On September 23, District Judge Deborah A. Batts of the Southern District of New York handed down her decision to dimiss all claims against J. Ezra Merkin (“Merkin”), the hedge funds (“Funds”) that he managed, and the auditors of the Funds. Judge Batts grounded her decision in Federal Rule of Civil Procedure 12(b)(6), which requires a plaintiff to plead “enough facts to state a claim to relief that is plausible on its face.” Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007).
Plaintiffs alleged in their third amended complaint that Merkin failed to disclose the Funds’ investments with Madoff, or that Merkin should have performed better due diligence in connection with the Madoff investments. Plaintiffs asserted seven claims against Merkin for violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”), as well as common law claims for breach of fiduciary duty, gross negligence, unjust enrichment, fraud, negligent misrepresentation, fraudulent concealment and breach of contract.
Plaintiffs alleged that Merkin’s auditors, BDO USA, BDO Cayman, and BDO Limited (the “Auditor Defendants”) failed to perform their work in a manner consistent with “Generally Acceptable Auditing Standards” (“GAAS”) and “Generally Accepted Accounting Principles” (“GAAP”), and that these Auditor Defendants should have done more to uncover Madoff’s fraud. Plaintiffs asserted six claims against the Auditor Defendants for violations of section 10(b) of the Exchange Act, as well as common law claims for breach of fiduciary duty, aiding and abetting breach of fiduciary duty, unjust enrichment, common law fraud, and negligent misrepresentation.
More specifically, the plaintiffs alleged that Merkin, as manager of the Funds, made various misrepresentations, including how the funds were to be managed; where and how investments would be made; and what Merkin’s role was to be in management of the Funds. Plaintiffs alleged that these misrepresentations occurred through the dissemination of prospectuses and offering memoranda, as well as part of quarterly reports, presentations and individual statements made by Merkin to investors.
Section 10(b) Claims
Material Misrepresentation or Omission
Judge Batts found that the plaintiff’s “cherry-picked” language from the offering memoranda to bolster their fraud claim, and she held that the language that plaintiffs relied upon in offering memoranda and prospectuses to state a claim for fraud must be read in the context of each entire document. In re Morgan Stanley Info. Fund Sec. Litig., 592 F.3d 347, 365-66 (2d Cir. 2010) (“[w]hen analyzing offering materials for compliance with the securities laws, we review the documents holistically and in their entirety…[t]he literal truth of an isolated statement is insufficient; the proper inquiry requires an examination of ‘defendants’ representations, taken together and in context.'”); see also olkey v. Hyperion 1999 Term Trust, Inc., 98 F.3d 2, 5 (2d Cir. 1996) (“prospectuses must be read ‘as a whole.'”).
Judge Batts referenced language in the offering memoranda stating that it expressly advised that “the success of the [Funds] may also be dependent upon other money managers or investment advisors to Other Investment Entities” and that “the actions or inactions on the part of other money managers…may affect the profitability of the [Funds].” Judge Batts continued that “[e]ach Fund offering memoranda also warned that Merkin could delegate investment discretion to third-party managers without notice to, or the consent of, any investor in the Funds, and that when he delegated such authority he did not have responsibility for the “investment decisions of any independent money managers.”” Reading all of the language together, Judge Batts held that there was no actionable misrepresentation or omission.
The judge also held that plaintiffs’ allegations that Merkin improperly delegated investment authority to Madoff and did not conduct proper due diligence were without merit. Relying upon Second Circuit precedent, Judge Batts held that the alleged failure to conduct due diligence generally does not give rise to a securities fraud claim; instead it lies in a breach of contract action.
Judge Batts went further and explained that “this Court will not recognize a §10(b) claim against those who did business with Madoff, simply by imputing the suspicions of a few (albeit, wise) people who suspected Madoff’s fraud before it was ever discovered.” According to Judge Batts, Madoff’s “considerable reputation” negated justification for imputing knowledge of misconduct to those who did business with Madoff as Merkin had done.
Scienter
Scienter is a required element for a successful 10(b) claim. Plaintiffs must “alleg[e] facts: (1) showing that the defendants had both motive and opportunity to commit the fraud; or (2) constituting strong circumstantial evidence of conscious misbehavior or recklessness.”
Judge Batts succinctly dealt with the element of scienter by pointing to Second Circuit precedent, which held that an investment advisor who recommends investments in a fund that turns out to be a Ponzi scheme will not ordinarily be held liable for securities fraud unless the investor alleges particular facts giving rise to a strong inference that the advisor either had fraudulent intent, or acted with “conscious recklessness” as to truth or falsity of the advisor’s statements to the investor.
Judge Batts’ also discussed the application of the Securities Litigation Uniform Standards Act of 1998 (or SLUSA), as well as New York’s Blue Sky Law (or the Martin Act), to the case at bar. Ultimately, Judge Batts’ dismissed all of plaintiff’s claims with prejudice, except for the breach of contrat claim which she allowed plaintiffs to replead should they so desire.
In sum, victims of the Madoff scheme have lost another battle in the search for deep pockets to pay back the money that was stolen from them. Note that the investors claimed that their fund manager didn’t conduct proper due diligence because the real problem is that the investors themselves did not conduct proper due diligence. Investors must protect themselves by spending the time and money to hire a professional who has zero conflicts of interest to conduct due diligence. Of course Merkin had a conflict of interest vis-a-vie his investors — he was getting paid to manage their money. Until investors understand the necessity of ensuring they receive conflict-free advice, they will inevitably be left with the short end of the stick.
Contact Wittenberg Law before you invest. Wittenberg Law has not conflicts. Your interests always come first.