Clawback: Ponzi Victims to be Double Screwed, but more legal fees

Alleged Madoff victims may be vulnerable to other victims' claims

The Los Angelos Times by Carol J. WIlliams - February 16, 2009

Those who profited before suffering losses -- including retirees and charities -- could be hit with demands to give back cash in a settlement.

Santa Monica retiree Bob Braslau considers himself a victim of accused fraud mastermind Bernard L. Madoff.  But the court-appointed bankruptcy trustee, he fears, might consider him a beneficiary. Braslau was among the thousands who lost money when the Madoff fund collapsed amid allegations that it was a $50-billion Ponzi scheme. But because Braslau had taken out some proceeds over the years, he could be forced to return those earnings if a court determines they weren't real investment returns, simply money from other victims. "I do feel in jeopardy," said Braslau, a former aerospace engineer for TRW Inc. who invested with Madoff through Stanley Chais, a Beverly Hills money manager. "People are going to be frantic in trying to recover their money."  Some of the charities and foundations that lost millions with Madoff are also potential targets in the gathering scramble to recover cash from those who profited to distribute among those who did not. Madoff, 70, has been under house arrest at his luxury Manhattan apartment since Dec. 11. The former Nasdaq chairman is reported to be cooperating with investigators while awaiting trial on securities fraud charges.

Irving Picard, a partner with law firm Baker Hostetler appointed by the federal Bankruptcy Court to recover assets for distribution to defrauded investors, has so far found $830 million and sent out 8,000 letters to potential claimants. In pursuit of other funds from the lost Madoff fortune, Picard is expected to employ a little-used legal tool, the "clawback" suit, to collect what remains of the alleged scheme's payouts for a more equitable redistribution, analysts say. The track record for clawbacks is limited because Ponzi scheme victims are typically left with little that can be recovered. Retrieving funds can also be difficult if those who profit take their proceeds abroad, where the trustee may have no jurisdiction. But there have been successful efforts to recover money. After the Bayou Management hedge fund, run by Wall Street stalwarts Samuel Israel III and Daniel Marino, collapsed in 2005, the court-appointed receiver managed to recover about one-third of the $450 million lost by investors.

In another case, groups affiliated with the Church of Scientology agreed in 2006 to pay back $3.5 million they received from former Santa Barbara money manager Reed Slatkin and others who invested with him. Slatkin is set for release in 2014 from the U.S. penitentiary at Lompac, where he has been serving time in connection with a $593-million operation in which money from some investors was used to pay off others -- the classic definition of a Ponzi scheme. "The legal basis for the trustees being able to clawback is the allegation that the transfer of any of the proceeds to anyone in a Ponzi scheme is a fraudulent conveyance," said Bob Klueger, a Los Angeles attorney who specializes in asset protection. "The theory behind it is that if it was a Ponzi scheme, the trustee is not bound by any considerations of who got in early and who got in late. The trustee is permitted to treat everyone the same, take back all money invested and divide it up evenly among all the investors," Klueger said.

Klueger worked for two clients hit by clawback lawsuits for their role in funneling investment money to Slatkin. His clients settled with the bankruptcy trustee for an undisclosed amount that was returned to the pool of investors. Most investors who suffered losses in Madoff's scheme, both individuals and institutions, didn't deal directly with the New York magnate, instead putting their money in through feeder funds such as Brighton Co., which was run by Chais, a Beverly Hills investor and philanthropist. The founder of the Chais Family Foundation, a contributor to Jewish causes around the world, Chais is the target of a $250-million civil suit and has folded the foundation for lack of funds. Investments that were structured as part of retirement plans are exempt from clawback lawsuits, legal experts note, but that is of little comfort to Braslau. He was simply an investor, and he feels exposed.

He declined to say how much he lost but said it was more than he took out over the 30-plus years he was invested. He does not blame Chais, however, saying he was "99.99% convinced" that Chais knew nothing about Madoff's corrupt dealings, given that Chais was providing money from friends, relatives and charitable groups. Chais did not return phone messages from The Times. Joe Grundfest, a Stanford University securities law professor, predicted complex and controversial legal actions among the Madoff victims, including charitable foundations with considerable assets that could be tapped and thousands who counted on the fund's proceeds to support them in old age. "You can imagine that litigation of that sort gives rise to many potential problems and appearances of harshness," said Grundfest, raising the prospect of charities that used investment proceeds for humanitarian causes being hit with demands for the return of money already spent. "It's going to be hotly litigated."

In New York, Atty. Gen. Andrew Cuomo has already signaled that such investors are under scrutiny. He has served subpoenas on at least a dozen universities and nonprofits that took investment advice from Madoff intermediary J. Ezra Merkin. "Anything withdrawn within 90 days of the bankruptcy filing most certainly would be targeted," said Donald Chase, a securities litigator who represents clients who consider themselves Madoff victims. "Beyond that, what everyone is bracing for, if you take the Bayou case as an example and blueprint, is the trustee filing claims against anyone who redeemed or received profits in the last six years." A primary residence is fully protected from bankruptcy seizure in a few states, such as Florida and Texas, but in California the homestead exemption is only $75,000 per couple under 65 and $200,000 for those at or above retirement age. The statute of limitations in most states for recovering fraudulent redemptions is six years, four in California. But lawyers warn that the statutes are often ambiguous, neither clear nor consistent about when the clock begins running.

Others who could be sued for return of allegedly ill-gotten gains include executives of now-bankrupt funds who drew exorbitant salaries or severance packages even as the portfolios they were managing were sliding. "People are entitled to get paid for their work. But golden parachutes are different," Los Angeles bankruptcy attorney Arthur Greenberg said. "If you've got just a plain fraudster, the answer is he's going to be giving back what he took from the estate." Reed Kathrein, a Berkeley securities litigator, said he had his doubts that the bankruptcy trustee in the Madoff case would target victims such as Braslau with clawback suits. "Certainly, if they try to come back after people like that, there's going to be a massive revolt and a big fight," said Kathrein, noting that even some who came out ahead were unwitting victims. "You can only squeeze so much blood out of a stone." carol.williams@latimes.com

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Madoff Victims Face Grim Prospects in Court: Jane Bryant Quinn
BLOOMBERG Commentary by Jane Bryant Quinn - February 11, 2009

Feb. 11 (Bloomberg) -- The securities laws may be your worst enemy if you lost money in the Madoff scam. Investors are suing the feeder funds that channeled their money to Bernard Madoff, charging the feeders with fraud, negligence or breach of fiduciary duty. On the surface, the cases sound like slam dunks. They’re not. Congress and the courts have spent more than a decade writing and affirming laws that protect companies from irate investors. Those laws may turn out to be feeder fund protection acts.

For bilked investors, the problems begin with the federal Private Securities Litigation Reform Act (PSLRA), passed in 1995. It was designed to reduce the number of “frivolous” securities lawsuits filed in federal courts. In essence, it says that investors can’t proceed with a case unless they already have facts in hand that strongly suggest a deliberate fraud. By this standard, it’s not enough to claim that the feeders failed to investigate Madoff or issued financial statements later found to be false. You have to show that the feeder probably knew about the fraudulent scheme, or recklessly disregarded evidence of it, or that the fund violated a written commitment -- say, by investing all of your money with a single manager when it specifically promised not to. You need documentary evidence showing that your claim is strong.

Stupid, Not Criminal

The feeders will argue that they didn’t know what Madoff was up to, that they vetted him along with other managers and that everyone was fooled. They have a good chance of getting your case dismissed. “Stupid” isn’t a triable offense. Prior to the PSLRA, you could start your case with minimal evidence and use pre-trial discovery to search for more. The feeder would have to turn over e-mails and other documents that might show it had doubts about the Madoff accounts. Today, however, you need such evidence just to begin, and it’s tough to get.

You also can’t argue that the feeders are liable because their actions made the fraud possible. In 1994, the Supreme Court ruled that investors may not sue advisers -- investment banks, lawyers, accountants -- that aid and abet a securities fraud (the case was Central Bank of Denver vs. First Interstate Bank of Denver). Abetters have get-out-of-jail-free cards. You might get a break if Madoff made secret kickbacks to one or more feeder funds, to bring in more cash. No one knows if that happened. If it did and Madoff confesses to it, that could be enough evidence of fraud to get you into court, says John C. Coffee, a professor of law at Columbia University in New York.

Seeking Friendlier Courts

Most securities fraud cases have to be brought in federal court, but there’s potentially a second road to justice. Instead of claiming fraud, investors can claim that the feeders breached their fiduciary duty -- a charge that’s tried in state courts. It doesn’t require proof of fraudulent intent. “Getting these cases into state courts is crucial for the litigation, because success will depend heavily on getting access to the feeder funds’ records,” says James Cox, professor of law at Duke University in Durham, North Carolina. There’s a hitch. Class actions involving the securities laws and covering more than 50 people can easily be moved by the defendant to the inhospitable federal courts. A case can also be moved for other reasons -- for example, if it was filed in a different state from the one where the feeder has its main office.

Court Hurdles

Many of these cases will wind up in New York, where some of the principal feeders are located. That creates yet another problem. A state law called the Martin Act prevents individuals from filing claims under New York securities laws. Only the attorney general can pursue an action. You can’t even pursue a breach-of-fiduciary-duty claim in New York’s courts, if the breach involves a securities case. It has to go to the federal courts -- a finding affirmed as recently as July 2007. In that case, South Cherry Street LLC, an investment group, sued Hennessee Group LLC, a consultant, for recommending the Bayou Group, a hedge-fund Ponzi that blew up in 2005. The judge, Colleen McMahon, also found that, even if Hennessee’s principals had egregiously failed to investigate Bayou, they weren’t liable for South Cherry’s losses as long as they didn’t deliberately shut their eyes to what was going on.

Pursuing Deep Pockets

Her decision is on appeal and lawyers are watching it closely. “It’s a stark example of how many barriers there are now to private investors seeking to recover,” says attorney Joel Laitman of Schoengold Sporn Laitman & Lometti in New York. Investors are pursuing one other set of deep pockets: The institutions chosen by the feeder funds to be custodians of the assets. Custodians are supposed to hold your investments and account for them. Their presence made people feel secure. Most custodial contracts, however, permit the appointment of subcustodians, says Dominic Hobson, editor-in-chief of London- based GlobalCustodian, which covers the field. Ideally, the sub should be independent but the contract may not require it. In this case, the institutions handed off to Madoff, acting as his own custodian. Custodial contracts typically require that subs be chosen carefully and monitored, Hobson says. An institution might argue, successfully, that it did indeed monitor Madoff but was craftily misled. This isn’t to say that the feeder funds are safe, only that lawsuits face surprising hurdles. Investors whose contracts include an arbitration clause might do better. Arbitrations don’t follow the securities laws. At the very least, you’ll have a chance to make your case.

(Jane Bryant Quinn, a leading personal finance writer and author of “Smart and Simple Financial Strategies for Busy People,” is a Bloomberg News columnist. She is a director of Bloomberg LP, parent of Bloomberg News. The opinions expressed are her own.) To contact the writer of this column: Jane Bryant Quinn in New York at jbquinn@bloomberg.net