Should Sterling have spotted Madoff fraud?

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Disgraced Wall Street financier Bernard Madoff (center) arrives at a US Federal Court on March 12, 2009 in New York.

John Donnelly III, who successfully defended a net loser from a "clawback lawsuit" in the recent Allen Stanford fraud case, spoke with ESPN.com about how difficult it might be for trustee Irving Picard to prove Fred and Jeff Wilpon and Saul Katz knew, or should have known, Bernard Madoff was a fraud.

Picard is alleging the Wilpons put their heads in the sand in order to up the amount sought from $300 million in supposed false profits from the Ponzi scheme to the forfeiture of principal as well, which could raise a judgment to $1 billion.

Is there anything favorable to the defendants, or in terms of what Mr. Picard is alleging, anything particularly compelling in Section IX, which deals with whether the Wilpons and Saul Katz ought to have known something untoward was going on with Bernard Madoff?

“As you know, it is an absolutely gigantic complaint. And I have had a chance to go through it. One thing that jumps out to me is the receiver -- being Picard, the receiver/trustee, because it’s also in bankruptcy -- goes to great lengths to point out that the defendants named here had access to highly specialized, highly professionalized information and advice that the average investor who might get caught up in one of these schemes would have no have access to, in that they had basically their own investment entity, the Sterling Stamos entity the receiver calls it, that was allegedly advising them that there were red flags about Madoff, that there were problems and issues of lack of transparency and it was hard to replicate the exact strategy and get the same kind of returns. And I think that’s important, because the trustee is trying to distinguish these defendants from an average person who may not have had access to any specialized knowledge and is just looking at it from a less-than-refined perspective.

“One of the things that you’re likely to see from defendants in these cases when it comes to red flags, especially in a long-running Ponzi scheme, is something along the lines of, ‘How can you hold me responsible and say I should have realized something was wrong when the regulators who were supposed to be watching it didn’t pick up on it right away? So how can you hold me accountable for not noticing those red flags?’ And in some respects that can be a powerful argument if you’re just talking about a schoolteacher who has got a little extra money that they invest in something and they get caught up in a Ponzi scheme.

“But I think the receiver here -- and I think it’s one of the reasons that he goes into such great detail in this complaint -- is he really lays out a story and gives specific examples which he contends establishes that they had more than just the ordinary information, that they had access to some very sophisticated people in the industry, who were telling them that there were some red flags here, that there were problems here.”

I know that these are just allegations, not proven. But assuming those items in Section IX identifying the list of red flags can be substantiated at trial, compared to other cases where the defendants have been held liable for “unclean hands” and forfeited principal in addition to profit, how solid is this case? Would you say this is one of the stronger ones? Weaker?

“Well, it’s tough to handicap, and I know that’s somewhat of an unsatisfying answer when you’re trying to communicate it to the general public. But it is difficult to handicap because it is such a fact-specific inquiry.

“But, generally, leaving aside some of the detailed potential defenses like statute of limitations and other issues that may come into play, if you just take it that everything happened within the relevant time frame and is potentially recoverable and look at the red-flag issue, if the receiver can prove these up, then that shifts the burden to the other side to prove as an affirmative defense that they were innocent. That can be hard to do. These are certainly the type of allegations that if the receiver can prove [those], [it] could lead to a finding against the defendants that they should have known.

“I think he has in the complaint, and if it were to get to trial, I think the trustee would try to establish and differentiate these defendants from a run-of-the-mill investor, saying, ‘Hey, look, this is rarified air that we’re dealing with here. These people are extremely wealthy. They have access to this information.’ They were apparently, according to the allegations, caught -- and I say caught as an investor, not as a perpetrator -- in the Bayou Ponzi scheme a few years ago.

“That’s definitely worth a look as well, because prior to Madoff, that was one of the biggest ones going, and it got a lot of press back then. [So Picard would assert] they knew or should have known. And then the receiver tells a compelling story within his complaint as to why somebody might turn a blind eye toward indicia of fraud.

“But again, as you stated, it’s the receiver’s complaint. And the defendants have not had their opportunity to come back and state their view of the facts in their case, which I’m sure they will do.”

You already addressed the argument that if the government did not catch Madoff sooner, why should the Wilpons or Saul Katz have suspected fraud and known. But another factor they’re likely to bring up is, ‘Hey, look, we recommended people we have an affinity for to invest with Madoff. It’s not like we were trying to sucker other people into investing and have them lose their money to fuel Ponzi profits for us. Relying on Madoff being a family friend for years and years and years, we gave him the benefit of the doubt. We steered people who we have an affinity for to these funds because we thought it was aboveboard.’ Could that be a compelling defense?

“Sure, I think they can argue that. And if those are the facts, then it would be up to the trier of facts, a jury, to decide, ‘OK, which is which in terms of what’s happening?’ If they get to that point, if it gets to a trial and it didn’t resolve itself before trial, the defendants are going to have to try to reconcile the allegations of information, assuming there are facts to support the allegation, with their other actions. And they’re going to have to explain, ‘OK, we recommended this. Here’s why we recommended this. Here’s why we continued to invest even though we were told X, Y and Z -- that there were red flags, and this was dangerous,’ if that’s true.

“Yeah, you can certainly try to tell that story and say, ‘Wait a second. I’m innocent. I just got caught up in this. I had no idea that there was a fraud going on. And I couldn’t have known. If I would have known, I wouldn’t have put people that I love and care for in that type of position.’ And maybe that’s compelling.

“The other side is a lot of times these things come up when people are talking about it, and they say, ‘Well, who do you use [to invest]?’ Someone says, ‘Well, I use this guy and he’s been great. I’ve generated these great returns.’ And that’s how that other person gets involved. In a lot of Ponzi schemes, it is a lot of word of mouth, and people are introduced by friends or relatives. You hear stories from investors who say, ‘You know, when I first looked at it, it sounded a little too good to be true, but I know so-and-so, who told me, ‘No, I’ve already got a return on my investment,’ so this is legit.’ And they rely on that relationship and invest. And frankly that’s something that the Ponzi schemer is relying on, that the people that they’ve paid and who have realized these paper profits and gotten back some profits, even though they end up being false profits, are going to spread the word to their friends and family and it’s going to result in more business. In many of these Ponzi schemes there’s an air of exclusivity to it that can be very attractive for people. That’s part of what gets them caught up in something that when they step back they say, ‘Geez, maybe that wasn’t a good idea, but I had these examples of other people I know and trust having already done well.’”

I’ve talked to experts last week and pretty much covered it, but I wanted to make sure you don’t see it differently: If Irving Picard can substantiate that from certain funds $300 million was withdrawn over principal, even if other funds had lost money that Sterling possessed, is it fairly established at a bare minimum that the judgment -- even if there was no knowledge, no should have known -- that the $300 million would be the base number for the award?

“I agree, with a slight caveat. I would phrase it this way: that the general rule in these types of Ponzi schemes is that false profits are going to go back to the estate. The so-called ‘net winners’ have to disgorge their profits. The question I have with those additional accounts is: How do you factor in what is a profit? And I don’t know the details about the accounts.

“For example, if you had in your name five different accounts at a Ponzi scheme for a total of a $100,000 investment. I’m going to say there are five accounts of $20,000 each. And on two of those accounts you cashed them out and you get $30,000 for each of them. You can look at that and say, ‘OK, on those accounts, you had a profit of $10,000 on each -- total profit of $20,000. You have to give that back.’ Alternatively, even though they’re under separate numbers, if they’re all under your name, and just your name, so that it’s your account, and there is no distinguishing it with an account with, say, you and your parents or your wife or what have you with somebody else, if you’re the defendant, you’re going to argue: ‘No, no, no. That needs to be concluded together. You need to look at my total investment of $100,000. I only got $60,000 out. I’m actually a net loser of $40,000. Just because I put them under separate numbers for accounting reasons, it’s still my money.’”

What the defense attorneys said in their press release last Friday is that Picard has selectively picked accounts that had false profits of $300 million, but other accounts he did not include had net losses of $160 million. So even if you accept the $300 million figure, at most the net false profit should be $140 million, if I understood it correctly.

But I suppose the counter to that from Picard would be that there were 483 accounts administered through Sterling, with different incorporations and variations of owners. So the ‘net loser’ accounts under normal circumstances would just get in line with other Madoff victims for a payout from the trustee. But since Sterling had ‘unclean hands,’ assuming that’s proven, those ‘net loser’ funds are subordinated and go to the back of the line and get nothing, while the false profit accounts are responsible for paying back $300 million in extra withdrawn over principal, plus the principal.

“That does seem to be a complex and fair summary. The devil on that is going to be in the details, which are out there to some extent. But the information is so large. The trustee has been living with it presumably for a long time and has nailed that down. And it’s just not clear to me from the outside exactly what the breakdown is on the accounts. That doesn’t surprise me. So the defense is going to try to loop them in together. But if they are registered separately under different entities, the receiver would have a pretty good argument for, ‘No, those are separate entities.’”

Is my understanding correct that you actually have represented a ‘net loser’ in a case, so you’ve had direct experience with this?

“Yes, I have. In 2009, in the [R. Allen] Stanford fraud, which was based out of Texas and had things in Antigua, it was discovered maybe about two months after Madoff. There were actions going on down there. It started out in Dallas in terms of the court. And we represented an investor on appeal who was a net loser, but who had gotten some proceeds back. What the receiver in that case had tried to do was take the position that anybody who got anything back, even if you were a net loser, would have to disgorge that money -- put it back in the estate, and then get in line with everybody else to get whatever they could recover. So you’d get 10 cents on the dollar, or something like that. And we were able to prevail in that case. Ultimately, the Court of Appeals agreed with our side, and there were some other defendants aligned with us. And the SEC was on our side, saying, ‘No, no, no. That’s not how it works. If you’re a net loser and you’ve got some money back, you can keep that up to your principal. And then when you start getting those profits, you’ve got to give the profits back because in a Ponzi scheme there are no profits. It’s all a big sham.’”

John V. Donnelly III joined Cozen O’Connor’s Philadelphia office in April 2009 as a member in the Commercial Litigation Department. Prior to joining the firm, he was an associate with Dechert LLP in Philadelphia and Covington & Burling in Washington, D.C.

John has extensive experience in complex commercial litigation matters. He has represented corporations and individuals in securities fraud class actions; financial services litigation; breach of fiduciary duty cases, and contract disputes. He has also conducted internal investigations for numerous companies, and represented companies and individuals in connection with government investigations and other matters concerning white collar crime.

Representative Matters

• Represented Select Medical Corporation and individual company officers in class action securities litigation

• Represented Adelphia Communications Corporation in billion dollar accountants’ liability litigation resulting from financial wrongdoing and subsequent collapse of Adelphia

• Recovered frozen funds on behalf of individual in connection with the alleged $7 billion Ponzi Scheme of Stanford International Bank

• Represented the directors of a Cayman Islands-based hedge fund in breach of fiduciary duty and negligence claims arising out of a $180 million fraud committed by the fund’s investment advisor

• Conducted internal investigations for publicly traded companies, including several Fortune 500 companies

An active author, John wrote “Faced with a Government Civil Investigation? Beware, More Danger May be Lurking Beneath the Surface -- The Ninth Circuit’s Recent Decision in U.S. v. Stringer?,” which was published in the Securities Regulation Law Journal (2008). He is a member of the Philadelphia Chapter of the American Bar Association’s White Collar Criminal Defense Group and its Young Lawyers Steering Committee.The Legal Intelligencer.

John earned his law degree from Harvard Law School, where he was a member of the Journal on Legislation, and his undergraduate degree, cum laude, from Harvard College. Following law school, he served as a law clerk for the Hon. Ronald Legueux of the U.S. District Court for the District of Rhode Island.