A New York federal district court has dismissed a lawsuit brought by two investors in Bernard Madoff’s Ponzi scheme who sought to hold the federal government liable for the purported gross negligence of the Securities and Exchange Commission (“SEC”) in failing to detect the massive fraud. Molchatsky v. United States, 2011 WL 1471798 (S.D.N.Y. 2011). Judge Laura Taylor Swain dismissed the action for lack of subject matter jurisdiction on the grounds of sovereign immunity, holding that the exception to the government’s sovereign immunity set forth in the Federal Tort Claims Act (“FTCA”) did not apply. Specifically, because the court found that the SEC’s actions complained of were discretionary, the FTCA sovereign immunity exception was inapplicable.  

Allegations of Negligence and Incompetence

The complaint alleged that plaintiffs had suffered $2.4 million in losses as a result of the Madoff scheme. They premised their lawsuit on allegations that the SEC and its agents and employees failed in their oversight, investigations and examinations to detect, disclose and end the scheme perpetuated by Madoff and his firm, Bernard L. Madoff Investment Securities LLC (“BLMIS”), despite numerous tips and warnings beginning in 1992. The plaintiffs’ allegations were largely borrowed from a 457-page report prepared by the Office of Inspector General entitled “Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme – Public Version” (“OIG Report”) released on August 31, 2009, six weeks before the plaintiffs filed their lawsuit. That report concluded that “despite numerous credible and detailed complaints, the SEC never properly examined or investigated Madoff’s trading and never took the necessary, but basic, steps to determine if Madoff was operating a Ponzi scheme.”

The court’s decision chronicles numerous instances when the SEC was purportedly notified of the suspicious nature and improbable success of BLMIS, but either failed outright to respond to these seemingly credible notifications or neglected to conduct competently the few investigations it did undertake. The most egregious claims against the SEC included allegations that different offices or divisions within the SEC failed to coordinate with one another because they were ignorant of concurrent investigations or because of “an atmosphere of jealousy and secrecy” between them; that tips specifically alerted the SEC to the existence of a Ponzi scheme, but the agency responded by investigating “front-running” instead; and that several investigations were limited to interviewing Madoff rather than conducting a more in-depth review of documents, which the SEC deemed “burdensome.”

More specifically, according to the complaint, the SEC ignored the repeated admonitions of Harry Markopolos, an industry analyst and Certified Fraud Examiner. Markopolos allegedly contacted the SEC no less than four times — in May 2000, March 2001, October 2005 and June 2007 — to alert it to the likelihood of a Ponzi scheme, often providing extensive documentation of Madoff’s fraud that included evidence and analysis as well as a proposed investigation strategy. The SEC either ignored his communications; declined to investigate after minimal consideration; or conducted a limited investigation, much of which was managed by an “inexperienced, junior staff member” and “was compromised by the vendetta of a supervisor against Markopolos.”

The plaintiffs further alleged that, “if the SEC had performed its functions with the most basic level of competence, it would have discovered Madoff’s scheme” as early as June 1992, well before each of the plaintiffs invested in the scheme, and years before the economic crisis of 2008 made it impossible for Madoff to continue his Ponzi scheme, compelling his confession.

The Scope of the Federal Tort Claims Act

The U.S. government enjoys sovereign immunity, immunizing it from civil suits or criminal prosecutions, unless federal legislation specifically authorizes otherwise. The FTCA provides such an exception to this immunity by permitting plaintiffs to bring an action against the government “for money damages . . . for injury or loss of property, or personal injury or death caused by the negligent or wrongful act or omission of any employee of the Government while acting within the scope of his office or employment, under circumstances where the United States, if a private person, would be liable to the claimant in accordance with the law of the place where the act or omission occurred.”  

The FTCA, however, contains an exception to this waiver of sovereign immunity. Known as the “discretionary function exception” (“DFE”), the FTCA provides that the FTCA’s immunity waiver does not apply to “[a]ny claim . . . based upon the exercise or performance or the failure to exercise or perform a discretionary function or duty on the part of a federal agency or an employee of the Government, whether or not the discretion involved be abused.” As the court explained, sovereign immunity and the DFE are each based on “three core principles: separation of powers, protection of decisionmaking by government policymakers, and preservation of public revenues and property.”

For the DFE to apply, thus barring a waiver of sovereign immunity, courts have developed two conditions that must be satisfied. First, the alleged action or failure to act must have been discretionary — requiring some “element of judgment or choice” by the government actor — rather than have been compelled or mandated by a statute or regulation. Second, the “judgment or choice” must have been grounded in considerations of public policy or otherwise “susceptible to policy analysis.” Put more simply, an act of discretion triggers the DFE if it is the type of judgment or choice that would be made after taking an applicable governmental policy into consideration.

Discretionary Conduct Entitled to Sovereign Immunity

The U.S. government moved to dismiss the plaintiffs’ claims that the SEC had negligently failed to detect the Madoff fraud, by asserting that the DFE applied and, thus, that the government was entitled to sovereign immunity stripping the court of jurisdiction to hear the dispute. The government argued that the DFE shielded it from liability “because the SEC’s decision regarding whom to investigate and how to conduct such investigations are discretionary.”  

As a preliminary step in its analysis, the court noted that the plaintiffs, in bringing a claim pursuant to the FTCA, had the burden of showing that the DFE does not apply to their claims. The plaintiffs argued that their allegations fell outside the scope of the DFE because the SEC’s responses to warnings about Madoff and BLMIS were not discretionary but, rather, violated agency mandates found in the Securities and Exchange Act of 1934 (the “Act”) or provided for by internal guidelines and practices or formal policies. For example, the plaintiffs alleged that the SEC failed to comply with internal policies regarding the proper method to file investigative reports, and that it failed to seek investigative materials from third-party sources when it was warranted.  

In considering the first prong of the DFE inquiry, whether the conduct the plaintiffs complained of was either discretionary or in violation of a particular statute or regulation binding the agency, the court determined that the plaintiffs failed to identify a “specific, non-discretionary mandate that the SEC conduct investigations under particular circumstances, or that such investigations be conducted in a particular manner.” The only provision of the Act which the plaintiffs’ complaint cited directs authorities who are conducting concurrent investigations to share their information. Even that provision, the court found, had to be read in the context of another section of the Act that directs the SEC to coordinate with other agencies only “as appropriate,” thereby casting this directive as discretionary. The court determined that the remaining allegations that the SEC had violated agency policies or practices also failed to “demonstrate[e] relevant mandatory obligations.” Here, the court also noted that many instances of the purported wrongdoing cited by the complaint were actually vague allegations of unacceptable conduct rather than allegations of specific acts or omissions that constituted violations of specific and direct agency mandates. Accordingly, the court held that the plaintiffs had failed to satisfy their initial burden of showing their injuries were caused by a negligent violation of a non-discretionary duty. Further, the court observed that the Act itself and other SEC guidelines actually define the agency’s investigative and enforcement authority as permissive and discretionary. As a result, the judiciary has routinely rejected challenges to the SEC actions as it did here.  

With respect to the second prong, whether the allegations of wrongdoing implicate considerations of public policy, the court pointed to the historical disinclination of the judiciary to allow suits against the SEC. The court noted that, because of the agency’s “inherent policy-oriented nature, often involving considerations of resource allocation and opportunity costs,” courts are “ill-suited” to second guess SEC decision making. Importantly, the court stated that courts analyzing the second prong of the DFE test must examine the “general nature of the conduct at issue” rather than the individual factual allegations of SEC wrongdoing. Therefore, no matter how troublesome the allegations of, for example, “jealousy, secrecy, laziness [or] inexperience” underlying the SEC’s failure to detect Madoff’s fraud, because the general nature of SEC activity is rooted in policy considerations, the complaint failed to satisfy the second prong as well. Accordingly, the DFE applied, negating the applicability of the FTCA’s waiver of sovereign immunity.  

Finally, the plaintiffs asserted that they were entitled to jurisdictional discovery to learn more about the specific mandatory policies that existed and were potentially violated. The court rejected this request, holding that the plaintiffs had identified no statutory or regulatory provision to suggest the existence of SEC guidelines violations of which further discovery might uncover.  

Conclusion

The most telling impact of the court’s decision is its assertion that “detrimental reliance by members of the public on assumptions that government agencies will perform regulatory functions competently is not determinative of the ability of injured citizens to seek redress against the Government in a civil action.” Given the highly inflammatory nature of the complaint’s alleged wrongdoing and the terrible losses that plaintiffs, like so many others, suffered because of Madoff’s scheme, it is difficult to conceive of what kind of allegations would support an action against the SEC under the FTCA.