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June 18, 2010


Having discussed the liability of the SEC for negligence in Part I of this post, this Part II shall discuss issues relating to the liability of FINRA, large banks and funds, and certain accountants.

FINRA seems to somehow have fallen between the cracks. After early interest in its potential liability -- it and a predecessor had, after all, examined Madoff's broker dealer business once every two years for four decades, but had uncovered nothing -- little if anything seems to have been written about it. I have not ready any complaints asserting FINRA's liability, and do not even know whether any cases have been filed against it.

Early on -- in Congressional testimony if memory serves, and elsewhere too -- FINRA had denied culpability on the ground that it (and its relevant predecessor, the NASD) had authority over and had examined only the broker dealer side of Madoff's business, not the investment advisor side. Implicit in this ("stovepiping") denial of culpability, and dubious to many of us, was the claim that a competent investigation of the broker-dealer side would not have turned up information that would have revealed the fraud on the investment advisor side. Today the stovepipe defense for FINRA looks even more dubious because it now seems fairly well established that Madoff was taking and using money from the investment advisor (Ponzi) side of the business to support the continuation of the broker-dealer side, which, it has been claimed, might otherwise have collapsed. It would seem, at least, that a competent, non-negligent investigation of the broker dealer side by FINRA and its relevant predecessor would have uncovered, at minimum, that the broker-dealer side was being propped up by money from the investment advisor (Ponzi) side, and would have created questions and/or forced actions which would have led in one way or another to the collapse of the Ponzi scheme.

Because of the lack of currently available information about the possible role of FINRA, it is not possible to presently be certain about its liability. Discovery will be necessary in litigation to fully flesh out what it did and failed to do. All that one can say with utter certainty at present is that one should be dubious about the non liability of a major financial industry organization -- one which paid Mary Schapiro $3 million per year, no less -- that investigated Madoff once every two years for decades but found nothing.

I turn now to the liability of large banks and funds. This can be divided into various parts. There is, first, and perhaps most conventionally, the liability of large institutions for negligently failing to do due diligence before sending their investors' money to Madoff. There already are many such suits by their investors based on this negligent failure. The claims of negligence involve many of the ideas raised in the IG's reports and, before that, by Harry Markopolos and others who complained fruitlessly to the SEC. Banks and hedge funds failed to insure that Madoff actually purchased, sold and had custody of securities and options, failed to make relevant inquiries of possible counterparties or government agencies, ignored the identity of Madoff's purported auditor, ignored that there were vastly insufficient options to cover Madoff's purported securities trades, ignored (and/or accepted) the vast sums being paid to feeders even though these amounts were contrary to industry standards, ignored that other Wall Street outfits were unable to replicate the consistency of Madoff's results, ignored the fact that they couldn't "see" the consequences of Madoff's trading in the markets, etc. All of these negligent failures of due diligence render banks and funds liable for negligence to their investors. Recognizing this, as well as for other reason, a few of the institutions have sought to enter settlements -- deeply inadequate ones in my judgment -- with their investors.

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The liability of large institutions to their investors is the easy case. A more difficult question is whether the institutions could be liable to other persons than their investors, could be liable, for example, to persons who invested with Madoff directly.

One's immediate reaction to this question as a lawyer is that such liability is unlikely, even very unlikely. The reason is that for scores of years there has had to be some connection, some direct relationship, between two parties for one to be liable to the other in this kind of situation. (The needed relationship has sometimes been called "privity.") Only when the needed relationship existed was one person said to have the required "duty of care" towards the other. In the kind of situation existing here, where there is a fund, its investors, and third parties who invested in Madoff but not through the fund, the necessary relationship (or privity) would be said to exist between the fund and its investors, but not between the fund and the third parties who invested but not through the fund. So the fund could be liable only to its investors for negligence, not to third parties. This was a way of limiting the parties to which and thereby the extent to which the fund (or any other entity in a similar position) could be liable.

More recently there have been some inroads on the basic idea. Traditionally, for instance, an accountant was considered in privity with and could be liable to a client for negligence, but was not in privity with and was not liable to a third party who relied on the accountant's work and opinions when buying property from the client. But now there have been some inroads under which, despite the lack of privity or a relationship between the accountant and the third party, the accountant can be liable to the third party if the accountant knew that the third party would rely on his work when dealing with the client. This is sometimes described as the question of foreseeability: it was foreseeable to the accountant that the third party would rely on his work and he therefore can be liable to the third party for negligence.

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Lawrence R. Velvel is a cofounder and the Dean of the Massachusetts School of Law, and is the founder of the American College of History and Legal Studies.

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