Court Tosses Madoff Investors' Lawsuit Against SEC

Despite the 'regrettable inaction' by the Securities and Exchange Commission ("SEC") in failing to detect Bernard Madoff's historic $65 billion Ponzi scheme, a federal appeals court ruled that those victimized by Madoff's fraud could not hold the SEC accountable for negligence.  Citing a law that protects federal agencies in the exercise of their discretionary powers, a three-judge appellate panel of the Second Circuit Court of Appeals upheld a lower court's dismissal of the lawsuit.  

Investors brought the lawsuit after a highly critical report by the SEC's inspector general that highlighted a myriad of missed opportunities to detect Madoff's fraud at an earlier stage that could have prevented billions of dollars in losses.  This included several reports by Harry Markopolos, an independent financial fraud investigator who raised questions regarding the legitimacy of Madoff's operation.  These claims went largely unheeded, aided by an inter-office communication system that effectively impeded the flow of information between various SEC branch offices. This disconnect between branch offices was highlighted in the Second Circuit's opinion, which noted:

“As a result of the S.E.C.’s repeated failure to alert other branch offices of ongoing investigations, properly review complaints and staff subsequent inquiries, and follow up on disputed facts elicited in interviews, the S.E.C. missed many opportunities to uncover Madoff’s multibillion-dollar fraud.”

Following the report by the inspector general, the SEC took extensive steps not only to discipline those responsible for failing to detect Madoff, but also orchestrated a massive overhaul of the way the agency deals with the receipt of tips and complaints.  After the internal watchdog's report was filed, the SEC hired an outside Washington law firm to recommend disciplinary action against any employees associated with Madoff's fraud.  By law, the SEC is prohibited from disciplining former employees, and the decision to terminate any employee must come directly from the agency's human resource director.  The law firm's investigation ultimately recommended the termination of one employee unless that would have an adverse effect on the agency's work.  That employee was ultimately suspended for thirty days without pay, demoted, and had their pay decreased.  Seven other employees were also disciplined, with punishments ranging from a seven-day suspension to pay reductions.

The SEC also focused on encouraging the flow of information between its regional offices, enacting reforms that dealt mainly with the inflow of tips and complaints from the public.  Under the previous system, access to tips and complaints was limited to the specific branch office where originally received.  Thus, a complaint received at the Boston office was essentially inaccessible to any other regional office for review or dissemination to other employees.  In March 2011, the SEC implemented a Tips, Complaints and Referrals database which, known to insiders as TCR, established a database for inter-agency use.  An important addition was the new partnership with the Federal Bureau of Investigation, which allowed the agencies to cooperate on investigations.  As a result of TCR, all SEC employees are now able to view and add information once a tip or complaint is received by their office.

Earlier this year, another federal appeals court reached a similar result in dismissing a separate lawsuit filed by Madoff investors against the SEC, again finding that the suit fell within the Commission's discretionary powers and thus was shielded under an exception to the Federal Tort Claims Act.  

One of the attorneys representing the victims, Howard Kleinhendler, has vowed to appeal the issue to the United States Supreme Court.

A copy of the Report of Investigation conducted by the Office of Inspector General is here.