MADOFF: THE LIABILITY OF THE SEC, FINRA,
LARGE BANKS AND FUNDS, AND ACCOUNTANTS
June 16, 2010
PART I.
It has been obvious since shortly after December 11, 2008 that complete information and ideas about the Madoff scandal would not come out quickly, in a rushing torrent. Rather information, after the initial disclosures, would keep coming out slowly, over time. History and personal experience both teach that that is always the way things are with regard to major events (an idea recently reinforced upon me yet again by reading the latest book about "The Man Who Never Was," a story of the hoax regarding the invasion of Sicily in World War II that took decades to be revealed with something that at least seems close to completeness). One would like to know everything immediately, or at least quickly. But one knows it will take years, sometimes decades.
It does seem probable that a capital opportunity for the public -- and we the victims -- to learn a huge amount more about the Madoff matter in one fell swoop was missed when Judge Chin accepted a guilty plea from Madoff rather than requiring a trial at which evidence would have to be presented. But I suppose the government might claim that avoiding a trial -- and even more so in the case of Frank DiPascali -- enabled investigators to learn a lot more than they otherwise would have. While I am dubious, this is a question which will not be confidently answerable for several years yet.
In the meanwhile information, as expected, has been coming out, even if slowly. In particular, excellent sources of information and ideas seem to include the SEC Inspector General's two Reports on the Madoff case; the IG's two reports on the all too analogous Stanford scam; and complaints, among others, filed against J.P. Morgan Chase, against a money manager, now owned by the Bank of New York, called Ivy Asset Management, against Banco Santander, Price Waterhouse and subsidiaries or components of each, and against the SEC. There have also been two legal opinions of consequence (aside from Judge Lifland's opinion on net equity, which can be ignored for present purposes). Both involve governmental immunity under the Federal Tort Claims Act: one is in a California case asserting the SEC's negligence in Madoff, and the other is in a case involving the negligence of the Army Corps of Engineers that led to the destruction of New Orleans during Hurricane Katrina.
One can have high confidence in the information and ideas in the SEC Inspector General's reports, of course. Necessarily, one should not have as high a degree of confidence in the complaints, because they are adversary documents and are comprised of allegations rather than of truths shown by evidence at trial. Yet most -- even nearly all -- of what they say has the ring of truth (and some of it, even much of it, is known to be true on the basis of prior information).
As for what is said in the two opinions, one is an intelligent assessment of what is necessitated by modern conditions. The other is simply imbecilic.
These various informational sources are relevant to several issues I would like to discuss in a two-installment post. The issues are important because they already are involved in major suits or are likely to be involved in suits that will be filed in future. One could write huge amounts about the involvements, about the relationships. I shall, however, try to confine myself by and large to only the most crucial points, which tend to get buried in the clouds of words appearing in the formal documents written by lawyers and judges.
Let us begin with the issue of the government's liability arising from the unbelievable negligence of the SEC. This is an issue on which, as is common in the legal profession, many lawyers waxed definitive when the Madoff case broke. Lawyers were quick to confidently say, on the basis of very little if any knowledge, that the government cannot be sued. The accuracy of this highly confident but knowledge-free reaction is open to serious doubt.
The problem arises because there is a medieval doctrine called sovereign immunity, under which the government cannot be sued. Though the doctrine is a relic of the days of kings and is wholly inconsistent with the rule of law, it is still followed in many instances. And, at bottom, it is this doctrine that accounts for the lawyerish knee-jerk reactions against the possibility of suit based on the SEC's horrendous conduct.
However, the doctrine of sovereign immunity has been waived by Congress in the Federal Tort Claims Act for matters that fall within that Act. Governmental negligence is one such matter, so under the waiver the government can be sued on account of the fantastic negligence of the SEC.
The waiver does not apply, however, if the matter involved is based on the policy of a given statute or statutes (like the various federal securities acts) and/or is a matter in which a government agency had discretion. The two ideas are often run together; there is no waiver, for example, if a governmental action, though it ultimately proved unsuccessful or even negligent, was within an agency's discretion in seeking to carry out the policy of a statute (such as the securities acts). So the question here is going to come down to whether, in conducting itself with horrible negligence, the SEC was acting within the policy of the securities laws and/or was exercising legitimate, permissible discretion in its enforcement of those laws.
One would think that, as the old saying goes, to put this question is to answer it. A powerful policy of the securities laws is to protect investors against fraud. It is utterly bizarre to argue that SEC personnel could be acting in accordance with the policy of the securities laws, rather than against such policy, by conducting themselves with such fantastic negligence that thousands or maybe even tens of thousands of people were defrauded out of their money instead of the fraud readily being caught and stopped by investigatory methods so simple that they are highly conventional -- methods such as (among many others) contacting counterparties to see if transactions had in fact occurred, contacting the Depository Trust Company to find out what securities Madoff held in his account there, contacting the NASD to see what trades he had engaged in, and determining (as various large funds did), whether there were enough options to cover his alleged strategy. It is correlatively and equally bizarre to say that SEC personnel had discretion to negligently fail to take even the most conventional investigatory steps and to thereby negligently thwart the deep seated securities law policy of stopping fraud.
Yet this bizarre claim is precisely what the government -- lacking anything else to say, I suppose -- is saying in the Madoff case. To be sure, it dresses up the claim in abstractions, such as saying that it has discretion on what to investigate and how deeply, etc. But at bottom it is saying (i) that it is free to be as negligent as it wishes, yet to remain immune from liability under the Federal Tort Claims Act even though the Act waives immunity for negligence, because (ii) everything it does ipso facto constitutes carrying out the policy of the securities laws and is a matter of discretion. As I shall come back to later in discussing the Katrina case, the government's claim would destroy the FTCA's waiver of immunity for negligence because, as the judge opined of the Corps of Engineers' argument in the Katrina case, the government's argument turns every single agency decision into one of policy-laden discretion no matter how negligent, no matter how contrary to established principles, and no matter how destructive to how many people whom the government is supposed to protect.
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