Implications for banks as Madoff litigation grinds on

Peter J. Henning
Financier Bernard Madoff leaves Manhattan Federal court March 10, 2009 in New York City.
Mario Tama | Getty Images

It has been nearly five years since the Ponzi scheme perpetrated by Bernard L. Madoff came to light, and litigation surrounding the case grinds on.

The trustee seeking to recover funds for defrauded investors, Irving H. Picard, asked the Supreme Court to overturn a lower court decision barring him from pursuing banks for their role in helping perpetuate the fraud.

Meanwhile, the prosecution of five former employees of Mr. Madoff's firm began last week. The criminal trial is likely to expose more tidbits about the operation of the long-running fraud, including lurid details about sexual liaisons among staff members involving perhaps even Mr. Madoff himself. Yet, despite the titillating aspects of the case, it is really more of a footnote to his scheme.

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The more important case concerns Mr. Picard's efforts to recover funds from a number of banks, including JPMorgan Chase, UBS, HSBC and UniCredit. He accused them of aiding in the Madoff scheme by ignoring warning signs about the fraud that allowed it to grow. As time went on, the scheme cost investors about $17 billion, and wiped out billions more, as they were led to believe the money was safely in their accounts.

The trustee's claim against JPMorgan alone seeks nearly $19 billion, so recovering even a portion of that amount could add significantly to the $9 billion Mr. Picard has already gathered to compensate investors.

As is frequently the case, the issue is not about the banks' role in the fraud—at least not yet. Rather, it focuses on whether certain arcane legal doctrines will permit the lawsuits to move forward. The banks have been successful in obtaining dismissals of the complaints on the ground that Mr. Picard does not have the authority to pursue claims on behalf of the defrauded investors.

The initial problem Mr. Picard faced is a doctrine called "in pari delicto," or mutual fault, which prevents a firm from suing others for their role in its own misconduct. The New York Court of Appeals, the state's highest court, explained in a 2010 decision involving the failed futures firm Refco that this "principle has been wrought in the inmost texture of our common law for at least two centuries."

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As the trustee for Mr. Madoff's failed securities firm, Mr. Picard took over its claims—in a sense, "stepping into the shoes" of the entity. That also means any defenses that could be asserted against Mr. Madoff also apply, so his wrongdoing is attributed to Mr. Picard for the purpose of deciding any claim. The in pari delicto rule is usually invoked on the ground that a court will not decide a dispute between two thieves about who gets the loot.

The United States Court of Appeals for the Second Circuit leaned heavily on this doctrine in upholding the dismissal of Mr. Picard's claims against the banks because the losses were equally attributable to Mr. Madoff. It found that the trustee's legal arguments to avoid the impact of the rule "are resourceful, but they all miss the mark."

Madoff trustee Picard appealing to Supreme Court

In his petition to the Supreme Court to review the federal appeals court's decision, Mr. Picard tries to step out of Mr. Madoff's shoes and into those of the investors who can pursue claims against the banks for their role in the Ponzi scheme. He relies primarily on another legal principle called "subrogation," which allows one party to take over the claims of another. This is used most often in the insurance area, where the insurer pays off the policy holder and then seeks compensation from anyone who caused the harm.

Mr. Picard argues that a provision of the law under which he was appointed, the Securities Investor Protection Act, gives him the authority to pursue the investor claims. The statute provides that if payments are made to customers of a failed securities firm by the Securities Investor Protection Corporation, then "in addition to all other rights it may have at law or in equity, [the trustee] shall be subrogated to the claims of such customers."

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According to the petition made to the Supreme Court, the appellate court misinterpreted the law by reading it too narrowly to prevent him from suing the banks. He argues that if the lower court's position is not overturned, then "when third parties collaborate with a broker to defraud its customers – something that is inevitable given a Ponzi scheme's unquenchable thirst for more investors and more money – there will never be enough funds available to compensate investors' losses."

Trying to figure out whether the Supreme Court will decide to review a case is almost always a guessing game. The court reviews a very small number of cases out of the thousands of petitions it receives, so the odds are against Mr. Picard's case being considered.

Mr. Picard's brief identifies conflicting decisions by other federal courts about whether a trustee can be subrogated to the claims of investors, which is one ground for the Supreme Court to step in to reconcile differing legal interpretations. But the issues in the case are narrow, so while the dollar figure from Mr. Madoff's fraud is significant, the legal issues may not come up with enough regularity to necessitate further review.

One indicator of potential interest in the case is whether the Supreme Court seeks out the views of the Securities and Exchange Commission on the issues. The S.E.C. has oversight responsibility of the Securities Investor Protection Corporation, and its views could carry some weight if it agrees with Mr. Picard that the federal appeals court misinterpreted the law.

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The banking industry is sure to line up against further review, and will argue vehemently on behalf of the appellate court's decision that the case should not proceed further. If Mr. Picard is successful in being able to sue the banks, the potential liability of financial firms could be enormous because to succeed, every Ponzi scheme needs a bank account and other accouterments of financial legitimacy.

The banks have been successful so far in blocking lawsuits seeking to hold them responsible for the extensive losses Mr. Madoff inflicted on his investors. If Mr. Picard is able to switch to a new pair of shoes and pursue them, there is a good chance that he can obtain additional settlements on behalf of investors.

—By Peter J. Henning, The New York Times.