Madoff Investors Face Uphill Battle In Lawsuit Against SEC

Nov 22 2010 | 5:40pm ET

By Mikhail Iliev, Who's In My Fund? -- Several Madoff investors have just sued the Securities and Exchange Commission for personal injury claiming it was grossly negligent in handling the Madoff investigations and ignored a series of red flags about his activities, as reported by FINalternatives. But the investors will have their work cut out for them.

There  have been other lawsuits by Madoff investors against the SEC claiming negligence, but this case represents the first class action suit attempted against the SEC.

Although generally the US government can be sued for injuries caused by the negligence of its employees, it is excused of liability if the employees were given discretion to act.

Suits against the SEC face even more hurdles. For one, Congress specifically intended to exclude the SEC from the reach of the personal injury statute.

Congress also gave the SEC a lot of investigative and enforcement discretion when it wrote the securities laws. The body of these laws is littered with clauses providing that the SEC “may, in its discretion, make such investigations as it deems necessary” and “may in its discretion bring an action in the proper district court of the United States.”

Only one of the cases against the SEC, in California, has been resolved so far. There, the government used the “discretionary act” exclusion to defend against the investors’ claim that SEC investigators ignored numerous red flags and tips regarding Madoff and failed to communicate among one another about their conclusions.

The California court sided with the government and threw out the case ruling that the investors failed to prove the SEC had no discretion to decide “when to investigate, how to investigate, and whether or not to take enforcement actions.”

The complaint in the present case largely repeats the grievances in the California case. So, are investors here trying to do over and over the very same thing at which they have failed before? Or is there a new angle that investors can exploit?

“On the face of it, the suit is hardly novel and will likely fail,” Arrent Fox litigation partner Mark Radke told, “although this being a new suit in front of a different judge one never really knows.”

While the complaint itself is silent on the matter, reports in the press have indicated that investors may rely in part on the November 2009 Louisiana decision in In Re Katrina Canal Breaches Consolidated where the U.S. Army Corps of Engineers was found negligent in it operation and maintenance of a levee.

That case, however, may not be of much use here. “One should remember that in the Louisiana decision, the Corps was directly at fault in that they built and operated the levee that caused the damage,” Radke said. “Here, it was Madoff who caused all the losses not the SEC.”

The complaint does include the interesting claim that the SEC disregarded facts and allegations about Madoff because they were biased in favor of people such as Madoff “who were seen as reputable members of society.” But as the earlier California decision noted that only goes to show that employees of the SEC may have abused their discretion when investigating Madoff. And assuming employees had discretion to begin with, abuse of such discretion is specifically allowed by the same federal statute which the investors have used to bring their claim against the government.

Finally, let’s not forget the real world circumstances in which the SEC operates. The agency is understaffed and underfunded when compared to banking regulators. It is only able to inspect less than 10 percent of investor managers annually compared to its broker-dealer counterpart, the Financial Industry Regulatory Authority, which routinely inspects more than half of its members annually. No doubt, Congress was fully aware of these limitations and chose to grant the SEC a lot of discretion in picking and choosing how it expends its scarce resources.

All this, of course, should not detract from the fact that SEC proved inadequate in detecting and curbing Madoff’s Ponzi scheme. Aggrieved investors should have the right to seek relief for the SEC’s failures in the court of public opinion and ask for changes in the way the agency operates. However, seeking relief in the court of law seems a bridge too far.

“In this instance, it appears the investors are simply looking for deep pockets,” Radke said.  Indeed, none run deeper than those of the US government.

Mikhail Iliev is a contributing editor of Who's In My Fund?, a site which groups hedge fund investors by investment, allowing them to communicate directly and discretely with each other in a secure environment and share news and opinion on their investments. Mikhail practiced law for 11 years as an associate at Dewey LeBoeuf, LLP and as Senior Vice President at KBC Financial Products. He has extensive experience in the field of securities law and private investments and has advised clients on financing and offering matters for domestic and offshore funds, mergers and acquisitions and securities regulation. He is also a visiting professor at Segal Graduate School of Business in Vancouver, Canada where he has taught courses on securities regulation and ethics.

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