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CLAIMS ON THE SEC
FROM Madoff Theft
Jaime Cuevas Dermody 561 278-4100
jaime@fe.net
12
October 2009
ã Financial Engineering 1 LLC,
2009
(0.)
INTRODUCTION
In Section (1.) we analyze a tort liability of the
Securities and Exchange Commission (“SEC”) under the
Federal Tort Claims Act (“FTCA”), as amended (28
U.S.C.
§
1346(b), 2671-2680).
This tort stems from the:
(i.) failure of the SEC
line auditor to comply with its own procedures in auditing
Bernard L. Madoff Investment Securities LLC and Bernard L.
Madoff Investment Advisors LLC,
(ii.) the SEC line
auditor falsely purporting to have conducted an audit in
1999 and in 2004, and
(iii.) the subsequent loss
manifest by Mr. Madoff’s 11 December 2009 announcement that
the operation of his client’s managed accounts was a
multi-billion-dollar Ponzi scheme.
Section (2.) considers the
specific types of losses involved, and Section (3.) briefly
outlines the procedure for such client’s to seek relief from
the SEC. Note that the Congressional Research Office has
prepared an insightful and far-more general analysis of both
the Federal Tort Claims Act and the important court cases
related to it.
That report was a guide to this analysis.
(1.)
SEC LIABILITY
There is a long,
well-established common-law doctrine of sovereign immunity
for national governments. This was articulated in many
court decision, most notably in the Supreme Court case of
Federal Housing Administration v. Burr, 309 U.S. 242,
244 (1940). Under this doctrine, tort relief from a
sovereign requires the sovereign’s consent. In the United
States this was accomplished by the Senate passing a bill
for each case. In 1946 the Congress sought its own relief
from the volume of such bills, by granting statutory waiver
of sovereign immunity for a broad class of torts. This law
was revised as cited above in 1948.
With four major classes of
exception, it made the United States liable:
“….
for injury or loss of property, or personal injury or death
caused by the negligent or wrongful act or omission of any
employee of the government while acting within the scope of
his office or employment, under circumstances where the
United States, if a private person would be liable to the
claimant in accordance with the law of the place where the
act or omission occurred.”1
Two of these classes are
basically statutory. The first appears in 28 U.S.C. §
2680(h) and is know as the Intentional Tort Exception. It
excludes from the FTCA, torts: “….arising out of
assault, false imprisonment, false arrest, malicious
prosecution, abuse of process, libel, slander,
misrepresentation, deceit, or interference with contractual
rights. ….” unless committed by “…. investigative or law
enforcement officer of the United States Government.”
The second exception is that any liability under the FTCA
stems only from a “negligent or wrongful act or omission” in
28 U.S.C. § 1346(b). This precludes “strict liability”
(i.e., tort without culpability). See Dalehite v. U.S.,
346 U.S. 14, 44-45 (1953).
The third major class of
exception arose in Feres v. U.S., 340 U.S. (1950) and
excludes injury to military personnel in the line of duty.
In that case, the Supreme Court read the FTCA “to fit, so
far as will comport with its words, into the entire
statutory scheme of remedies against the Government to make
a workable, consistent and equitable whole.” See that
case at 139.
These major classes of
exception and several minor exceptions, like the postal
exception (28 U.S.C § 2680(b)) are clearly not applicable to
the tort liability at hand. We are thus left with the
discretionary function exception as the only one potentially
at issue here. This exception is based on 28 U.S.C. §
2680(a) and precludes Government liability from torts
“based upon the exercise of performance or the failure to
exercise or perform a discretionary function”. The most
famous interpretation of this exception is found in
Dalhite v. U.S., 346 U.S. 15 (1953). The Supreme Court
defined that discretion by these words in that case at
34-36:
“is
the discretion of the executive or administrator to act
according to one’s judgment of the best course …. It ….
Includes more than the initiation of programs and
activities. It also includes determinations made by
executives and administrators in establishing plans,
specifications or schedules of operations. Where there is
room for policy judgment and decision there is discretion.
It necessarily follows that the acts of subordinates in
carrying out the operations of governments in accordance
with official directions cannot be actionable.”
The
Supreme Court put a finer point on this interpretation in
Berkovitz v. U.S., 486 U.S. 531 (1988):
“a court must first
consider whether the action is a matter of choice for the
acting employee …. Conduct cannot be discretionary unless it
involves an element of judgment or choice …. Thus the
discretionary function exception will not apply when a
federal statute, regulation, or policy specifically
prescribes a course of action for an employee to follow. In
this event, the employee has no rightful option but to
adhere to the directive …. The exception …. protects only
governmental actions and decisions based on considerations
of public policy.”
In
the 1999 and 2004 SEC audits of Bernard L. Madoff Investment
Advisors and Bernard L. Madoff Investment Securities, the
same line SEC auditor failed to follow even the most
rudimentary of SEC procedures. In fact he failed to follow
any established audit procedure. The most basic of any
audit procedure is to confirm the assets of an enterprise,
in this case the securities purchased in the Client’s
managed accounts. Since no assets were ever purchased,
there was no sample ever taken. No executive or
administrative policy or procedure directed such failure,
nor was there such to lie about it by signing the SEC
finding of no violation of compliance, and thus purporting
to have conducted an SEC audit. Hence, the S.E.C employee’s
acts of omission and commission are not exempt from the
statutory waiver of sovereign immunity afforded by the FTCA.
We
find a clear match for this SEC liability in comparing two
Supreme Courts decisions. In Berkovitz v. U.S. cited above,
the Supreme Court held that the National Institute of
Health’s (then) Division of Biologic Standards and the Food
and Drug Administration’s Bureau of Biologics (“NIH and
FDA”) could be held liable for failing to follow their
own regulations. In this case plaintiffs claimed that these
agencies:
“adopted a policy of testing all vaccine lots for compliance
with safety standards and preventing the distribution to the
public of any lots that fail to comply. …. Further allege
that notwithstanding this policy, which allegedly leaves no
room for implementing officials to exercise independent
policy judgment, employees of the Bureau knowingly approved
a lot that did not comply with safety standards.”
The
Supreme Court distinguished this case from U.S. v. Varig
Airlines, 467 U.S. 797 (1984), where it applied the
discretionary function exemption to the Federal Aviation
Administration’s (“FAA”) policy of only spot checking
aircraft of a given type, rather than checking every
plane. In that case FAA employees carried out the
administrative policy, in marked contrast to the NIH and FDA
employees above that failed to carryout the administrative
policy of their agencies. U.S. v. Varig Airlines
applied the standard set in Dalehite v. U.S.:
“Here, the FAA has determined that a program of “spot
checking” manufactures’ compliance with minimum safety
standards best accommodates the goal of air transportation
safety and the reality of finite agency resources. Judicial
intervention in such decisionmaking through private tort
suits would require the courts to “second guess” the
political, social, and economic judgments of an agency
exercising its regulatory function …. It follows that the
acts of FAA employees in exercising the “spot check” program
in Accordance with agency directives are protected by the
discretionary function exemption as well …. The FAA
employees who conducted compliance reviews of the aircraft
involved in this case were specifically empowered to make
policy judgments.”
(2.) TYPES OF DAMAGES
The
most obvious loss in the Madoff managed accounts is the
contributed capital that was lost by clients. A more subtle
loss of many investors is the opportunity cost of earnings
on their contributed capital. If an investor had not
invested in the Madoff managed accounts, say because the SEC
had audited them, and thus discovered that there were no
assets in the managed accounts, then the investor would have
earned some return on that contributed capital elsewhere.
The question is what return.
One
answer is the return earned on the client’s other
investments during the time of their Madoff accounts
purported to exist. A lazy judge might prefer the
simplicity of one of the Applicable Federal, either short-,
mid-, or long-term. To make a Madoff victim whole as Tort
law is designed to do, we would need to find what they would
have earned if the SEC had actually performed the first
Madoff audit in 1999 or not false signed the letter
purporting to have conducted an audit. This, in turn,
requires an examination of the other investment
opportunities they faced. We can use the purported return
up to 11 December 2009, as an upper bound on this return.
(3.) CLAIM PROCEEDURE
Within two years of
first discovering the tort and its cause, the victim must
present a claim to the federal agency whose employee(s) gave
rise to the claim (28 U.S.C.
§ 2675).
If that agency mails a denial of that claim within six
months, then the victim has six months to file suit in
Federal District Court (28
U.S.C.
§ 2401, 2675). Otherwise, there is no time limit on filing
suit.
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