Again as in so many areas of professional and economic life, we must marry those professionals’ economic interests to the stopping of fraud when they learn of its existence or possibility.

To rely on knowledgeable private parties to root out illegality even though there also are governmental agencies devoted to the same purpose, and to marry the private parties’ economic interests to this, is nothing unusual. It is one of the purposes behind antitrust treble damage suits, behind suits for discrimination in the workplace, and behind whistleblower suits. The principle is as applicable here, in the securities fraud area, as it is there.

The worst possible thwarting of Congress’ goal of protecting investors, especially small ones, would be to do the opposite of marrying professionals’ economic interests to the rooting out of fraud. For such opposite would be to permit professionals to take advantage of known or suspected frauds, including Ponzi schemes, by making large profits from frauds at the expense of unsuspecting innocent investors. When a financially expert institution learns of facts giving rise to the suspicion of fraud, fidelity to the intent of Congress, and fidelity to plain honesty and decency, require the institution to try to determine the truth -- the expert institution is on inquiry notice because it suspects fraud -- and also require the institution to report the unhappy facts to government agencies charged with maintaining honesty in investments -- the SEC, FINRA and state securities commissions -- so that wrongdoers can both be stopped and brought to justice.
The idea that one cannot remain silent and take advantage of a possible problem -- here the idea that large financially expert institutions which learned of facts that, given their knowledge and expertise, should have put them on inquiry notice that Madoff was a fraud and they should not use the Madoff fraud to reap huge profits without investigating the situation first -- is not a new or novel idea in American or English law. For scores or hundreds of years knowledgeable parties have not been permitted to remain silent while making fortunes because of innocent victims. A manufacturer of airplane parts who reasonably suspects possible defects that could cause a plane to crash cannot with impunity sell the parts to an airplane manufacturer without providing notice of the possible defects, and make fortunes from doing so. Rather, the manufacturer must take steps to determine whether the defects exist and must correct them if they do exist. The parts manufacturer who fails to take these remedial steps will be liable to persons (or their heirs) who are injured or killed in crashes caused by the defective parts. The same obtains with regard to the manufacturer or seller of car parts, and with regard to companies which manufacture medicines. To speak of impunity from suit by injured third parties for such culprits would be considered ludicrous. To speak of them as having no duty to foreseeably injured or killed third parties, and as being able to benefit financially to the tune of hundreds of millions or even billions of dollars from their failure to seek to detect the truth and make corrections, is similarly ludicrous, since it is just another way of granting immunity from suit for reprehensible and immoral conduct.

Yet it appears that here, where the same principles are applicable, certain large financial institutions -- which are said to have made enormous sums from or because of Madoff while suspecting that a fraud was in progress -- are claiming that they had no duty to investigate and are not liable to third parties whose injuries were not only foreseeable but were certain to occur at some point. It is also claimed that this is demanded by the banking law of the Second Circuit -- which has never faced a problem of such magnitude as the current one, a problem involving a fraud that is by far the largest in history and was enabled by large banking institutions, the same kind of institutions and sometimes the very same institutions whose reckless conduct caused the current devastating recession.(1) Why these large institutions should be able to make fortunes while evading Congress’ repeatedly implemented desire to protect small investors escapes us. And why these large institutions should escape the principles of duty, investigation and corrective action applicable to, say, manufacturers of airplane or car parts or manufacturers of pharmaceuticals, likewise escapes us. Evasion of responsibility for failure to investigate reasonable and sometimes strongly-held suspicions while making fortunes because of the crime seems to be the result of limitless greed.

The attempted evasion of responsibility for failure to investigate in the face of red flags, while making giant sums because of Madoff’s fraud, is an unconscionable device for enabling the large institutions to escape from liability scot-free. It will cause innocent small investors not to recoup their losses because, without recovery from the culpable institutions which made fortunes while ignoring badges of fraud -- i.e., while ignoring red flags -- the losses of the innocent investors cannot be sufficiently recouped. This untoward, anti-Congressional-intent result is only the more indefensible when one considers the nature of the red flags themselves, all of which -- or nearly all of which – were generally unknown to the small investor, but many of which -- sometimes most or all of which -- were known to the large institutions or investors whose cases have been brought to the District Court for the Southern District by withdrawals of references. So powerful and well known to institutions were these red flags that it is proper to regard the institutions as having actual knowledge that some kind of fraud or illegality was in progress and that its precise nature might very well be a Ponzi scheme. Some of these oft-flagrant red flags apparently were known to all the large professional financial institutions whose cases are now before the District Court for the Southern District, and the Trustee has mentioned most or all of these red flags in complaints and briefs. Others of the red flags, also mentioned by the Trustee, were known to some but not all of these large institutions. But rarely if ever were any of them known to small investors. Here are some of the more important ones that have been talked of since Madoff’s fraud was revealed on December 11, 2008 -- since Madoff got busted, one might say:

1. Because of the amount of money he supposedly was running, the execution of Madoff’s split strike conversion strategy required more options than existed on exchanges or, apparently, in the world. Nor would Madoff identify the supposed counterparties from whom or to whom he supposedly was buying and selling options over the counter.

2. Madoff appeared to have an uncanny, and impossible, ability to buy stocks at their lowest price on a given day and to sell them at their highest price on a given day.

3. Madoff did his own custodial and clearing functions. There was no way to know whether the assets he claimed to be holding really existed.

4. Madoff was extraordinarily secretive: he would not meet with experts who wished to do due diligence, would refuse to respond to crucial questions when he did meet with them, and forbade his feeder funds from mentioning that they had put their money with him.

5. Though the 703 Account at JPMC was supposedly for the purpose of buying and selling securities (by the scores or hundreds of millions of dollars at a time), no money went out of the account to securities dealers from whom stocks would have been bought and no money came into it from securities dealers to whom stocks would have been sold.

6. Though Madoff supposedly was buying and selling huge quantities of stocks, his supposed trading could not be “seen” in the market and never seemed to move the market.

7. Madoff’s accountant was a one-man shop. Nor was it registered with the Public Company Accounting Oversight Board or subject to peer oversight.

8. So called FOCUS reports that Madoff filed with the SEC were false. They vastly understated cash and loans.

9. Wall Street was rife with rumors that Madoff was a fraud -- that he was illegally front running or a Ponzi scheme. People on Wall Street knew of these rumors but kept the rumors to themselves.

10. Family members held the highest positions at Madoff’s firm.

11. Experts were unable to replicate his results.

12. Madoff obtained his compensation in a way that experts found incomprehensible because he left vast sums on the table.

13. Regular transfers of huge sums went back and forth scores of times between Madoff and Norman Levy for no observable business purpose, thus indicating that the 703 fund was being used for some unknown nefarious purpose.

14. Experts though Madoff’s results were too good to be true.(2)

15. Various characteristics of Madoff’s scheme appeared to ape those of other schemes which had been exposed, such as the Petters, Bayou and Refco frauds.

There were other red flags as well as those listed above, but the foregoing list illustrates that there were major badges of fraud, observable to Wall Street experts, which should have resulted in them investigating Madoff’s scheme, refusing to do business with him (as a few did refuse because of suspicions raised by red flags), and blowing the whistle on him to state and federal authorities. In fact, knowledge of particular red flags -- such as the lack of sufficient options to support Madoff’s purported trading, his ability to always sell at a day’s highest price and buy at it’s lowest, the inability to “see” his supposed buying and selling in the market, the failure of monies in the 703 Account to be used to buy securities or to flow in from the sale of securities, and Madoff’s false reporting to the SEC -- were not only badges of fraud that should have resulted in banks refusing to continue doing business with Madoff, but were proof that some form of fraud was in process and that it likely was a Ponzi scheme. Indeed, if one knew the foregoing facts relating to monies in the 703 Account not being used to buy securities and not stemming from the sale of securities, one had to conclude the fraud was a Ponzi scheme.

That the existence of some form of fraud was self evident, or should have been, to financial professionals is reflected in quotations in the Trustee’s amended complaint against J.P. Morgan Chase dated June 24, 2011. The amended complaint quotes one Wall Street figure, “Robert Rosenkranz of Acorn Partners, a fund of funds manager and an investment adviser to high net worth individuals,” as saying that Accorn had performed due diligence on Madoff years before December 11, 2008, and had “concluded [on the basis of only a few of the red flags, not nearly all of them or even half of them] ‘that fraudulent activity was highly likely.’” Trustee’s Amended Complaint Against JPMorgan Chase dated June 24, 2011, pp. 67-68. Acorn had thought that even the relatively few badges of fraud it observed “‘were not merely warning lights, but a smoking gun.’” It had believed “‘that the account statements and trade confirmations [it had managed to get access to] were not bona fide but were generated as part of some sort of fraudulent or improper activity.’” (Id., p. 68.)
The huge financial institutions whose cases have been removed from the Bankruptcy Court to the District Court via withdrawal of references did not do the due diligence which they could have done -- and that a few professionals like Acorn did do --and which their knowledge gave them a duty to do. Instead, for their own massive financial benefit, these institutions, whose cases are now in the District Court, sucked small investors into Madoff’s fraud and/or facilitated the fraud, thus indicating that the Trustee is right when he repeatedly accuses these gigantic companies of forgoing their responsibilities to others in service of making huge sums of money for themselves.

Amici believe that financial institutions which ignored red flags known to them should not be allowed to escape liability, and particularly should not be allowed to escape it by arguing that they have no duty to inquire into the existence of a fraud that would devastate thousands of persons, could thus facilitate the fraud and make hundreds of millions or billions of dollars with impunity from suit, and can be liable only if they had actual knowledge that a fraud was taking place. To allow financial institutions to escape liability to innocent victims if the institutions did not have actual knowledge of fraud here, but only knowledge which they ignored of red flags indicating the possibility of fraud or, as Acorn thought, the virtual certainty of fraud, would be like allowing airplane parts manufacturers to escape liability to victims if they did not have actual knowledge, but only suspected, that there were defects in parts which then caused crashes that killed dozens, scores or hundreds of people. It would be like allowing drug manufacturers to escape liability to victims who are seriously sickened by or die from a drug which the manufacturers only suspected was defective but did not actually know to be defective.(3)

And it would frustrate the Congressional intent to protect investors, particularly small ones -- a Congressional intent repeatedly stated in the Congressional reports and rife throughout the floor debates on SIPA and its amendments. The only way to carry out that Congressional intent in the case of a giant fraud like Madoff’s is to recover ill gotten money from those who facilitated the fraud -- a fraud whose size, devastation and facilitation by huge banking institutions has never before confronted the courts.

Here, as the Trustee has repeatedly said, the efforts of the large institutions whose cases have been withdrawn from the Bankruptcy Court to the District Court -- the large institutions that ignored red flags known to them -- were instrumental in enabling Madoff’s fraud to keep going from about 1999 or 2000 to December 2008 -- to keep going even when Madoff’s Ponzi scheme would otherwise have run out of funds and failed. By enabling the fraud to continue, the large banks’ efforts caused there to be thousands of additional victims, caused a vast increase in the losses of investors who were in Madoff from the 1980s or 1990s and who innocently kept putting in more money or taking out (for living purposes) funds which they thought they had every right to but which the Trustee now seeks to claw back from them, and enabled the institutions to make nearly unimaginable sums of money. The protection of small investors envisioned by Congress, and fundamental long-standing principles of law long applicable to large companies, require that the culpable institutions here be liable to recompense the innocent investors, who sometimes are people of advanced age, and whose finances were blasted or destroyed by a fraud which the institutions greatly facilitated for their own multibillion dollar benefit.(4)

(1) The claim being made about what allegedly is demanded by Second Circuit banking law is very dubious at best. The subject is discussed in Lerner v. Fleet Bank, 459 F.3d 273 (C.A. 2, 2006).

(2) To the unsophisticated small investor, Madoff’s results seemed explicable for several reasons. There were highly successful mutual funds which made more than he did over 10 and 15 year periods. His investment results also were no better than and sometimes were below, even far below, the amounts made by recognized investment leaders like Bill Miller of Legg Mason, who finished ahead of the S&P for fifteen straight years, Warren Buffett, Bill Gross of PIMCO, Julian Robertson and George Soros. These people were (and are) recognized as having unusual financial acumen, and to small people there was no apparent reason why Madoff wasn’t another such individual. As for the consistency of his returns, and the sparse periods of losses, this seemed plausible to average investors because Madoff did not seek large gains but only small incremental gains, which is a technique for avoiding losses, and, very importantly, he supposedly bought options that provided downside protection. Not to mention that his technique appeared to conform to Warren Buffett’s three well known (and oft proven right) rules for investment success: (1) Don’t lose money. (2) Don’t lose money. And (3) never forget rules 1 and 2. Experts on Wall Street, however, regarded Madoff’s results as inexplicable and too good to be true, but kept their opinions largely to themselves and certainly did not make their opinions public, so small investors never knew of them.

(3) Just as is true in the examples regarding defects known to parts or drug manufacturers, whether any particular financial institution had enough knowledge of red flags to be culpable is a question for the trier of fact. Our point is simply that the financial institutions, like manufacturers, cannot automatically escape from liability, as they are attempting to do.

(4) The principles concerning red flags set forth in this amicus brief are applicable regardless of whether a lawsuit is permissibly brought against a large financial institution by the Trustee in order to recoup money for investors or is brought by the investors themselves. Whether the Trustee can permissibly bring third party claims to obtain money for investors is an issue that is currently before the Court. As the Court knows, the Trustee lost on this issue before Judge Rakoff.