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Legal Roadblocks of Colorado Business Litigation Feeder Fund Claims

Ina previous blog post, Madoff’s Ponzi Scheme: Feeder Fund Liability, I discussed a Denver based investment firm who, as a feeder fund, found themselves tangled up in Madoff’s Ponzi Scheme. I would now like to look at some of the challenges of litigating these types of cases.
Colorado business litigation suits against feeder funds include claims for fraud, negligence, and breach of fiduciary duty. But what are the legal roadblocks?
The biggest obstacle to claims against the feeder fund may be the protection Congress bestowed upon investment funds more than a decade ago. In the Private Securities Litigation Reform Act (PSLRA) of 1995, Congress determined that the investor must not only prove negligent failure of the feeder funds to investigate the Ponzi schemer, but also must prove that any feeder fund advice bordered on intentional fraud. And for the most part, those claims must be filed in a federal courthouse.
The typical investor is unaware of the detailed relationship between the feeder fund and the Ponzi scammer, such as Bernie Madoff. As in other technical cases where the factual basis of the misconduct is often known only to the defendant, such as a medical negligence case, the investor seeks to learn about the relationship between the feeder fund and the Ponzi schemer through discovery rules. Investors begin taking depositions of people with knowledge and use those depositions to establish the basis of the wrongdoing.
Under the PSLRA, however, Colorado federal courts, including Denver, may require detailed factual allegations against the feeder fund without the benefit of discovery depositions. Congress essentially requires fraud victims to “shoot in the dark.”.
However, while fraud claims in the federal courts may be difficult under the PSLRA, breach of fiduciary duty claims can be filed in state courts. Whether it stays there, though, without a transfer to the federal court depends on complex procedural rules. A Washington Post article earlier this year (“Madoff Investors Face Dim Prospects in Court”, February 22, 2009, by Quinn) describes the difficulties in making claims against feeder funds. Quinn acknowledges that these cases may “sound like slam dunks” but:
“They are not. Congress and the courts have spent more than a decade writing and affirming laws that protect companies from irate investors. Those laws may turn out to be feeder fund protection acts.”
One final disappointment to an investor in a feeder fund is that its loss may not be insured. Bank accounts are insured by the FDIC up to $250,000. Investment accounts in a feeder fund that is registered under security regulations are insured by the Securities Investors Protection Corp (SIPC) up to $500,000. However, if the fraud or other misconduct was not perpetrated by a licensed fund/broker, there is no coverage at all. Once again, this gap in protection is a by-product of the anti-regulatory attitude part of Congress.
For more information on litigating these types of claims, contact a Colorado Business Litigation attorney.

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