First published in Securities Litigation Insights, Issue 2, Winter 2010
By Jennifer Poppe and Nikolay Vydashenko
| Read more articles from Securities Litigation Insights, Winter 2010 here. |
In one of the first significant decisions rendered in litigation arising out of the Madoff Ponzi scheme, Judge Louis Stanton of the U.S. District Court for the Southern District of New York dismissed securities fraud claims brought by the Securities
and Exchange Commission (SEC) against Cohmad Securities Corporation (Cohmad), its Chairman and CEO Maurice Cohn, its President and COO Marcia Cohn, (Cohmad and the Cohns collectively, the “Cohmad Defendants”), and its former Vice President Robert Jaffe (collectively, “Defendants”).1 The court allowed certain claims alleging technical violations of the securities laws to proceed, and granted the SEC leave to file an amended complaint.
This decision illustrates how defendants may succeed at the motion to dismiss stage by, in addition to pointing to the lack of plausibility of plaintiffs’ allegations, affirmatively offering competing inferences that may be drawn from plaintiffs’ allegations. In response to the SEC’s allegations aimed at establishing a “strong inference” of scienter, i.e., fraudulent intent, the Defendants offered both specific competing inferences that addressed certain of the allegations, and an overarching competing explanation that addressed the SEC’s principal theory, which was that the Defendants should have known of Madoff’s Ponzi scheme due to their relationship with Madoff. The Cohmad Defendants’ primary competing explanation was that “the defendants were not the only ones who Madoff fooled” and that “Madoff’s principal regulators . . . as well as sophisticated financial institutions, individuals, and other market participants, also were unable to discover the fraud Madoff perpetrated for more than twenty years.”2 The court appeared to credit the Cohmad Defendants’ explanation, as it concluded that “the complaint supports the reasonable inference that Madoff fooled the defendants as he did individual investors, financial institutions, and regulators.”3
Judge Stanton’s decision also has significance for future cases brought by regulators, because it reaffirms that the Supreme Court’s landmark Iqbal decision, requiring a complaint to “contain sufficient factual matter . . . to state a claim for relief that is plausible on its face,”4 applies with equal force to claims brought by both private litigants and regulators.
The SEC’s Enforcement Action
Following Madoff’s admission that he was operating a Ponzi scheme, the SEC commenced enforcement actions against a number of other entities and individuals who referred investors to Bernard L. Madoff Investment Securities, LLC (BMIS) — Madoff’s investment advisory business that was generating fictitious profits. The SEC’s action against the Defendants is one of the first Madoff-related cases to produce a decision at the motion to dismiss stage.
In its complaint, the SEC alleged that Madoff used Cohmad, a registered broker-dealer, to market BMIS. BMIS allegedly paid Cohmad and Cohmad’s registered representatives fees for referring investors to BMIS, and Cohmad allegedly derived a majority of its revenues from these referral fees.5 The SEC did not allege that the Defendants knew of Madoff’s fraud. Rather, the SEC’s theory of fraudulent intent was that the Defendants “helped mislead investors into believing that Madoff was too successful to need new investment and that he would only begrudgingly allow a privileged few (and well-connected) investors to give him money to manage.”6
The SEC’s complaint alleged two types of claims, categorized by Judge Stanton as “securities fraud claims” and “technical” violations claims.7 The securities fraud claims assert that the Defendants violated and aided and abetted Madoff’s violations of § 10(b) of the Securities Exchange Act of 1934, § 17(a) of the Securities Act of 1933, and §§ 206(1) and (2) of the Investment Advisers Act of 1940.8 These claims are generally predicated upon the theory that the Defendants acted with fraudulent intent in marketing BMIS. The alleged technical violations include aiding and abetting violations of registration, compensation, and filing regulations under various provisions of the Exchange Act of 1934 and the Investment Advisers Act of 1940. Unlike the securities fraud claims, these latter claims do not require the SEC to plead and prove the Defendants’ fraudulent intent.
The Motions to Dismiss
The Defendants moved to dismiss all of the securities fraud claims and certain of the technical violations claims asserted against them.
The Cohmad Defendants principally argued that the SEC’s complaint contained so few factual allegations — as opposed to speculative statements and legal conclusions — that it failed to satisfy the requirements of Iqbal and Twombly9 that a claim be plausible on its face. Specifically, Defendants pointed to the SEC’s failure to identify (1) any act, statement, or omission by any of the Defendants that defrauded any investors, and (2) any “red flags” that plausibly may have established Defendants’ recklessness in failing to detect Madoff’s fraud.
The Cohmad Defendants also argued that the SEC’s complaint failed to establish a “strong inference” of Defendant’s fraudulent intent. To state the securities fraud claims alleged in the complaint, the SEC was required to plead facts giving rise to a strong inference of the Defendants’ fraudulent intent. In accordance with the plausibility requirements of Iqbal and Twombly, this required allegations of facts (not legal conclusions) that (1) show the Defendants had “both motive and opportunity to commit fraud,” or (2) “constitute strong circumstantial evidence of conscious misbehavior or recklessness.”10 According to the Cohmad Defendants, rather than establishing a “strong inference” of fraudulent intent, the SEC’s allegations led to the inference that Madoff fooled the Defendants, along with many other market participants and regulators.
The Court’s Decision
The court’s decision rested on the initial premise that,
[t]here is nothing inherently fraudulent about referring customers to an investment adviser for fees, and the complaint does not allege statements or omissions by defendants that are fraudulent absent awareness or notice that Madoff's investment advisory business was a sham. Thus, to state its securities fraud claims, the SEC must show that defendants knew of, or recklessly disregarded, Madoff’s fraud. In other words, one who conducts normal business activities while ignorant that those activities are furthering a fraud is not liable for securities fraud.11
Securities Fraud Claims
Judge Stanton’s analysis of the securities fraud claims focused on the element of fraudulent intent, as this element is required to state all of the SEC’s alleged securities fraud claims. The court grouped the SEC’s fraudulent intent allegations in four categories, and found that each category of allegations failed to show knowledge, or reckless disregard, of Madoff’s fraud.12
Cohmad’s compensation arrangement
The SEC’s first attempt to plead the requisite scienter centered on allegations concerning Cohmad’s compensation arrangement with BMIS. The SEC alleged that BMIS compensated Cohmad each year with a percentage of the original capital investment brought into BMIS by Cohmad registered representatives for as long as the investor’s account was open, provided that the amount of capital subject to fee calculations was reduced by any withdrawals made from the investor’s account. According to the SEC, this arrangement served to motivate the Cohmad Defendants to “discourage investors from withdrawing any funds that might exceed the amount of the individual investments.”13
The Cohmad Defendants argued that the compensation arrangement was consistent with Cohmad’s alleged role, which was to introduce prospective investors to BMIS. Given this limited role, it made sense “that Madoff would have compensated Cohmad based on the amount of funds new investors brought to BMIS through Cohmad rather than on any subsequent appreciation in the accounts attributable to BMIS’s trading prowess.”14 The court agreed with the inference offered by the Cohmad Defendants, reasoning that “Cohmad referred customers to a purported investment adviser and provided customer service, but it had no role in investment decisions, so it is logical that Cohmad did not earn fees on ‘profits’ from investment.”15
Madoff’s requests for secrecy
The second category of scienter allegations was Madoff’s requests for secrecy concerning the investment advisory business. The SEC alleged that Madoff requested secrecy in marketing BMIS by banning written marketing materials and making it known that investments from anyone who worked in the securities industry would not be accepted as such investors would “ask too many questions.”16 Accordingly, Cohmad representatives allegedly “strategically circulated among wealthy individuals in exclusive milieus” and “projected themselves as individuals who became wealthy through BMIS,” and, when approached by potential investors who asked if they could invest with BMIS, would “agree to try to put in a good word with Madoff.”17
The court held that these allegations amount to “fraud by hindsight,” which cannot be used to allege an intent to defraud.18 Rather than accepting the SEC’s inferences, which were improperly colored by hindsight, the court credited the Cohmad Defendants’ competing explanation for Madoff’s secrecy, quoting from their motion to dismiss that “anyone who watches TV commercials or reads magazine ads can attest that the projection of an ‘aura of exclusivity’ is a common marketing tactic.”19 Thus, the court held that Madoff’s alleged desire for secrecy did not lead to a plausible inference that the Cohmad Defendants should have known that he was engaged in a massive Ponzi scheme.20
Cohmad’s alleged technical violations
The third category of scienter allegations was Cohmad’s alleged failure to disclose the full extent of its relationship with BMIS in Cohmad’s regulatory filings and books and records. According to the SEC, Cohmad’s business relationship with BMIS was inadequately described in Cohmad’s Form BD and its Annual Audit Reports.21
The court held that in the absence of any other facts showing that Defendants were on notice of Madoff’s fraud, the SEC’s chain of inferences — that Cohmad’s alleged failure to disclose the full extent of its relationship with BMIS showed an intention to conceal that relationship, and that such concealment was undertaken because Defendants knew that Madoff was committing fraud — is “speculative and flimsy.”22
Alleged irregularities in Jaffe’s BMIS accounts
The fourth category of scienter allegations relates to Jaffe only. The SEC alleged that there were irregularities in Jaffe’s BMIS accounts, such as outsized annual returns and a backdated trade.23 The court held that the high returns could not be viewed as suspicious in light of Madoff’s reputation, and that Jaffe may have reasonably believed that the single backdated trade over the twelve years that he maintained his account with BMIS was a result of an innocent error.24
Technical Violations Claims
In Counts 5 and 7 of its complaint, the SEC alleges that the Cohmad Defendants aided and abetted BMIS’s violations of § 206(4) of the Investment Advisers Act and Rule 206(4)-3 thereunder, and of § 15(b)(7) of the Exchange Act and Rule 15b7-1 thereunder.
The court held that the SEC failed to plead the requisite elements of these claims, because the complaint does not allege that the Cohmad Defendants performed any acts that would have enabled BMIS’s violations, such as holding themselves out as BMIS registered representatives or hiding their relationship with BMIS from clients that the Cohmad Defendants allegedly solicited.25
In Count 6 of its complaint, the SEC alleged that Maurice Cohn and Marcia Cohn aided and abetted Cohmad’s violation of § 15(b)(1) of the Exchange Act and Rule 15(b)-3 thereunder, which requires a broker-dealer’s Form BD and amendments to be accurate. Only Maurice Cohn moved to dismiss this Count, arguing that he was not liable because he did not sign the Forms BD and amendments at issue. The court denied this aspect of the motion to dismiss, holding that Maurice Cohn’s position as Chairman and CEO of Cohmad conferred upon him a duty to ensure that the filings were accurate.26
* * *
The Cohmad decision illustrates the ability of defendants in securities fraud cases to successfully challenge the reasonableness and plausibility of the inferences to be drawn from the plaintiffs’ allegations, even in cases where the plaintiff is a regulator. Moreover, the decision illustrates the persuasive power of offering the defendant’s own, competing inferences at the motion to dismiss stage. The imperative to offer a competing, innocent explanation is even more essential where the theory of liability is premised on defendant’s alleged role in assisting a much larger fraud.
For more information, please contact Vinson & Elkins lawyers Jennifer Poppe or Nikolay Vydashenko. Visit our website to learn more about V&E's Securities Litigation practice. Get a .pdf of this issue of Securities Litigation Insights e-newsletter here.
1 S.E.C. v. Cohmad Sec. Corp., No. 09 Civ. 5680, 2010 WL 363844 (S.D.N.Y. Feb. 2, 2010). Vinson & Elkins LLP represents Cohmad Securities Corporation, Maurice Cohn, and Marcia Cohn in this action.
2 The Cohmad Defendants’ Motion to Dismiss, p. 1.
3 Cohmad, 2010 WL 363844 at *2.
4 Ashcroft v. Iqbal, __ U.S. __, 129 S. Ct. 1937, 1949 (2009).
5 Cohmad, 2010 WL 363844 at *1.
6 SEC’s Memorandum of Law in Opposition to Cohmad and the Cohn’s Motion to Dismiss, p. 1.
7 Cohmad, 2010 WL 363844 at *1.
8 Id.
9 Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007).
10 Kalnit v. Eichler, 264 F.3d 131, 138 (2d Cir. 2001).
11 Cohmad, 2010 WL 363844 at *1.
12 Id. at *3.
13 Id.
14 The Cohmad Defendants’ Motion to Dismiss, p. 25.
15 Cohmad, 2010 WL 363844 at *3.
16 Id., quoting SEC’s complaint, ¶ 48.
17 Id. at *4, quoting SEC’s complaint, ¶ 26.
18 Id. at *4.
19 Id., quoting the Cohmad Defendants’ Memorandum of Law in Support of Motion to Dismiss, p. 25.
20 Id.
21 Id. at *4-5.
22 Id. at *5.
23 Id.
24 Id. at *5-6.
25 Id. at *6.
26 Id. at *7.