Now that Bernard L. Madoff Investment Securities LLC is in bankruptcy and being liquidated by the SIPC trustee, its victims are focusing upon intermediaries, including so-called "feeder funds" and investment advisers, their corporate parents and affiliates, and their accountants as potential "deep pockets" from whom to obtain potential additional recoveries. With one prominent feeder fund already in bankruptcy, and the likelihood that others will follow, the ability of victims to assert sustainable claims against related entities will be crucial to recovery.

In recent decisions by Judge Lewis A. Kaplan in In re Parmalat Sec. Litig., 2009 WL 179920 (S.D.N.Y. Jan. 27, 2009), and Judge Shira A. Scheindlin in The Pension Committee of the University of Montreal Pension Plan v. Banc of America Securities, LLC, , 2009 WL 29649 (S.D.N.Y. Jan. 5, 2009), two cases unrelated to the charged Madoff Ponzi scheme, the courts considered the viability of claims against entities and individuals at a distance from alleged fraudulent transactions.

Judge Kaplan explored the impact of the U.S. Supreme Court decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta Inc., 128 S. Ct. 761 (2008), on the common law doctrine of vicarious liability as well as control person liability under §20(a) of the Securities Exchange Act of 1934.

Judge Scheindlin's most recent decision also considered the control liability issue among many other relevant federal securities and common law issues, including extraterritorial jurisdiction, federal pre-emption, fiduciary duty law, negligence and professional malpractice. Because the law is unsettled in the Second Circuit and the issues have significance for Madoff and other fraud loss recovery litigation, Judge Kaplan's consideration of vicarious liability and the approach of both judges the issue of control person liability under §20(a) are worth close review.

Vicarious Liability

In Stoneridge, the Supreme Court addressed the exposure of secondary actors to private claims under §10(b) and held that "[r]eliance by the plaintiff upon the defendant's deceptive acts is an essential element of the Section 10(b) private cause of action." 128 S. Ct. at 769. To sustain liability against a secondary actor, "[t]he conduct of the secondary actor must satisfy each of the elements or preconditions for liability." Id.

In In re Parmalat, Stoneridge was the keystone of a motion for summary judgment by defendant Deloitte Touche Tohmatsu, a Swiss verein that served as a global umbrella organization for accounting firms around the world, but which was allegedly a separate and distinct entity from its member organizations. Deloitte Italy, a member organization, was alleged to have been a primary violator of §10(b) in connection with an accounting fraud perpetrated by its client, Parmalat, an allegation not challenged. DTT argued, (1) it could not be vicariously liable for the acts of its member organization under Stoneridge, and (2) it was not liable as a control person under §20(a) because it did not control the member organization and had acted in good faith. Judge Kaplan rejected both arguments and denied DTT's motion for summary judgment.

Although Judge Kaplan acknowledged that if "considered in a vacuum," aspects of Stoneridge would seem to apply to common law agency principles, including respondeat superior, he was not persuaded that Stoneridge "undermined the viability of established circuit precedent" permitting application of the common law principle of respondeat superior to hold principals liable for §10(b) violations by their agents. 2009 WL 179920 at *3. Judge Kaplan, observed that if the Supreme Court intended "any such transformation of this long-settled principle of American law," Stoneridge would have made its intention clear.

Citing concern that acceptance of DTT's argument "would undermine the ability of defrauded investors to obtain meaningful compensation, as individual employees who are personally culpable in the usual case seldom are capable of paying judgments of the requisite magnitude," Judge Kaplan rejected an argument that "would confine liability for securities law violations committed by corporate officers and employees to the individual malefactors and limit recovery against the corporations that employed them and, frequently, benefited from the securities violations."

In assessing whether sufficient evidence of an agency relationship between DTT and its various member firms existed, Judge Kaplan focused upon the element of control as "the essential characteristic of the principal-agency relationship" and, where the existence of the agency relationship is uncertain, as a "critical indicator." Id. at *4. Judge Kaplan found sufficient evidence of DTT's control to warrant denial of DTT's summary judgment motion, including control over professional activities, such as setting policies, requiring licensing agreements, determining engagements, resolving professional disagreements and supervising legal and risk management issues.

'Pension Comm. VI'

In Pension Comm. VI, 20 investors in two offshore hedge funds alleged that the entity managing the funds and its principal concealed losses by manipulating the market price of certain thinly-traded shell companies shares held by the funds thereby artificially inflating the net asset values of the funds at the end of each month. Plaintiffs asserted federal securities and common law claims against the funds administrator (Citco NV), its indirect parent (Citco Group), and three former directors of one fund, who were also officers of Citco NV. Those defendants moved for summary judgment which was granted in part and denied in part.

Plaintiffs asserted a claim under §20(a) against Citco Group based upon its alleged status as a control person of Citco NV, the alleged primary violator. Citing prior decisions of the Second Circuit , Judge Scheindlin addressed whether Citco Group controlled Citco NV and was a "culpable participant" under the established elements of control person liability:

To establish a prima facie case of control person liability, a plaintiff must show (1) a primary violation by the controlled person, (2) control of the primary violator by the defendant, and (3) that the defendant was, in some meaningful sense, a culpable participant in the controlled person's fund. 2009 WL 29649 at *6.

Controlling Person

Judge Scheindlin found sufficient evidence of control to warrant denial of the motion for summary judgment on that issue. 2009 WL 29649, at *13. Despite the indirect parent-subsidiary relationship, Citco Group argued (1) there was no evidence that it dictated the policies and procedures employed by Citco NV, and (2) there was no evidence that it had actual control over the day-to-day administrative services provided by Citco NV to the funds.

Judge Scheindlin found those assertions contradicted by evidence that an employee of another Citco Group subsidiary was acting on behalf of the corporate parent in overseeing the activities of Citco NV and reporting regularly to Citco Group's executive committee.

Culpable Participation

As Judge Scheindlin observes, the Second Circuit has not defined the requirement that a controlling entity be a "culpable participant." 2009 WL 29649 at *13 n. 192. The issue is one of both pleading and proof. Must the plaintiff plead, either in conformity with the general pleading standard of Rule 8 or the more stringent standards of Rule 9(b) and the Private Securities Litigation Reform Act, and prove scienter, or is it the defendant's burden to prove that it acted in "good faith"?

Judge Scheindlin did not resolve the scienter issue finding sufficient evidence that Citco Group may have been a culpable participant, even under the stricter liability standard, because an employee of a separate Citco Group subsidiary was acting on behalf of Citco Group in overseeing the fund administrator's business.

In a potential counterpoint to Judge Kaplan's view of vicarious liability, Judge Scheindlin was careful to note that she rejected the argument that a subsidiary employee's knowledge of the fraud alone could be imputed to the corporate parent to establish culpable participation because it "could result in the imposition of liability on parent companies based merely on the suggestion that one of its subsidiary companies' employees was an agent of the parent company and that he or she was aware of the fraudulent scheme." Id., n. 191. She focused instead upon the evidence that the employee here had been specifically delegated the task of overseeing the administration of the fund's operations on behalf of Citco Group.

Despite finding it unnecessary to determine the issue, Judge Scheindlin noted that she previously held, in deciding motions to dismiss in Pension Comm. III, that scienter need not be pled on a §20(a) claim for control person liability. Judge Schneidlin ruled similarly in In re IPO Sec. Litig., 241 F. Supp. 2d 281, 395-96 (S.D.N.Y. 2003), as did Judge Denise Cote in In re WorldCom Inc. Sec. Litig., 294 F. Supp. 2d 392, 415 (S.D.N.Y. 2003).

Although Judge Kaplan also recognized that the scienter issue "is a point of debate within the Circuit," he agreed with Judge Scheindlin that the defendant bears the burden of proving lack of culpable participation or good faith as an affirmative defense to a §20(a) claim. In re Parmalat Sec. Litig., 2009 WL 179920 at *3 n. 32. Judges Kenneth Karas and John Koeltl have disagreed, finding that scienter must be plead with the particularity required under Rule 9(b) and the Private Securities Litigation Reform Act, and proven to sustain control person liability claims under §20(a).

Those courts holding that no pleading or proof of scienter on the part of the controlling person is required point to the express language of §20(a).

Every person who, directly or indirectly, controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable, unless the controlling person acted in good faith and did not directly induce the act or acts constituting the violation or cause of action. (Emphasis added.)

They argue that the text requires that defendants bear the burden of establishing good faith. They also argue that the "culpable participation" requirement delineated by the Second Circuit in First Jersey does not equate with scienter, but rather conduct that is blameworthy, which may be unintentional or unknowing. See IPO Sec. Litig., 241 F. Supp. 2d at 394 n. 182.

Those courts that would impose a scienter requirement for control person liability claims under §20(a) also cite to First Jersey. Indeed, in Lapin, Judge Karas pointed to the sequence of the discussion of control person liability in First Jersey, explaining the plaintiff's burden to allege with particularity a primary violation, control of the primary violator, and culpable participation by the controlling person, and "[o]nce the plaintiff makes out a prima facie case of §20(a) liability, the burden shifts to the defendant to show he acted in good faith." Lapin, 506 F. Supp. 2d at 247, citing First Jersey, 101 F.3d at 1472-73.

Conclusion

Issues of secondary liability, including vicarious and control person liability, are unresolved in the Second Circuit, and their resolution will have a major impact on current and future cases. Although the facts in In re Parmalat may have provided an easier vicarious liability analysis than in many cases, it remains open whether the Second Circuit will construe Stoneridge as essentially barring vicarious liability.

As Judge Kaplan noted, that would make corporate responsibility difficult to establish in many instances, including in many of the secondary or deep pocket relationships such as are involved in the Madoff fraud. Similarly, resolution of the control person liability issue, on which the district courts in the circuit are split, will have a major impact on Madoff-related cases as well as on other fraud cases.

The views of Judges Scheindlin and Kaplan would result, particularly at the pleading stage, in less difficulty for Madoff victims and others in sustaining claims against control persons, especially non-public, foreign-based corporations as to which little information may be available to support particularized pleading of the elements of control and culpable participation.

However, it seems doubtful the Second Circuit would agree that scienter is not required. While we look forward to Second Circuit clarification of these important principles of secondary, including deep pocket, liability, precedent would suggest agency principles will remain—score one for the plaintiffs looking for deep pockets—but pleading and proof of scienter will be required for control person liability—score one for the deep pockets.

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