It has been just over two years since the world learned about the Ponzi scheme perpetrated by Bernard Madoff. It was a scheme, according to the Madoff trustee, that was facilitated through a complex network of individuals, feeder funds and advisers who pooled investments with Madoff and, in the process, deliberately or recklessly ignored red flags of fraud. While the Madoff trustee seeks to recover whatever he can for the many victims of the fraud, we have seen a number of cases outside of trustee-initiated lawsuits analyzing the complex relationships among investors, advisers and funds. These cases have the potential to further shape securities law jurisprudence in ways that, depending on the issue, might embolden or give pause to the plaintiffs' bar. Of particular note are three recent cases out of the Southern District of New York--relating to a seldom-used "fraud on the agent" theory and, separately, what it means to give advice "in connection with the purchase or sale of a security."
In re Beacon Associates Litigation, F.Supp. 2d, 2010 WL 3895582 (Oct. 5, 2010 S.D.N.Y.) involved claims, including federal securities claims, by a group of investors against, among others, the feeder funds in which they invested and advisers to the feeder funds. On the advisers' motion to dismiss, the advisers argued that they had no direct contact with the plaintiffs and, therefore, that the plaintiffs could not have relied on any of the allegedly misleading statements. The plaintiffs acknowledged that the advisers made no statements directly to the investors, but argued, under principles of agency law, that misrepresentations made to an agent--here, the feeder funds--are made to the principal as well.
The court noted that the "lack of direct communication between [the advisers] and Plaintiffs poses difficulties for pleading reliance." But the court acknowledged that it would be a "strange result to allow a third party to make misrepresentations to a principal's agent, misrepresentations which played a leading role in causing catastrophic investment losses to the principal and relatively minor harm to the agent himself, to permit the third party to escape liability to the principal under the federal securities laws." In reaching that conclusion, the court adopted a "fraud on the agent theory," which has the potential to greatly expand liability within--and even outside--the context of adviser suits and to make the pleading of reliance far easier for plaintiffs bringing federal securities claims.
The case also raises the question of how broadly courts will interpret the requirement that the advice be provided "in connection with the purchase or sale of a security"--an issue that, oddly, can work to the advantage of both plaintiffs and defendants. The advisers argued that their advice was not "in connection with the purchase or sale of a security" because the only security that the investors purchased was a share in the feeder fund, and the fund did not act as the investors' agent in making that investment decision. The court was compelled to analyze the complex relationship among investors, feeder funds, advisers and Madoff, and concluded that the advisers' alleged misstatements were, in fact, made "in connection with the purchase or sale of a security" because, among other reasons, the alleged misstatements related to the advisers' appraisal of Madoff (who purchased and sold securities), and the adviser consulted the funds about the allocation of investments, including in Madoff.
This interpretation of the "in connection with" requirement is not always unhelpful for companies finding themselves on the defense. Newman v. Family Mgmt. Corp., F.Supp. 2d, 2010 WL 4118083 (Oct. 20, 2010 S.D.N.Y.) and Saltz v. First Frontier, LP, 2010 WL 5298225 (Dec. 23, 2010 S.D.N.Y.) involved state law claims against sub-feeder funds of Madoff and the question of whether the claims were barred by the Securities Litigation Uniform Standards Act (SLUSA), which preempts state law claims in which defendants made a material misrepresentation in connection with the purchase or sale of a security. The sub-feeder funds, on their motion to dismiss, argued that certain state law claims were barred by SLUSA. The plaintiffs, not surprisingly, argued that SLUSA did not apply to those claims because the alleged misrepresentations by the sub-feeder funds related to the plaintiffs' purchase of shares in the limited partnership, and were too attenuated from the purchase or sale of securities by Madoff. The court, relying in part on the Beacon case, found that the alleged misstatements related, in part, to the diligence that was conducted of Madoff's trading strategy, and therefore were "in connection with the purchase of sale of a security" and thus barred by SLUSA.
It is not yet clear whether the Madoff-related cases will break any new ground. But what is clear is that the courts, in trying to untangle the various claims against those dealing with Madoff, may well be forced to test the limits of the securities laws, with potentially significant impact on the application of those laws going forward.