The federal district court in New Jersey has ruled that a charity defrauded in the Madoff Ponzi scheme may bring claims against Bernard Madoff’s brother, Peter Madoff. The Lautenberg Foundation et al. v. Peter Madoff, (Sept. 9, 2009).
After Bernard Madoff pled guilty to securities fraud charges, The Lautenberg Foundation, a New Jersey charitable institution, and two individual Lautenberg investors sued Bernard’s brother Peter Madoff (Peter), who was a 40-year employee of Bernard Madoff Investment Securities (BMIS). Peter had served as BMIS’s senior managing director, director of trading, chief compliance officer and general counsel and, according to the Investment Adviser Registration filed with the SEC, he and Bernard Madoff were the two control persons of BMIS. The complaint also alleged that Peter had also created the technology through which customers could perform trade transactions via computer and that he was responsible for the day-to-day management of the trading desk. His other duties included overseeing the management and policies of BMIS, verifying and reporting its financial condition, establishing and implementing a compliance program of internal controls, and detecting and reporting all violations of laws or regulations by BMIS.
Judge Stanley R. Chesler granted in part and denied in part Peter’s motion to dismiss in a decision that highlights the many pleading hurdles to bringing viable federal securities law and state common law claims against other alleged participants in the Madoff fraud.
Although the court dismissed certain of the securities fraud claims under Section 10b-5 based alleged affirmative fraudulent representations by Peter or on “scheme liability,” it allowed the 10b-5 claims based on failure to disclose. Judge Chesler ruled that the pleadings contained sufficient inferences to suggest that Peter acted with scienter – in other words, that he either knew of the fraud or wrongdoing, or he recklessly disregarded numerous “red flags” that would have alerted him to the fraudulent scheme. Those “red flags” included such things as the extraordinary consistency of BMIS’s positive returns over many years, the unusual secrecy of the investment advisory services, the twoperson firm engaged as its outside auditor and the lack of electronic real-time access by customers to their trading accounts. Given these allegations, the court found that the inference of scienter, under a recklessness standard, was at least as compelling as any opposing inference.
The court was not persuaded by Peter’s argument that the complaint failed to meet the “in connection with the purchase or sale of a security” element of Section 10(b) inasmuch as the essence of the fraud was that BMIS actually had never made any purchases or sales of securities. Judge Chesler found this argument hyper-technical, stating: “given the wrongdoing targeted in this case, which goes to the heart of investor confidence and concerns about transparency and ethics, Section 10(b) clearly applies.”
Judge Chesler also found that there were sufficient allegations, again based on the circumstances of Peter’s role in BMIS, to make out the necessary element of “culpable participation” in a violation of Section 20(a) of the Securities Exchange Act. The court went on to hold that, at least under New Jersey law, Peter could be considered a fiduciary with respect to BMIS customers. Judge Chesler reasoned that, while it was undisputed that BMIS qualified as a fiduciary because of the discretionary authority it exercised over customer accounts, it was unclear whether Peter owed a fiduciary duty based on his status as a corporate insider. While New York law did not impose on a controlling shareholder, officer or director a fiduciary duty to the corporation’s customers, New Jersey had a more expansive standard and, given that one of the plaintiffs was a New Jersey-based charitable institution, New Jersey law could ultimately be applied to the issue. If so, a fiduciary duty could arise from Peter’s status as a “powerful insider” with “significant powers and responsibilities at BMIS, particularly with respect to its financial condition and legal compliance.” The claims based on negligence also were deemed legally sufficient, given the court’s imposition of a fiduciary standard. The claims for negligent misrepresentation, however, could not stand under either New Jersey or New York law because the complaint did not allege that Peter himself was directly involved in making any misrepresentation.
The court’s decision is enlightening on the more expansive basis for fiduciary status that may exist under New Jersey law, as well on the pleading elements needed to allege liability on third persons for the Madoff fraud.