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Legal Update

Southern District Court of New York Holds “Red Flags” Insufficient to Allege Scienter in Madoff-Related Federal Securities Class Action

13 January 2011
Mayer Brown Legal Update

Judge Leonard Sand of the District Court of the Southern District of New York recently dismissed securities and common law fraud claims asserted by investors against a “fund of funds” that invested with Bernard L. Madoff Securities LLC (BMIS) for failure to adequately allege scienter. Saltz v. First Frontier, LP, No. 10 Civ. 964 (S.D.N.Y. Dec. 23, 2010). 

Specifically, Judge Sand rejected plaintiffs’ argument that a “sub-feeder” fund, First Frontier LP (the “FF Fund”), knew or should have known about “extremely obvious red flags” because they were public knowledge. The court dismissed plaintiffs’ securities fraud claims against the FF Fund because they failed to allege that the FF Fund acted with “conscious recklessness” or had “motive and opportunity to commit fraud.” 

Plaintiffs invested with the FF Fund with the understanding, based on the offering materials, that the fund would invest substantially all of its assets with BMIS. The FF Fund did not deal directly with BMIS, though. Rather, it invested in a feeder fund, Beacon Associates LLC (the “Beacon Fund”). The Beacon Fund engaged Ivy Asset Management Corporation (Ivy) to provide it with advice regarding the selection and allocation of the Beacon Fund’s assets among investment manager and investment pools. And, according to the complaint, Ivy was Beacon Fund’s link to Madoff. It is important to note that plaintiffs knew nothing about the Beacon Fund or Ivy’s involvement until after Madoff’s fraud had been revealed.

Plaintiffs identified a number of purported “red flags” that were publicly known prior to the official announcement of Madoff’s fraud. These included Madoff’s consistent investment returns, the secrecy of his strategy, his unusual fee structure, his claims that he bought near daily lows and sold near highs with “uncanny consistency,” reported results that were inconsistent with his split-strike trading strategy and that fact that he had an unknown two-man operation audit his business. Plaintiffs alleged that the FF Fund acted with “conscious recklessness” because it knew or should have known about the red flags and that “they had an obligation to investigate but did not.” 

According to the court, plaintiffs’ theory has been routinely rejected where, as in this case, plaintiffs offered no evidence that defendants were actually aware of most of the alleged red flags, and those red flags that defendants were aware of were not so serious as to permit an inference of intent to defraud. After citing a string of recent decisions within the district, the court continued that “[f]or twenty years, Madoff operated this fraud without being discovered and with only a handful of investors withdrawing their funds as a result of their suspicions. An inference of scienter based on publicly available red flags is simply not as cogent and compelling as the opposing inference of nonfraudulent intent.”

Judge Sand’s analysis in this regard is particularly interesting because several of the complaints launched against “fund of funds” contain similar allegations that red flags should have alerted the funds to Madoff’s fraud. It will be interesting to see how this case, as well as several other recent and analogous decisions, affect private litigation related to Madoff’s fraud moving forward.

For more information about this decision or any other matter raised in this Legal Update, please contact , , or .

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