Little hope of recovery of lost Madoff millions

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NEWS ANALYSIS: Little hope of recovery of lost Madoff millions

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By Joanna Ludlam, Matthew, Arnold & Baldwin

It is too early to predict with certainty what the effects of the alleged fraud carried out by Bernard Madoff will be. What is already clear is that the number of investors affected is considerable.


The swindle touched banks, hedge funds, fund of funds and wealthy individuals. In these difficult financial times, the victim are anxious to recover as much of their loss as possible.
Who they should target and the legal basis for claims are two issues that are exercising legal minds.

Claimants alleging investment fraud against Madoff's company, Bernard L Madoff Investment Securities (BMIS) are unlikely to be able to recover much. BMIS has been described as a "lean and starved corpse".

Instead of throwing good money after bad, claimants would be well advised to focus on recovering funds from the third-party institutions that channeled money to Madoff, such as banks, hedge funds and investment companies, as well as auditors and even regulators who should have spotted the scam.

Several federal class-action lawsuits have already been filed in the US against these types of defendants. A number of law firms have announced they represent scores of Madoff investors with potential claims.

The focus of these claims will be how the defendants missed the irregularities. Funds of funds (FoFHs) are paid significant fees to carry out due diligence. Many of these FoHFs appear to have been rather lax in this process. Others appear to have been imprudent by putting all of their clients' funds into one basket (Madoff's). The question that needs to be answered is whether they were acting as reasonable and prudent investor son behalf of their clients.

Not only do the victims have negligence claims, but there is also the question of breaches of regulatory obligations. In the UK the Financial Services Authority (FSA) Rules state "a firm must take reasonable care to ensure the suitability of its advice and discretion decisions for any customer who is entitled to rely on its judgment".

The FSA regulates hedge fund managers in the UK (unlike the Securities and Exchange Commission (SEC) in the US). It will want to know if these regulated entities complied with their duties. Any offenders face large fines and the potential withdrawal of their FSA accreditation, with the result that they can no longer operate in the UK.

There may also be claims against the regulators. One US woman who lost nearly $2 million with Madoff is focusing her attention on the SEC. Its statutory purpose is to protect the public interest. She has issued proceedings, alleging the SEC was negligent in failing to detect the fraud.

There have been harsh criticisms of the US regulatory system on both sides of Atlantic. Nicola Horlick, fund manager of the Bramdean Alternatives Fund which reportedly invested an estimated $30.4 million with Madoff, said "It is astonishing that this apparent fraud seems to have been continuing for so long, possibly for decades. The allegations appear to point to a systemic failure of the regulatory and securities markets regime in the US."

How likely claims are to succeed is an open question. Administrative law claims against public bodies are fraught with difficulty. The UK courts are historically reluctant to treat government agencies as insurers by holding them liable for losses suffered by private entities.

As for claims against UK-based institutions such as FoHFs and investment advisers, it will not be difficult for the claimants to establish that these entities owed them a legal duty of care. The challenge will lie in establishing liability. They will need to prove that the companies investing the money failed to carry out due diligence properly and, had they done so, they would have seen the ‘red flags' and decided it was too risky to invest.

The problem is this was a fraud perpetrated by a highly regulated company right under nose of the regulators. Sophisticated investors were duped. Many factors, not least the extraordinary methods used by Madoff to cover his tracks, will make it difficult to establish that defendants negligently failed to take heed of the warning signs. Many will have carried out objectively adequate due diligence which failed to uncover any concerns.

Nevertheless, many respected funds did conduct due diligence and turned Madoff down, correctly identifying red flags and deciding not to risk investment. Press reports and numerous would-be investors in both the US and UK have said they had grave concerns about the Madoff operation from as early as 2000.

In a report sent to the SEC in 2005 one US investor, Harry Markopolos, described BMIS as likely to be "the world's largest Ponzi scheme". If these potential investors saw through Madoff, arguably others (including the SEC itself) should have heard the same warning bells.

Even if liability is established, there are problems of causation to overcome. The argument goes that, even if their due diligence had left certain questions unanswered, Madoff had made so much money for investors over the years that claimants would arguably have run a calculated risk in order to have a slice of the Madoff pie.

Even assuming the courts find against the FoHFs, the ultimate concern is whether their pockets will be deep enough to pay out to successful claimants in any event. The current financial crisis, coupled with the magnitude of the claims involving Madoff, could sound the death knoll for many of these companies.

Some may view insolvency as an attractive alternative to fighting a law suit. Litigation may not be worth the trouble and expense.

There may be no magical legal theory providing a clear path to recovery. Litigation or no litigation, banks, funds and regulators are expected to carry out wide scale reviews of the internal procedures that failed to detect the fraud.


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