With respect to the due diligence issues, the answer depends on the financial professional’s role in the process at the time the decision to invest was made and on what role the financial professional had in reviewing the ongoing performance of that investment. The outside accounting firm performing the hedge fund’s audit would normally not be involved in the hedge fund’s decision to invest, directly or indirectly through a money manager, with Madoff. Nor is the hedge fund’s auditor involved in monitoring that investment.

But the independent auditor’s certified financial statements for the hedge fund’s calendar year are normally distributed to the members or limited partners of the feeder fund entrusting its money to Madoff. The opinion contained in those certified financial statements generally confirms the existence of the feeder fund’s assets. If a significant portion of those assets are in fact nonexistent, then the outside auditing firm is potentially liable to the investors.

A number of suits have been filed accusing everyone associated with the Madoff scheme of violating the anti-fraud provisions of the federal securities laws. As to the financial professional, it is my belief that those claims have little likelihood of succeeding because it would be very difficult to allege and practically impossible to prove that the financial professional had the intent to defraud. Under the Public Securities Litigation Reform Act (PSLRA), the plaintiff must allege strong circumstantial evidence to demonstrate the requisite scienter (criminal intent). In In re Bayou Hedge Fund Litigation, 534 F. Supp.2d 405 (S.D.N.Y. 2007), the court held that plaintiff could not properly allege the requisite scienter against the investment advisor because the allegations did not approximate an actual intent to aid in the fraud being perpetrated by the operator of the ponzi scheme in question. The Court noted that even if the investment advisor had performed its due diligence perfectly, it probably would not have discovered the fraud since the operator of the ponzi scheme had deceived both the investment community and the SEC for a number of years. It follows that the financial professional employed by an investment advisor or the outside auditor in the Madoff matter would not be subject to a fraud claim under either federal or state law. This is especially the case where the hedge fund principals invested their own money with Madoff.

However, there are a number of state law claims, especially ones sounding in negligence, to which the financial professional could be vulnerable. The law of negligence varies from state to state. The threshold issue as to the outside auditor is whether or not it owes a duty to the hedge fund investor. Under New York law, "[a] duty of care may arise where the parties are in contractual privity or have a relationship ‘so close as to approach that of privity.’" Pension Committee of Univ. of Montreal Pension Plan v. Banc of America Securities, LLC 446 F.Supp. 2d 163, 199 (S.D.N.Y 2006). In order to properly allege that duty of care, a plaintiff must establish the following:

• an awareness by the maker of the statement that the statement was to be used for a particular purpose; and
• reliance by a known party on this statement in furtherance of that purpose, and
• some conduct by the maker of the statement linking it to the relying party and evidencing an understanding of that reliance.

In Pension Fund, plaintiff was able to properly allege a negligence claim against the hedge fund. Under New York law, professional malpractice is a species of negligence, thus subjecting the outside accounting firm to potential liability.

As to the financial professional who is employed by the hedge fund, his or her individual liability would be dependent upon what role that person played in the initial decision to invest money with Madoff and in the separate, subsequent decision(s) to continue maintaining that investment. The question is what kind of information did the hedge fund ask for? If it received information and data which upon a proper review would have disclosed the possibility that Madoff was not purchasing or selling the securities described in the monthly statements and confirmation slips, that raises serious questions as to whether the hedge fund acted negligently. Serious questions would also be raised if the hedge fund did not receive any monthly statements or confirmation slips.

What other red flags were present to put the hedge fund on notice that this may have been a Ponzi scheme or require it to conduct further investigation? The publicly available red flags are now being reported in the press. But what about the red flags raised in direct dealings between the hedge fund or the advisors acting on its behalf and Madoff or his employees?

Outside accounting firms face some different issues. First, a hedge fund’s certified financial statements are normally furnished to investors along with the Form K-1 only after the close of a particular fiscal year. Accordingly, what duty would the outside accounting firm have had to the individual investor at the time that the investor made his investment with the hedge fund? I believe that there is no such duty owed by the hedge fund’s outside auditors to the hedge fund investor at the time of investment. That factor would also impact on what is the appropriate measure of damages. In verifying the assets supposedly owned by the hedge fund or feeder fund, what steps did the independent accounting firm follow to confirm that these assets were in fact owned by that fund? What additional steps should have been taken? What were the red flags, if any? The facts in each case will be different.

We recently handled a case where the court held that an outside auditor that advised an individual to use a particular money manager could be held negligent under New York law. Friedman v. Anderson, 23 A.D.3d 163 (1st Dep’t 2005). The negligence law of each state that may be applicable to the dispute must be investigated. In addition, there may be state law claims for negligent misrepresentation, civil conspiracy, violation of some state statute, aiding and abetting a breach of fiduciary duty or other claims that a creative plaintiff’s counsel may devise. A defendant’s insurance coverage, policy exclusions, and the insurer’s duty to defend are also relevant.

Since the statutes of limitations for bringing a suit naming a financial professional run for a number of years, these issues will be faced by the courts for some time to come. As a financial professional, you should take the opportunity before you are named in a suit to analyze and assess your potential liability and to review your insurance coverage.

You should also ensure that potentially relevant documents are preserved, especially electronically generated computer data. Now is the time to not only assess your potential exposure but also to create a protocol to locate, organize and maintain your records. Undoubtedly, the best time to gather evidence helpful to your defense is before a suit has been filed.

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CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Contact him at 212.490.3232 or visit www.securitiescounselors.com