Aiding and abetting, a Madoff family affair: why secondary actors should be held accountable for securities fraud through the restoration of the private right of action for aiding and abetting liability under the federal securities laws.

Author:Nunziato, Melissa C.

In the first few weeks of December 2008, Bernard L. Madoff confessed to running what he described as, "basically, a giant Ponzi scheme." (1) In reality, what Madoff described in such modest terms was a scheme of massive proportions, what has been referred to as "America's largest financial fraud ever." (2) The exact scope of the Madoff scheme is still unraveling; however, it is estimated that thousands of investors lost somewhere between twenty and sixty-five billion dollars. (3) Madoff purported to invest the savings of some four thousand clients, and these investors spanned across forty-eight of the fifty states, (4) as well as throughout Europe, Latin America, and Asia. (5) But it all was a sham, perhaps from the very beginning.

In part, what makes the Madoff affair so notable is that Bernie Madoff and his family members were well-known and respected in the securities industry. Many members of the Madoff family held securities licenses, were considered experts in the field, and worked alongside Bernie in his brokerage business. Despite their involvement and expertise in the business, to date none of the family members other than Bernie Madoff have been held liable for participating in the scam. Indeed, the current regulatory framework insulates them from private civil liability. On July 30, 2009, however, Senator Arlen Specter, on behalf of himself and cosponsors Edward Kaufman, John Reed and Sheldon Whitehouse, introduced S. 1551, the Liability for Aiding and Abetting Securities Violations Act of 2009, which would reinstate a private cause of action against those alleged to have aided and abetted securities fraud violations under section 20 of the Securities Exchange Act of 1934. (6) This Comment discusses how the Madoff family represents a class of potential defendants who remain shielded from private civil liability because investors are unable to bring causes of action against those who aid and abet securities fraud, and proposes that Senator Specter's bill is the appropriate mechanism to restore the right of private litigants to sue aiders and abettors. Part I of this Comment discusses the Madoff Affair, including Madoff's massive Ponzi scheme and how the scam went undetected by regulators for nearly half a century. Also discussed in Part I is how the brokerage firm that Bernie Madoff began in 1960 was a family business, the role that the Madoff family played in its operation, and the inability of investors to seek retribution from alleged secondary actors like the Madoff family. Part II outlines the history of the private cause of action under section 10(b) of the Securities Act and SEC Rule 10b-5. Specifically, Part II examines the implication of the private cause of action for aiding and abetting securities fraud, and the significant case law and legislation that have impacted the right of private litigants to pursue secondary actors. Finally, Part III discusses the ability of Senator Specter's bill to reinstate the private right of action for aiding and abetting liability. This Comment concludes that there is a need to restore the private right because the current enforcement mechanisms by the Securities and Exchange Commission are insufficient.


    1. The Madoff Ponzi Scheme: "America's Largest Financial Fraud"

      Madoff got his start in the securities industry after graduating from Hofstra University in Long Island, in 1960. (7) He began his brokerage business, Bernard L. Madoff Investment Securities (BMIS), on Wall Street in Downtown Manhattan, and later moved his entire operation to Midtown, where he occupied the seventeenth, eighteenth, and nineteenth floors of the Lipstick Building. (8) Many of Madoff's early customers were referrals from an accounting firm, Alpern & Heller, owned and operated by Sol Alpern, Bernie Madoff's father-in-law. (9) The accounting firm would later be taken over by Frank Avellino and Michael Bienes, who would go on to raise over half a billion dollars in referrals for Madoff. (10)

      Madoff first became well-known on Wall Street through his successful brokerage business. (11) Madoff was an accomplished market maker, (12) and as such he alone handled over tive percent of the stocks sold on the New York Stock Exchange by 1989. (13) Additionally, BMIS was one of the first five broker-dealers to incorporate the NASDAQ (National Association of Securities Dealers Automated Quotation system) into its trading business and take advantage of its potential for efficient trading. (14) Madoff also assisted in the creation of the Intermarket Trading System ("ITS"), which later "exploded onto Wall Street." (15) Additionally incorporated into the firm was software designed by Bernie's brother, Peter Madoff, allowing BMIS to execute trades at the best price possible in a matter of seconds. (16) BMIS was one of the first firms to utilize computerized trading techniques, and from it, Madoff was able to make a fortune in the market by helping to "revolutionize trading." (17)

      It now seems apparent that while all of these innovations furthered Bernie Madoff's success as a trader and market maker, his knowledge of the markets and compliance rules also enabled him to create and operate his Ponzi scheme. At some point after 1960, (18) Madoff began a highly exclusive investment advisory business, and selected customers from his brokerage firm to invest into his advisory business in order to fuel his scheme. (19) Although many were under the impression that Madoff ran his own hedge fund, (20) Madoff denied being a manager of--or even an advisor to--a hedge fund; rather he claimed that he only executed a particular trading strategy for his hedge fund clients, known as the "split-strike H conversion." (21) Madoff's strategy did not purport to be a get-rich-quick scheme (at least not for his investors). Rather, the goal of the investment strategy was to yield steady and average returns with minimal risk, which is what made it so appealing to so many investors. (22) In reality, Madoff kept his existing clients happy by paying them consistent returns using money that came in from new clients or existing clients who were looking to increase their investments.

      At the peak of his scheme, Madoff reported that his firm BMIS had "'more than $700 million in firm capital [and] ... rank[ed] among the top 1% of US Securities firms.'" (23) He also represented that his advisory business operated with over seventeen billion dollars in assets under management. (24) Nonetheless, even Bernie Madoff could not avoid the impact of the market losses of the financial crisis in 2008. By definition, a Ponzi scheme requires a steady flow of income in order to stay afloat; (25) however, during the latter half of 2008, rather than contributing money to Madoff, his investors were looking to pull out. As was typical in the past, when Madoff received requests from his advisory clients to withdraw portions of their assets, he could cover the costs of the withdrawals using investments from other clients. However, in 2008 Madoff faced redemption requests from clients totaling about seven billion dollars, and Madoff was unable to keep up with his clients' demands for cash. (26) On December 10, 2008, unable to sustain the facade any longer, Madoff admitted to his sons that his advisory business was all "one big lie," and that all the money was gone and the business was insolvent. (27)

    2. Regulatory Loopholes and Enforcement Mishandling Allow Madoff to Avoid Detection

      While Madoff was eventually arrested and charged with fraud, he managed to fool investors and regulators for almost half a century. So how did he pull it off? While many agencies, including the Federal Bureau of Investigation ("FBI"), the Department of Labor-Employee Benefit Security Administration ("DOL-EBSA"), the Internal Revenue Service ("IRS") and t he Securities and Exchange Commission ("SEC"), have all been involved in the investigation of the scheme since its unraveling (and some before that), (28) it seems that Madoff was able to locate and exploit regulatory loopholes and inefficiencies in order to keep his "advisory business" highly secretive and successful. As one author wrote, "[t]here are no heroes in the Madoff story; only villains and suckers." (29) While this explanation is overly simplistic and unsympathetic (especially to victims who unknowingly invested their savings through feeder funds which utilized, but did not identify Madoff as their hedge fund manager), the general theme is appropriate in terms of regulation and regulators. Although Madoff publicly claimed that he managed over seventeen billion dollars in assets, (30) he did not register with the SEC as an investment advisor until 2006. (31) Up to that point, Madoff insisted that he was not required to register as an advisor because he claimed to have less than fifteen discretionary accounts, thus qualifying for a broker-dealer exemption. (32) This allowed Madoff to be subject to less regulatory oversight by the SEC and FINRA, which only conducted examinations related to Madoff's broker-dealer firm on the eighteenth and nineteenth floors of the Lipstick Building. (33) In fact, these two regulators were totally clueless as to the fact that Madoff ran any operation at all on the seventeenth floor. (34) Additionally, regulators were under the impression that Madoff was running a hedge fund. (35) Madoff flew under the regulatory radar because hedge funds are neither required to register with the SEC nor subject to the same reporting requirements as other types of investments. (36)

      In addition to loopholes and problems associated with the American "patchwork" system of regulation of the financial industry, (37) Madoff also avoided detection in part because regulators missed and/or ignored significant red flags. The SEC's Office of the Inspector General ("OIG")...

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