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Madoff 101: Total Immersion for Lawyers

In a New York conference room, lawyers learned the ins-and-outs of the coming wave of Madoff litigation.

By Roger Parloff, senior editor
February 26, 2009: 12:54 PM ET

NEW YORK (Fortune) -- If you think you dodged the Madoff bullet, can you really be sure? Say, for instance, you briefly invested five years ago in a fund, and that fund in turn invested in a fund-of-funds that invested in a feeder fund that invested with Madoff. Could the Madoff trustee knock on your door and demand that you return any profits?

Questions like that one attracted about 90 attorneys representing investors, hedge funds, auditors, and insurance companies to a conference room at New York's Harvard Club Wednesday. They were attending a Berlitz-style, total-immersion course in how to handle civil litigation stemming from Bernie Madoff's alleged Ponzi-scheme.

Speakers estimated that since Madoff's arrest for securities fraud on December 11, about 120 Madoff-related class-actions have been filed - mainly suits on behalf of investors who indirectly (and often unwittingly) invested in Madoff's sham investment funds when they entrusted their money to funds-of-funds like Fairfield Greenwich, Kingate Management, Tremont Group, or Ezra Merkin's Ascot, Gabriel and Ariel Partners. (Those funds have all said that they were themselves victims of Madoff's fraud.)

Many additional suits are expected to be brought by high-rolling individuals and institutional investors in the months to come. (Those who sustained particularly heavy losses and who can afford to bring their own individual cases usually prefer to do so, rather than joining class actions. In an individual suit the plaintiff exercises more control over his suit and can pay his attorney only hourly fees rather than a contingent fee amounting to a healthy percentage - usually 25% or more - of the entire recovery.)

Topics at Wednesday's conference ranged in difficulty from challenging to impenetrable. For instance, if a direct investor in Madoff is seeking partial reimbursement for his losses from the federally-sponsored Securities Investor Protection Commission's limited insurance program (up to $500,000), can he still take an immediate tax loss? (Answer: Probably not. Accordingly, if he lost many millions more than the SIPC-insured portion, it may make sense for him to just waive his SIPC claim.) If a client has been paying taxes on illusory Madoff gains, can he get those back? (Yes, but only for the past three years.) And if the client invested in a U.S.-based fund-of-funds that invested in a Grand Cayman-based feeder fund that invested in Madoff, does he need to retain offshore counsel to consider trying to put the feeder fund into liquidation? (Maybe, but he better retain Grand Cayman counsel fast because the best ones are all being snapped up and conflicted out of helping him.)

Easily the hottest topic on the agenda was the issue of so-called clawbacks: If an investor put money directly into Madoff but redeemed some or all of his investment before Madoff's arrest, would Irving Picard, the trustee in charge of gathering assets for pro-rata distribution to bilked investors, come after him for the money he already took out? Short answer: yes, if the investor had gains. And it's even conceivable that the investor might have to cough up principal.

While it might seem unexpected and far-fetched to an uninitiated observer that an investor who merely managed to get back from Madoff his bare principal - i.e., exactly what he had put in years earlier without a dime of interest - might nevertheless still have to cough that up to the trustee, that was essentially the holding in a February 2007 ruling concerning the Connecticut-based Bayou Group of hedge funds, which collapsed in 2006 due to a Ponzi scheme.

The Bayou scam left in its wake a scarred landscape that was somewhat different from the one left by Madoff in that most Bayou investors either emerged fully redeemed (having managed to withdraw both their principal and "earnings" before the scheme was discovered) or fully bilked (having lost everything). In that context, U.S. Bankruptcy Judge Adlai Hardin, Jr., of White Plains, N.Y., ruled that redeemed investors' principal payments could be clawed back by the trustee in an effort to equalize all investors' losses. The controversial ruling is now on appeal to the U.S. District Court for the Southern District of New York.

The consensus among the speakers at Wednesday's conference - which included key lawyers from opposing sides of the Bayou case - seemed to be that Picard would probably not go after any principal payments redeemed by innocent direct investors, but that he would go after any "phantom profits" earned by investors who derived any earnings over and above their bare principal. Moreover, he could and would probably do so, the speakers thought, for moneys returned to investors for up to six years prior to Madoff's arrest.

Even tougher clawback questions, however, bedevil indirect Madoff investors. Would Picard seek, for instance, clawbacks from investors who had managed to redeem principal or phantom profits from so-called Madoff feeder-funds, like Ascot, before the scheme came to light? And what about second-tier investors who had their money in funds-of-funds, which in turn had invested some of their money in Madoff feeder funds like Ariel - could Picard go after them? Or, for that matter, what about third-tier investors, who invested in funds-of-funds that invested in funds-of-funds that invested in Madoff feeder funds, and so on. (Answer: Speakers doubted Picard would seek clawbacks from indirect investors; but if a feeder fund itself went bankrupt, then the feeder's own bankruptcy trustee might have to go after that fund's investors for clawbacks.)

The conference was organized by HB Litigation Conferences, which, at the end of last year, bought out what was formerly known as the Mealey's Conference program, which is well-known to attorneys for organizing crash courses in such litigation-spawning mass disasters as Vioxx painkillers, Fen-phen diet pills, lead paint, and, of course, the original, perennial, and inextinguishable mass-tort: asbestos. HB is already planning additional Madoff conferences in Florida, California and Chicago. To top of page


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