The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

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By Topic: Madoff

  • From Vol. 5 No.37 (Sep. 27, 2012)

    Second Circuit Upholds Dismissal of Hedge Fund Investors’ Securities Fraud and Negligence Suits Against Fund Auditors, KPMG and Ernst & Young, Based on their Alleged Failure to Detect Madoff Fraud

    Individuals and hedge funds that invested in certain Bernard L. Madoff feeder funds that were managed by Tremont Group Holdings, Inc. and its affiliates (Tremont) initiated lawsuits in the U.S. District Court for the Southern District of New York (District Court) against Tremont and accounting firms KPMG LLP, KPMG (Cayman) and Ernst & Young LLP (together, Auditors).  The plaintiffs claimed that the Auditors were liable for securities fraud, common law fraud, negligence and breach of fiduciary duty arising out of their audit of certain Tremont funds that invested with Bernard L. Madoff Investment Securities, LLC (Madoff) and their failure to detect the Madoff fraud.  The District Court granted the Auditors’ motion to dismiss the complaint for failure to state a claim against the Auditors.  The U.S. Court of Appeals for the Second Circuit has upheld that dismissal.  This article summarizes the investors’ claims as well as the Court of Appeals’ decision and reasoning.

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  • From Vol. 4 No.34 (Sep. 29, 2011)

    Two Recent Federal Court Decisions Clarify the Differing Treatment under SIPA of Returned Principal and Fictitious Profits

    Two recent federal court decisions – one at the circuit level and the other at the district court level, and both arising out of the Madoff Ponzi scheme – offer further clarification on the differing legal status of returns to investors in a fraud of invested principal versus returns of fictitious profits.  In turn, the differing legal status of these two categories of returns impacts the extent to which the trustee can claw back money from investors and the extent to which investors can make valid claims on the estate.  See “Two Key Levels of Risk Facing Hedge Funds That Buy or Sell Bankruptcy Claims,” The Hedge Fund Law Report, Vol. 4, No. 27 (Aug. 12, 2011).  For hedge fund managers that trade Madoff claims or other bankruptcy claims, these legal decisions will impact the investment calculus.  The circuit court decision also offers important insight on the complex process of calculating “net equity” under SIPA – an issue that many hedge fund managers first encountered when trying (often with limited success) to get money out of Lehman’s failed U.S. prime brokerage business, and an issue that continues to impact the value of Madoff claims.  See generally “Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices,” The Hedge Fund Law Report, Vol. 4, No. 25 (Jul. 27, 2011).

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  • From Vol. 4 No.27 (Aug. 12, 2011)

    Two Key Levels of Risk Facing Hedge Funds That Buy or Sell Bankruptcy Claims

    The bankruptcy claims trading market is growing at a rapid clip.  By one estimate, the global bankruptcy claims trading market grew by five times, from $8 billion in 2009 to $40 billion in 2010.  According to our sources, even with significant cash on corporate balance sheets, sovereign credit concerns are likely to lead, directly or indirectly, to corporate defaults – particularly in Europe – which will only increase the size of the claims trading opportunity set.  Claims trading is complex, interdisciplinary, obscure, laborious and largely unregulated.  In short, it is the sort of investment activity for which certain hedge funds are ideally structured and staffed; and, not surprisingly, trading by hedge funds has been a significant driver of the growth in claims trading.  See “Treatment of a Hedge Fund’s Claims Against and Other Exposures To a Covered Financial Company Under the Orderly Liquidation Authority Created by the Dodd-Frank Act,” The Hedge Fund Law Report, Vol. 4, No. 15 (May 6, 2011).  As hedge fund managers that participate in claims trading know, and as managers that consider entry into the claims trading market quickly find out, investment outcomes when trading claims are powerfully influenced by legal considerations.  See “Second Circuit Adopts Broad Interpretation of Bankruptcy Code § 546(e) Safe Harbor for Securities ‘Settlement Payments,’ Ruling that Safe Harbor Applies to Enron’s Redemptions of Its Own Commercial Paper Prior to Maturity,” The Hedge Fund Law Report, Vol. 4, No. 24 (Jul. 14, 2011).  And legal considerations typically apply to claims trades at two levels – the estate level and the trade level.  The chief risk at the estate level is that the ultimate value of the estate will depart significantly from the expected value of the estate at the time of purchase of a claim.  The chief risks at the trade level are that the claim will be disallowed, reduced or subordinated, or that the seller of the claim itself will become insolvent.  This article analyzes the two levels of legal risk in claims trading by examining two different sources.  First, with respect to “estate risk,” this article provides a comprehensive analysis of a recent decision by Judge Rakoff in the Madoff liquidation.  That decision generally held that the Trustee does not have standing to bring common law claims against third parties on behalf of creditors of the Madoff estate or the estate itself.  While one typically thinks of spreadsheets rather than standing when thinking about hedge fund returns, this decision may have a material impact on the value of Madoff claims, in which a robust market has developed.  (As of immediately prior to the Rakoff decision, Madoff claims were trading for 65 to 70 cents on the dollar.)  The common law claims that Judge Rakoff did not permit to proceed sought approximately $8.6 billion from deep-pocketed defendants.  Further, a significant portion of the expected value of the Madoff estate consisted (at least prior to this decision) of anticipated proceeds from similar common law claims against similarly situated defendants, i.e., large financial institutions that served as “conduits” for investments into the Madoff operation.  Moreover, Rakoff’s decision was stern, unambiguous and forcefully reasoned.  According to our sources, the decision is unlikely to be reversed or revised on appeal.  Second, with respect to trade risk, this article outlines an insightful recent article authored by Lawrence V. Gelber, David J. Karp, and Jamie Powell Schwartz, Partner, Special Counsel and Associate, respectively, at Schulte Roth & Zabel LLP.  In particular, this article outlines the relevant points from the Schulte article regarding “notional amount risk,” “counterparty credit risk” and how to mitigate both categories of risk in claim trade documentation.  In short, any hedge fund manager considering the purchase of a bankruptcy claim must ask two questions in order to assess whether to purchase and at what price: How big is the pie?  And how secure will my access to the pie be?  The purpose of this article is to highlight issues that are relevant in answering these two questions.

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  • From Vol. 4 No.22 (Jul. 1, 2011)

    What Hedge Fund Managers Need to Know About Information and Data Security

    While hedge fund executives are experts at identifying and managing the risks relating to their financial assets and portfolios, they generally do not have the time or expertise to focus on the security of their people and intellectual property assets.  However, all organizations – especially financial institutions – must be prepared for the inherent risks and responsibilities associated with doing business in an online world through a sound digital risk management strategy.  The appropriate approach to digital risk management varies from firm to firm based on unique business models and requirements.  However, all hedge fund managers should take a risk-based approach to security and ensure that the approach is aligned with the way executives manage other business issues.  While physical security and information security present different challenges, they are strongly related, are part of internal controls and should be managed using an integrated strategy.  In a guest article, Edward Stroz, Co-President of Stroz Friedberg, a digital risk management and investigations firm, and Steven Garfinkel, Vice President of Stroz Friedberg’s Business Intelligence & Investigations Division – and both former FBI Special Agents – outline the most critical aspects involved in implementing a digital risk management program for hedge fund managers.

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  • From Vol. 2 No.43 (Oct. 29, 2009)

    Federal District Court Holds that Investor in Hedge Fund that Invested in Madoff Operation Must Arbitrate His Claims against the Financial Adviser Who Recommended Investment in the Hedge Fund

    Plaintiff Larry Wald (Wald) had a long business relationship with defendants 1 Financial Marketplace Securities, LLC (1 Financial Securities), and its Chief Executive Officer, Kevin M. Ross (Ross).  In 2002, in connection with the opening of an IRA account, Wald signed client account forms required by 1 Financial Securities.  The agreement contained a provision that called for any dispute “arising out of or relating to your business or this agreement” to be submitted to arbitration.  From 2007 through February 2008, Ross solicited investments by Wald in a hedge fund run by affiliates of the defendants.  The fund turned out to be a Madoff feeder fund and Wald’s entire investment was lost.  Wald sued the defendants in federal court, alleging various counts of federal and state securities fraud, breach of fiduciary duty, breach of contract and similar claims.  Defendants, pointing to the arbitration clause in the client agreement, moved to compel arbitration.  On October 5, 2009, the district court agreed that the arbitration clause was applicable to Wald’s claims, even though the investment was not made through 1 Financial Securities, and directed the parties to arbitrate the dispute.  This article examines the relevant facts and explains the court’s reasoning.

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  • From Vol. 2 No.40 (Oct. 7, 2009)

    What Can Hedge Fund Managers Learn From the SEC’s Failure to Catch Madoff? An Interview with Charles Lundelius, Senior Managing Director at FTI Consulting, Inc.

    FTI Consulting Inc. (FTI), a global business advisory firm, substantially assisted the Securities and Exchange Commission’s (SEC) Office of Inspector General (OIG) in preparation of its report on the agency’s responses – or failures to respond – to a series of “red flags” regarding Bernard Madoff and Bernard Madoff Investment Securities LLC (BMIS).  For more on that report, see “SEC Recommends More Hedge Fund Oversight in Audit on Its Failure to Uncover Madoff Fraud; House Oversight and Government Reform Committee Chairman Questions SEC Competence,” The Hedge Fund Law Report, Vol. 2, No. 38 (Sep. 24, 2009).  Charles Lundelius, a Senior Managing Director in the FTI Forensic and Litigation Consulting Practice, led the FTI engagement team, and thus has a uniquely clear perspective on the OIG’s review, the omissions in the SEC’s approach as determined by the OIG, structural flaws at the SEC as identified by the OIG and the OIG’s suggestions for remedying those flaws.  The Hedge Fund Law Report recently interviewed Lundelius, focusing on his experience assisting the OIG in preparation of its report.  The full transcript of that interview is included in this issue of The Hedge Fund Law Report, and touches on topics including: what FTI is and what they do; the most salient red flags that were missed by the SEC in the Madoff context; structural problems that may exist at the SEC and OCIE; the tendency of investigators to view new evidence in light of old experience; how the SEC – and for that matter, hedge funds and funds of funds – can use news and information services to discover information that may lead to red flags and ultimately to decisions against investments or in favor of redemptions; how the OIG’s report can offer tips to hedge funds of funds on how to conduct effective due diligence and how to detect fraud; and the role of hedge fund manager Renaissance Technologies in the Madoff investigation.

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  • From Vol. 2 No.38 (Sep. 24, 2009)

    SEC Recommends More Hedge Fund Oversight in Audit on Its Failure to Uncover Madoff Fraud; House Oversight and Government Reform Committee Chairman Questions SEC Competence

    On September 4, 2009, the Securities and Exchange Commission (SEC) published the report of its Office of the Inspector General (OIG) chronicling the failure of its enforcement and examinations staff to uncover Bernard Madoff’s fraud despite numerous red flags dating as far back as 1992.  In an accompanying statement, SEC Chairwoman Mary Schapiro pledged her agency’s continuing and careful review of the report to “learn every lesson we can to help build upon the many reforms we have already put into place.”  Meanwhile, in a letter dated September 3, 2009 to Chairwoman Schapiro, House Oversight and Government Reform Committee Chairman Edolphus Towns (D-N.Y.), asked whether the level of experience of the SEC’s employees has improved since Congress authorized the SEC to increase compensation in 2002.  He also pledged to hold a hearing on the subject.  Then, on September 10, 2009, SEC Inspector General H. David Kotz testified before the Senate Banking Committee regarding the audit of the agency’s failed oversight of Bernard Madoff.  He told the committee to expect more reports, more revelations of missteps, and more recommendations aimed at improving nearly every aspect of operations within the Office of Compliance Inspections and Examinations (OCIE), and of procedures within the Division of Enforcement (DoE).  This article summarizes the major findings of the OIG report, the concerns expressed in Chairman Towns’ letter, and the pertinent details of Inspector General Kotz’ testimony before the Senate Banking Committee.

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  • From Vol. 2 No.21 (May 27, 2009)

    Can the Madoff Trustee Recover Disbursements of Fictitious Investment Returns Made to “Remote” Transferees?

    What happens under the Bankruptcy Code if the recipient of a voidable transfer has transferred the property received from a bankrupt debtor to a third party?  Specifically, can the bankruptcy trustee, or the trustee in a proceeding under the Securities Investor Protection Act of 1970, seek the property in question from the third party, or would the trustee be limited to seeking its value from the original transferee?  The short answer is that trustees generally may have the statutory authority to bring recovery actions against remote transferees with respect to such property, but such remote transferees may have robust defenses that render it legally and practically difficult to collect from them.  Recent actions brought by Irving Picard, the Madoff trustee, against the Fairfield Greenwich Group and Jeffrey Picower and his foundation and related entities exemplify the disconnect between available legal remedies and the low likelihood of collection.  This article examines the statutory landscape and the factual context of Picard’s recent actions.

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  • From Vol. 2 No.9 (Mar. 4, 2009)

    Certain Madoff Investors May Find Themselves in an Unusual Dual Role – As Potential Lawsuit Plaintiffs or SIPA Claimants, but also as Potential Clawback Defendants

    Various investors in the collapsed investment management business of Bernard L. Madoff Investment Securities LLC (BMIS) may find themselves in an unusual double role, both offensive and defensive.  On the offensive side, those investors are trying to recoup all or part of their investments with BMIS, as potential beneficiaries of the Securities Investors Protection Act (SIPA) proceeding being conducted by court-appointed trustee Irving Picard, a Baker Hostetler partner; as claimants on the limited insurance provided by the Securities Investor Protection Corporation (generally, $500,000 for lost or stolen securities and $100,000 for lost or stolen cash); or as plaintiffs in lawsuits against BMIS, its service providers and others (generally alleging claims in the nature of negligence and breach of fiduciary duty).  On the defensive side, many of those same BMIS investors may be subject to so-called “clawback” lawsuits, that is, generally, actions by the trustee to recover profits paid out to (and in some cases principal invested by) investors within a certain period prior to the filing of the SIPA proceeding, for distribution to other investors.  We describe the specific forms that such clawback actions can take, who can be subject to such actions and whether the trustee would be likely to seek recovery of profits and principal or just profits.  We also discuss the various offensive option available to certain direct and indirect Madoff investors.  In the course of our discussion, we highlight important points raised at the Madoff Litigation Conference hosted by HB Litigation Conferences on February 25, 2009.

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  • From Vol. 2 No.8 (Feb. 26, 2009)

    Ogier Discusses Potential Causes and Courses of Action Available to Investors in Madoff “Feeder Funds” Organized in the British Virgin Islands

    On December 11, 2008, having admitted to masterminding what would appear to have been a $50 billion Ponzi scheme through his brokerage firm, Bernard L Madoff Investment Securities LLC (BMIS),  Bernard Madoff was arrested and charged with securities fraud.  On December 15, 2008, the Securities Investor Protection Corporation commenced liquidation proceedings against BMIS and a Bankruptcy Trustee was appointed over it.  Concerned that they are very unlikely to make any significant recoveries out of the liquidation of BMIS, investors in the Madoff “feeder funds” are now looking at possible ways of recovering their losses from the feeder funds and their third party service providers such as their administrators, custodians and investment managers.  In an exclusive contributed article, Robert Foote, Managing Associate and Barrister in the British Virgin Islands (BVI) office of leading offshore law firm Ogier, explores some of the causes and courses of action that might be open to such investors under BVI law.  The discussion has particular relevance for investors in Madoff feeder funds organized as BVI entities.

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  • From Vol. 2 No.8 (Feb. 26, 2009)

    MAXAM Fund Sues Auditors Over Madoff Losses

    On Friday, January 30, 2009, MAXAM Absolute Return Fund L.P. (MAXAM) filed a lawsuit in Connecticut Superior Court against its auditors Goldstein Golub Kessler LLP (GGK) and McGladrey & Pullen LLP (M&P and, collectively, the Auditors) alleging professional negligence, with the goal of recovering losses in connection with MAXAM’s investments in Bernard L. Madoff Investment Securities LLC (BMIS).  Implicit in the suit is the recognition that investment funds that invested in Madoff’s purported investment management business are unlikely to see any material recovery from Madoff himself or the firm he controlled.  Accordingly, plaintiffs are looking to service providers – even those who, like the Auditors in this case, provided services to the investor rather than to BMIS or Madoff.  As a general matter, while the facts of each case are unique, courts have not been receptive to claims against service providers in connection with alleged investment frauds, in the absence of any privity of contract between the service provider and the bad actor, or any independent bad act on the part of the service provider.  We describe the allegations in the complaint, including the specific claims of failure to follow Generally Accepted Auditing Standards.

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  • From Vol. 2 No.6 (Feb. 12, 2009)

    Senate Banking Committee Grills Regulators on Missing Madoff, Discusses Possibility of Requiring Investment Advisers to Keep Assets at Independent Custodians

    On January 27, 2009, the Senate Banking Committee held a hearing to examine Bernard L. Madoff’s alleged $50 billion Ponzi scheme, how it escaped detection for years and what regulatory changes would prevent similar future schemes.  At the hearing, lawmakers discussed the possibility of requiring investment advisers to maintain customers’ securities with independent custodians, rather than at their own brokerage affiliates.  They also urged senior SEC officials to re-evaluate how they prioritize complaints, examinations and inspections.  We describe the hearings in detail, with a particular focus on the discussion of the potential independent custodian requirement.

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  • From Vol. 2 No.4 (Jan. 28, 2009)

    Can the Madoff Trustee Recover Fictitious Investment Gains Distributed to Investors Prior to Inception of the SIPA Proceeding?

    Possession, they say, is nine-tenths of the law.  But sections of the Bankruptcy Code (incorporated, in pertinent part, by reference into the Securities Investor Protection Act of 1970 (SIPA)) providing for avoidance of preferential transfers and fraudulent conveyances demonstrate that possession is not invariably determinative of ownership.  This point has renewed relevance in light of the alleged $50 billion Ponzi scheme orchestrated by Bernard Madoff.  The question for many investors who thought they got out unscathed is now: will the SIPA trustee be able to require them to return money already paid out?  Investors who lost all or substantially all of their investments with Madoff are asking the same question, since it looks increasingly likely that any recovery for Madoff investors will come from claw back of formerly distributed amounts as opposed to discovery of hidden cash.  We explore these questions in detail, outlining the statutory bases of recovery actions, defenses to such actions, relevant precedents, statute of limitations concerns and hedge fund marketing issues.

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  • From Vol. 2 No.4 (Jan. 28, 2009)

    Holtz Rubenstein Reminick LLP Hosts “Town Hall Meeting” on Madoff Matters, Including: Filing of SIPC Claim Forms, Redress Via Tax Refunds, Insurance Claims and More

    On January 21, 2009, accounting firm Holtz Rubenstein Reminick LLP (HRR) hosted at the Jumeirah Essex House a town hall-style meeting on “Implications and Consequences of the Alleged Fraud of Bernard Madoff.”  The panel included three HRR partners, a securities lawyer and the CEO of an investment adviser.  We report on the key ideas discussed at the meeting, including practical recovery and tax tips for investors affected by the alleged Madoff Ponzi scheme.

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  • From Vol. 2 No.2 (Jan. 15, 2009)

    Can Madoff Investors Claim “Theft Loss” Tax Deductions?

    If there’s a silver lining to the alleged Madoff Ponzi scheme, it may be the ability of defrauded investors to take “theft loss” deductions for their losses.  Generally, a theft loss deduction is limited to the tax basis of the investment minus previous deductions, depreciation or amortization, plus any commissions or transaction costs.  In other words, as a general matter, the IRS will not permit theft loss deductions with respect to purported “gains” or “income” from a Ponzi scheme or other investment fraud – amounts referred to, in this context, as “phantom income.”  We explain the mechanics of the relevant Internal Revenue Code Provisions and Treasury Regulations, detail relevant precedent and offer a “to do” list for Madoff investors considering claiming a tax loss deduction with respect to their Madoff-related losses.

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  • From Vol. 2 No.2 (Jan. 15, 2009)

    Pension Plan Sues Tremont Fund of Funds and Others Alleging Red Flags Missed in Alleged Madoff Scheme

    On December 30, 2008, Group Defined Pension Plan & Trust, a Jersey City, New Jersey-based pension plan, sued Tremont Partners Inc. and a hedge fund of funds it manages, as well as affiliated entities, the fund’s auditor and others, alleging violations of federal securities laws and New York state law.  We provide details of the factual and legal allegations in the complaint, and end with a coda, inspired by a recent Seventh Circuit decision, on a circuit split regarding the right to remove securities class action cases from state to federal court.

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  • From Vol. 2 No.1 (Jan. 8, 2009)

    From Bayou to Madoff: Feeder Funds, Claw-Backs, Make-Wholes and More

    On December 16, 2008, the Securities Investor Protection Corporation initiated liquidation proceedings with respect to Bernard L. Madoff Investment Securities LLC.  In some respects, the events surrounding that filing recall, though with larger numbers, the fall of the Bayou hedge funds in the summer of 2005.  Bayou too was a complex, multi-year pyramid scheme that deceived even sophisticated investors with falsified books approved by obscure (or in Bayou’s case, nonexistent) auditors.  We discuss the implications (and limits) of the analogy between the Bayou and Madoff cases, and lawsuits and the likelihood of future suits against Madoff feeders.  Also, we explore the question: is it possible that Madoff feeders will make investors whole for Madoff-related losses, as some major banks have done for their clients in other contexts?

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