What just happened?

On 4th June, the Judge who sentenced Bernie Madoff to 150 years behind the bar, rejected the infamous fraudster’s request to be released early from prison.[1]

What does it mean?

Most people that come across this case study cannot fathom how Madoff ‘singlehandedly’ carried out the largest Ponzi-scheme ever, worth $19 billion US Dollars at the time he was caught. A Ponzi-scheme is a fraudulent investing scam which promises high rates return with little risk to the earlier investors by acquiring new investors to pay them.[2] At LawMiracle, we explain to our audiences as to how Madoff achieved such infamous feat. Firstly, Madoff’s reputation in the relevant market[3], the aura surrounding his family’s accomplishment within the financial sector[4] and the contribution he made to the society through donations to charities and politicians[5] bought him respect from regulators and access to powerful, wealthy investors.[6] Madoff had also built relationships with his clients through a ‘characteristic-based trust’[7] which involves engagement with people that share similar characteristics with the person.[8] The Fraudster used this trust to commit affinity fraud by targeting the Jewish community and other likeminded organisations.[9] This allowed him to recruit clients in both quantity and quality that were reputed and had adequate resources to facilitate his fraudulent scheme.[10]

Such trust also gave a false pretence to the investors that the economic exchanges were functioning properly.[11] Therefore, concealing potential red flags that may have arisen after a due-diligence was carried out by some investors on the fraudulent scheme.[12] For instances, the investors relied on the SEC ‘s investigation on Madoff’s scheme and found no abnormalities with it.[13] Although it is open to dispute that the cause of this was due to the incompetence of the SEC in dealing with the matter through means of a weak internal control and inadequate resources[14] to carry out an effective investigation.[15] This is because of Madoff’s personal ties to the SEC chairman and lower level connections made through Madoff’s niece who married a SEC attorney. This attorney had a supervisory role in the Madoff scandal and was previously part of a board that hindered the pursuance of the scandal in the initial SEC investigation.[16]

At LawMiracle, we argue that Madoff was not the only culprit that was responsible for the largest Ponzi scheme in history. Sophisticated investors also played a significant role in expanding the scheme. It follows, US policy makers have failed to allow private litigants to prosecute these ‘sophisticated investors’ as secondary violators. Therefore, illustrating a massive enforcement gap within the US judicial system.

How does this affect the legal industry?

Family (his wife and sons), auditors (KMPG, PWC etc) and banks such as JP Morgan are all alleged to have been involved with the Madoff Scandal.[17] However, investors are rarely held to be accountable on the same accord by academics who broadly characterise investors as victims of Madoff. This view is weak as it restricts the alleged involvement of certain individuals considered to be ‘sophisticated investors. These investors have the financial expertise and resources to gain access to information which they deem to be important for their investment decisions.[18] Therefore, they are able to fend for themselves in the capital market.[19] For instance, a hedge fund manager convinced a charity to withdraw their investment from Madoff after failing to replicate Madoff’s strategy.[20] This illustrates a situation where unbeknownst to Madoff and other innocent investors, these sophisticated investors could potentially use their resources and expertise in the field to replicate the scheme, find red flags which indicates that their investments are used to sustain a Ponzi scheme and then take advantage of this by investing double the amount of money. This is because, they now know that their investment will not fail, and it is certain that good returns will be made.[21]

At LawMiracle, we believe that these investors were committing securities fraud as a Ponzi-scheme requires a steady flow of income to stay afloat and where more money is invested to it, the bigger the scheme becomes. [22] It follows, that more innocent new and current investors are then targeted by Madoff to maintain his operation and when the scheme is exposed, a lot of people would lose out on their investments.

A legal recourse to prosecute these investor would be to encourage private litigants to seek damages from individuals that may have played a part in the scandal.[23] However, as Nunziato rightly notes, private litigants are restricted from using the statutory provision set under SEC Rule 10b-5[24] to prosecute these ‘sophisticated investors’ as ‘secondary actors’ who allegedly carry out manipulative and deceptive practices.[25] This is because, secondary actors are those individuals that do not commit the primary violations which requires an actionable public misstatement or an omission made to which the innocent investor relied upon under the federal securities law.[26] On the contrary, a secondary violator’s role may not derive from an agreement[27], but aid and abet primary violators whilst having the knowledge or awareness that they are carrying out an unlawful act.[28]

It follows, that although it could be disputed that these alleged sophisticated investors had contributed in creating a larger aftermath of losses in the Ponzi-scheme, there were no actions or public misstatements made by these sophisticated investors which was relied upon by innocent investors to invest money in Madoff.[29] In Layman terms, there was no evidence of these sophisticated investors which demonstrated that their action encouraged a large portion of people investing in Madoff’s scheme. This shows an enforcement gap as the conduct of these sophisticated investors (Secondary Violator) investing large quantities of money to the scheme is just as dangerous and equally as damaging as the conduct of Madoff (Primary Violator) operating the Ponzi-scheme.[30] Thus, like Nunziato’s view on other alleged secondary violators such as Madoff’s family members, these sophisticated investors are immune from the private civil liability unless they meet the requirements of a primary violation. Therefore, being recognised as a primary violator.[31]

Written by Amarjit Tark

Assessing Firms:

#ClearyGottliebSteen&HamiltonLLP #Debevoise&PlimptonLLP #KramerLevinNaftalis&FrankelLLP #Paul, Weiss,Rifkind,Wharton&GarrisonLLP #Sullivan&CromwellLLP #AkinGumpStraussHauer&FeldLLP #DavisPolk&WardwellLLP #DechertLLP #Gibson,Dunn&CrutcherLLP #Latham&WatkinsLLP #MilbankLLP #Skadden,Arps,Slate,Meagher&FlomLLP&Affiliates #Wachtell,Lipton,Rosen&Katz #Cohen&GresserLLP #Covington&BurlingLLP #FreshfieldsBruckhausDeringerUSLLP #Fried,Frank,Harris,Shriver&JacobsonLLP

References:

[1] Reuters, ‘Bernie Madoff fails in bid for compassionate release from prison’ (The Guardian, 5th June 2020) and MarketWatch, ‘Judge denies early release for Bernie Madoff, says he deserves to die behind bars’ (Yahoo News, 4th June 2020)

[2] James Chen, ‘Ponzi Scheme; (Investopedia, 4th May 2020)

[3] “i.e his post as a chairman of NASDAQ in the past” in Smith F, 'Madoff Ponzi Scheme Exposes the Myth of the Sophisticated Investor.' (2010) 40(2) U Balt L Rev 215 255, 256, 263 and 264.

[4] Peter Madoff was the form vice chairman at FINRA; Chew R, ‘A Madoff Whistle-Blower Tells His Story’ (TIME, 4 February 2009) < http://content.time.com/time/business/article/0,8599,1877181,00.html> accessed 19 November 2018

[5] See Mohammad I. Azim and Saiful Azam, ‘‘Bernard Madoff’s ‘Ponzi Scheme’: Fraudulent behaviour and the Role of Auditors’ (2016) Accountancy Business and the Public Interest 122, 124.

[6] See Mohammad I. Azim and Saiful Azam, ‘‘Bernard Madoff’s ‘Ponzi Scheme’: Fraudulent behaviour and the Role of Auditors’ (2016) Accountancy Business and the Public Interest 122, 128 and 129 and Weiner AS, 'Net Equity Only Comes with Net Equality: An Exploration of an Alternative Remedy for Victims of Ponzi Schemes.' (2012) 84(2) Temp L Rev 523, 527.

[7] Zucker, Lynne G, ‘Production of Trust: Institutional Sources of Economic Structure, 1840-1920’ (1986) 8 Research in Organizational Behavior 53.

[8] Stolowy H, ‘Information, trust and the limits of “intelligent accountability” in investment decision making: Insights from the Madoff case’ (2011) HEC Research Papers Series 956, 969 HEC Paris

[9] Ibid. See Smith F, 'Madoff Ponzi Scheme Exposes the Myth of the Sophisticated Investor.' (2010) 40(2) U Balt L Rev 215, 229.

[10] Mohammad I. Azim and Saiful Azam, ‘‘Bernard Madoff’s ‘Ponzi Scheme’: Fraudulent behaviour and the Role of Auditors’ (2016) Accountancy Business and the Public Interest 122, 128 and 129.

[11] Stolowy H, ‘Information, trust and the limits of “intelligent accountability” in investment decision making: Insights from the Madoff case’ (2011) HEC Research Papers Series 956, 973 HEC Paris. US Securities and Exchange Commission, Office of Investigations: Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme – Public Version – (Report No. OIG-509, August 31, 2009) 25 and 427 and Van de Bunt, H., ‘Walls of secrecy and silence: the Madoff case and cartel in the construction industry’ (2010) 9(3) Criminology and Public Policy’ 435 analogy on Rebecca Nash, Martin Bouchard & Aili Malm, ‘Twisting trust: social networks, due diligence, and loss of capital in a Ponzi scheme’ (2018) 69(1) Crime Law Soc Change 67, 71.

Stolowy H, ‘Information, trust and the limits of “intelligent accountability” in investment decision making: Insights from the Madoff case’ (2011) HEC Research Papers Series 956, 974 HEC Paris. US Securities and Exchange Commission, Office of Investigations: Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme – Public Version – (Report No. OIG-509, August 31, 2009) 425.

[12] Stolowy H, ‘Information, trust and the limits of “intelligent accountability” in investment decision making: Insights from the Madoff case’ (2011) HEC Research Papers Series 956, 973 HEC Paris. US Securities and Exchange Commission, Office of Investigations: Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme – Public Version – (Report No. OIG-509, August 31, 2009) 25 and 427.

[13] Stolowy H, ‘Information, trust and the limits of “intelligent accountability” in investment decision making: Insights from the Madoff case’ (2011) HEC Research Papers Series 956, 974 HEC Paris. US Securities and Exchange Commission, Office of Investigations: Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme – Public Version – (Report No. OIG-509, August 31, 2009) 425.

[14] US Securities and Exchange Commission, Office of Investigations: Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme – Public Version – (Report No. OIG-509, August 31, 2009) 36.

[15] Langevoort DC, 'The SEC and the Madoff Scandal: Three Narratives in Search of a Story.' (2009) (4) Mich St L Rev 899, 913.

[16] Langevoort DC, 'The SEC and the Madoff Scandal: Three Narratives in Search of a Story.' (2009) (4) Mich St L Rev 899, 904 and See Goldfarb Z.A, ‘SEC Lawyer Raised Madoff Concerns but Was Rebuffed’ (LA Times, 2 July 2009) < https://notices.californiatimes.com/gdpr/latimes.com/ > accessed 24 November 2018. Also read Report based on Madoff Investment Securities from Harry Markopoulos to the SEC (7 November 2005) < https://www.sec.gov/news/studies/2009/oig-509/exhibit-0293.pdf > accessed 6 December 2018 and US Securities and Exchange Commission, Office of Investigations: Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme – Public Version – (Report No. OIG-509, August 31, 2009) 20.

[17] See Jonathan Stempel, ‘JPMorgan wins dismissal of Madoff investors' U.S. lawsuit’ (Reuters, 18 May 2016) < https://www.reuters.com/article/us-jpmorgan-madoff-idUSKCN0Y92IK> Dated accessed 28/4/19 and Erik Larson, ‘The Madoff Players: Where Are They Now?’ (Bloomberg, 11 December 2018) < https://www.bloomberg.com/news/articles/2018-12-11/the-bernie-madoff-ponzi-scheme-who-s-where-now> Date Accessed 28/4/19

[18] Smith F, 'Madoff Ponzi Scheme Exposes the Myth of the Sophisticated Investor.' (2010) 40(2) U Balt L Rev 215

[19] See Section 4(a)(2) of the Securities Act 1933 and Smith F, 'Madoff Ponzi Scheme Exposes the Myth of the Sophisticated Investor.' (2010) 40(2) U Balt L Rev 215, 243.

[20] Smith F, 'Madoff Ponzi Scheme Exposes the Myth of the Sophisticated Investor.' (2010) 40(2) U Balt L Rev 215, 260

[21] Report based on Madoff Investment Securities from Harry Markopoulos to the SEC (7 November 2005) < https://www.sec.gov/news/studies/2009/oig-509/exhibit-0293.pdf > accessed 6 December 2018 and Weiner AS, 'Net Equity Only Comes with Net Equality: An Exploration of an Alternative Remedy for Victims of Ponzi Schemes.' (2012) 84(2) Temp L Rev 523, 552.

[22] Melissa C. Nunziato, ‘Aiding and Abetting, a Madoff Family Affair: Why Secondary Actors Should Be Held Accountable for Securities Fraud through the Restoration of the Private Right of Action for Aiding and Abetting Liability under the Federal Securities Laws’ (2010) 73 Alb. L. Rev 603, 607.

[23] Melissa C. Nunziato, ‘Aiding and Abetting, a Madoff Family Affair: Why Secondary Actors Should Be Held Accountable for Securities Fraud through the Restoration of the Private Right of Action for Aiding and Abetting Liability under the Federal Securities Laws’ (2010) 73 Alb. L. Rev 603, 615 and 616. Note: “The SEC has the power to prosecute secondary violators for aiding and abetting. However, they lack the resources to detect and investigate fraud violation making them ineffective in this instances” at Melissa C. Nunziato, ‘Aiding and Abetting, a Madoff Family Affair: Why Secondary Actors Should Be Held Accountable for Securities Fraud through the Restoration of the Private Right of Action for Aiding and Abetting Liability under the Federal Securities Laws’ (2010) 73 Alb. L. Rev 603,627, 635, 636 and 637; Stolowy H, ‘Information, trust and the limits of “intelligent accountability” in investment decision making: Insights from the Madoff case’ (2011) HEC Research Papers Series 956, 974 HEC Paris. See US Securities and Exchange Commission, Office of Investigations: Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme – Public Version – (Report No. OIG-509, August 31, 2009) 36 and 425.

[24] Rule 10b-5, Securities and Exchange Act of 1934.

[25] Melissa C. Nunziato, ‘Aiding and Abetting, a Madoff Family Affair: Why Secondary Actors Should Be Held Accountable for Securities Fraud through the Restoration of the Private Right of Action for Aiding and Abetting Liability under the Federal Securities Laws’ (2010) 73 Alb. L. Rev 603, 615 and 616.

[26] See Mason Richard C, ‘Civil Liability for Aiding and Abetting’ (2006) 61(3) Business Lawyer 1135 < http://eds.b.ebscohost.com/eds/detail/detail?vid=11&sid=894adc46-ae27-4af5-b73f-f10c0bad29c0%40sessionmgr120&bdata=JnNpdGU9ZWRzLWxpdmU%3d#AN=edsgcl.152994492&db=congale> Date accessed 29/04/2019.

[27] See Mason Richard C, ‘Civil Liability for Aiding and Abetting’ (2006) 61(3) Business Lawyer 1135 < http://eds.b.ebscohost.com/eds/detail/detail?vid=11&sid=894adc46-ae27-4af5-b73f-f10c0bad29c0%40sessionmgr120&bdata=JnNpdGU9ZWRzLWxpdmU%3d#AN=edsgcl.152994492&db=congale> Date accessed 29/04/2019.

[28] Ibid. See Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A (1994) 511 U.S. 164, 191 and Stoneridge Investment Partners v. Scientific-Atlanta (2008) 552 U.S. 148 in contrast Brennan v. Midwestern United Life Ins. Co. 259 F. Supp. 673 (N.D. Ind. 1966). See Mason Richard C, ‘Civil Liability for Aiding and Abetting’ (2006) 61(3) Business Lawyer 1135 < http://eds.b.ebscohost.com/eds/detail/detail?vid=11&sid=894adc46-ae27-4af5-b73f-f10c0bad29c0%40sessionmgr120&bdata=JnNpdGU9ZWRzLWxpdmU%3d#AN=edsgcl.152994492&db=congale> Date accessed 29/04/2019.

[29] Melissa C. Nunziato, ‘Aiding and Abetting, a Madoff Family Affair: Why Secondary Actors Should Be Held Accountable for Securities Fraud through the Restoration of the Private Right of Action for Aiding and Abetting Liability under the Federal Securities Laws’ (2010) 73 Alb. L. Rev 603, 632 and Wilkes CJ, 'Secondary-Actor Liability in a Post-Stoneridge World: Yes, a Successful Suit against Secondary Actors is Still Possible.' (2010) 40(4) Seton Hall L Rev 1811, 1819.

[30] Phrase derived from, Brennan v. Midwestern United Life Ins. Co. 259 F. Supp. 673, 680 (N.D. Ind. 1966) and Melissa C. Nunziato, ‘Aiding and Abetting, a Madoff Family Affair: Why Secondary Actors Should Be Held Accountable for Securities Fraud through the Restoration of the Private Right of Action for Aiding and Abetting Liability under the Federal Securities Laws’ (2010) 73 Alb. L. Rev 603, 621. See example of an aider lending money and knowing that it would assist in the fraudulent scheme in Mason Richard C, ‘Civil Liability for Aiding and Abetting’ (2006) 61(3) Business Lawyer 1135 < http://eds.b.ebscohost.com/eds/detail/detail?vid=11&sid=894adc46-ae27-4af5-b73f-f10c0bad29c0%40sessionmgr120&bdata=JnNpdGU9ZWRzLWxpdmU%3d#AN=edsgcl.152994492&db=congale> Date accessed 29/04/2019 analogy on affirmative assistance in Aetna Casualty, Surety v. Leahey Constr. Co. 219 F.3d 519, 537 (6th Cir. 2000)

[31] Melissa C. Nunziato, ‘Aiding and Abetting, a Madoff Family Affair: Why Secondary Actors Should Be Held Accountable for Securities Fraud through the Restoration of the Private Right of Action for Aiding and Abetting Liability under the Federal Securities Laws’ (2010) 73 Alb. L. Rev 603, 632.