This Week In Securities Litigation (January 9, 2009)

This week, the Madoff scandal continued to dominate securities litigation news. Congressional hearings opened in the House of Representatives about the matter with testimony from the SEC’s Inspector General, who is conducting an internal inquiry regarding the Commission’s investigative efforts in this matter. The Senate, as a prelude to its hearings, sent the SEC a document request for all its Madoff related documents. In each of these inquiries, the SEC will undoubtedly have to explain why it did not discovery the claimed Madoff Ponzi scheme earlier.

The Commission filed two enforcement actions this week based on alleged Ponzi schemes. In addition, the Justice Department brought two criminal cases based on earlier SEC enforcement actions which named alleged Ponzi scheme operators as defendants. The Department also continued to focus on FCPA enforcement, bringing another case in which an individual pled guilty. Finally, Cornerstone Research reports that the number of securities class actions filed last year increased significantly.

The Madoff Scandal

The U.S. House of Representatives began hearings this week regarding the Madoff scandal with the testimony of SEC Inspector General H. David Kotz. SEC Chairman Cox had previously asked Mr. Kotz to conduct an internal investigation into what happened in earlier Commission investigations and inspections regarding Madoff. In his congressional testimony, Mr. Kotz promised a full and complete inquiry which will be significantly broader than the one requested by Chairman Cox. Mr. Kotz’s testimony is discussed in detail here.

The Senate is also planning hearings into the question of why the SEC failed to discover the Madoff Ponzi scheme earlier. In anticipation of those hearings, the Senate Banking Committee sent the SEC a request for the production of all documents relating to its inquiries and inspections of Mr. Madoff and his entities, as discussed here.

Both the House and Senate hearings are likely to focus on matters such as the case opening and closing forms from a 2006 SEC inquiry into Mr. Madoff’s activities, also discussed here. Those documents state that the SEC received allegations from a source deemed credible that Mr. Madoff was conducting a Ponzi scheme. The SEC documents also state that Mr. Madoff had violated the securities laws and that one of his largest hedge fund investors failed to adequately disclose to its shareholders that their funds were invested with Mr. Madoff. Nevertheless, the preliminary inquiry was closed.

The Madoff scandal is also spawning private litigation. Essentially, there are two groups of private suits as discussed in detail here. One is the typical securities damage suit against Mr. Madoff and his entities. The second, which may be the harbinger of the future, is by investors the so-called “feeder” funds (like the one discussed above in the SEC documents). The feeder funds placed investor money with Mr. Madoff for investment.

Finally, in the criminal case against Mr. Madoff, prosecutors requested that the Court revoke Mr. Madoff’s bail. The request was based on a claim that Mr. Madoff violated an asset freeze order by giving about $1 million in goods to relatives. Defense attorneys deny this claim, although they admitted Mr. Madoff did give some items to family members. Both sides have submitted briefs on the issue. A ruling is expected Friday.

SEC enforcement

The SEC brought two enforcement actions this week based on claimed Ponzi schemes it did discover:

SEC v. Forte, Case No. 2:09-cv-00063 (E.D. Pa. Filed Jan 7, 2009) (alleging a $50 million Ponzi scheme from 1995 to the present); and

SEC v. Gen-See Capital Corp., Civil Action No. 09 CV 0014 (W.D.N.Y. Filed Jan. 8, 2009) (alleging a Ponzi scheme which has raised millions of dollars).

In addition, the Department of Justice recently brought two criminal cases based on claimed Ponzi schemes where the Commission had brought actions earlier:

U.S. v. Steinger, Case No. 08-21158-CR (S.D. Fla. Filed Dec. 23, 2008) (alleging a $1.25 billion Ponzi scheme; the SEC previously filed an emergency action which halted the scheme in 2004 as noted here); and

U.S. v. James, Case No. 2:08-CR-20674 (E.D. Mich. Filed Dec. 23, 2008) (alleged Ponzi scheme based on an earlier SEC action, SEC v. James, Case No. 08-61516 Civ. (S.D. Fla. Filed Sept. 24, 2008).

FCPA

The focus on FCPA enforcement continued with the entry of a guilty plea by Mario Covino, an Italian citizen residing in California who was employed by an Orange County, California based manufacturing company. U.S. v. Covino, Case No. 8:08-cr-00336 (C.D. Cal. Filed Dec. 17, 2008).

According to the information, Mr. Covino paid about $1 million in bribes between March 2003 and August 2007 to secure business. The bribes were paid to officials in Brazil, China, India, Korea, Malaysia and the UAE. Mr. Covino also admitted providing false information to internal auditors during an inquiry into the payments and to deleting e-mails. The company reportedly earned about $5 million in profits from the contracts secured through the corrupt payments.

Mr. Covino pled to a one count information charging conspiracy to make corrupt payments in violation of the FCPA. Sentencing is scheduled for July 20, 2009.

Private litigation

Last year, there was a 19% increase in the number of federal securities class action suits compared to the prior year, according to Cornerstone Research. Specifically, in 2008 there were 210 class action complaints filed compared to 176 in the prior year. About half of the cases filed were against companies in the financial services sector.

The SEC And The Madoff Scandal: Can The Commission Restore Confidence In Its Ability To Protect Investors?

Disclosures regarding the Madoff scandal continue to paint a grim picture for the SEC’s ability to fulfill its statutory obligations. The Senate banking committee sent the SEC an extensive document request in preparation for hearings about the agency’s role in the Madoff matter. What will be produced in response? At a minimum, the response should include documents from the 2006 informal inquiry opened to investigate claims that Mr. Madoff ran a Ponzi scheme and deceived the SEC staff which closed by the New York office after talking to Mr. Madoff and one of his largest hedge fund clients with a recommendation of no enforcement action.

The Senate hearings into what happed when the SEC investigated and inspected the operations of Mr. Madoff are beginning with a letter to the SEC by the Senate Committee on Banking, Housing and Urban Affairs. That letter, dated January 5, 2009, requests the production all document relating to prior SEC and FINRA examinations and investigations of Bernard L. Madoff, LLC (“BLM”) including: 1) complaint letters from market participants regarding Mr. Madoff and his operations; 2) a complete list of SEC and FINRA examinations of Mr. Madoff’s firm; 3) all internal communications regarding BLM; and 4) all e-mails between SEC staff and personnel at the Madoff firm.

What will the Committee find as a result of its document request? At a minimum, the Committee should review the opening and closing documents to a 2006 informal inquiry into BLM by the SEC’s New York office — and that will be more than enough to spark many questions about the SEC’s investigations.

The internal SEC documents from that investigation establish that that, beginning in January 2006, the SEC’s New York Regional Office opened and closed an investigation involving Bernard L. Madoff Securities LLC and two of its largest hedge fund clients. According to the Case Opening Report, the informal inquiry began with a report that BLM “operates an undisclosed multi-billion dollar investment advisory business … as a Ponzi scheme.” The evidence is from an undisclosed source who had provided helpful information in the past, according to the SEC documents.

Although the report from the confidential informant lacked detail, in view of the amounts involved, the staff obtained the production of documents BLM and the two hedge fund customers. Those customers were Fairfield Sentry Limited and Greenwich Sentry, L.P., affiliates of Fairfield Greenwich Group. In addition, a voluntary interview of a BLM officer was conducted.

Based on the then-available evidence, the Case Opening Report concludes that: (1) BLM was an undisclosed investment advisor to the hedge funds; (2) during an examination of BLM by the staff “Bernard L. Madoff — mislead the examination staff about the nature of the strategy implemented in the Sentry Funds’ and certain other hedge fund customers’ accounts, and [3] also withheld from the examination staff information about certain of these customers accounts … .” Finally, the report notes that BLM acted as an unregistered investment advisor to other hedge funds. This evidence warranted further inquiry according to the Case Opening Report.

The scope of the subsequent inquiry can be ascertained by reviewing the Case Closing Recommendation form which summarizes the available evidence and conclusions from the inquiry. Investigators took the informal testimony of two additional witnesses — Bernard Madoff and a representative of Fairfield. At that point, investigators recommended that the inquiry be closed.

The conclusions in the Case Closing Recommendation largely reiterate those from the Case Opening Report: 1) BLM acted as an investment advisor to certain hedge funds, institutions and high net worth individuals without complying with the registration requirements of the Investment Advisor’s Act; 2) Fairfield’s disclosures to its investors did not adequately describe BLM’s advisory role; and 3) during a recent examination of BLM by the New York Regional office, Mr. Madoff “did not fully disclose to the examination staff either the nature of the trading conducted in the hedge fund accounts or the number of such accounts at BLM.”

Despite finding violations of the federal securities laws and a lack of candor by Mr. Madoff, the report recommends that the inquiry be closed. This conclusion is based on the fact that BLM and Fairfield voluntarily remedied the violations and “because those violations were not so serious as to warrant an enforcement action.”

Neither the Case Opening Report nor the Case Closing Recommendation discusses the accusation by the confidential informant that the unregistered investment business of Mr. Madoff was a Ponzi scheme. In fact, the Ponzi scheme allegation in the Case Opening Report is not specifically mentioned or discussed in the Case Closing Recommendation. While that Recommendation does state that the confidential informant claimed the investment returns for hedge fund clients were the result of fraud, it does not discuss or analyze that allegation. Likewise, the Recommendation does not mention what investigative steps, if any, were taken to explore either the Ponzi scheme or fraudulent returns questions.

Even if these are the only documents furnished to the Committee, SEC officials will have more than enough questions to answer when they appear for testimony. And, perhaps more importantly, the SEC will have a lot to do to convince a panel of skeptical Senators and the investing public that it can in fact fulfill its statutory mandate and protect investors in the future.