New York Attorney General Andrew Cuomo has launched a two-pronged probe of a prominent New York financier who invested the money of universities and charities with Bernard H. Madoff, who allegedly operated a massive Ponzi scheme.
Two separate units of the attorney general's office, its Charities and its Investor Protection bureaus, have separate and overlapping jurisdiction to probe the financier, J. Ezra Merkin, because many of the clients whose money he placed with Madoff are nonprofit groups.
The two bureaus enforce different laws and have different missions, raising the possibility that the investigation could be a two-edged sword for Merkin's nonprofit clients, raising the possibility that the state agency might consider whether the organizations have been lax in handling their funds.
Cuomo's probe of Merkin could take on added importance from a decision argued last Friday before the 2nd U.S. Circuit Court of Appeals, which, if affirmed, could make it more difficult to bring private lawsuits against "feeder" funds such as the three managed by Merkin, Ascot, Ariel and Gabriel.
That case, South Cherry Street v. Hennessee Group, SDNY 06-CV-2943, is being viewed in the legal community as potentially "the cornerstone of the defense that feeder funds are expected to raise" against claims that they are responsible for Madoff fund losses, said Richard L. Jarashow, a securities litigation partner in the New York office of McGuireWoods.
In South Cherry Street, 534 F. Supp. 2d 406, Southern District of New York Judge Colleen McMahon dismissed in July a securities fraud lawsuit brought by an investor against an advisory firm that placed $1.5 million with the Bayou Hedge Fund, which was later discovered to be operating a Ponzi scheme. McMahon noted that Bayou ran the scheme and concealed the fraud from the market and the Securities and Exchange Commission for nine years.
Similarly, Madoff's scheme escaped notice despite complaints to the SEC in the late 1990s.
Merkin has sat on the boards of both Yeshiva University and the Levy Institute of Economics at Bard College, institutions that, combined, have claimed Madoff-related losses of $18 million.
Merkin, who served on the Yeshiva board for six years before the Madoff scandal broke, was chairman of the university's investment committee. Madoff was a board member as well since 1996. Both men resigned on Dec. 12.
Also, Merkin faces two additional suits over Madoff-related losses brought by two educational institutions that were his clients: New York University, which claimed losses of $24 million, and New York Law School, $3 million.
In all, the attorney general's office has issued subpoenas to 15 nonprofits that gave money to Merkin to manage.
The New York Times has reported that Merkin's three investment funds have placed money raised from investors with Madoff funds, which resulted in more than $2 billion in losses. The Times also reported that Merkin had collected more than $40 million a year in fees from his investors.
Merkin, in addition to running his funds, was the nonexecutive chairman of GMAC, the financing arm of General Motors, a post he recently resigned.
TWO PRINCIPAL STATUTES
The main tool used by the Attorney General's Investor Protection Bureau is the state's Martin Act, which gives it broad power to recover investor losses caused by fraudulent dealings in the marketing of securities.
There is no private cause of action under the Martin Act, General Business Law §352, but when the investor protection unit pursues fraud claims, it is not required to show a key element of common law fraud claims, scienter or guilty knowledge. That frees the investor protection unit to recover damages from a securities professional without having to prove that he had known his actions were going to cause losses.
The Charities Bureau is responsible for enforcement of the state's Not-for-Profit Law, which likewise confers broad authority on the agency to recover damages on behalf of charitable organizations victimized by a fraud. But the law also imposes fiduciary responsibilities upon board members in overseeing their organizations.
Sally G. Blinken, a partner specializing in nonprofit work at the New York office of Venable, said it is "curious" that the attorney general had issued subpoenas to determine if any of the 15 nonprofits had been the victims of a fraud. When the office is seeking to stand in the shoes of a victimized charity, she said, the "usual" route is to send a letter requesting needed information.
Blinken spent seven years at the agency, five of them in Charities Bureau's enforcement section, before joining Venable in June.
"At the very least," she stated, the probe "is casting a bright light on the investment policies and protocols in place at some of New York's leading academic institutions and nonprofits."
Under the Not-for-Profit Law, she said, voluntary board members are not liable for damages absent a showing that they were paid for their work or had a financial interest in the matters they handled for the organization.
Even so, she said, the attorney general's office could issue a report detailing a board's failure to properly inquire about the nature of an investment or issue a code of conduct to make sure that lapses found in the course of an investigation do not recur.
Depending on how serious the breaches are, Blinken added, the office might negotiate a settlement that would require a charity to follow certain "best practices" or, in an extreme case, require the removal of one or more board members.
James J. Fishman, an expert in nonprofit law and visiting professor at Brooklyn Law School, agreed that unpaid board members are immune from recovery claims as long as they have no financial stake in the matters they handled. But, he added, nonprofits could be exposed to "a shame risk."
Another lawyer with extensive dealings with the attorney general's office said that before issuing the subpoenas the office had asked some nonprofits to come to the office to discuss their dealing with Merkin.
"The attorney general's office says it is looking at Merkin, but subpoenas are subpoenas, and it makes me nervous," the lawyer said.
However, a source familiar with the investigation said the focus is "primarily upon Merkin" and the "charities are viewed as victims."
The probe is being headed by Eric Corngold, executive deputy attorney general for economic justice, and David Markowitz, the head of the Investor Protection Bureau. Jason Lilien, the head of the Charities Bureau, is a member of the team as are at least five other lawyers drawn from the two units.
The attorney general's investigation could take on added significance in light of the South Cherry case, which was argued in the 2nd Circuit on Jan 16.
In that case, Judge McMahon dismissed an investor's private action to recover $1.5 million brought under §10(b) of the Securities Act of 1933, claiming that its investment advisor had assured it that it would conduct an extensive five-step due diligence inquiry when in fact it had not conducted any due diligence.
But, McMahon wrote, "failure to conduct due diligence is not the same thing as knowing of or closing one's eye to a known 'danger.'"
South Cherry, McMahon wrote, alleged "no facts" to suggest that the advisory firm, the Hennessee Group, knew or suspected that Bayou, where it placed the monies, was a Ponzi scheme.
The Hennessee Group's failure to discover the fraud, she wrote, "merely places it alongside the SEC, the IRS, and every other group that reviewed [the hedge fund's] finances."
One "substantial" inference that may be drawn from the alleged facts, she wrote, "is that due diligence would not have uncovered the fraud."
John C. Coffee Jr., a securities expert at Columbia Law School and a New York Law Journal columnist, said that while the ruling if upheld on appeal might give plaintiffs "some mileage" it is "easily distinguishable" and "not dispositive."
In South Cherry, the investment was made "in part upon Hennessee's due diligence screening," Coffee said, while Merkin is alleged to have made the decision to invest his client's money in Madoff funds without telling them he was doing so.
Merkin's lawyer, Andrew J. Levander, was unavailable for comment. He has denied any wrongdoing on the part of his client, saying his client also was a victim of Madoff.