JOINT REPLY MEMORANDUM of LAW in Support Re: (66 in 1:09-Cv

Pacific West Health Medical Center Inc. Employees Retirement Trust et al ...ld Greenwich Group et al Doc. 130 Att. 1

APPENDIX A

1. Stephenson v. Citco Group Ltd., No. 09 Civ. 00716(RJH), 2010 WL 1244007 (S.D.N.Y. Apr. 1, 2010)

2. Meridian Horizon Fund, LP v. Tremont Group Holdings, Inc., No. 09 Civ. 3708(TPG), 2010 WL 1257567 (S.D.N.Y. Mar. 31, 2010)

3. In re Tremont Sec. Law, State Law & Ins. Litig., 08 Civ. 11117(TPG), 2010 WL 1257580 (S.D.N.Y. Mar. 30, 2010)

4. Barron v. Igolnikov, No. 09 Civ. 4471(TPG), 2010 WL 882890 (S.D.N.Y. Mar. 10, 2010)

5. SEC v. Cohmad Sec. Corp., No. 09 Civ. 5680(LLS), 2010 WL 363844 (S.D.N.Y. Feb. 2, 2010)

6. Backus v. Conn. Cmty. Bank, N.A., No. 3:09-CV-1256, 2009 WL 5184360 (D. Conn. Dec. 23, 2009)

7. Levinson v. PSCC Servs., Inc., No. 3:09-CV-00269(PCD), 2009 WL 5184363 (D. Conn. Dec. 23, 2009)

8. CRT v. Merkin, No. 601052/09 (N.Y. Sup. Ct. May 5, 2010)

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invested partnership's funds in Ponzi scheme, were Only the Westlaw citation is currently available. derivative of those of partnership for standing purposes; limited partner did not allege an injury to himself independent of the injury to partnership. United States District Court, S.D. New York. G. Philip STEPHENSON, as Trustee of the Philip [2] Partnership 289 370 Stephenson Revocable Living Trust, Plaintiff, v. 289 Partnership CITCO GROUP LIMITED; CITCO Fund Services 289VIII Limited Partnership (Europe) BV; CITCO (Canada), Inc.; and Pricewa- 289k370 k. Actions Between Partners. Most terhousecoopers, LLP (an Ontario limited liability Cited Cases partnership), Defendants. Even if limited partner was a third party beneficiary of No. 09 CV 00716(RJH). contracts between investment partnership and partnership's administrators and its independent auditor, April 1, 2010. his breach of contract claims against administrators and independent auditor based on their investment of Background: Limited partner in investment partner- partnership's funds in Ponzi scheme, were derivative ship which invested the investor's funds in a Ponzi of those of partnership for standing purposes; limited scheme brought a direct action against partnership's partner did not allege an injury to himself independent administrators and its independent auditor. Defen- of the injury to partnership. dants filed three separate motions seeking to dismiss the complaint in its entirety. [3] Partnership 289 370

Holdings: The District Court, Richard J. Holwell, J., 289 Partnership held that: 289VIII Limited Partnership (1) breach of fiduciary duty claims brought by limited 289k370 k. Actions Between Partners. Most partner were derivative of those of partnership for Cited Cases standing purposes; Limited partner's negligence and fraudulent induce- (2) Martin Act preempted limited partner's negligence ment claims against investment partnership's admin- and breach of fiduciary duty claims; and istrators and its independent auditor, which were (3) complaint against auditor did not adequately allege based on investment of partnership's funds in Ponzi scienter. scheme, were direct to the extent that they alleged violation of a duty owed to potential investors at large Motions granted. and that such violations induced limited partner to invest in the partnership, and therefore limited partner had standing to bring his inducement claims directly. West Headnotes

[4] Accountants 11A 8 [1] Partnership 289 370 11A Accountants 289 Partnership 11Ak6 Contracts, Employment, and Compensa- 289VIII Limited Partnership tion 289k370 k. Actions Between Partners. Most 11Ak8 k. Performance of Contract; Duties and Cited Cases Liabilities. Most Cited Cases Breach of fiduciary duty claims brought by limited partner in investment partnership against partnership's administrators and its independent auditor, which Partnership 289 370

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289 Partnership 184I Deception Constituting Fraud, and Liability 289VIII Limited Partnership Therefor 289k370 k. Actions Between Partners. Most 184k2 Elements of Actual Fraud Cited Cases 184k3 k. In General. Most Cited Cases Martin Act, New York's blue sky statute, preempted limited partner's negligence and breach of fiduciary Fraud 184 4 duty claims against investment partnership's administrators and its independent auditor based on their in- 184 Fraud vestment of partnership's funds in Ponzi scheme. 184I Deception Constituting Fraud, and Liability McKinney's General Business Law § 352-c. Therefor 184k2 Elements of Actual Fraud [5] Securities Regulation 349B 242 184k4 k. Intent. Most Cited Cases

349B Securities Regulation Fraud 184 50 349BII State Regulation 349BII(A) In General 184 Fraud 349Bk242 k. What Law Governs. Most 184II Actions Cited Cases 184II(D) Evidence Limited partner's claims against New York investment 184k50 k. Presumptions and Burden of partnership's administrators and its independent au- Proof. Most Cited Cases ditor for breach of fiduciary, negligence, gross negli- Under New York law, a fraud claim requires a ma- gence, and aiding and abetting breach of fiduciary terial misstatement, known by the perpetrator to be duty involved the sale of securities “within or from” false, made with an intent to deceive, upon which the New York for purposes of the New York's Martin Act; plaintiff reasonably relies and as a result of which he relevant securities were shares of the New York in- sustains damages; the requisite state of mind is a de- vestment partnership's fund, fund's shares were sold liberate intent to deceive, however, intent can be from New York to primarily domestic investors, and demonstrated by recklessness of sufficient degree to all of the general partners were located in New York. create an inference of intent. McKinney's General Business Law § 352-c.

[8] Federal Civil Procedure 170A 636 [6] Federal Civil Procedure 170A 1772 170A Federal Civil Procedure 170A Federal Civil Procedure 170AVII Pleadings and Motions 170AXI Dismissal 170AVII(A) Pleadings in General 170AXI(B) Involuntary Dismissal 170Ak633 Certainty, Definiteness and Par- 170AXI(B)3 Pleading, Defects In, in Gen- ticularity eral 170Ak636 k. Fraud, Mistake and Con- 170Ak1772 k. Insufficiency in General. dition of Mind. Most Cited Cases Most Cited Cases Although under fraud pleading rule, scienter need not A claim has facial plausibility when the plaintiff be alleged with great specificity, plaintiffs are still pleads factual content that allows the court to draw the required to plead the factual basis which gives rise to a reasonable inference that the defendant is liable for the strong inference' of fraudulent intent. Fed.Rules misconduct alleged; if the factual averments permit no Civ.Proc.Rule 9(b), 28 U.S.C.A. reasonable inference stronger than the mere possibility of misconduct, complaint should be dismissed. Fed.Rules Civ.Proc.Rule 8(a)(2), 28 U.S.C.A. [9] Securities Regulation 349B 60.51(2)

[7] Fraud 184 3 349B Securities Regulation 349BI Federal Regulation 349BI(C) Trading and Markets 184 Fraud 349BI(C)7 Fraud and Manipulation

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349Bk60.50 Pleading 349Bk60.51 In General [12] Securities Regulation 349B 60.45(3) 349Bk60.51(2) k. Scienter. Most Cited Cases 349B Securities Regulation Mere receipt of compensation and the maintenance of 349BI Federal Regulation a profitable professional business relationship for 349BI(C) Trading and Markets auditing services does not constitute a sufficient mo- 349BI(C)7 Fraud and Manipulation tive for purposes of pleading scienter in securities 349Bk60.43 Grounds of and Defenses to fraud action. Securities Exchange Act of 1934, § Liability 21D(b)(2), 15 U.S.C.A. § 78u-4(b)(2); Fed.Rules 349Bk60.45 Scienter, Intent, Know- Civ.Proc.Rule 9(b), 28 U.S.C.A. ledge, Negligence or Recklessness 349Bk60.45(3) k. Accountants, [10] Securities Regulation 349B 60.45(3) Attorneys, Underwriters and Brokers. Most Cited Cases 349B Securities Regulation 349BI Federal Regulation Securities Regulation 349B 60.51(2) 349BI(C) Trading and Markets 349BI(C)7 Fraud and Manipulation 349B Securities Regulation 349Bk60.43 Grounds of and Defenses to 349BI Federal Regulation Liability 349BI(C) Trading and Markets 349Bk60.45 Scienter, Intent, Know- 349BI(C)7 Fraud and Manipulation ledge, Negligence or Recklessness 349Bk60.50 Pleading 349Bk60.45(3) k. Accountants, 349Bk60.51 In General Attorneys, Underwriters and Brokers. Most Cited 349Bk60.51(2) k. Scienter. Most Cases Cited Cases For an accountant to be found to have acted recklessly Failure by accountant to comply with generally ac- during an audit, its alleged misconduct must ap- cepted accounting principles (GAAP) or other such proximate an actual intent to aid in the fraud being irregularities are insufficient to establish recklessness perpetrated by the audited company. sufficient to give rise to strong inference of scienter in securities fraud action; to rise to the state of mind [11] Securities Regulation 349B 60.51(2) required, those allegations must be coupled with evidence of corresponding fraudulent intent.' Securities 349B Securities Regulation Exchange Act of 1934, § 21D(b)(2), 15 U.S.C.A. § 349BI Federal Regulation 78u-4(b)(2); Fed.Rules Civ.Proc.Rule 9(b), 28 349BI(C) Trading and Markets U.S.C.A. 349BI(C)7 Fraud and Manipulation 349Bk60.50 Pleading [13] Securities Regulation 349B 60.51(2) 349Bk60.51 In General 349Bk60.51(2) k. Scienter. Most 349B Securities Regulation Cited Cases 349BI Federal Regulation Securities fraud complaint against auditor of invest- 349BI(C) Trading and Markets ment partnership which invested its funds in Ponzi 349BI(C)7 Fraud and Manipulation scheme did not adequately allege scienter based on 349Bk60.50 Pleading failure in general to follow generally accepted ac- 349Bk60.51 In General counting principles (GAAP), failure to discover that 349Bk60.51(2) k. Scienter. Most partnership lacked adequate internal controls to dis- Cited Cases cover the Ponzi scheme itself, and failure to investi- In the accounting context, failure to identify problems gate Ponzi scheme despite the existence of “red flags.” with the defendant company's internal controls and Securities Exchange Act of 1934, § 21D(b)(2), 15 accounting practices does not constitute recklessness U.S.C.A. § 78u-4(b)(2); Fed.Rules Civ.Proc.Rule sufficient to give rise to strong inference of scienter in 9(b), 28 U.S.C.A.

--- F.Supp.2d ----, 2010 WL 1244007 (S.D.N.Y.) (Cite as: 2010 WL 1244007 (S.D.N.Y.)) securities fraud action. Securities Exchange Act of Mosle, LLP, Andrew M. Genser, Mindy M. Yu, 1934, § 21D(b)(2), 15 U.S.C.A. § 78u-4(b)(2); Kirkland & Ellis LLP, New York, NY, Matthew Fed.Rules Civ.Proc.Rule 9(b), 28 U.S.C.A. Buckley, Amy E. Crawford, Brenton Rogers, David Tressler, Emily Nicklin, Timothy A. Duffy, Kirkland [14] Securities Regulation 349B 60.45(3) & Ellis LLP, Chicago, IL, for Defendants.

349B Securities Regulation MEMORANDUM OPINION AND ORDER 349BI Federal Regulation 349BI(C) Trading and Markets RICHARD J. HOLWELL, District Judge: 349BI(C)7 Fraud and Manipulation 349Bk60.43 Grounds of and Defenses to *1 The parties are individuals and entities who, like Liability most of the country, were unaware until December 349Bk60.45 Scienter, Intent, Know- 2008 that Bernie Madoff was operating a Ponzi ledge, Negligence or Recklessness scheme.FN1,FN2 Unlike most of the country however, 349Bk60.45(3) k. Accountants, the parties had the misfortune of being directly in- Attorneys, Underwriters and Brokers. Most Cited volved. Cases The plaintiff is G. Philip Stephenson, the trustee and Securities Regulation 349B 60.51(2) namesake of the Philip Stephenson Revocable Living Trust, which invested $60 million as a limited partner 349B Securities Regulation in a fund called Greenwich Sentry. Greenwich Sentry 349BI Federal Regulation in turn invested most of its assets with Bernie Madoff 349BI(C) Trading and Markets Investment Securities (BMIS), the fake fund through 349BI(C)7 Fraud and Manipulation which Madoff perpetrated his multi-billion dollar 349Bk60.50 Pleading fraud. Greenwich Sentry is not a party to this action, 349Bk60.51 In General but as one of a number of so-called “feeder funds” 349Bk60.51(2) k. Scienter. Most provided a vehicle for plaintiff (among others) to Cited Cases invest with BMIS. Greenwich Sentry had as its ad- Allegations that an auditor ignored “red flags” that ministrator defendant Citco (Canada) Inc., and as its would place a reasonable auditor on notice that the sub-administrator defendant Citco Fund Services audited company was engaged in wrongdoing, when (Europe) Inc. FN3 Finally, defendant Pricewaterhou- coupled with allegations of generally accepted ac- seCoopers Canada (“PWC”) was Greenwich Sentry's counting principles (GAAP) and generally accepted independent auditor.FN4 accounting standards (GAAS) violations, are sufficient to support a strong inference of scienter in se- Plaintiff has never received back a penny of the $60 curities fraud action; however, the auditor must have million that his trust invested in BMIS through actually been aware of the red flags, either because Greenwich Sentry. As a result of that loss he has they are alleged to have had actual knowledge or be- brought this direct action against Greenwich Sentry's cause the red flags were so obvious that the auditor administrators and its independent auditor.FN5 The must have been aware of them. Securities Exchange Complaint FN6 features seven state law claims: (I) Act of 1934, § 21D(b)(2), 15 U.S.C.A. § 78u-4(b)(2); breach of fiduciary duty against Citco, (II) gross neg- Fed.Rules Civ.Proc.Rule 9(b), 28 U.S.C.A. ligence against Citco, (III) negligence/professional Herbert I. Deutsch, Christian Vincent Cangiano, Je- malpractice against PWC, (IV) fraud against PWC, remy Evan Deutsch, Deutsch, Coffey & Metz, LLP, (V) breach of contract (third party beneficiary) against New York, NY, for Plaintiff. Citco, (VI) breach of contract (third party beneficiary) against PWC, and (VII) aiding and abetting breach of Amanda McGovern, Dyanne Eyce Feinberg, Eliza- fiduciary duty, against Citco and PWC. beth A. Izquierdo, Lewis Nathan Brown, Terence Michael Mullen, Gilbride Heller & Brown P.A, Mi- The defendants have filed three separate motions ami, FL, Eliot Lauer, Michael Joseph Moscato, Ti- seeking to dismiss the complaint in its entirety. ( [38], mothy Neil McCabe, Curtis, Mallet-Prevost, Colt & [43], and [46].) With respect to plaintiff's breach of

--- F.Supp.2d ----, 2010 WL 1244007 (S.D.N.Y.) (Cite as: 2010 WL 1244007 (S.D.N.Y.)) fiduciary duty, gross negligence, negligence, and and securities in the account. (Cl.¶ 26.) Madoff re- aiding and abetting breach of fiduciary duty claims, ported account data and trading results back to defendants assert preemption by the Martin Act, New Greenwich Sentry, which were in turn handed over to York's blue sky law. With respect to plaintiff's fraud Greenwich Sentry's administrator and auditor to claim, PWC contends that the Complaint does not process reports. (Cl.¶ 26.) plead fraud with particularity as required by Federal Rule of Civil Procedure 9(b). With respect to all The limited partners bought shares of Greenwich claims, defendants assert that (1) they are derivative Sentry, which in turn invested in BMIS. They could and cannot be brought directly by Stephenson, and (2) withdraw funds monthly by placing requests directly they are not adequately plead and should be dismissed with Greenwich Sentry, which would either pay them pursuant to Federal Rule of Civil Procedure 12(b)(6). out of a separate account that it maintained for the purpose of monthly adjustments, (Cl.¶ 27), or forward For the reasons that follow the Court finds that plain- the requests to BMIS which would send back the tiff's first, second, third, and seventh causes of action funds for distribution. In December 2008 when the are preempted by the Martin Act, and that his first, Ponzi scheme was disclosed, Greenwich Sentry second, third, fifth, sixth, and seventh causes of action ceased honoring withdrawal requests. (Cl.¶ 29.) are derivative and cannot be brought directly. The Court also finds that plaintiff's fourth claim, alleging The Citco defendants acted in various capacities as fraud against PWC, has not been plead with an ade- Greenwich Sentry's hedge fund administrators. Ac- quate allegation of scienter. Accordingly the Court cording to the complaint, Citco Group Limited (CGL) dismisses plaintiff's complaint in its entirety. is an integrated financial services holding company that includes among its subsidiaries Citco (Canada), I. BACKGROUND Inc. and Citco Fund Services (Europe) BV. (Cl.¶ 8.) Operating solely through its subsidiaries, CGL *2 The factual allegations in the Complaint are as represents itself and its subsidiaries as the world's top follows: providers of hedge fund administration services. (Cl.¶ 11.) CGL explains these services on its web site: 1. The parties and other relevant entities Our Hedge Fund Service offering includes fund Several non-parties (other than, of course, BMIS) had accounting and net asset value calculations, investor important roles in the facts underlying the complaint. relations services, anti-money laundering com- Most central among them is Greenwich Sentry, the pliance, corporate & legal services, ... tax reporting Madoff feeder fund that connects plaintiff to the de- and financial statement preparation. Citco's online fendants. Greenwich Sentry operates principally out reporting tools, ... offer both investment managers of New York, where its offices are located. (Cl.¶ 6.) and investors an extensive suite of online reports to Greenwich Sentry was set up by Fairfield Greenwich provide them with the tools they need to operate Group, a Delaware limited liability company that efficiently and effectively. Citco also offers a com- operates principally out of New York, and which also plete front-to-back offering for single manager set up a number of Madoff feeder funds similar to funds, combining portfolio capture and real-time Greenwich Sentry. (Cl.¶¶ 6-7.) Fairfield Greenwich's position monitoring technology ... with middle and “core product business model is the investment man- back office operations support. (Cl.¶ 12.) agement and oversight of the split strike conversion strategy, implemented through [the feeder funds],” *3 Citco (Europe) Inc. is a Netherlands limited liabil- and Fairfield Greenwich made substantial representa- ity company and wholly owned subsidiary of CGL tions as to the extent and quality of its due diligence in that operates principally out of Amsterdam. (Cl. ¶ 9.) that capacity. (Cl.¶¶ 31-38.) It has been Greenwich Sentry's fund administrator since September 1, 2006. (Cl.¶ 9.) Citco (Europe) was Greenwich Sentry operated as a “feeder fund,” placing primarily responsible for: communicating with limited substantially all of its Limited Partners' investments partners, maintaining a record of accounts, processing into a brokerage account in the custody of Madoff, subscriptions and withdrawals, preparing and main- who acted as trader, broker, and custodian of all funds taining financial and accounting records and state-

--- F.Supp.2d ----, 2010 WL 1244007 (S.D.N.Y.) (Cite as: 2010 WL 1244007 (S.D.N.Y.)) ments, calculating account balances, arranging for the Sentry, a profit and loss statement showing the results provision of accounting, clerical, and administrative of operations of Greenwich Sentry and its net capital services, and maintaining corporate records. (Cl.¶ 49.) appreciation or net capital depreciations, a statement of such Partner's closing capital account and the Citco (Canada) Inc. is a Canadian corporation and manner of its calculation and the Partner's opening wholly owned subsidiary of CGL that operates prin- capital account and partnership percentage for the then cipally out of Ontario, Canada. (Cl.¶ 9.) Citco (Can- current fiscal year.” (Cl.¶ 98.) ada) was delegated by Citco (Europe) to function as sub-administrator of Greenwich Sentry. (Cl.¶ 10.) It *4 Plaintiff decided to invest with Greenwich Sentry has done so since September 2006. (Id.) (and in turn BMIS) in early 2008. On February 20, 2008, Stephenson received documents about one of The Citco entities issued reports as to Greenwich Greenwich Sentry's sister funds, Fairfield Sentry, and Sentry's portfolio and limited partners' NAV valua- was told that the documents for Greenwich Sentry tions, which they represented they would verify and were similar but not then available. The documents he investigate through due diligence applying their sub- received included a Fairfield Sentry Private Placement stantial expertise in that area. (Cl.¶ 45.) They held Memorandum, a powerpoint presentation, two “tear- themselves out as a fiduciary to the investors of the sheets” of initial performance data for Fairfield Sen- funds they administered. (Cl.¶ 46.) According to their try, and a due diligence questionnaire that described website: the roles of Citco and PWC in Fairfield's funds. (Cl.¶ 106.) On February 27, 2008, plaintiff received a “re- By providing fully independent services, we act as a turn attribution analysis” showing net profits for reliable fiduciary to safeguard the interests of in- Fairfield Sentry of 9.38% in 2006 and 7.34% in 2007, vestors. We train our staff to provide specialist ac- with the understanding that the figures would be ap- counting and valuation support, investor relations, plicable to Greenwich Sentry because they corporate services, and day to day management. represented the returns generated by BMIS. (Cl.¶ (Cl.¶ 46.) 107.)

PricewaterhouseCoopers, LLP (PWC) is an Ontario In March 2008 plaintiff received an estimated monthly limited liability partnership, (Cl.¶ 14), and a member fund report for Greenwich Sentry showing a gain in firm of PricewaterhouseCoopers International, which February 2008, a Greenwich Sentry Limited Partner- operates a network of inter-connected member firms ship Agreement, its PPM, and a Subscription Agree- providing auditing, accounting and other investment ment. (Cl.¶ 108.) The Greenwich Sentry PPM, dated and advisory services across an international platform, August 2006, described how the Limited Partners' maintaining centralized control over information, funds would be invested: it described the split strike training, standards of care, marketing, and quality of conversion strategy, and explained that the strategy work. (Cl.¶ 15.) The network of Pricewaterhouse- was “implemented by Benard L. Madoff Investment Coopers entities hold themselves out and operate as a Securities LLC ... through accounts maintained by the unified business entity comprising a leading ac- Partnership at that firm....The services of BLM and its counting and auditing firm with specialized expertise personnel are essential to the continued operation of in hedge funds and investment vehicles. (Cl. ¶ 15; Cl. the Partnership, and its profitability, if any.” (Cl.¶ 28.) ¶ 60.) Defendant PWC was the auditor of Greenwich Plaintiff decided to invest in the funds, knowing and Sentry from 2006 through 2008. (Cl .¶ 16.) It con- relying on the strength of Citco's approval as admin- ducted an annual audit of Greenwich Sentry, (Cl.¶ 63), istrator and PWC's approval as auditor because he had for the purposes of which it was given complete access learned as an experienced investor that the adminis- to Greenwich Sentry's records. (Cl.¶ 65.) It annually tration and auditing of hedge funds was vital to their issued an unqualified audit report, with the salutation security. (Cl.¶¶ 109-115.) “To the Partners of Greenwich Sentry, L.P.” attesting to the accuracy of Greenwich Sentry's financial Plaintiff individually executed his first subscription statements. (Cl.¶ 63.) In preparing this report PWC and deposited $60 million in Greenwich Sentry's New undertook to “prepare an annual audited financial York bank accounts on or about April 1, 2008. (See report setting forth a balance sheet of Greenwich Subscription Documents, Citco Fund Services Ex. A.)

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He subsequently executed a new subscription on June 1, 2008 transferring the partnership assets into his Third, the Complaint generally alleges that a red flag trust. (Cl.¶¶ 115-117.) Although he never withdrew was created by the fact that BMIS used manual trades funds from the account, he received monthly updates despite Madoff's reputation “as an early and enthu- on his investment detailing his “gains.” By October siastic proponent of electronic trading,” that Madoff 31, 2008, plaintiff had received seven monthly NAV refused to permit any “due diligence reviews” or sheets from Citco demonstrating that his $60 million “performance audits” of those manual trades, and that had risen in value to $62,540,565. (Cl.¶ 120.) Ac- such a review would have revealed the Ponzi scheme. cording to the NAVs, by the end of November 2008 he (Cl.¶¶ 142-146.) had totaled gains of 6.59% in just seven months, while the Dow Jones Industrial Average had lost 33.44% Fourth, because BMIS' account statements were fake, and the S & P 500 had lost 37.65%. (Cl.¶ 121.) the cash in Greenwich Sentry's accounts did not ac- However by December 11, 2008, those numbers had tually exist. Accordingly, the Complaint alleges that been called into doubt: upon learning of the Madoff cash and position reconciliations between Greenwich scheme, Stephenson requested withdrawal of the en- Sentry's books and the results reported by BMIS tirety of his account, but his requests were ignored. FN7 would have necessarily revealed material discrepan- (Cl.¶ 129.) His investment had been wiped out. cies. (Cl.¶¶ 147-149.) (Cl.¶ 130.) Fifth, the Complaint alleges that the PPM permits 2. Suspicious facts surrounding BMIS BMIS to engage in securities lending of the securities in its portfolio. Because BMIS did not actually own *5 The Complaint describes a number of red flags securities, however, it did not engage in securities surrounding BMIS “during the time that Citco and lending. A review of securities lending practices PWC provided services to Greenwich Sentry” that it would have raised a red flag because it would have alleges should have “placed them on notice of the been irrational for BMIS to forego the investment Ponzi Scheme.” (Cl.¶ 134.) income that securities lending would have provided. (Cl.¶¶ 150-151.) Similarly, because BMIS did not take First, plaintiff alleges that operational risk was high out commercial bank loans in order to re-invest in because BMIS had complete control over all aspects itself (despite higher rates of return than prevailing of the trades: it held the securities, executed the trad- interest rates), the Complaint alleges that its opera- ing strategy, and reported results. “As a result there tions were irrational and suspicious. (Cl.¶ 161-163.) was no segregation of duties among independent re- porters and thus a lack of internal control which re- Sixth, the reported results of BMIS were much higher sulted in a lack of investment transparency such that and more stable than other firms using the same risk management was materially compromised.” strategy. (Cl.¶¶ 152-156 .) (Cl.¶¶ 135-136.) Seventh and finally, the independent auditor for Second, the complaint alleges that BMIS' transactions BMIS, Friehling and Horowitz, was small, not well were at variance with market evidence. In several known, and not properly certified. (Cl.¶¶ 157-160.) cases, the positions that BMIS claimed to have placed using the split-strike conversion methodology were *6 Although the Complaint alleges that these red flags actually in excess of the actual open interest in the S & “were material,” that they “would and/or should have P 100 Put & Call market in those securities. (Cl.¶ 138.) placed” defendants on notice of the Ponzi scheme, and Furthermore, the complaint alleges that BMIS' that they existed “during the time that Citco and PWC over-the-counter option agreements would have been provided services to Greenwich Sentry and the Li- more expensive than similar trades made over the S & mited Partners,” (Cl.¶ 134), and although it describes P 100 Put & Call market, and that this would have the flags in some detail, (Cl.¶ 135-163), it does not “materially reduced profits” because of the higher allege actual knowledge of them by PWC and Cit- transaction costs. The decision to engage in more co.FN8 expensive over-the-counter trades, then, was supi- cious. (Cl.¶¶ 137-141.)

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3. Citco and PWC did not discover the Ponzi relied upon by potential investors and limited partners. scheme (Cl.¶ 92-94.) It knew that its reports were material to an understanding of Greenwich Sentry's financial The Citco entities allegedly had obligations to inves- position, and that since partnership interests were not tigate these red flags, to confirm the accuracy of publicly traded there was no independent market BMIS' representations, to accurately calculate NAVS, evidence to which investors could refer. (Cl.¶ 93.) For and to confirm the accuracy of account statements. those reasons, plaintiff relied on PWC's unqualified (Cl.¶¶ 164-169.) Nonetheless, they allegedly failed to audits in deciding to make his investment. (Cl.¶ 94.) do so. (Id.) Citco “failed to advise Plaintiff that the Nonetheless, PWC did not uncover the Madoff fraud Madoff Firm was engaging in a Ponzi scheme, and and, as a result, did not qualify its audits. that the Madoff Firm and/or Greenwich Sentry was or would become insolvent.” (Cl.¶ 171.) They failed to 4. Stephenson's claims advise plaintiff that money from new investors was being used to pay the withdrawals of older investors, *7 Plaintiff has brought this action against Citco and permitted Madoff to act jointly as custodian and PWC, claiming, in essence, that they failed to ade- broker, and did not investigate any of the purported quately carry out their duties to him and the Green- red flags. (Cl.¶¶ 165, 173-180 .) In general, Citco is wich Sentry Fund, and that those failures (1) led to alleged to have failed in each aspect of its fund ad- Greenwich Sentry's maintenance of its position in ministration to discover the Madoff scheme, (Cl.¶¶ BMIS, and (2) induced plaintiff to invest in Green- 164-183, 198-201), or to discover that Greenwich wich Sentry. Thus, these failures allegedly caused the Sentry and Fairfield Greenwich did not have the in- loss of his investment. Specifically, the Complaint ternal controls required to themselves discover such a alleges: (1) breach of Citco's fiduciary duties; (2) scheme. (Cl.¶¶ 184-197.) grossly negligent fund administration by Citco; (3) negligent auditing by PWC; (4) fraudulent misrepre- PWC had a number of obligations under GAAS and its sentation by PWC; (5) breach of Citco's fund admin- own best practices in its audits. It was required to istration contracts, (6) breach of PWC's audit con- satisfy itself, on the basis of competent evidence, that: tracts, and (7) aiding and abetting, by all defendants, Greenwich Sentry's financial statements had been FGB and Greenwich Sentry's breach of fiduciary duty. audited in accordance with GAAS, were fair presentations of partners' financial positions, and that inter- II. DISCUSSION nal controls had been adequately evaluated. (Cl.¶ 87.) Further, PWC was obligated to qualify its opinion 1. Standing when an unqualified opinion could not be expressed, disclose sufficient information to allow a reader to appreciate the nature of the reported upon transac- Defendants assert that plaintiff lacks standing to pur- tions, consider the likelihood of significant error in the sue his claims directly because they are derivative of information supplied to it, and consider the relation- the partnership's claims and ought to be brought in the ship between Greenwich Sentry, Citco, and BMIS. partnership's name. Both parties and the Court agree (Cl.¶ 87.) Specifically, AU 332.20 states that, when that Delaware law, specifically the test set forth in dealing with service organizations such as BMIS was Tooley v. Donaldson, Lufkin, & Jenrette, Inc., 845 to Greenwich Sentry, “[t]he auditor may be unable to A.2d 1031 (Del.2004), controls on this issue. (PWC sufficiently limit audit risk without obtaining eviden- Mem. 7; Pl. Opp. 13; Citco Mem. 14 (all treating tial matter about the operating effectiveness of one or Tooley as setting forth the relevant test.); See Debussy more of the service organization's controls.” (Cl.¶ 78.) LLC v. Deutsche Bank AG, No. 05 Civ. 5550, 2006 However according to the Complaint, PWC did not WL 800956, at *3 (S.D.N.Y. Mar.29, 2006) (“When follow this rule: PWC never met with the accountants deciding issues of ‘shareholder standing,’ that is, for BMIS, never reviewed their work, nor ever had whether claims should be brought directly or deriva- contact with BMIS outside of two non-audit meetings. tively, courts must look to the law of the fund's state of (Cl.¶ 79.) incorporation.”). The Tooley test provides that in determining whether a claim is direct or derivative a court should inquire into “(1) who suffered the alleged PWC understood that its auditing work would be harm (the corporation or the suing stockholders, indi-

--- F.Supp.2d ----, 2010 WL 1244007 (S.D.N.Y.) (Cite as: 2010 WL 1244007 (S.D.N.Y.)) vidually); and (2) who would receive the benefit of tribution of misleading PPMs to investors in [ponzi any recovery or other remedy (the corporation or the entity itself] are the property of those investors, and stockholders, individually).” Tooley, 845 A.2d at may be asserted only by them ...”). To support this 1033. “The stockholder's claimed direct injury must argument, plaintiff adds in its opposition papers the be independent of any alleged injury to the corpora- allegation, absent from the complaint, that Greenwich tion. The stockholder must demonstrate that the duty Sentry was itself a Ponzi scheme. (Pl. Opp. 16 (“to the breached was owed to the stockholder and that he or extent that Greenwich Sentry kept investors' money in she can prevail without showing any injury to the its own accounts without transfer to BMIS, which it corporation.” Id. at 1039. “[T]he determination of used to ‘net out’ to pay redemption requests based on whether a claim is derivative or direct in nature is the NAV statements of Citco and audited financials by substantially the same for corporate cases as it is for PWC, it was a freestanding Ponzi scheme”).) But the limited partnership cases.” Albert v. Alex. Brown complaint does not allege that Greenwich Sentry held Management Services, Inc., No. Civ.A. 762-Nm 2005 money to an extent that could possibly support the WL 2130607, at *12 (Del.Ch. Aug.26, 2005). contention that Greenwich Sentry was a freestanding Ponzi scheme, FN9 nor does it actually allege that At the outset the Court will address three of plaintiff's Greenwich Sentry was a freestanding Ponzi FN10 arguments that could apply broadly to all of the scheme. claims. Third, plaintiff argues that Greenwich Sentry did not First, plaintiff prefaces his argument on the standing suffer any harm because “it was a passive vehicle” for issue by pointing out that “[a]t the pleading stage, the investing with BMIS. (Pl.Opp.15.) However plaintiff allegations of the Complaint with respect to standing cites no authority to support its contention that a must be accepted as true and construed in favor of the “passive” investment partnership is not a separate plaintiff.” (Pl.Opp.11.) While it is true that the Court legal entity that suffers direct injury from (direct) must accept factual allegations as true, the court investment in a Ponzi scheme. To the extent that cannot merely rely on “plaintiff's characterization of plaintiff is seeking to distinguish a limited partnership his claims in the complaint, but ... must look to all the from a corporation, “[t]he test for distinguishing direct facts of the complaint and determine for itself whether from derivative claims in the context of a limited a direct claim exists .” San Diego County Employees partnership is substantially the same as that used when Retirement Assoc. v. Maounis, No. 07 Civ. 2618, 2010 the underlying entity is a corporation.” E.g. Anglo Am. WL 1010012, at *19 (S.D.N.Y. Mar.15, 2010) (quot- Security Fund, L.P. v. S.R. Global Int'l Fund, L.P., 829 ing Dietrich v. Harrer, 857 A.2d 1017, 1027 A.2d 143, 150 (Del.Ch.2003). (Del.Ch.2004); citing In re Syncor Int'l Corp. Share- holders Litig., 857 A.2d 994, 997 (Del.Ch.2004) Turning to the application of Tooley, the parties con- (“under Tooley, the duty of the court is to look at the found the Tooley test in this case by conflating all of nature of the wrong alleged, not merely at the form of plaintiff's claims into one inquiry. (See Citco Mem. words used in the complaint”)). Accordingly the Court 23; Pl. Opp. 11-19.) But there is no reason that some limits its favorable construction to the factual allega- claims arising out of a case or controversy could not tions of plaintiff's complaint, and does not take plain- be direct while other claims arising out of that case or tiff's averments that its claims are direct at face value. controversy are properly derivative. Grimes v. Do- nald, 673 A.2d 1207, 1212-13 (Del.1996) (“the same *8 Second, plaintiff argues that “in the context of a set of facts may result in direct and derivative Ponzi scheme, the damages to investors are treated as claims”). Since the Tooley test inquires into what duty individual claims which they may purs[u]e against was breached, what injury was suffered, and what third parties, and are not derivative claims belonging relief is available, these factors must be determined to the corporation.” (Pl.Opp.13.) But plaintiff's claims with respect to each claim. Some claims, such as those are alleged to be derivative of Greenwich Sentry's, not alleging individual inducement to invest and viola- BMIS', and there is no basis for extending this doc- tions of duties owed to Stephenson individually and trine to non-ponzi entities that lost money in a Ponzi separately from the partnership, may be direct. Others, scheme. Cf. Hirsch v. Arthur Andersen & Co., 72 F.3d based on duties owed primarily to Greenwich Sentry 1085 (2d Cir.1995) (“claims predicated upon the dis- and based on the injury the fund suffered when Ma-

--- F.Supp.2d ----, 2010 WL 1244007 (S.D.N.Y.) (Cite as: 2010 WL 1244007 (S.D.N.Y.)) doff wiped out its investments, are likely derivative. any alleged injury to the corporation. The stockholder Accordingly the Court addresses whether each of must demonstrate that the duty breached was owed to plaintiff's claims is direct or derivative in turn. the stockholder and that he or she can prevail without showing any injury to the corporation.”). A. Counts I, alleging breach of fiduciary duty and VII, alleging aiding and abetting breach of fidu- B. Counts V and VI, alleging breach of contract, ciary duty, are derivative are derivative

*9 [1] Count I alleges breach of fiduciary duty against [2] Stephenson seeks to enforce the engagement con- the Citco entities. Count VII alleges that Citco and tracts between Greenwich Sentry and defendants di- PWC aided and abetted the breach of fiduciary duty by rectly by asserting that as a limited partner he was a Fairfield Greenwich. Even if plaintiff's breach of fi- third party beneficiary of those contracts. Even if that duciary duty claims were not pre-empted by the Mar- were true,FN12 Stephenson could not demonstrate an tin Act (which they are, as discussed below), the Court injury (a breach of that contract) independent of injury would dismiss them because they are derivative. to Greenwich Sentry (the promisee and primary beneficiary of the contract). Plaintiff does not allege an The first prong of the Tooley test is who suffered the independent injury or breach of contractual obliga- harm. Plaintiff's breach of fiduciary duty claims do not tions specific to him, but rather a general breach of the allege an injury to Stephenson independent of the contracts that is applicable to the partnership at large, injury to Greenwich Sentry. The gravamen of plain- and as such he could not demonstrate his own injury tiff's breach of fiduciary duty claims is a failure to without demonstrating that the partnership was in- administer the fund such that the Madoff Ponzi jured. Accordingly, these claims are also derivative. scheme would be discovered. (“If Citco had not acted See Primavera Familienstiftung v. Askin, No. 95 Civ. in manner [sic] alleged above, and had not failed to 8905, 1996 WL 494904, at *9 (S.D.N.Y. Aug.30, detect and/or advise Plaintiff of the Ponzi scheme ... 1996) (finding third party contract derivative under Plaintiff would not have suffered its loss.” Cl. ¶ 227; pre-Tooley “special injury” test) (quoting Orban v. “Citco was reckless in that it failed to review con- Field, Civ. A. No. 12820, 1993 WL 547187, at *9 flicting information that it had a duty to reconcile and (Del.Ch. Dec.30, 1993) (“[t]he idea of shareholders monitor, and unreasonably and recklessly ignored the having directly enforceable rights as third party bene- red flags.” Cl. ¶ 228.) A claim for deficient manage- ficiaries to corporate contracts is, I think, one that ment or administration of a fund is “a paradigmatic should be resisted. One of the consequences of limited derivative claim.” Albert v. Brown Mgmt. Serv., Inc., liability that shareholders enjoy is that the law treats No. Civ.A. 762-N, 2005 WL 2130607, at *13 (Del.Ch. corporations as legal persons not simply agents for Aug.26, 2005) (citing, e.g. Kramer v. W. Pac. Indus., shareholders”)); Cashman v. Coopers and Lybrand, Inc., 546 A.2d 348, 353 (Del.1988) (“A claim of 251 Ill.App.3d 730, 191 Ill.Dec. 317, 623 N.E.2d 907, mismanagement ... represents a direct wrong to the 910-11 (Ill.App.Ct.1993) (same). If Stephenson corporation that is indirectly experienced by all wishes to enforce the engagement contracts he should shareholders. Any devaluation of stock is shared col- make demand upon Greenwich Sentry to do so and, if lectively by all the shareholders, rather than inde- that is unavailing, bring a derivative action in its stead. pendently by the plaintiff or any other individual shareholder. Thus, the wrong alleged is entirely de- C. Counts II, III, and IV, alleging gross negligence, rivative in nature.”).FN11 If, as alleged, defendants negligence, and fraud, are direct to the extent they breached a fiduciary duty by not discovering that allege inducement Greenwich Sentry's accounts were invested in what would become the most infamous Ponzi scheme in *10 [3] Plaintiff's claims based on theories of negli- recent history, it necessarily injured Greenwich Sentry gent and fraudulent inducement are direct to the extent in so doing. Therefore plaintiff cannot prevail on this (and only to the extent) that they allege (1) violation of claim without showing injury to the partnership a duty owed to potential investors at large and (2) that Greenwich Sentry itself, and accordingly the claim is such violations induced plaintiff to invest in Green- derivative. Tooley, 845 A.2d at 1039 (“The stock- wich Sentry. While the Court has its doubts that holder's claimed direct injury must be independent of plaintiff's negligence and gross negligence claims

--- F.Supp.2d ----, 2010 WL 1244007 (S.D.N.Y.) (Cite as: 2010 WL 1244007 (S.D.N.Y.)) adequately so plead,FN13 plaintiff's fraud claim clearly practices by investigating and intervening at the first alleges such a theory. Such claims are direct because indication of possible securities fraud on the public they allege a harm suffered by plaintiff independent of and, thereafter, if appropriate, to commence civil or the partnership and a duty to plaintiff that is not criminal prosecution merely derivative of PWC's fiduciary duties to the partnership. See e.g. Calcutti v. SBU, Inc., 273 CPC Intl. v. McKesson Corp., 70 N.Y.2d 268, 277, F.Supp.2d 488 (S.D.N.Y.2003) (discussing duties that 519 N.Y.S.2d 804, 514 N.E.2d 116 (1987). In fur- accountants owe to the general public). “[T]he main therance of this desired consistency, the New York dividing line between direct and derivative claims Court of Appeals in McKesson held that there is no styled as ‘fraudulent inducement,’ [is] whether the private right of action under the Act, as “consistency plaintiff has alleged some injury other than that to the of purpose with the statute includes consistency with corporation.” Big Lots Stores, Inc. v. Bain Capital this enforcement mechanism.” Id. Although the Fund VII, LLC, 922 A.2d 1169, 1177 (Del.Ch.2006). McKesson court did not address the impact of this As plaintiff alleges, he knew of PWC's unqualified holding on existing common law claims featuring the audits prior to investing in Greenwich Sentry, and same or similar elements, shortly thereafter “three of “would not have made its initial investment in the appellate divisions interpreting the decision held Greenwich Sentry” if not for PWC's opinion. (Cl.¶ that the Martin Act preempts any common law claims 268.) And recovery on a claim based solely on in- within its purview.” Nanopierce Techs., Inc. v. ducement would only flow to those individuals, such Southridge Capital Management LLC, No. 02 Civ. as plaintiff alleges he was, who were so induced. For 0767, 2003 WL 22052894, at *2 (S.D.N.Y. Sept. 2, example, damages from an inducement claim based 2003). As Judge Sand explained in his comprehensive solely on a fraudulent November 5th, 1955 report overview of Martin Act preemption in Nanopierce, would only be available to that subset of limited “later New York state decisions adopted the same partners who invested after that date. Accordingly, rule,” id., as did “just about every federal court to plaintiff has standing to bring his inducement claims consider the question.” Id.; see also Pro Bono Invs., directly. Inc. v. Gerry, No. 03 Civ. 4347, 2005 WL 2429787, at *16 (S.D.N.Y. Sep. 30, 2005) (Koeltl, J.) (“Most New 2. Martin Act preemption York courts have further held that the [Martin] Act precludes a private right of action for common law A. Causes of action covered claims the subject matter of which is covered by the Martin Act....The federal courts have, almost without [4] Defendants assert that some, but not all, of plain- exception, adopted the same position.”) (citing Rego tiff's claims are preempted by the Martin Act, New Park Gardens Owners Ass'n v. Rego Park Gardens York's blue sky statute.FN14 See N.Y. Gen. Bus. L. § Assocs., 191 A.D.2d 621, 595 N.Y.S.2d 492, 494 (2d 352-c (2003).FN15 Specifically, defendants assert Dep't 1993); Eagle Tenants Corp. v. Fishbein, 182 preemption of Count I (breach of fiduciary duty), A.D.2d 610, 582 N.Y.S.2d 218, 219 (2d Dep't 1992); Count II (gross negligence), Count III (negligence and Horn v. 449 E. 57th Co., 151 A.D.2d 112, 547 professional malpractice), and Count VII (aiding and N.Y.S.2d 1, 5 (2d Dep't 1989); Marcus v. Frome, 329 abetting breach of fiduciary duty). They do not assert F.Supp.2d 464, 475-76 (S.D.N.Y.2004)). preemption of Count IV (fraud) or Counts V and VI (breach of contract). *11 In the only case by the Second Circuit to discuss the issue, it also adopted this approach and dismissed a The Martin Act authorizes the New York Attorney breach of fiduciary claim because of Martin Act General to enforce its provisions with implementing preemption: regulations and actions for restitution and damages for injured parties. See N.Y. Gen. Bus. L. § 353. The The New York Court of Appeals has held that there purpose of the Act is is no implied private right of action under the Martin Act, and other New York courts have determined to create a statutory mechanism in which the At- that sustaining a cause of action for breach of fidu- torney General would have broad regulatory and ciary duty in the context of securities fraud would remedial powers to prevent fraudulent securities effectively permit a private action under the Martin

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Act, which would be inconsistent with the Attorney causes of action related to a plaintiff's securities fraud General's exclusive enforcement powers thereund- claim that do not include scienter as an essential ele- er. ment are typically preempted by the Martin Act, in contrast to a claim requiring intent, such as a claim for Castellano v. Young & Rubicam, Inc., 257 F.3d 171, common law fraud.” (quoting Sedona Corp. v. La- (2d Cir.2001). denburg Thalmann & Co., Inc., No. 03 Civ. 3120, 2005 WL 1902780, at *22 (S .D.N.Y. Aug. 9, 2005))). Martin Act preemption does not extend to those common law claims that require additional elements *12 As may be observed, a multitude of courts have beyond what is required for Martin Act liability, such dismissed claims materially similar to the breach (and as common law fraud claims that require a showing of abetting breach) of fiduciary duty, negligence, and intent. As Judge Sand explained, New York courts gross negligence claims that defendants assert are have offered a persuasive justification for allowing preempted here. One closely analogous case is In re common law fraud claims to proceed while dismissing Bayou Hedge Fund Litig., id., in which the plaintiff negligent misrepresentation and breach of fiduciary brought a breach of fiduciary duty claim against its duty claims: “the latter two causes of action, like the investment advisor for allegedly conducting inade- Martin Act itself, do not require proof of deceitful quate diligence before recommending investment in a intent; common law fraud, however, does ... courts hedge fund that was ultimately revealed to be a Ponzi concerned with preserving the Attorney General's scheme. The court “concur[red] with the analysis set exclusive domain therefore preclude claims which forth in Castellano, Nanopierce, and a host of other essentially mimic the Martin Act, but permit common state and federal decisions finding breach of fiduciary law fraud claims, which require an additional ele- duty claims arising in the securities context to be ment.” Nanopierce, 2003 WL 22052894 at * 4 (citing preempted by the Martin Act,” and concluded that the Horn v. 440 E. 57th Co., 151 A.D.2d 112, 547 plaintiff's “cause of action for breach of fiduciary duty N.Y.S.2d 1, 5 (1st Dep't 1989) (“Fairly construed, [was] precluded by the Martin Act.” Id. at 422. [causes of action for negligent misrepresentation and breach of fiduciary duty] omit the element of a de- Although fraud claims had not traditionally been ceitful intent on defendant's part and substitute there- considered preempted under the Martin Act, the New fore the existence of a fiduciary relationship of trust York Court of Appeals recently found that even they and confidence.”); Whitehall Tenants Corp. v. Estate can be preempted, if the allegations are based on a of Olnick, 213 A.D.2d 200, 623 N.Y.S.2d 585, 585 filing required by the Attorney General's Martin Act (1st Dep't 1995) (“Without evidence of reliance ... or implementing regulations. In Kerusa Co. LLC v. intent to defraud ... plaintiff is endeavoring to vindi- W10Z/515 Real Estate Ltd. Partnership, 12 N.Y.3d cate [rights committed] exclusively to the Attorney 236, 879 N.Y.S.2d 17, 906 N.E.2d 1049 (N.Y.2009), General.”); Granite Partners L.P. v. Bear Stearns & the New York Court of Appeals was presented with a Co., 17 F.Supp.2d 275, 291 n. 8 (S.D.N.Y.1998) purported fraud stemming from “supposedly false and (“The Martin Act does not preclude private litigants fraudulent representations and material omissions in from bringing common law fraud claims because such [the defendant condo sponsor's] sales brochures and claims require a plaintiff to prove intent or scienter. advertisements.” The court noted that the alleged Therefore, courts allow these claims to proceed while omissions were in disclosure documents that the At- simultaneously dismissing negligent misrepresenta- torney General had required through a Martin Act tion and breach of fiduciary duty claims.”)). See also implementing regulation. Id. at 243-244, 879 Pro Bono Invs., 2005 WL 2429787 at *16 n. 16 N.Y.S.2d 17, 906 N.E.2d 1049 (the Attorney General (“Unlike Counterclaims Eight through Thirteen and has the power to regulate newly constructed condo- Fifteen [alleging inter alia, breach of fiduciary duty, miniums pursuant to N.Y. Gen. Bus. Law § 352-e(6)). negligence, and gross negligence], the common law Therefore the Court of Appeals determined that a fraud alleged in the Seventh Counterclaim is not fraud cause of action based on those omissions would ‘covered’ by the Martin Act because it requires an effectively be a private cause of action for a Martin additional element of deceitful intent.”); In re Bayou Act violation, violating the requirement that there is Hedge Fund Litig., 534 F.Supp.2d 405, 421 (“The vast no private right of action under the statute. Id. at majority of state and federal courts have found that 244-247, 879 N.Y.S.2d 17, 906 N.E.2d 1049 (citing

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McKesson, 70 N.Y.2d 268, 276-277, 519 N.Y.S.2d to § 352-c requires preemption of those common law 804, 514 N.E.2d 116 (1987)). Although the Court of claims that would impinge on his authority under that Appeals found the fraud cause of action preempted in section to prosecute certain securities violations. light of § 352-e(6), it did not address traditional Mar- tin Act preemption under § 352-c, such as whether Plaintiff cites a number of cases in support of his fraud causes of action implicating that section should contrary position, none of which reject the traditional also be preempted. understanding of Martin Act preemption or adopt plaintiff's view that preemption is limited solely to In a somewhat inverted reading of the case, plaintiff those cases rooted in a violation of the Attorney asserts that Kerusa narrowed the scope of Martin Act General's disclosure regulations (as opposed to the preemption and thus forecloses preemption of his other securities violations within the Act's purview). claims. As plaintiff reads Kerusa, it created a new test See Kramer v. W10Z/515 Real Estate Ltd. Partner- limiting Martin Act preemption to claims based solely ship, 44 A.D.3d 457, 844 N.Y.S.2d 18, 9-21 (1st Dep't on nondisclosures or violations of statutory require- 2007) (dealing, as Kerusa did, with fraud claim based ments created by the Martin Act itself. But as ex- on information in required disclosure documents); plained above, Kerusa only resolved whether a Hamlet on Old Oyster Bay Home Owners Assn., Inc. v. common law fraud claim, traditionally treated as Holiday Org., Inc., 59 A.D.3d 673, 874 N.Y.S.2d 508 non-preempted, could be preempted in the specific (2nd Dept.2009) (recognizing that duties imposed context presented. Nothing in the opinion suggests under Martin Act “are exclusively enforceable by the that the Court of Appeals, in expanding Martin Act Attorney General” and thus limiting negligence claim preemption into the fraud realm, intended to diminish against condominium to duties unrelated to Martin it with respect to other types of claims. A significant act); Bridge St. Homeowners Assn. v. Brick Condo- body of precedent has developed regarding preemp- minium Developers, LLC, 18 Misc.3d 1128(A), 856 tion of, inter alia, negligence and breach of fiduciary N.Y.S.2d 496 (Sup.Ct. Kings Co.2008) (basing deci- duty claims, and this Court is unwilling to conclude sion on unique interplay between Martin Act re- that the New York Court of Appeals tacitly overturned quirements and homeowner's rights against a negli- it. gent carpenter or condo builder); Country Pointe at Dix Hills Home Owners Assn. v. Beechwood Org., 21 *13 The reasoning of Kerusa supports the traditional Misc.3d 1110(A), 873 N.Y.S.2d 510 application of preemption to claims that are covered (Sup.Ct.Suff.Co.2008) (in condominium case, ad- by § 352-c of the Martin Act. As Kerusa explained, dressing Martin Act preemption of fraud and breach of the Martin Act allows the Attorney General to prom- contract claims only); Caboara v. Babylon Cove De- ulgate disclosure requirements for newly constructed vel., LLC, 54 A.D.3d 79, 862 N.Y.S.2d 535 (2nd Dep't condominiums. N.Y. Gen. Bus. Law § 352-e(6). 2008) (same). Permitting a fraud claim based on information contained in those disclosures would “expand the already Accordingly the Court finds that the overwhelming detailed disclosure requirements of the Martin Act by weight of authority supports Martin Act preemption of forcing parties to disclose [a wide array of problems] negligence and breach of fiduciary duty claims arising ... in order to avoid transforming every potential latent in the securities context. This is not the only court construction defect case into a claim for common-law dealing with state law claims related to the Madoff fraud on account of alleged omissions in Martin Act fraud to recently so find. Barron v. Igolnikov, No. 09 disclosures.” The decision to preempt fraud claims in Civ. 4471, 2010 WL 882890 (S.D.N.Y. Mar. 10, this instance is one narrow application of the policy 2010) also involved fallout from the Madoff Ponzi expressed in McKesson, that private causes of action collapse. In that action before Judge Griesa, plaintiff which impinge on the Attorney General's authority Andrea Barron brought a putative class action on under the Martin Act are preempted in order to behalf of all investors who acquired and/or held li- maintain the exclusivity of that authority. Just as the mited partnership interests in certain funds. Those application of that policy to § 352-e(6) in Kerusa led funds had invested indirectly with Madoff by allo- to preemption of certain fraud claims (because they cating a portion of their assets to four feeder funds. Id. would impinge on the Attorney General's authority at *2. The plaintiff claimed, much like Stephenson with respect to disclosure regulations), its application does, that there were “red flags” associated with

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Madoff that the fund's research division discovered or Sedona Corporation v. Ladenburg Thalmann & Co., should have discovered. Failure to warn of these red Inc., No. 03 Civ. 3120, 2005 WL 1902780 (S.D.N.Y. flags or to appropriately qualify account statements Aug. 9, 2005), despite the fact that the alleged misre- allegedly constituted (1) breach of fiduciary duty, (2) presentations had been made to the plaintiff outside of aiding and abetting breach of fiduciary duty, (3) gross New York, there was a sufficient nexus with New negligence, and (4) unjust enrichment. Noting that the York to implicate the Martin Act because of the importance of Martin Act preemption was unders- complaint's allegations that the defendant was situated cored by the fact that the New York Attorney General in New York, conducted communications from New has pending claims against one of the feeder funds York, and that the securities at issue were manipulated used, the court found that plaintiff's claims were and sold short in New York markets. Id. at *22 (dis- preempted by the Martin Act. Id. at *6. missing negligence, negligent misrepresentation, and breach of fiduciary duty claims). B. Geographic coverage Stephenson's complaint explains the substantial con- *14 Plaintiff's claims for breach of fiduciary duty, nection the sale of these securities had to New York in aiding and abetting that breach, negligence, and gross its introductory, venue, and jurisdiction sections. negligence are therefore preempted if they fall within Greenwich Sentry, the fund through which plaintiff the Martin Act's geographic purview, that is if they are invested in Madoff and lost his investment, is cen- based on activities engaged in to promote or induce tered in New York, it has its office “[w]ithin the State the sale of securities “within or from” New York. FN16 and County of New York” and it “was actively doing N.Y. Gen. Bus. Law § 352-c(1); Lehman Bros. business within the State and County of New York.” Commercial Corp. v. Minmetals Int'l Non-Ferrous (Cl.¶ 21.) “Greenwich Sentry's principal place of Metals Trading Co., 179 F.Supp.2d 159, 162 business is in the State and County of New York[, it] (S.D.N.Y.2001) (“that the transactions were ... within transacted business in and from the State and County or from New York [is] a nexus expressly required of New York in connection with the matters at issue,” under the Martin Act.”) Plaintiff asserts that they do (Cl.¶ 5), and it “maintained its bank accounts in con- not because, inter alia, defendants are not based in nection with the Fund at issue in the State of New New York and the limited partnership agreement York.” (Id.) Subscribers in Greenwich Sentry depo- contains a Delaware choice of law provision. Defen- sited their investments in Greenwich Sentry's bank dants have the better of the argument. accounts, located in New York. (See Subscription Documents, Citco Fund Services Ex. A.). Thus limited [5] Each of the challenged claims alleges inducement partnership shares in Greenwich Sentry were sold in to purchase or to maintain an interest in securities, so and from New York. the question under the Martin Act, then, is whether those securities were sold “within or from” New *15 The connections with New York go well beyond York.FN17 Several Courts in this District have found the fact that shares of Greenwich Sentry were sold that “a transaction is ‘within or from’ New York for from within the state. The NAVs on which plaintiff purposes of the Martin Act if a plaintiff alleges that a allegedly relied were sent “to Greenwich Sentry in ‘substantial portion’ of the events giving rise to a New York,” and “Citco Europe [and Citco Canada] claim occurred in New York.” Heller v. Goldin Re- needed to have, and did in fact have, regular and sys- structuring Fund, L.P., 590 F.Supp.2d 603, 611 n. 9 tematic contact with Greenwich Sentry and the (S.D.N.Y.2008); Abu Dhabi Commercial Bank, No. Greenwich Sentry General Partners (all of whom were 08 Civ. 7508, 2009 WL 2828018, at *14 (S.D.N.Y. located in New York) in order to perform the services Sept. 2, 2009) (quoting Heller ). Thus, the Igolnikov which it contracted to and did perform. (Id.; Cl. ¶ 22.) court found that the limited partnership interest pur- The complaint is explicit that “[t]he claims against chases in that case were “within or from” New York Citco Europe spring directly from and are directly because “plaintiff is a New York resident, Madoff's related to its contacts within the State and County of fraud was centered in New York, and the Selectinvest New York.” (Cl. ¶ 21 (as do the claims against Citco ARV LP fund in which plaintiff invested is a domestic Canada, Cl. ¶ 22, and as do those against PWC, Cl. ¶ fund managed by UBPAM from its New York head- 23).) Finally, not only was Greenwich Sentry in New quarters.” Igolnikov, 2010 WL 882890, at *6. And in York, but the fund in which it was principally in-

--- F.Supp.2d ----, 2010 WL 1244007 (S.D.N.Y.) (Cite as: 2010 WL 1244007 (S.D.N.Y.)) vested, BMIS, was also located principally in New 167 L.Ed.2d 929 (2007) (quoting Fed.R.Civ.P. York. 8(a)(2); Conley v. Gibson, 355 U.S. 41, 47, 78 S.Ct. 99, 2 L.Ed.2d 80 (1957) (abrogated in part by Twom- Plaintiff cites as contrary authority Pension Comm. of bly )). In Twombly, the Supreme Court held that to the Univ. of Montreal Pension Plan v. Banc of Amer- satisfy this standard, a complaint must contain ica Securities, LLC, 592 F.Supp.2d 608, 639-640 “enough facts to state a claim to relief that is plausible (S.D.N.Y.2009), wherein these same defendants failed on its face.” Id. at 570; See Starr v. Sony BMG Music to satisfy the geographic prong of the Martin Act. Entertainment, 592 F.3d 314, 321 (2d Cir.2010) However those claims did not have a sufficient nexus (quoting Twombly ). In Ashcroft v. Iqbal, --- U.S. ----, with New York because the securities at issue “[w]ere 129 S.Ct. 1937, 1949-50, 173 L.Ed.2d 868 (May 18, mostly marketed and sold to foreign investors, and 2009), the Court clarified three aspects of the analysis only a limited number of investors in the United States mandated by Twombly. First, the Court reiterated that participated.” Id. (not discussing where securities courts may not presume illegality when the “nub” of a were sold from). This case is much different. The complaint, id. at 1950, alleges conduct that is equally relevant securities here are shares of the Greenwich capable of being legal: “Where a complaint pleads Sentry fund that were sold “within or from” New facts that are ‘merely consistent with’ a defendant's York, it had primarily domestic investors, and ac- liability, it ‘stops short of the line between possibility cording to the complaint all of the General Partners and plausibility of ‘entitlement to relief.’ “ Id. at 1949 were located in New York. (Cl.¶ 22.) Furthermore in (quoting Twombly, 550 U.S. at 557). Second, the making its Martin Act determination Pension Com- Court held that only well-pled factual allegations are mittee did not explicitly address the locus from which entitled to a presumption of truth; “recitals of the the securities therein were sold. This Court finds in elements of a cause of action, supported by mere light of the plain language of the statute that the rele- conclusory statements, do not suffice.” Id. at 1949. Cf. vant inquiry is where securities are sold from, and so id . at 1960 (Souter, J., dissenting) (arguing that con- the fact that they were sold to a plaintiff in Texas, FN18 clusory statements should not be disregarded if ren- or that audit work occurred in Canada, is hardly out- dered plausible by the context in which they appear). come determinative. See supra, p. 29, n. 16. Third, the Court held that Twombly's “plausibility standard” was not limited to antitrust cases or those Because plaintiff's claims for breach of fiduciary, requiring complex discovery. While “[d]etermining negligence, gross negligence, and aiding and abetting whether a complaint states a plausible claim for relief breach of fiduciary duty involve the sale of securities will ... be a context-specific task,” Iqbal, 129 S.Ct. at within or from New York, they are preempted by the 1950, Twombly interpreted Rule 8 and therefore ap- Martin Act. Accordingly counts I, II, III, and VII of plies to “all civil actions.” Id. at 1953 (quoting the amended complaint are dismissed. Fed.R.Civ.P. 1). Under this understanding of Rule 8, a complaint alleging that the former Attorney General and the former Director of the Federal Bureau of In- 3. Plaintiff's fraud claim is inadequately plead vestigation engaged in purposeful discrimination did not state a claim, even though the complaint alleged Defendant PWC argues that plaintiff's fraud claim has that they had “willfully and maliciously agreed to not been plead adequately under Federal Rule 8(a)(2) subject” the plaintiff to harsh conditions of a con- or with the particularity required for fraud pleadings finement “as a matter of policy, solely on account of under Federal Rule 9(b). The Court will first address [his] religion, race, and/or national origin and for no the legal standards under both of these rules before legitimate penological interest.” Iqbal, 129 S.Ct. at addressing the adequacy of the complaint's fraud al- 1944. legations. *16 [6] Read together, Twombly and Iqbal suggest that “Federal Rule of Civil Procedure 8(a)(2) requires only the Court keep in mind two requirements when adju- ‘a short and plain statement of the claim showing that dicating a motion to dismiss that challenges the suffi- the pleader is entitled to relief,’ in order to ‘give the ciency of a complaint's factual allegations. First, al- defendant fair notice of what the claim is and the though the Court must still accept factual allegations grounds upon which it rests.’ “ Bell Atlantic Corp. v. as true, it should not credit “mere conclusory state- Twombly, 550 U.S. 544, 554, 127 S.Ct. 1955, 1964, ments” or “threadbare recitals of the elements of a

--- F.Supp.2d ----, 2010 WL 1244007 (S.D.N.Y.) (Cite as: 2010 WL 1244007 (S.D.N.Y.)) cause of action.” Iqbal, 129 S.Ct. at 1949. Second, Fleet Bank, N.A., 459 F.3d 273, 290-91 (2d Cir.2006). accepting creditable allegations as true, the Court must In order to survive a motion to dismiss, then, plaintiff also determine whether they plausibly suggest an must have either alleged motive and opportunity or entitlement to relief. See Harris v. Mills, 22 A.D. 379, facts constituting strong circumstantial evidence of 572 F.3d 66, 72 (2d Cir.2009) (adopting this reading conscious misbehavior or recklessness. He has not. of Iqbal). “A claim has facial plausibility when the plaintiff pleads factual content that allows the court to A. Motive and opportunity draw the reasonable inference that the defendant is liable for the misconduct alleged.” Iqbal, 129 S.Ct. at *17 [9] Plaintiff has not alleged that PWC had any 1949. If the factual averments permit no reasonable cognizable motive for fraud, so he cannot satisfy the inference stronger than the “mere possibility of mis- scienter requirement by alleging motive and opportu- conduct,” the complaint should be dismissed. Starr, nity. The only conceivable motive alleged by plaintiff 592 F.3d at 321 (quoting Iqbal, 129 S.Ct. at 1950). is PWC's economic interest in maintaining Fairfield Greenwich as a client. (See Cl. ¶ 214.) However “[t]he [7] Under New York law, a fraud claims requires “a mere receipt of compensation and the maintenance of material misstatement, known by the perpetrator to be a profitable professional business relationship for false, made with an intent to deceive, upon which the auditing services does not constitute a sufficient mo- plaintiff reasonably relies and as a result of which he tive for purposes of pleading scienter. Zucker v. Sa- sustains damages.” E.g. Ambassador Factors v. saki, 963 F.Supp. 301, 308 (S.D.N.Y.1997) (citing Kandel & Co., 215 A.D.2d 305, 307, 626 N.Y.S.2d Duncan v. Pencer, No. 94 Civ. 0321, 1996 WL 19043, 803 (1st Dep't 1995). The requisite state of mind, then, at *9-10 (S.D .N.Y. Jan. 18, 1996); Friedman v. Ari- is a deliberate intent to deceive. However under New zona World Nurseries Ltd. Partnership, 730 F.Supp. York law (as in the federal securities law context) this 521, 532 (S.D.N.Y.1990), aff'd, 927 F.2d 594 (2d intent can be demonstrated by recklessness of suffi- Cir.1991). “To hold otherwise would effectively ab- cient degree to create an inference of intent. See State olish the requirement of pleading facts which support Street Trust Co. v. Ernst, 278 N.Y. 104, 111, 15 a strong inference of scienter against professional N.E.2d 416, 120 A .L.R. 1250 (1938) ( “heedlessness defendants.” Id., citing Duncan. And it is economi- and reckless disregard of consequence may take the cally irrational to risk your professional reputation, place of deliberate intention” in proving fraud claim license, and the possibility of legal liability simply in against auditor); compare Decker v. Mas- return for a professional services fee. Id. citing Shields sey-Ferguson, Ltd., 681 F.2d 111, 120 (2d Cir.1982) v. Citytrust Bancorp., Inc., 25 F.3d 1124, 1129-1130 (recklessness satisfies federal securities law's intent (2d Cir.1994) (dismissing fraud claim and also noting requirement when conduct is “highly unreasonable” that plaintiff's pleading technique, “to couple a factual representing “an extreme departure from the standards statement with a conclusory allegation of fraudulent of ordinary care”). intent,” is inadequate). Accordingly it is not plausible to suggest that PWC was motivated to risk its very [8] The Court tests the complaint's scienter allegations business in furtherance of maintaining Fairfield against Federal Rule of Civil Procedure 9(b), which Greenwich as a client. requires that fraud be plead with particularity. Fed.R.Civ.P. 9(b). Although under this rule “scienter B. Circumstantial evidence that PWC acted reck- need not be alleged with great specificity, plaintiffs lessly are still required to plead the factual basis which gives rise to a ‘strong inference’ of fraudulent intent.” [10][11] The only remaining basis for finding that Wexner v. First Manhattan Co., 902 F.2d 169, 172 (2d FN19 intent is alleged in the complaint, then, is evidence of Cir.1990) (applying Rule 9(b) pre-PSLRA). This recklessness sufficient to create an inference of Circuit has long held in the securities fraud context fraud.FN20 This standard is “demanding,” and “for an that such intent may be established only by “(a) al- accountant to be found to have acted recklessly during leging facts to show that defendants had both motive an audit, its alleged misconduct must approximate an and opportunity to commit fraud, or (b) by alleging actual intent to aid in the fraud being perpetrated by facts that constitute strong circumstantial evidence of the audited company.” In re Scottish Re Group Se- conscious misbehavior or recklessness.” Lerner v. curities Litigation, 524 F.Supp.2d 370, 385

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(S.D.N.Y.2007); see e.g. In re IMAX Securities Litig., 720 (quoting Novak v. Kosaks, 216 F.3d 300, 309 (2d 587 F.Supp.2d 471, 483 (S.D.N.Y.2008); Rothman v. Cir.2000)) (both noting that neither such allegations Gregor, 220 F.3d 81, 98 (2d Cir.2000). The complaint nor GAAS violations are sufficient to establish reck- alleges three kinds of misconduct by PWC that led to lessness, “[t]o rise to the state of mind required, these misstatements in its audits: (1) failure in general to allegations must be coupled with evidence of ‘cor- follow GAAP, (2) failure to discover that Greenwich responding fraudulent intent”) Sentry lacked adequate internal controls to discover the Madoff fraud itself, and (3) failure to investigate (iii) Red flags BMIS despite the existence of red flags that, if discovered, should have raised suspicions about its op- [14] Although allegations of GAAP violations and erations. investigatory failures do not alone establish recklessness, they can when combined with allegations that (i) GAAP the auditor ignored red flags. Plaintiff argues that because the Complaint sets forth that PWC failed “to [12] Although they are not irrelevant to the issue of heed ‘red flags' about [BMIS] which internal controls recklessness, “allegations of GAAP and GAAS vi- would, if enforced, detect,” an inference of reckless- olations are not sufficient, on their own, to establish ness is warranted. (Pl.Opp.43.) Indeed, allegations scienter.” In re AOL Time Warner, Inc. Securities and that an auditor ignored “red flags” that would place a “ERISA” Litig., 381 F.Supp.2d at 240. “[F]ailure [by reasonable auditor on notice that the audited company PWC] to comply with Generally Accepted Account- was engaged in wrongdoing, “when coupled with ing Practices or other such irregularities are insuffi- allegations of GAAP and GAAS violations, are sufficient to establish recklessness. To rise to the state of cient to support a strong inference of scienter.” In re mind required, these allegations must be coupled with AOL Time Warner, Inc. Sec. And “ERISA ” Litig., 381 evidence of corresponding fraudulent intent.” West F.Supp.2d 192, 240 (S.D.N.Y.2004); see In re Allou Virginia Investment Management Board v. Doral Distributors, Inc., 395 B.R. 246 (Bkrt- Financial Corp., 344 Fed.Appx. 717, 179-720 (2d cy.E.D.N.Y.2008) (reviewing New York common law Cir.2009) (discussing defendants' argument that fraud claim and noting that “at the pleading stage ... plaintiff “failed to plead facts giving rise to the strong allegations of GAAS violations, coupled with allega- inference of scienter required by Fed.R.Civ.P. 9(b) tions that significant ‘red flags' were ignored, can and the [PSLRA]”); see, e.g. In re Scottish Re Group suffice to withstand a motion to dismiss”). However Securities Litigation, 524 F.Supp.2d at 385 (scienter the auditor must have actually been aware of the red standard “requires more than a failure to follow flags, either because they are alleged to have had GAAP”); Whalen v. Hibernia Foods PLC, No. 04 Civ. actual knowledge or because the red flags were so 3182, 2005 WL 1799370, at *3 (S.D.N.Y. Aug.01, obvious that the auditor must have been aware of 2005) (“Allegations of GAAP and GAAS violations them: “merely alleging that the auditor had access to alone are insufficient” to demonstrate strong cir- the information by which it could have discovered the cumstantial evidence of conscious misbehavior or fraud is not sufficient.” In re IMAX Securities Litig., recklessness). 587 F.Supp.2d 471, 484 (S.D.N.Y.2008). “While a red flag need not reveal to a defendant all aspects of a (ii) Failure to investigate internal controls at Green- given fraud, plaintiffs must allege that facts which wich Sentry come to a defendant's attention would place a reasonable party in defendant's position on notice of *18 [13] The allegations that PWC failed to ade- wrongdoing.” In re Refco, Inc. Securities Litigation, quately investigate Greenwich Sentry's internal safe- 503 F.Supp.2d 611, 649 (S.D.N.Y.2007). guards, independent of the fraud at BMIS, do not satisfy the scienter element of plaintiff's fraud claim. Thus, complaints alleging that an auditor had actual “In the accounting context, failure ‘to identify prob- knowledge of and consciously disregarded red flags lems with the defendant company's internal controls have been found to sufficiently plead scienter. See and accounting practices does not constitute reck- SEC v. Gold, No. 05 Civ. 4713, 2006 WL 3462103, at lessness' “ West Virginia Investment Management *4-5 (E.D.N.Y. Aug. 18, 2006) (noting that scienter Board v. Doral Financial Corp., 344 Fed.Appx. 717, can be inferred where “auditor consciously disregards

--- F.Supp.2d ----, 2010 WL 1244007 (S.D.N.Y.) (Cite as: 2010 WL 1244007 (S.D.N.Y.)) red flags,” and finding allegation in complaint that Priceline.Com Inc. Securities Litig., 342 F.Supp.2d auditor “knew that ... selling prices were below their 33, 56 (D.Conn.2004) (“Even if the court could infer inventory cost sufficient to allege recklessness” (em- that [auditor] was aware of the [nine] red flags set phasis in original)); Jacobs v. Coopers & Lybrand, forth herein, which is no small leap, the red flags are L.L.P., No. 97 Civ. 3374, 1999 WL 101772, at *2, not so egregious as to render [auditor's] audit a farce”); *14-15 (S.D.N.Y. Mar.01, 1999) (fraud claim against Zucker v. Sasaki, 963 F.Supp. 301, 309 auditor survived motion to dismiss where complaint (S.D.N.Y.1997) (allegations of fraud by accountant alleged that defendant auditor's workpapers indicated insufficient where claim that it “knew or recklessly that it had examined and consciously disregarded disregarded adverse facts” based solely on status as suspicious documents); AOL Time Warner, Inc. Se- auditor); and Cohen v. Franchara Corp., 478 F.2d curities And “ERISA ” Litigation, 381 F.Supp.2d 192 115, 123 (2d Cir.1973) (“It is not enough for plaintiff (S.D.N.Y.2004) (inference of scienter supported in to show that defendant failed to detect certain material presence of red flags combined with “specific allega- facts when [it] had no reason to suspect their exis- tions beyond E & Y's status as an auditor,” distin- tence.”). guishing complaint from those where allegations of recklessness “based solely on [ ] status as an auditor”); Accordingly, only those red flags that PWC is alleged Whalen v. Hibernia Foods PLC, 2005 WL 1799370, at to have known of, or that are so obvious that PWC *3-4 (S.D.N.Y.2005) (recklessness where complaint must have known of them, can support an inference of alleged GAAP and GAAS violations as well as that intent. See The Limited v. McCrory Corp., 683 auditor “knew about and ignored a wide variety of red F.Supp. 387, 395 (S.D.N.Y.1988) (dismissing aspect flag[s]”). of fraud claim against independent auditor for which “factual allegations tending to establish knowledge” *19 In a handful of other cases, red flags have been were lacking, but not aspect of claim where auditor considered so obvious that knowledge of them by the was alleged to have “been apprised of the details of an auditor could be presumed. See In re Oxford Health event” constituting a red flag)). Judge Lynch's sum- Plans, Inc. Sec. Litig., 51 F.Supp.2d 290, 295 mary of the inquiry in Refco is apt here: “there was (S.D.N.Y.1999) (GAAP violations plus “additional certainly a monster under the bed; the question is facts showing that there were numerous red flags that whether anyone had a reason to look there.” In re [auditor defendant] must have been aware of, if it were Refco, Inc. Securities Litigation, 503 F.Supp.2d 611, conducting any kind of audit” are sufficient to create 649 (S.D.N.Y.2007). strong inference of reckless behavior); In re Philip Services Corp. Securities Litig., 383 F.Supp.2d 463, The complaint alleges that there were seven red flags 475 (S.D.N.Y.2004) (“because the red flags would be regarding the Madoff operation: (1) operational risk clearly evident to any auditor performing its duties, was at a high level, in part because Madoff was both one could reasonably conclude that [auditor] must trader and custodian; (2) BMIS' transactions were at have noticed the red flags, but deliberately chose to variance with market evidence; (3) BMIS did not disregard them”) (quoting In re Leslie Fay Companies permit access to its computers, and many of its re- Sec. Litig., 871 F.Supp. 686, 699 (S.D.N.Y.1995)). ported trades could not have actually taken place at the prices reported; (4) there were position and cash On the other hand, without a plausible allegation that breaks between Greenwich Sentry's records and defendant auditors knew of red flags, general allega- BMIS' records; (5) BMIS forewent potential revenue tions of red flags have been found insufficient to by not engaging in securities lending or taking out demonstrate scienter. See In re Refco, Inc. Securities commercial bank loans in order to re-invest in itself; Litigation, 503 F.Supp.2d at 663 (“plaintiffs have FN21 (6) BMIS reported incredibly consistent success; made no allegations whatsoever as to how the THL and (7) BMIS' independent auditor, Friehling and Defendants' ‘unfettered access' would have led them Horowitz, was small, not well known, and not prop- across particular documents in which the red flags erly certified. would have been apparent, and these allegations must therefore fail [because] there is no allegation sup- *20 The Complaint does not allege whether or how porting a ‘strong inference’ that the defendants were PWC acquired knowledge of most of these red flags. actually aware of the red flags in question.”); In re In one section, the Complaint describes a number of

--- F.Supp.2d ----, 2010 WL 1244007 (S.D.N.Y.) (Cite as: 2010 WL 1244007 (S.D.N.Y.)) general red flags surrounding the Madoff scheme, and tries, Inc. v. Sum Holding L.P., 949 F.2d 42, 48 (2d in another it sets forth conclusory allegations regard- Cir.1991) (“It is the usual practice upon granting a ing PWC's failure to investigate BMIS and to follow motion to dismiss to allow leave to replead.”). up on the red flags. Aside from the allegation at the outset of the section describing the red flags that they SO ORDERED. “required Citco and PWC respectively to investigate and resolve under their respective duties, responsibil- FN1. One notable exception is Harry Mar- ities and representations of the others' duties to Plain- kopolos, a now famous Madoff whis- tiff, but neither did [sic],” (Cl.¶ 134), and indirect tle-blower who was reportedly aware of the conclusory references to “red flags for auditors to fraud much earlier. See Assessing the Madoff consider that PWC knew and/or consciously avoided Ponzi Scheme Before the H. Comm. on Fi- knowing were present,” (Cl.¶ 205(o)), and “red flags nancial Services, 111th Cong. (2009) which PWC knew, should have known and/or con- (statement of Harry Markopolos, Chartered sciously avoided knowing were present,” (Cl.¶ Financial Analyst and Certified Fraud Ex- 266(m)), PWC is not plausibly alleged to have had aminer), http:// knowledge of specific red flags. Granted, the com- www.house.gov/apps/list/hearing/ finan- plaint alleges facts sufficient to support the conclusion cialsvcs_dem/markopolos020409.pdf. that certain suspicious facts surrounded Madoff's operation, but the complaint does not connect those red flags to PWC through factually sufficient allega- FN2. At the risk of stating the already well tions that PWC actually knew of or uncovered them. known, a Ponzi scheme is a fraudulent investment fund that generates the false appearance of profit by paying early investors Two of the alleged red flags are such that PWC “must out of the money invested by subsequent have” known of them. First, PWC had to be aware that investors. The name comes from Charles BMIS consistently reported excellent results, as the Ponzi, an early 20th century fraudster who statements it audited reflected that. However, even in famously abused this practice. the present economic climate the Court is unwilling to hold that success in securities trading is a red flag. Second, PWC must have known that Madoff was both FN3. Defendant Citco Group Limited is a broker and custodian of the accounts because that fact third Citco entity which has a relationship was a basic aspect of the Greenwich Sentry's operation with Citco (Canada) and Citco Fund Services and was explained at the outset of the PPM. (See (Europe) that the Court need not delve into Greenwich Sentry PPM at 2, Ex. A. to Duffy Dec.) because it is granting the parties' pending Although the Court does see this as something of a red motions to dismiss on unrelated grounds. The flag, it is far too mild to support an inference of reck- Court appreciates that there are important lessness on the part of PWC. Particularly considering differences between the Citco entities. that PWC was not the auditor of BMIS, but rather of a However because those differences are im- fund that invested in BMIS, this red flag alone is in- material to the Court's decision to dismiss the sufficient to satisfy Rule 9(b)'s requirement of parti- Complaint, the Court does not reach Citco cularity. Without an allegation that PWC had know- Group Limited's agency liability arguments ledge of further red flag(s), the Complaint does not and refers to the Citco defendants collec- adequately allege scienter. Plaintiff's fraud claim tively as “Citco” throughout. against PWC is dismissed without prejudice. FN4. Stephenson is a Texan and the Ste- III. CONCLUSION phenson Trust is formed under the laws of the State of Texas. (Cl.¶ 18.) The defendants are not Texans: Citco Group is a citizen of the For the foregoing reasons defendants' motions to Cayman Islands-British West Indies; Citco dismiss, [38], [43], and [46], are granted and plaintiff's Europe is a citizen of the Netherlands; Citco complaint is dismissed in its entirety. Count IV, al- Canada is a citizen of Canada; and PWC leging fraud against PWC, is dismissed without pre- Canada is a citizen of Canada. (Id.) The judice and with leave to replead. See Cortec Indus- amount in dispute, $60 million, is greater

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than $75,000. Accordingly the Court has Sentry had implemented adequate safe- diversity jurisdiction over plaintiff's state law guards in the face of clear operational risk, claims pursuant to 28 U.S.C. § 1332(a). and clear ‘red flags' for auditors to consider that PWC knew and/or consciously FN5. Greenwich Sentry itself, as well as each avoided knowing were present in this case, of the defendants here, are parties to a large including those heretofore alleged; (¶ consolidated action before Judge Marrero, 205(o)) Anwar et al. v. Fairfield Greenwich Limited, et. al., Docket No. 09 CV 00118, Master File Giving the Complaint its most favorable No. 09CV0118. That action includes class possible reading, this sub-paragraph in- claims and, upon initial reading of the concludes an indirect assertion of knowledge solidated amended complaint therein, Ste- on the part of PWC. But to the extent it phenson appears to be a member of at least does, that allegation is both completely one of the purported classes. conclusory and far too general (alleging knowledge of ‘heretofore alleged’ red FN6. The Court refers to the July 2, 2009 flags wholesale) to adequately allege corrected amended complaint as “Com- knowledge of the individual red flags in plaint” throughout this opinion. Stephenson the Complaint. filed his initial Complaint on January 26, 2009, and it was subsequently referred to this FN9. The closest the Complaint comes is ¶ Court on February 17, 2009[3]. Plaintiff filed 125: an amended complaint [36] on June 29, 2009, and filed a corrected amended complaint [37] [R]equests by Limited Partners in Green- on July 2, 2009. wich Sentry for such redemptions or return, which could be made at the end of FN7. In Madoff's own words: any month pursuant to the governing agreement, were made to Greenwich Sen- In fact, I never made those investments I try and/or Citco, which then forwarded promised clients, who believed they were such requests to the Madoff Firm. Madoff invested with me in the split strike con- acted on those requests and forwarded the version strategy. To conceal my fraud, I funds to Greenwich Sentry and/or Citco, misrepresented to clients, employees, and which in turn returned funds to the re- others that I purchased securities for clients questing Limited Partners. These redemp- in overseas markets.... I knowingly caused tions were an integral and essential ele- false trading confirmations and client ac- ment of scheme [sic] in order to avoid count statements that reflected the bogus collapse and disclosure of the Ponzi transactions and positions to be created and Scheme. (emphasis added) sent to clients purportedly involved in the split strike conversion strategy. All that this alleges is that Greenwich Sentry forwarded requests to Madoff and (Cl. ¶ 132 quoting United States v. Madoff, then forwarded money back. While in re- Hearing Tr. March 12, 2009 at 23-30.) trospect this modus operandi of Greenwich Sentry (and, probably, other feeder funds) FN8. The closest the complaint comes is ¶¶ helped to sustain Madoff's fraud, it does 205(o) and 266(m), which both similarly not, without more, implicate Greenwich reference the red flags as being “known” but Sentry in the Ponzi scheme. do not allege knowledge: FN10. The closest the Complaint comes is PWC failed, contrary to GAAS require- the title of section E., “Greenwich Sentry is ments, to satisfy itself that Greenwich discovered to be part of a Ponzi scheme.” (Cl. between ¶ 122 and ¶ 123.) However this

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section does not go on to allege anything other than what is known, that Greenwich FN13. The Court does not reach the question Sentry was invested in a Ponzi scheme. of whether plaintiff has adequately plead negligence or gross negligence because it FN11. This rule is not limited to internal finds such claims to be preempted by the managers. See Debussy, 2006 WL 800956, at Martin Act. See infra pt. 2(a). *3 (applying Tooley and finding breach of fiduciary duty claim against portfolio man- FN14. The Martin Act was first passed in ager derivative because “the injury flowing 1921. It was sponsored in the New York from a claim of mismanagement-although State Legislature by its namesake, Francis J. admittedly here not by a corporate board of Martin, a state legislator who later became a directors but rather by the portfolio manager state court judge. Jerry W. Markham, A fi- of the Trust's assets-is a “wrong to the cor- nancial history of modern U.S. corporate poration”). scandals: from Enron to Reform 148 (2006).

FN12. If the Court were to reach this ques- FN15. This section states: tion, it would hold that Stephenson was not an intended beneficiary of the agreements. It shall be illegal and prohibited for any Nothing within the four corners of either the person, partnership, corporation, company, Citco or PWC agreements expresses an intent trust or association, or any agent or em- to benefit third parties. Yet that is what is ployee thereof, to use or employ any of the required. See Trans-Orient Marine Corp. v. following acts or practices: Star Trading & Marine, Inc., 925 F.2d 566, 573 (2d Cir.1991). Although the services were performed for the benefit of the mem- (a) Any fraud, deception, concealment, bers of the partnership, that does not indicate suppression, false pretense or fictitious or that the parties intended to benefit individu- pretended purchase or sale; als in their personal capacities but rather partners as the constituent members of the (b) Any promise or representation as to the partnership. The PWC engagement letter future which is beyond reasonable expec- explicitly disclaims an intent to benefit indi- tation or unwarranted by existing cir- vidual third parties. Under the heading “Re- cumstances; liance by Third Parties” it states: “[t]he financial statement audit will not be planned or (c) Any representation or statement which conducted in contemplation of reliance by is false, where the person who made such any specific third party ...” (January 11, 2007 representation or statement: (i) knew the Engagement letter, Ex. C. to Duffy Aff.) And truth; or (ii) with reasonable effort could the Citco administrator contract contains an have known the truth; or (iii) made no inurement and nonassignment clause that reasonable effort to ascertain the truth; or undermines any argument that the contract- (iv) did not have knowledge concerning ing parties intended to benefit third parties. the representation or statement made; “An inurement clause, when taken together where engaged in to induce or promote the with a prohibition of assignments, on the issuance, distribution, exchange, sale, ne- other hand, does suggest that the parties did gotiation or purchase within or from this not intend that third parties benefit from the state of any securities or commodities, as contract. Language specifying that the bene- defined in section three hundred fifty two fit of a contract is to inure to the contract's of this article, regardless of whether is- signatories arguably is superfluous unless it suance, distribution, exchange, sale, nego- serves to limit the category of beneficiaries.” tiation or purchase resulted. Piccoli A/S v. Calvin Klein Jeanswear Co., 19 F.Supp.2d 157, 164 (S.D.N.Y.1998). FN16. Neither party disputes that limited

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partnership interests are considered securities not decided in the context of the federal for purposes of the Martin Act. See N.Y. pleading standards, particularly Rule 9(b), Gen. Bus. Law § 352(1); Mayer v. Oil Field and the Court is to apply federal procedural Sys. Corp., 721 F.2d 59, 65 (2d Cir.1993). rules to state law claims when it is sitting in diversity. See generally Hanna v. Plumer, FN17. The Martin Act asks whether securi- 380 U.S. 460, 85 S.Ct. 1136, 14 L.Ed.2d 8 ties were sold within or from New York. It (1965) (Federal Rules of Civil Procedure are does not ask whether the activities giving rise procedural rules to which federal courts sit- to a complaint were within New York. The ting in diversity must adhere). So should a Martin Act covers misrepresentations “en- federal court sitting in diversity apply the gaged in to induce or promote the issuance, composite doctrine to state law fraud claims? distribution, exchange, sale, negotiation or purchase within or from [New York] of any Precedent seems to indicate that it should: securities or commodities ...” N.Y. Gen. Bus. the other courts in this circuit to have tested L. § 353. Of course to some extent the locus state law fraud claims against Rule 9(b) of the facts giving rise to a claim will inform have, either explicitly or tacitly, taken that the location of a sale of securities, but the approach. See Bay Harbour Management statutory text plainly provides that the dis- LLC v. Carothers, 282 Fed.Appx. 71 (2d positive geographic factor is where the se- Cir.2008) (after analyzing plaintiff's fed- curities are being sold from. eral securities claims under the composite standard (and citing Lerner for the test FN18. A focus solely on the location of the quoted, infra, in the text), holding that purchaser would defy the statute's “from or “[f]or the same reasons set forth above, within” language. A sale “from” New York [plaintiffs] have failed to plead facts, with goes “to” someplace else: a New York to the particularity required by Federal Rule New York sale would be “within” the state. of Civil Procedure 9(b), that could give rise to a claim for common law fraud”); Can- FN19. The case-law in this area presents a ada, Inc. v. Aspen Technology, Inc., 633 situation that strains the Erie doctrine. Since F.Supp.2d 15, 29-30 (S.D.N.Y.2009) the passage of the Private Securities Litiga- (finding federal case-law not controlling tion Reform Act (PSLRA), the case-law has because “the instant case does not concern developed applying both Federal Rule 9(b) fraud under the PSLRA but rather common and the PSLRA to allegations of fraudulent law” but nonetheless finding it “persua- intent. Federal Rule 9(b) is undisputedly sive,” and applying it to common law fraud procedural, but the PSLRA's scienter rule, set claim) (citing Glidepath Holding B.V. v. forth in 15 U.S.C.A. § 78u-4(b)(2), although Spherion Corp., 590 F.Supp.2d 435, 451 procedural is explicitly limited by its terms to (S.D.N.Y.2007) (federal law interpreting actions arising under chapter 15 of the PSLRA persuasive authority in assessing U.S.Code. (although the PSLRA's “strong adequacy of pleading of common law inference” language had been used by this fraud claim.)); Hammerstone NV, Inc. v. Circuit in the 9(b) context prior to its pas- Hoffman, No. 09 CV 2685, 2010 WL sage, see e.g. Shields v. Citytrust Bancorp, 882887, at *10 (S.D.N.Y. Mar.10, 2010) Inc., 25 F.3d 1124, 1128 (2d Cir.1994)). As (“Although a common law fraud claim the cases have developed since the passage of need not meet the particularity require- the PSLRA, Federal Rule 9(b) has become ments of the PSLRA, it still must meet the entangled with § 87u-4(b)(2), and the result nearly identical requirements of Rule is a composite doctrine combining a gener- 9(b).”). ally applicable procedural rule with one that is statutorily limited to federal claims in its The parties have not argued that the Court application. The New York State cases cited should abandon the composite case-law, by plaintiff are not helpful because they were and indeed both plaintiff and PWC cite to

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cases invoking the PSLRA as if those cases are controlling. (See Pl. Opp. 44; PWC Mem. 9-10.) Accordingly the Court applies the Rule 9(b) case-law without regard (beyond this footnote) to the fact that it concomitantly invokes the PSLRA.

FN20. Plaintiff has not alleged or argued a “conscious misbehavior” theory separate from his theory that the allegations support an inference of recklessness.

FN21. The complaint treats these two decisions to forego revenue as independent red flags. The Court groups them for the sake of clarity.

S.D.N.Y.,2010. Stephenson v. Citco Group Ltd. --- F.Supp.2d ----, 2010 WL 1244007 (S.D.N.Y.)

END OF DOCUMENT

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fied ERISA Fund, Ltd. (“Meridian Diversified ERI- Only the Westlaw citation is currently available. SA”), Meridian Diversified Compass Fund, Ltd. (“Meridian Diversified Compass”), and Meridian Absolute Return ERISA Fund, Ltd. (“Meridian Ab- United States District Court, solute”). These function as partnerships but are tech- S.D. New York. nically Cayman Islands corporations. The Off-Shore MERIDIAN HORIZON FUND, LP, Meridian Hori- Plaintiffs invested in Rye Select Broad Market XL zon Fund II, LP, Meridian Diversified Fund, LP, Me- Portfolio Limited (the “XL Portfolio Fund”), a hedge ridian Diversified Fund, LTD., Meridian Diversified fund organized as a Cayman Islands corporation. Erisa Fund, LTD., Meridian Diversified Compass Tremont Partners acted as the investment manager of Fund, LTD ., and Meridian Absolute Return Erisa the XL Portfolio Fund pursuant to an advisory Fund, LTD., Plaintiffs, agreement. v. TREMONT GROUP HOLDINGS, INC., Tremont Partners, Inc., Tremont (Bermuda) Limited, Oppen- The Market XL Fund and the XL Portfolio Fund heimer Acquisition Corporation, Kpmg LLP, and (collectively, the “XL Funds”) did not invest directly Kpmg (Cayman), Defendants. with Madoff. Rather, the XL Funds' returns were No. 09 Civ. 3708(TPG). derived from leveraged instruments in other single-manager hedge funds managed by Tremont Part- ners and Tremont (Bermuda) Limited (“Tremont March 31, 2010. Bermuda”) referred to as the “Reference Entities.” The Reference Entities were single-manager funds, OPINION for which all asset management decisions were delegated to Madoff and BMIS. THMPAS P. GRIESA, District Judge. None of the plaintiffs alleges having invested directly *1 This action arises from Bernard L. Madoff's mas- in the Reference Entities. sive Ponzi scheme. Plaintiffs are hedge funds that invested all of their assets in two hedge funds ma- Defendants naged by Tremont Partners, Inc. (“Tremont Part- ners”), which served as feeder funds by investing the Defendants are Tremont Partners, Tremont Bermuda, funds' assets with Madoff and his investment firm, Tremont Partners' and Tremont Bermuda's parent Bernard L. Madoff Securities LLC (“BMIS”). company, Tremont Group Holdings, Inc. (“Tremont Group”) (collectively, the “Tremont Defendants”); Plaintiffs Tremont Group's corporate parent, Oppenheimer Acquisition Corporation (“Oppenheimer”); and the Three of the plaintiff funds are Meridian Horizon XL Funds' auditors, KPMG LLP (“KPMG”) and Fund, L.P. (“Meridian Horizon”), Meridian Horizon KPMG (Cayman) (“KPMG Cayman”). Fund II, L.P. (“Meridian Horizon II”), and Meridian Diversified Fund, L.P. (“Meridian Diversified”), The Motions sometimes referred to as the “On-Shore Plaintiffs.” These are Delaware limited partnerships that invested This opinion addresses the motions to dismiss which in the Rye Select Broad Market XL Fund, L.P. (the defendants KPMG and KPMG Cayman have filed. “Market XL Fund”), a Delaware limited partnership in KPMG and KPMG Cayman assert that plaintiffs' which Tremont Partners is the general partner. claims should be dismissed on multiple grounds pursuant to Rules 9(b), 12(b)(1), and 12(b)(6) of the The other plaintiff funds, referred to as the “Off-Shore Federal Rules of Civil Procedure and the Private Se- Plaintiffs,” are Meridian Diversified Fund, Ltd. curities Litigation Reform Act (“PSLRA”), 15 U.S.C. (“Meridian Diversified Limited”), Meridian Diversi-

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§ 78u-4(b). Specifically, KPMG and KPMG Cayman used principal from new customers to pay returns to argue that: (1) plaintiffs fail to plead with particularity other customers. In fact, he never purchased a single a violation of Section 10(b) of the Exchange Act; (2) security, instead depositing client funds in, and paying plaintiffs fail to plead their common law fraud claims redemptions from, an account at Chase Manhattan with particularity; (3) plaintiffs' common law claims Bank. And the account statements and trade tickets for negligence are preempted by the Martin Act, N.Y. that Madoff had been sending to customers were Gen. Bus. Law § 352 et seq.; and (4) to the extent complete fabrications. Madoff admitted that the au- plaintiffs' claims are not dismissed, they are subject to dited financial statements he filed with the SEC were mandatory arbitration. In addition, KPMG Cayman false and misleading. asserts that the court lacks subject matter jurisdiction over the Off-Shore Plaintiffs' claims. Upon the revelation of this fraud, the United States Attorney for the Southern District of New York *2 As explained below, KPMG and KPMG Cayman's charged Madoff with violations of the federal securi- motions to dismiss are granted. ties laws. On March 13, 2009, Madoff pleaded guilty to these charges. Bernard Madoff has since been THE COMPLAINT sentenced to 150 years in prison for his crimes. While the conviction is not pled in the complaint, which was The following allegations are taken from the com- filed about two months before the sentencing, the plaint and the documents on which it relies. For the court takes judicial notice of this fact as a matter of purpose of these motions, the allegations in the com- public record extensively and globally covered in plaint are assumed to be true. news.

Madoff's Ponzi Scheme On April 6, 2009, the New York Attorney General brought civil fraud charges under New York's Martin Act against hedge fund operator J. Ezra Merkin based The basic facts surrounding Madoffs fraudulent Ponzi on his feeder funds' role in supplying money to Ma- scheme are well-known. For years, Madoff reported doff. The Attorney General alleges that Merkin fun- consistent, steady annual gains of 10 to 12 percent by neled his clients' money to Madoff without permis- purportedly investing his customers' assets through an sion in exchange for management and incentive fees, options trading strategy called “split-strike conver- failed to conduct sufficient due diligence, and ignored sion,” which involved the supposed purchase and sale glaring “red flags” related to Madoffs investments. of stocks in the S & P 100 Index as well as options on FN1 Although not alleged in the complaint, the court takes that index. Madoff sent account statements and judicial notice of the New York Attorney General's trade tickets to his customers ostensibly reflecting this lawsuit as a matter of public record thoroughly cov- trading. ered in the media.

FN1. The “split-strike conversion” strategy Tremont Defendants and Oppenheimer purportedly entailed the purchase of 30 to 40 large capitalization S & P 500 stocks and the simultaneous sale of out-of-the-money calls Plaintiffs allege that the Tremont Defendants, through on the S & P 100 Index and the purchase of the funds, invested enormous amounts of money with out-of-the-money puts on the S & P 100 In- Madoff and received fees for doing so. Plaintiffs dex. allege that this was done with the knowledge, approval, support, and assistance of its parent company, Oppenheimer. On December 11, 2008, news broke that Madoffs securities trades were a sham. Through BMIS, Ma- doff had created the impression that he was operating *3 Plaintiffs allege that they invested in the XL Funds a legitimate investment advisory business, all the because the Tremont Defendants-in offering mate- while masterminding a vast $50 billion Ponzi scheme rials, responses to due diligence questionnaires, and for nearly 20 years. Rather than using his customers' direct conversations-represented that they were inti- money to purchase publicly traded securities, Madoff mately familiar with Madoff's and BMIS's operations. The Tremont Defendants further assured that they

Slip Copy, 2010 WL 1257567 (S.D.N.Y.) (Cite as: 2010 WL 1257567 (S.D.N.Y.)) closely monitored Madoff's and BMIS's transactions, for the funds. Consequently, by failing to obtain this internal controls, and operational risk. And through confirmatory evidence, KPMG and KPMG Cayman monthly performance reports, yearly financial state- could not have complied with professional auditing ments, and discussions, the Tremont Defendants told standards because if they had, then they undoubtedly plaintiffs that the assets Madoff and BMIS managed would have uncovered Madoff's Ponzi scheme by for the Reference Entities existed and were appre- discovering that the audits performed by BMIS's ac- ciating in value. Based upon these representations, counting firm, Friehling & Horowitz, were a complete plaintiffs made and ultimately retained their invest- sham. Moreover, plaintiffs contend that KPMG and ments in the XL Funds. KPMG Cayman knew that investors in the XL Funds were relying on their audit opinions as assurance that Private Placement Memoranda the assets in the XL Funds were accurately reported. In fact, had KPMG or KPMG Cayman issued anything The Tremont Defendants sold limited partnership other than an unqualified audit opinion, plaintiffs interests in the XL Funds pursuant to private place- would not have invested in the XL Funds and imme- ment memoranda (“PPMs”). The PPMs effectively diately would have redeemed any existing invest- identified Madoff as the Reference Entities' manager, ments. stating that each “Reference Entity attempts to ac- complish its investment objective by investing the *4 Plaintiffs do not suggest, however, that either majority of the assets with one investment manager KPMG or KPMG Cayman was engaged to audit the (the ‘Manager’) who employs a ‘split-strike conver- financial statements of Madoff's businesses at any sion strategy.’ “ The PPMs also informed potential time. investors that all investment functions would be concentrated with the chosen investment manager. Spe- The Claims in This Action cifically, the PPMs explained that “[w]hile the Man- ager is entitled to utilize various broker-dealers to The complaint contains 15 counts, however only execute, settle, and clear securities transactions, it Counts X-XV pertain to KPMG and KPMG Cayman. intends to only use the services of one broker-dealer, Counts X and XI allege violations of the federal se- of which the Manager is the sole principal.” curities laws, Section 10(b) of the Exchange Act and Rule 10b-5 of the Securities and Exchange Commis- KPMG and KPMG Cayman sion. Counts XII and XIII are for common law fraud, and Counts XIV and XV are for negligence. The KPMG audited the 2006 and 2007 financial state- claims against the Tremont Defendants and Oppen- ments of the Market XL Fund and, in that capacity, heimer-for securities fraud under Section 10(b) of the issued unqualified audit opinions to the On-Shore Exchange Act, control person liability under Section Plaintiffs stating that its audits complied with Gener- 20(a) of the Exchange Act, fraud, breach of fiduciary ally Accepted Auditing Standards (“GAAS”). KPMG duty, and negligence-are not addressed here. Cayman audited the XL Portfolio Fund's 2006 and 2007 financial statements and sent allegedly DISCUSSION GAAS-compliant audit opinions to the Off-Shore Plaintiffs. Standard on a Motion to Dismiss

Plaintiffs allege that KPMG and KPMG Cayman In reviewing a motion to dismiss pursuant to failed to conduct their audits in accordance with Fed.R.Civ.P. 12(b)(6), the court must accept the fac- GAAS and knowingly and recklessly issued false and tual allegations set forth in the complaint as true and misleading audit opinions. Plaintiffs assert that be- draw all reasonable inferences in favor of the plaintiff. cause the Reference Entities, and thus the XL Funds, See Cleveland v. Caplaw Enters., 448 F.3d 518, 521 relied on BMIS for virtually all portfolio management, (2d Cir.2006). “To survive a motion to dismiss, a trade execution, and custodial services, GAAS re- complaint must contain sufficient factual matter, acquired KPMG and KPMG Cayman to obtain sufficient cepted as true, to state a claim to relief that is plausible independent audit evidence to corroborate the exis- on its face.” Ashcroft v. Iqbal, --- U.S. ----, ----, 129 tence of the assets Madoff and BMIS claimed to hold S.Ct. 1937, 1949, 173 L.Ed.2d 868 (2009). “A claim

Slip Copy, 2010 WL 1257567 (S.D.N.Y.) (Cite as: 2010 WL 1257567 (S.D.N.Y.)) has facial plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable For purposes of stating a Section 10(b) claim, scienter inference that the defendant is liable for the miscon- means an actual intent “to deceive, manipulate, or duct alleged.” Id. While a complaint need not supply defraud.” Ernst & Ernst v. Hochfelder, 425 U.S. 185, “detailed factual allegations,” it must consist of more 193 n. 12, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976). A than “labels and conclusions” or a “formulaic recita- plaintiff may satisfy the requirement to plead scienter tion of the elements of a cause of action.” Bell Atl. by alleging facts (1) showing that the defendants had Corp. v. Twombly, 550 U.S. 544, 555, 127 S.Ct. 1955, both motive and opportunity to commit the fraud or 167 L.Ed.2d 929 (2007). Unless a plaintiff's (2) constituting strong circumstantial evidence of well-pleaded allegations have “nudged [its] claims conscious misbehavior or recklessness. See Ganino v. across the line from conceivable to plausible,” the Citizens Utils. Co., 228 F.3d 154, 168-69 (2d complaint must be dismissed. Id. at 570. Cir.2000). Moreover, for an inference of scienter to be strong, it must be more than merely plausible or rea- Section 10(b) of the Exchange Act (Counts X, XI) sonable-it must be “cogent and at least as compelling as any opposing inference of nonfraudulent intent.” Section 10(b) of the Exchange Act, 15 U.S.C. § Tellabs, 551 U.S. at 310. In short, to determine 78(j)(b), prohibits conduct “involving manipulation or whether a plaintiff's purported inferences of scienter deception, manipulation being practices ... that are are sufficiently “strong,” the court must consider both intended to mislead investors by artificially affecting the inferences urged by the plaintiff and any compet- market activity, and deception being misrepresenta- ing inferences rationally drawn from all the facts al- tion, or nondisclosure intended to deceive.” Field v. leged, taken collectively. See ECA, 553 F.3d at 198. Trump, 850 F.2d 938, 946-47 (2d Cir.1988). To state a claim under Section 10(b) of the Exchange Act, a The standard for pleading auditor scienter is de- plaintiff must allege facts sufficient to show that, in manding. See In re IMAX Secs. Litig., 587 F.Supp.2d connection with the purchase or sale of securities, the 471, 483 (S.D.N.Y.2008). Allegations of GAAS vi- defendant made a false material representation or olations without corresponding fraudulent intent are omitted to disclose material information, with scien- insufficient to state a securities fraud claim against an ter, upon which plaintiff relied, and that plaintiff's independent accountant. See Rothman v. Gregor, 220 reliance was the proximate cause of the injury. See F.3d 81, 98 (2d Cir.2000); Chill v. Gen. Elec. Co., 101 ECA & Local 134 IBEW Joint Pension Trust of Chi- F.3d 263, 270 (2d Cir.1996). cago v. JP Morgan Chase Co., 553 F.3d 187, 197 (2d Cir.2008). A claim for relief under Section 10(b) is For recklessness on the part of a non-fiduciary ac- subject to the heightened pleading requirements of countant to satisfy securities fraud scienter, such Fed.R.Civ.P. 9(b) and the PSLRA. See ATSI recklessness must be conduct that is highly unrea- Commc'ns v. Shaar Fund Ltd., 493 F.3d 87, 99 (2d sonable, representing an extreme departure from the Cir.2007). Indeed, under both Rule 9(b) and Section standards of ordinary care. It must, in fact, ap- 101(b) of the PSLRA, allegations must be made “with proximate an actual intent to aid in the fraud being particularity” and give “rise to a strong inference that perpetrated by the audited company. the defendant acted with the required state of mind,” namely, “to deceive, manipulate or defraud.” Tellabs, Rothman, 220 F.3d at 98. Put another way, a plaintiff Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, must allege that the accounting practices were so 313-14, 127 S.Ct. 2499, 168 L.Ed.2d 179 (2007). deficient that the “audit amounted to no audit at all, or an egregious refusal to see the obvious, or investigate *5 KPMG and KPMG Cayman challenge the validity the doubtful, or that the accounting judgments which of the complaint on scienter, loss causation, and re- were made were such that no reasonable accountant liance grounds. As discussed in detail below, because would have made the same decisions if confronted the court finds that plaintiffs have failed to plead with the same facts .” In re Scottish Re Group Secs. scienter adequately, the court need not consider the Litig., 524 F.Supp.2d 370, 385 (S.D.N.Y.2007). issues of loss causation and reliance. A complaint might reach the “no audit at all” threshold Scienter by alleging that the auditor disregarded specific “red

Slip Copy, 2010 WL 1257567 (S.D.N.Y.) (Cite as: 2010 WL 1257567 (S.D.N.Y.)) flags” that would place a reasonable auditor on notice Cayman were similarly in the dark. that the audited company was engaged in wrongdoing to the detriment of its investors. See In re AOL Time But most critically, plaintiffs' allegations of GAAS Warner Secs. & “ERISA” Litig., 381 F.Supp.2d 192, violations here are even less meaningful because 240 n. 51 (S.D.N.Y.2004). Under this framework, neither KPMG nor KPMG Cayman was hired to audit however, merely alleging that the auditor had access Madoff's businesses or to issue an opinion on the to the information by which it could have discovered financial statements of BMIS. Rather, KPMG and the fraud is not sufficient. See Rothman, 220 F.3d at KPMG Cayman's only role was to audit the financial 98; see also In re aaiPharma Inc. Secs. Litig., 521 statements of the XL Funds. The notion that a firm F.Supp.2d 507, 513 (E.D.N.C.2007) (rejecting theory engaged to audit the financial statements of one client that auditor's access to information could support an (the XL Funds) must conduct audit procedures on a inference of scienter, noting that “merely because a third party that is not an audit client (BMIS) on whose person has broad access to every book in a library does financial statements the audit firm expresses no opi- not mean that the person has read and chosen to ignore nion is unprecedented and has no basis. facts contained in a particular book in the library”). Plaintiffs' failure to plead scienter is fatal to their *6 Plaintiffs allege that KPMG and KPMG Cayman federal securities claims. Accordingly, plaintiffs' Sec- misrepresented that they performed audits that com- tion 10(b) claims against KPMG and KPMG Cayman plied with GAAS because if they had in fact adhered are dismissed. to GAAS, they necessarily would have discovered Madoffs fraudulent conduct. Specifically, plaintiffs Common Law Fraud (Counts XII, XIII) contend that the concentration of advisory, brokerage, and custodial functions at BMIS necessitated “heightened professional skepticism” on the part of KPMG To state a claim for common law fraud in New York, a and KPMG Cayman, and their failure to verify the plaintiff must show a material representation or reported assets and trades from independent sources omission of fact, made with knowledge of its falsity, “in the face of known dangers” amounted to a mea- with scienter or an intent to defraud, upon which the ningless audit. And Friehling & Horowitz's unreliable plaintiff reasonably relied, and that such reliance audits of BMIS were easily discoverable and thus caused damage to the plaintiff. See May Dep't Stores should have caused KPMG and KPMG Cayman to Co. v. Int'l Leasing Corp., 1 F.3d 138, 141 (2d view BMIS's role as custodian suspiciously. Cir.1993). Courts in the Second Circuit have found that the elements of common law fraud are “essentially the same” as those that must be pleaded to es- As described above, merely alleging a shoddy audit in tablish a claim under Section 10(b) and Rule 10b-5. violation of GAAS does not establish the necessary See Fezzani v. Bear, Stearns & Co., 592 F.Supp.2d intent to defraud sufficient to impose Section 10(b) 410, 423 (S.D.N.Y.2008). liability. Moreover, plaintiffs' reference to the concentration of functions at BMIS as a “red flag” indi- cator of fraud is equally unavailing-the XL Funds' *7 As noted above, the elements of Section 10(b) PPMs plainly disclosed to investors that the invest- claims are essentially the same as those for common ment manager (i.e., Madoff) would use a firm in law fraud in New York. Since plaintiffs' Section 10(b) which he was the sole principal to perform brokerage claims do not survive, plaintiffs' common law fraud and custodial duties. And plaintiffs fail to allege that claims, based on the same allegations of fact, must be KPMG or KPMG Cayman was aware of any of con- dismissed as well. crete facts indicative of Madoffs fraud. Rather than plaintiffs' theory that KPMG and KPMG Cayman Martin Act Preemption (Counts XIV. XV) could not have acted innocently when they told plaintiffs that they conducted GAAS-compliant audits, the The Martin Act prohibits, more compelling inference as to why Madoff's fraud went undetected for two decades was his proficiency (a) Any fraud, deception, concealment, suppression, in covering up his scheme and deceiving the SEC and false pretense or fictitious or pretended purchase or other financial professionals. KPMG and KPMG sale;

Slip Copy, 2010 WL 1257567 (S.D.N.Y.) (Cite as: 2010 WL 1257567 (S.D.N.Y.))

because plaintiffs allege that they were deceived into (b) Any promise or representation as to the future purchasing interests in limited partnerships that were which is beyond reasonable expectation or unwar- supposed to invest in securities, only to find them- ranted by existing circumstances; selves victims of Madoffs elaborate Ponzi scheme. And plaintiffs' non-fraud claims for negligence do not (c) Any representation or statement which is false, require proof of scienter. where the person who made such representation or statement: (i) knew the truth; or (ii) with reasonable *8 While plaintiffs acknowledge that they allege mi- effort could have known the truth; or (iii) made no srepresentations and omissions by the defendants in reasonable effort to ascertain the truth; or (iv) did connection with their federal securities claims, plain- not have knowledge concerning the representation tiffs assert that their common law claims do not con- or statement made. tain any allegations of dishonesty and deception. Moreover, plaintiffs cite Cromer Fin. Ltd. v. Berger, N.Y. Gen. Bus. Law. § 352-c(l). New York courts No. 00 Civ. 2498, 2001 WL 1112548, at *4 (S.D.N.Y. construe the Martin Act liberally and have held that Sept.19, 2001), Hamlet on Olde Oyster Bay Home the statute vests the New York Attorney General with Owners Ass'n, Inc. v. Holiday Org., Inc., 59 A.D.3d the sole authority to prosecute state law claims in- 673, 874 N.Y.S.2d 508, 512 (2d Dep't 2009), Caboara volving securities sounding in fraud that do not require v. Babylon Cove Dev., LLC, 54 A.D.3d 79, 862 proof of intent to defraud or scienter. See Castellano v. N.Y.S.2d 535, 538-39 (2d Dep't 2008), and Scalp & Young & Rubicam. Inc., 257 F.3d 171, 190 (2d Blade, Inc. v. Advest, Inc., 281 A.D.2d 882, 722 Cir.2001); First Energy Leasing Corp. v. Attor- N.Y.S.2d 639, 640 (4th Dep't 2001), to bolster their ney-General, 68 N.Y.2d 59, 64, 505 N.Y.S.2d 855, argument that the Martin Act does not preempt their 496 N.E.2d 875 (1986). There is no implied private otherwise well-pleaded claims even if the conduct right of action for any claim covered by the Martin comes within the Act's scope. Act. See CPC Intl. Inc. v. McKesson Corp., 70 N.Y.2d 268, 275, 519 N.Y.S.2d 804, 514 N.E.2d 116 (1987). Plaintiffs' non-fraud claims fall squarely within the Martin Act's preemptive reach. First, plaintiffs' claims Courts routinely dismiss common-law securities involve a security within the meaning of the Act based claims under the Martin Act based on conduct that is on their ownership of limited partnership interests and “within or from” New York sounding in fraud or shares in the XL Funds. Second, the Martin Act's deception that do not require pleading or proof of geographic prong is easily satisfied. Substantial acts in intent. See Owens v. Gaffken & Barriger Fund, LLC, furtherance of the alleged wrongdoing indisputably No. 08 Civ. 8414(PKC), 2009 WL 3073338, at *13 occurred “within or from” New York-plaintiffs were (S.D.N.Y. Sept.21, 2009). Limited partnership inter- managed from and within the State of New York; the ests are considered securities for purposes of the Tremont Defendants have their principal place of Martin Act. See N.Y. Gen. Bus. Law § 352(1); Mayer businesses in New York; defendants disseminated v. Oil Field Sys. Corp., 721 F.2d 59, 65 (2d Cir.1993). offering materials, financial disclosures, and audit And a transaction qualifies as “within or from” New reports to plaintiffs from New York; and Madoff's York for purposes of the Martin Act if a plaintiff al- fraud was based in New York. As such, the securities leges that a substantial portion of the events giving rise at issue here have a sufficient territorial nexus with to a claim occurred in New York. See, e.g., Sedona New York for purposes of Martin-Act preemption. Corp. v. Ladenburg Thalmann & Co., Inc., No. 03 Third, the complaint is centered on plaintiffs' allega- Civ. 3120(LTS)(THK), 2005 WL 1902780, at *22 tions of various misrepresentations and omissions (S.D.N.Y. Aug. 9, 2005) (applying Martin Act where with respect to the diligence performed on the funds. Complaint alleged proper venue in New York based Indeed, plaintiffs' non-fraud based causes of action on substantial part of the events or omissions giving incorporate by reference all of the preceding allega- rise to the claims occurred in the Southern District of tions of fraud in the complaint. Finally, the fact that New York). the New York Attorney General has brought claims under the Martin Act against Ezra Merkin and feeder fund Gabriel Capital Corp. for channeling fund assets Defendants contend that plaintiffs' non-fraud claims to Madoff highlights the appropriateness of Martin fall squarely within the Martin Act's preemptive scope

Slip Copy, 2010 WL 1257567 (S.D.N.Y.) (Cite as: 2010 WL 1257567 (S.D.N.Y.))

Act-preemption here.

And the line of cases that plaintiffs advance has been rejected repeatedly by courts in this district. See, e.g., Kassover v. UBS AG, 619 F.Supp.2d 28, 39 (S.D.N.Y.2008) (“Plaintiffs reliance on Caboara is unavailing ... Caboara appears to overlook a long-standing distinction between courts' treatment of common law fraud claims and that of other state law claims based on deceptive practices.”); Nanopierce Techs., Inc. v. Southridge Capital Meant ., LLC, No. 02 Civ. 0767(LBS), 2003 WL 22052894, at *4 (S.D.N.Y. Sept.2, 2003) (“Both Scalp & Blade and Cromer Finance stand as solitary islands in a stream of contrary opinion”). Indeed, although “there is some disagreement among New York's appellate courts as to whether the Martin Act preempts common law claims, the Second Circuit has adopted the First De- partment's rule that the Martin Act preempts common law tort claims in the securities context.” Abu Dhabi Commercial Bank v. Morgan Stanley & Co., Inc., No. 08 Civ. 7509(SAS), 2009 WL 2828018, at *14 (S.D.N.Y. Sept.2, 2009). Plaintiffs' argument-drawn from case law outside the First Department-is thus insufficiently persuasive in the face of substantial contrary authority.

*9 Given the amount of legal authority in this district favoring Martin Act-preemption for non-fraud common law claims based on deceptive acts committed in connection with the sale of securities within or from New York, dismissal of these claims is warranted. Accordingly, plaintiffs' common law claims for negligence are precluded by the Martin Act.

Because it is unnecessary to do so, the court declines to address defendants' remaining arguments in support of dismissal.

CONCLUSION

KPMG's and KPMG Cayman's motions to dismiss (Docket Nos. 21 and 27 on 09 cv. 3708) are granted.

S.D.N.Y.,2010. Meridian Horizon Fund, LP v. Tremont Group Hold- ings, Inc. Slip Copy, 2010 WL 1257567 (S.D.N.Y.)

END OF DOCUMENT

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against auditors of hedge funds which invested in Only the Westlaw citation is currently available. scheme, although complaint was filed two months before mastermind's sentencing, where convictions were a matter of public record extensively and glo- United States District Court, bally covered in news. S.D. New York. In re TREMONT SECURITIES LAW, STATE LAW AND INSURANCE LITIGATION. [2] Federal Civil Procedure 170A 1772 This Document Relates to: Securities Law Action 08 Civ. 11212(TPG). 170A Federal Civil Procedure No. 09 MD 2052. 170AXI Dismissal 08 Civ. 11117(TPG). 170AXI(B) Involuntary Dismissal 170AXI(B)3 Pleading, Defects In, in Gen- March 30, 2010. eral 170Ak1772 k. Insufficiency in General. Background: Hedge fund investors brought putative Most Cited Cases class action against funds' auditors, inter alia, arising While a complaint need not supply detailed factual out of massive Ponzi scheme in which funds invested, allegations to survive a motion to dismiss for failure to and alleging claims for securities fraud, common-law state a claim upon which relief can be granted, it must fraud, breach of fiduciary duty, negligent misrepre- consist of more than labels, conclusions, or a formu- sentation, and aiding and abetting breach of fiduciary laic recitation of the elements of a cause of action. duty. Auditors moved to dismiss. Fed.Rules Civ.Proc.Rule 12(b)(6), 28 U.S.C.A.

Holdings: The District Court, Thomas P. Griesa, J., [3] Federal Civil Procedure 170A 1772 held that: (1) investors failed to raise strong inference of scienter 170A Federal Civil Procedure against auditors as required to state § 10(b) securities 170AXI Dismissal fraud claim, and 170AXI(B) Involuntary Dismissal (2) claims for breach of fiduciary duty, negligent mi- 170AXI(B)3 Pleading, Defects In, in Gen- srepresentation, and aiding and abetting breach of eral fiduciary duty were pre-empted by New York's Martin 170Ak1772 k. Insufficiency in General. Act. Most Cited Cases Unless a plaintiff's well-pleaded allegations have Motions granted. nudged its claims across the line from conceivable to plausible, the complaint must be dismissed for failure to state a claim upon which relief can be granted. West Headnotes Fed.Rules Civ.Proc.Rule 12(b)(6), 28 U.S.C.A.

[1] Evidence 157 43(3) [4] Securities Regulation 349B 60.18 157 Evidence 349B Securities Regulation 157I Judicial Notice 349BI Federal Regulation 157k43 Judicial Proceedings and Records 349BI(C) Trading and Markets 157k43(3) k. Records and Decisions in 349BI(C)7 Fraud and Manipulation Other Actions or Proceedings. Most Cited Cases 349Bk60.17 Manipulative, Deceptive or Court would take judicial notice of Ponzi scheme Fraudulent Conduct mastermind's convictions for violating federal securi- 349Bk60.18 k. In General. Most Cited ties laws in action brought by hedge fund investors Cases

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Section 10(b) of the Exchange Act prohibits conduct (PSLRA); allegations must be made with particularity involving manipulation or deception, “manipulation” and give rise to a strong inference that the defendant being practices that are intended to mislead investors acted with the required state of mind, namely, to by artificially affecting market activity, and “decep- deceive, manipulate or defraud. Securities Exchange tion” being misrepresentation, or nondisclosure, in- Act of 1934, §§ 10(b), as amended, 15 U.S.C.A. §§ tended to deceive. 15 U.S.C.A. § 78(j)(b). 78j(b); 17 C.F.R. § 240.10b-5; Securities Exchange Act of 1934, § 21D, as amended, 15 U.S.C.A. § 78u-4. [5] Securities Regulation 349B 60.18 [7] Securities Regulation 349B 60.45(1) 349B Securities Regulation 349BI Federal Regulation 349B Securities Regulation 349BI(C) Trading and Markets 349BI Federal Regulation 349BI(C)7 Fraud and Manipulation 349BI(C) Trading and Markets 349Bk60.17 Manipulative, Deceptive or 349BI(C)7 Fraud and Manipulation Fraudulent Conduct 349Bk60.43 Grounds of and Defenses to 349Bk60.18 k. In General. Most Cited Liability Cases 349Bk60.45 Scienter, Intent, Know- To state a claim under § 10(b) of the Exchange Act, a ledge, Negligence or Recklessness plaintiff must allege facts sufficient to show that, in 349Bk60.45(1) k. In General. connection with the purchase or sale of securities, the Most Cited Cases defendant made a false material representation or For purposes of stating a § 10(b) claim, “scienter” omitted to disclose material information, with scien- means an actual intent to deceive, manipulate, or deter, upon which plaintiff relied, and that plaintiff's fraud. Securities Exchange Act of 1934, §§ 10(b), as reliance was the proximate cause of the injury. 15 amended, 15 U.S.C.A. §§ 78j(b); 17 C.F.R. § U.S.C.A. § 78(j)(b). 240.10b-5.

[6] Securities Regulation 349B 60.51(1) [8] Securities Regulation 349B 60.51(2)

349B Securities Regulation 349B Securities Regulation 349BI Federal Regulation 349BI Federal Regulation 349BI(C) Trading and Markets 349BI(C) Trading and Markets 349BI(C)7 Fraud and Manipulation 349BI(C)7 Fraud and Manipulation 349Bk60.50 Pleading 349Bk60.50 Pleading 349Bk60.51 In General 349Bk60.51 In General 349Bk60.51(1) k. In General. 349Bk60.51(2) k. Scienter. Most Most Cited Cases Cited Cases A plaintiff may satisfy the requirement to plead Securities Regulation 349B 60.51(2) scienter for a § 10(b) claim by alleging facts (1) showing that the defendants had both motive and opportunity to commit the fraud or (2) constituting 349B Securities Regulation strong circumstantial evidence of conscious misbe- 349BI Federal Regulation havior or recklessness. Securities Exchange Act of 349BI(C) Trading and Markets 1934, §§ 10(b), as amended, 15 U.S.C.A. §§ 78j(b); 17 349BI(C)7 Fraud and Manipulation C.F.R. § 240.10b-5. 349Bk60.50 Pleading 349Bk60.51 In General 349Bk60.51(2) k. Scienter. Most [9] Securities Regulation 349B 60.51(2) Cited Cases A claim for relief under § 10(b) is subject to the 349B Securities Regulation heightened pleading requirements for fraud claims and 349BI Federal Regulation the Private Securities Litigation Reform Act 349BI(C) Trading and Markets

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349BI(C)7 Fraud and Manipulation 349Bk60.50 Pleading 349B Securities Regulation 349Bk60.51 In General 349BI Federal Regulation 349Bk60.51(2) k. Scienter. Most 349BI(C) Trading and Markets Cited Cases 349BI(C)7 Fraud and Manipulation For an inference of scienter to be strong as required to 349Bk60.50 Pleading state a § 10(b) claim, it must be more than merely 349Bk60.56 k. Conduct of Accoun- plausible or reasonable; it must be cogent and at least tants or Attorneys. Most Cited Cases as compelling as any opposing inference of nonfrau- To state a securities fraud claim against an indepen- dulent intent. Securities Exchange Act of 1934, §§ dent accountant, a plaintiff must allege that the ac- 10(b), as amended, 15 U.S.C.A. §§ 78j(b); 17 C.F.R. § counting practices were so deficient that the audit 240.10b-5. amounted to no audit at all, or an egregious refusal to see the obvious, or investigate the doubtful, or that the [10] Securities Regulation 349B 60.51(2) accounting judgments which were made were such that no reasonable accountant would have made the 349B Securities Regulation same decisions if confronted with the same facts. 349BI Federal Regulation Securities Exchange Act of 1934, §§ 10(b), as 349BI(C) Trading and Markets amended, 15 U.S.C.A. §§ 78j(b); 17 C.F.R. § 349BI(C)7 Fraud and Manipulation 240.10b-5. 349Bk60.50 Pleading 349Bk60.51 In General [13] Securities Regulation 349B 60.56 349Bk60.51(2) k. Scienter. Most Cited Cases 349B Securities Regulation To determine whether a plaintiff's purported infe- 349BI Federal Regulation rences of scienter are sufficiently strong to state a § 349BI(C) Trading and Markets 10(b) claim, the court must consider both the infe- 349BI(C)7 Fraud and Manipulation rences urged by the plaintiff and any competing infe- 349Bk60.50 Pleading rences rationally drawn from all the facts alleged, 349Bk60.56 k. Conduct of Accoun- taken collectively. Securities Exchange Act of 1934, tants or Attorneys. Most Cited Cases §§ 10(b), as amended, 15 U.S.C.A. §§ 78j(b); 17 A complaint might reach the “no audit at all” threshold C.F.R. § 240.10b-5. for stating a securities fraud claim against an independent auditor by alleging that the auditor disre- [11] Securities Regulation 349B 60.51(2) garded specific red flags that would place a reasonable auditor on notice that the audited company was en- 349B Securities Regulation gaged in wrongdoing to the detriment of its investors; 349BI Federal Regulation under this framework, however, merely alleging that 349BI(C) Trading and Markets the auditor had access to the information by which it 349BI(C)7 Fraud and Manipulation could have discovered the fraud is not sufficient. Se- 349Bk60.50 Pleading curities Exchange Act of 1934, §§ 10(b), as amended, 349Bk60.51 In General 15 U.S.C.A. §§ 78j(b); 17 C.F.R. § 240.10b-5. 349Bk60.51(2) k. Scienter. Most Cited Cases [14] Securities Regulation 349B 60.51(2) Allegations of violations of Generally Accepted Au- diting Standards (GAAS) without corresponding 349B Securities Regulation fraudulent intent are insufficient to state a securities 349BI Federal Regulation fraud claim against an independent accountant. Se- 349BI(C) Trading and Markets curities Exchange Act of 1934, §§ 10(b), as amended, 349BI(C)7 Fraud and Manipulation 15 U.S.C.A. §§ 78j(b); 17 C.F.R. § 240.10b-5. 349Bk60.50 Pleading 349Bk60.51 In General [12] Securities Regulation 349B 60.56 349Bk60.51(2) k. Scienter. Most Cited Cases

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Hedge funds investors failed to raise strong inference of scienter against funds' auditors as required to state 349B Securities Regulation securities fraud claim by alleging that funds' auditors 349BII State Regulation were complicit in Ponzi scheme in which funds in- 349BII(B) Civil Effects of Violations vested because auditors ignored red flags and failed to 349Bk291 Rights, Liabilities, and Remedies uncover scheme, and that resulting audits violated 349Bk297 k. Recovery for Fraud. Most Generally Accepted Auditing Standards (GAAS); Cited Cases shoddy audit in violation of GAAS did not establish Limited partnership interests are considered “securi- intent to defraud, there were no allegations that audi- ties” for purposes of New York's Martin Act, under tors were aware of any facts indicative of Ponzi which the New York Attorney General has the sole scheme that they consciously disregarded, and most authority to prosecute state law securities fraud claims critically, auditors were never engaged to audit busi- that do not require proof of intent to defraud or nesses which operated Ponzi scheme or to issue an scienter. McKinney's General Business Law §§ opinion on Ponzi scheme businesses' financial state- 352(1), 352-c(1). ments. Securities Exchange Act of 1934, §§ 10(b), as amended, 15 U.S.C.A. §§ 78j(b); 17 C.F.R. § [17] Securities Regulation 349B 297 240.10b-5. 349B Securities Regulation [15] Fraud 184 3 349BII State Regulation 349BII(B) Civil Effects of Violations 184 Fraud 349Bk291 Rights, Liabilities, and Remedies 184I Deception Constituting Fraud, and Liability 349Bk297 k. Recovery for Fraud. Most Therefor Cited Cases 184k2 Elements of Actual Fraud Hedge funds investors' claims against funds' auditors 184k3 k. In General. Most Cited Cases for breach of fiduciary duty, negligent misrepresentation, and aiding and abetting breach of fiduciary duty Fraud 184 16 were pre-empted by New York's Martin Act, which provided New York Attorney General with sole au- 184 Fraud thority to prosecute claims sounding in fraud involv- 184I Deception Constituting Fraud, and Liability ing securities that did not require proof of intent to Therefor defraud or scienter, and that arose within New York; 184k15 Fraudulent Concealment funds were partnerships in which investors held li- 184k16 k. In General. Most Cited Cases mited partnership interests, which were considered To state a claim for common law fraud in New York, a securities for purposes of Martin Act, substantial acts plaintiff must show a material representation or in furtherance of alleged wrongdoing occurred within omission of fact, made with knowledge of its falsity, New York, and investors' claims centered on allega- with scienter or an intent to defraud, upon which the tions of various misrepresentations and omissions plaintiff reasonably relied, and that such reliance with respect to diligence performed on the funds. caused damage to the plaintiff. McKinney's General Business Law §§ 352-c(1), 352(1). [16] Securities Regulation 349B 249.1 OPINION 349B Securities Regulation 349BII State Regulation THOMAS P. GRIESA, District Judge. 349BII(A) In General 349Bk249 Particular Securities *1 This putative class action arises out of the massive 349Bk249.1 k. In General. Most Cited Ponzi scheme orchestrated by Bernard L. Madoff. Cases Plaintiffs are investors in hedge funds managed by Tremont Partners, Inc. (“Tremont Partners”), which Securities Regulation 349B 297 served as feeder funds by investing the funds' assets with Madoff and his investment firm, Bernard L.

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Madoff Securities LLC (“BMIS”). sition Corporation (“Oppenheimer”); MassMutual Holding LLC, Massachusetts Mutual Life Insurance As indicated, all of the funds in question were ma- Co. (collectively, “MassMutual Defendants”), the naged by Tremont Partners. Three of the funds were parent companies of Oppenheimer; and auditors the Rye Select Broad Market Fund, L.P. (the “Market KPMG LLP (“KPMG”), and Ernst & Young LLP (“E Fund”), the Rye Select Broad Market Prime Fund L.P. & Y”) (collectively, the “Auditors”). (the “Prime Fund”), and the Rye Select Broad Market XL Fund, L.P. (the “XL Fund”), sometimes referred to The Motions as the “Rye Funds.” These were Delaware partnerships in which Tremont Partners was the general This opinion addresses the motions to dismiss which partner and the investors were limited partners. The defendants E & Y and KPMG have filed. The Audi- partnership agreements authorized Tremont Partners tors FN1 assert that plaintiffs' claims should be dis- to delegate management of the funds' assets to a single missed on multiple grounds pursuant to Rules 9(b), manager chosen in its sole discretion. Based on this 12(b)(1), and 12(b)(6) of the Federal Rules of Civil grant of authority, Tremont Partners selected Madoff Procedure and the Private Securities Litigation or his company as the exclusive asset manager of the Reform Act (“PSLRA”), 15 U.S.C. § 78u-4(b). Spe- Rye Funds. The other fund was the Tremont Market cifically, the Auditors argue that: (1) plaintiffs fail to Neutral Fund, L.P. (“Market Neutral Fund”), a De- plead with particularity a violation of Section 10(b) of laware partnership in which Tremont Partners served the Exchange Act; (2) plaintiffs fail to plead their as the general partner and the investors as limited common law fraud claim with particularity; (3) plain- partners. In contrast to the Rye Funds, the Market tiffs' non-fraud common law claims for breach of Neutral Fund allocated fund assets to multiple outside fiduciary duty, negligent misrepresentation, and aid- investment managers. Tremont Partners chose Ma- ing and abetting breach of fiduciary duty are doff or his company as one of the asset managers, preempted by the Martin Act, N.Y. Gen. Bus. Law § investing 27% of fund assets with him. 352 et seq.; (4) all of plaintiffs' common law claims are preempted by the Securities Litigation Uniform Plaintiffs Standards Act (“SLUSA”), 15 U.S.C. §§ 78bb(f), 77p(b); and (5) plaintiffs' common law claims fail to Plaintiffs are Arthur M. Brainson (on behalf of the state a claim for relief. In addition, KPMG asserts that Arthur M. Brainson IRA R/O), Yvette Finkelstein, and to the extent plaintiffs state a valid claim, it is subject Group Defined Pension Plan & Trust (“Group De- to mandatory arbitration. fined”). Plaintiff Brainson is a limited partner in the Market Fund, plaintiff Finkelstein is a limited partner *2 As explained below, the motions to dismiss are in the Prime Fund, and Group Defined is a limited granted. partner in the Market Neutral Fund. There is no plaintiff who was an investor in the Rye Fund known THE COMPLAINT as the XL Fund. A class claim is asserted on behalf of the investors in all of the funds, even the XL Fund, The following allegations are taken from the consol- although no plaintiff claims to have been an investor idated and amended class action complaint (the in that fund. The court emphasizes that the class claim “Complaint”) and the documents on which it relies. is asserted on behalf of a single class. For the purpose of these motions, the allegations in the Complaint are assumed to be true. Defendants Madoff's Ponzi Scheme Defendants are Tremont Partners, Tremont Group Holdings, Inc. (“Tremont Group”), Tremont Capital The basic facts surrounding Madoff's fraudulent Management, Rye Investment Management, Robert Ponzi scheme are well-known. Madoff told his cus- Schulman, Jim Mitchell, and Rupert Allan (collec- tomers that he was investing their assets through a tively, the “Tremont Defendants”); Sandra L. Manzke; strategy called “split-strike conversion,” which in- the Rye Funds; the Market Neutral Fund; Tremont volved the supposed purchase and sale of stocks in the Group's direct corporate parent, Oppenheimer Acqui-

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S & P 100 Index as well as options on that index.FN2 dants-Oppenheimer and the MassMutual Defendants. Madoff sent account statements and trade tickets to Plaintiffs contend that there were various “red flags” his customers purporting to reflect this trading. which should have alerted these defendants as to the grave problems with Madoff, but these warnings were On December 11, 2008, news broke that Madoff, not heeded: that Madoff's returns could not be dup- through BMIS, had been operating an enormous $50 licated by others who attempted to do so using his billion Ponzi scheme for nearly 20 years. Rather than reported investment strategy; that the volume of using his customers' money to purchase publicly Madoff's purported options traded exceeded actual traded securities, Madoff used investments from new trading volumes reported by the markets; that BMIS's customers to pay returns to other customers. In fact, he records did not report customer activity; that BMIS never purchased a single security. And the account essentially was an inside, family business; that Ma- statements and trade tickets that Madoff had been doff ran his own back-office operations; and that sending to customers were complete fabrications. Madoff lacked transparency, limiting access to his These bogus trade confirmations were designed to books and records. As a result, so it is alleged, plain- give the appearance that Madoff had executed his tiffs' investments, to the extent that they were invested strategy with perfect market timing-buying stocks with Madoff, were completely lost. when they were towards the bottom of the price range for a given day and selling close to the peak. Madoff The Auditors admitted that the audited financial statements he filed with the SEC were false and misleading. *3 KPMG audited the financial statements of the funds and, in that capacity, issued single-page opi- [1] Upon the revelation of this fraud, the United States nions in March 2006, 2007, and 2008 stating that its Attorney for the Southern District of New York audits complied with Generally Accepted Auditing charged Madoff with violations of the federal securi- Standards (“GAAS”). Prior to KPMG, E & Y served ties laws. On March 13, 2009, Madoff pleaded guilty as auditor for the funds until at least 2004. to these charges. Bernard Madoff has since been sentenced to 150 years in prison for his crimes. While Plaintiffs allege that for many years, the Auditors not the conviction is not pled in this complaint, which was only failed to detect the massive fraud perpetrated by filed about two months before the sentencing, the Madoff during the course of their audits, but neg- court takes judicial notice of this fact as a matter of lected to notify investors of the risks associated with public record extensively and globally covered in investing in the funds. Plaintiffs assert that BMIS's news. role as investment advisor, broker, and custodian of the funds' assets required the Auditors to gather audit On April 6, 2009, the New York Attorney General evidence to corroborate the existence of the funds' brought civil fraud charges under New York's Martin assets and the trading activity from sources indepen- Act against hedge fund operator J. Ezra Merkin based dent of Madoff and BMIS. Consequently, by failing on his feeder funds' role in supplying money to Ma- to obtain this evidence, the Auditors could not have doff. The Attorney General alleges that Merkin complied with professional auditing standards be- steered his clients' money to Madoff without permis- cause if they had, then they surely would have unco- sion in exchange for management and incentive fees vered Madoff's Ponzi scheme. Plaintiffs, however, do and ignored glaring “red flags” related to Madoff's not suggest that either E & Y or KPMG audited the investments. financial statements of Madoff s businesses at any time. Tremont Defendants, Oppenheimer, and MassMutual Defendants Despite these allegations of fraudulent conduct, plaintiffs never assert that any of the defendants acted Plaintiffs allege that the Tremont Defendants, through in concert with Madoff to maintain the Ponzi scheme the funds, invested enormous amounts of money with or otherwise had any knowledge of the Ponzi scheme. Madoff and received fees for doing so. Plaintiffs And plaintiffs concede that the SEC also failed to allege that this was done with the knowledge, ap- uncover Madoff's fraud through its inquiries even proval, and assistance of the other corporate defen- after Harry Markopolos submitted a letter in May

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1999 and repeatedly voiced his concerns to the SEC about the legitimacy of Madoff's trading operations. *4 [4][5][6] Section 10(b) of the Exchange Act, 15 U.S.C. § 78(j)(b), prohibits conduct “involving ma- The Claims in This Action nipulation or deception, manipulation being practices ... that are intended to mislead investors by artificially The Complaint contains 11 counts, however only affecting market activity, and deception being misre- Counts I, III, VIII, X, XI pertain to the Auditors. presentation, or nondisclosure intended to deceive.” Count I alleges violations of the federal securities Field v. Trump, 850 F.2d 938, 946-47 (2d Cir.1988). laws, Section 10(b) of the Exchange Act and Rule To state a claim under Section 10(b) of the Exchange 10b-5 of the Securities and Exchange Commission. Act, a plaintiff must allege facts sufficient to show Counts III, VIII, X, and XI are based on various that, in connection with the purchase or sale of secur- common law theories-fraud, aiding and abetting a ities, the defendant made a false material representa- breach of fiduciary duty, negligent misrepresentation, tion or omitted to disclose material information, with and breach of fiduciary duty, respectively. The claims scienter, upon which plaintiff relied, and that plain- against the Tremont Defendants, Oppenheimer, and tiff's reliance was the proximate cause of the injury. MassMutual Defendants-for securities fraud under See ECA & Local 134 IBEW Joint Pension Trust of Section 10(b) of the Exchange Act, control person Chicago v. JP Morgan Chase Co., 553 F.3d 187, 197 liability under Section 20(a) of the Exchange Act, (2d Cir.2008). A claim for relief under Section 10(b) is fraud, negligent misrepresentation, breach of fiduciary subject to the heightened pleading requirements of duty, aiding and abetting breach of fiduciary duty, Fed.R.Civ.P. 9(b) and the PSLRA. See ATSI gross negligence and mismanagement, and unjust Commc'ns v. Shaar Fund Ltd., 493 F.3d 87, 99 (2d enrichment-are not addressed here. Cir.2007). Indeed, under both Rule 9(b) and Section 101(b) of the PSLRA, allegations must be made “with DISCUSSION particularity” and give “rise to a strong inference that the defendant acted with the required state of mind,” namely, “to deceive, manipulate or defraud.” Tellabs, Standard on a Motion to Dismiss Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 313-14, 127 S.Ct. 2499, 168 L.Ed.2d 179 (2007). [2][3] In reviewing a motion to dismiss pursuant to Fed.R.Civ.P. 12(b)(6), the court must accept the fac- The Auditors challenge the validity of the Complaint tual allegations set forth in the complaint as true and on scienter, loss causation, and reliance grounds. As draw all reasonable inferences in favor of the plaintiff. discussed in detail below, because the court finds that See Cleveland v. Caplaw Enters., 448 F.3d 518, 521 plaintiffs have failed to plead scienter adequately, the (2d Cir.2006). “To survive a motion to dismiss, a court need not consider the issues of loss causation complaint must contain sufficient factual matter, ac- and reliance. cepted as true, to state a claim to relief that is plausible on its face.” Ashcroft v. Iqbal, --- U.S. ----, ----, 129 S.Ct. 1937, 1949, 173 L.Ed.2d 868 (2009). “A claim Scienter has facial plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable [7][8][9][10] For purposes of stating a Section 10(b) inference that the defendant is liable for the miscon- claim, scienter means an actual intent “to deceive, duct alleged.” Id. While a complaint need not supply manipulate, or defraud.” Ernst & Ernst v. Hoch- “detailed factual allegations,” it must consist of more felder, 425 U.S. 185, 193 n. 12, 96 S.Ct. 1375, 47 than “labels conclusions” or a “formulaic recitation of L.Ed.2d 668 (1976). A plaintiff may satisfy the re- the elements of a cause of action.” Bell Atl. Corp. v. quirement to plead scienter by alleging facts (1) Twombly, 550 U.S. 544, 555, 127 S.Ct. 1955, 167 showing that the defendants had both motive and L.Ed.2d 929 (2007). Unless a plaintiff's well-pleaded opportunity to commit the fraud or (2) constituting allegations have “nudged [its] claims across the line strong circumstantial evidence of conscious misbe- from conceivable to plausible,” the complaint must be havior or recklessness. See Ganino v. Citizens Utils. dismissed. Id. at 570. Co., 228 F.3d 154, 168-69 (2d Cir.2000). Moreover, for an inference of scienter to be strong, it must be Section 10(b) of the Exchange Act (Count I) more than merely plausible or reasonable-it must be

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“cogent and at least as compelling as any opposing aaiPharma Inc. Secs. Litig., 521 F.Supp.2d 507, 513 inference of nonfraudulent intent.” Tellabs, 551 U.S. (E.D.N.C.2007) (rejecting theory that auditor's access at 310. In short, to determine whether a plaintiff's to information could support an inference of scienter, purported inferences of scienter are sufficiently noting that “merely because a person has broad access “strong,” the court must consider both the inferences to every book in a library does not mean that the urged by the plaintiff and any competing inferences person has read and chosen to ignore facts contained rationally drawn from all the facts alleged, taken col- in a particular book in the library”). lectively. See ECA, 553 F.3d at 198. [14] Plaintiffs allege that the Auditors were complicit [11][12] The standard for pleading auditor scienter is in Madoff's fraud because they ignored various “red demanding. See In re IMAX Secs. Litig., 587 flags” and failed to uncover the Ponzi scheme despite F.Supp.2d 471, 483 (S.D.N.Y.2008). Allegations of having unfettered access to the funds' records. Con- GAAS violations without corresponding fraudulent sequently, plaintiffs surmise that the Auditors did not intent are insufficient to state a securities fraud claim perform audits that complied with GAAS because if against an independent accountant. See Rothman v. they had, they undoubtedly would have discovered Gregor, 220 F.3d 81, 98 (2d Cir.2000); Chill v. Gen. Madoff's fraudulent conduct. Elec. Co., 101 F.3d 263, 270 (2d Cir.1996). The Auditors contend that it is simply not plausible *5 For recklessness on the part of a non-fiduciary that they, along with every auditor at every accounting accountant to satisfy securities fraud scienter, such firm who audited the financial statements of the funds recklessness must be conduct that is highly unrea- that invested with Madoff, participated in Madoff's sonable, representing an extreme departure from the fraud by virtue of failing to detect it. standards of ordinary care. It must, in fact, approximate an actual intent to aid in the fraud being As discussed above, alleging a shoddy audit in viola- perpetrated by the audited company. tion of GAAS does not establish the intent to defraud required to maintain a claim for securities fraud. And Rothman, 220 F.3d at 98. Put another way, a plaintiff while plaintiffs identify several purported “red flags” must allege that the accounting practices were so in the Complaint, they do not allege that the Auditors deficient that the “audit amounted to no audit at all, or were aware of any facts indicative of Madoff's fraud an egregious refusal to see the obvious, or investigate that they consciously disregarded-plaintiffs do not the doubtful, or that the accounting judgments which allege that Markopolos ever discussed his assessment were made were such that no reasonable accountant that Madoff was operating a Ponzi scheme with the would have made the same decisions if confronted Auditors or published it in the press, plaintiffs do not with the same facts .” In re Scottish Re Group Secs. assert that the Auditors knew that Madoff s returns Litig., 524 F.Supp.2d 370, 385 (S.D.N.Y.2007). could not be replicated by others, and plaintiffs do not claim that investors who elected not to deal with [13] A complaint might reach the “no audit at all” Madoff informed the Auditors of their decisions. threshold by alleging that the auditor disregarded Rather than plaintiffs' proposed inference that the specific “red flags” that would place a reasonable Auditors did not comply with GAAS because they auditor on notice that the audited company was en- ignored “red flag” warnings and failed to uncover the gaged in wrongdoing to the detriment of its investors. Ponzi scheme, the more compelling inference as to See In re AOL Time Warner Secs. & “ERISA” Litig., why Madoff s fraud went undetected for two decades 381 F.Supp.2d 192, 240 n. 51 (S.D.N.Y.2004); see was his proficiency in covering up his scheme and also In re Marsh & McLennan Cos. ., Inc. Secs. Litig., eluding the SEC and other financial professionals. 501 F.Supp.2d 452, 487 (S.D.N.Y.2006) ( “Merely labeling allegations as red flags ... is insufficient to *6 But most critically, the Auditors were never en- make those allegations relevant to a defendant's gaged to audit Madoffs businesses or to issue an opi- scienter.”). Under this framework, however, merely nion on the financial statements of BMIS. The Audi- alleging that the auditor had access to the information tors' only role is that they audited the financial state- by which it could have discovered the fraud is not ments of the Rye Funds and the Market Neutral Fund. sufficient. See Rothman, 220 F.3d at 98; see also In re The notion that a firm hired to audit the financial

--- F.Supp.2d ----, 2010 WL 1257580 (S.D.N.Y.), Fed. Sec. L. Rep. P 95,666 (Cite as: 2010 WL 1257580 (S.D.N.Y.)) statements of one client (the Rye Funds and the reasonable effort to ascertain the truth; or (iv) did Market Neutral Fund) must conduct audit procedures not have knowledge concerning the representation on a third party that is not an audit client (BMIS) on or statement made. whose financial statements the audit firm expresses no opinion has no basis. To impose liability on the Au- N.Y. Gen. Bus. Law. § 352-c(1). New York courts ditors would expand their limited, circumscribed duty construe the Martin Act liberally and have held that impermissibly. Accordingly, plaintiffs' Section 10(b) the statute vests the New York Attorney General with claim against the Auditors is dismissed. the sole authority to prosecute state law claims involving securities sounding in fraud that do not require Common Law Claims (Counts III, VIII, X, XI) proof of intent to defraud or scienter. See Castellano v. Young & Rubicam, Inc., 257 F.3d 171, 190 (2d A: Fraud Cir.2001); First Energy Leasing Corp. v. Attor- ney-General, 68 N.Y.2d 59, 64, 505 N.Y.S.2d 855, [15] To state a claim for common law fraud in New 496 N.E.2d 875 (1986). There is no implied private York, a plaintiff must show a material representation right of action for any claim covered by the Martin or omission of fact, made with knowledge of its fal- Act. See CPC Intl. Inc. v. McKesson Corp., 70 N.Y.2d sity, with scienter or an intent to defraud, upon which 268, 275, 519 N.Y.S.2d 804, 514 N.E.2d 116 (1987). the plaintiff reasonably relied, and that such reliance caused damage to the plaintiff. See May Dep't Stores *7 [16] Courts routinely dismiss common-law securi- Co. v. Intl. Leasing Corp., 1 F.3d 138, 141 (2d ties claims under the Martin Act based on conduct that Cir.1993). Courts in the Second Circuit have found is “within or from” New York sounding in fraud or that the elements of common law fraud are “essen- deception that do not require pleading or proof of tially the same” as those that must be pleaded to es- intent. See Owens v. Gaffken & Barriger Fund, LLC, tablish a claim under Section 10(b) and Rule 10b-5. No. 08 Civ. 8414(PKC), 2009 WL 3073338, at *13 See Fezzani v. Bear, Stearns & Co., 592 F.Supp.2d (S.D.N.Y. Sept.21, 2009). Limited partnership inter- 410, 423 (S.D.N.Y.2008). ests are considered securities for purposes of the Martin Act. See N.Y. Gen. Bus. Law § 352(1); Mayer As noted above, the elements of Section 10(b) claims v. Oil Field Sys. Corp., 721 F.2d 59, 65 (2d Cir.1993). are essentially the same as those for common law And a transaction qualifies as “within or from” New fraud in New York. Since plaintiffs' Section 10(b) York for purposes of the Martin Act if a plaintiff al- claim does not survive, plaintiffs' common law fraud leges that a substantial portion of the events giving rise claim, based on the same allegations of fact, must be to a claim occurred in New York. See, e.g., Sedona dismissed as well. Corp. v. Ladenburg Thalmann & Co., Inc., No. 03 Civ. 3120(LTS)(THK), 2005 WL 1902780, at *22 (S.D.N.Y. Aug. 9, 2005) (applying Martin Act where B: Martin Act Preemption Complaint alleged proper venue in New York based on substantial part of the events or omissions giving The Martin Act prohibits, rise to the claims occurred in the Southern District of New York). (a) Any fraud, deception, concealment, suppression, false pretense or fictitious or pretended purchase or [17] The Auditors contend that plaintiffs' non-fraud sale; claims fall squarely within the Martin Act's preemptive scope because plaintiffs allege that they were (b) Any promise or representation as to the future deceived into purchasing interests in limited partner- which is beyond reasonable expectation or unwar- ships that were supposed to invest in securities, only to ranted by existing circumstances; find themselves victims of Madoff's elaborate Ponzi scheme. Moreover, none of plaintiffs' non-fraud (c) Any representation or statement which is false, claims-for breach of fiduciary duty, negligent misre- where the person who made such representation or presentation, and aiding and abetting breach of fidu- statement: (i) knew the truth; or (ii) with reasonable ciary duty-requires proof of scienter. In support of effort could have known the truth; or (iii) made no their position, defendants reference more than twenty

--- F.Supp.2d ----, 2010 WL 1257580 (S.D.N.Y.), Fed. Sec. L. Rep. P 95,666 (Cite as: 2010 WL 1257580 (S.D.N.Y.)) decisions rendered by judges in this district preempt- the Second Circuit has adopted the First Department's ing non-fraud common law claims. rule that the Martin Act preempts common law tort claims in the securities context.” Abu Dhabi Com- Plaintiffs do not contest that their common law claims mercial Bank v. Morgan Stanley & Co., Inc., No. 08 contain allegations of dishonesty and deception and Civ. 7509(SAS), 2009 WL 2828018, at *14 (S.D.N.Y. involve securities that were sold within or from New Sept.2, 2009). Plaintiffs' argument-drawn from case York. Instead, in an attempt to escape Martin law outside the First Department-is thus insufficiently Act-preemption, plaintiffs cite Cromer Fin. Ltd. v. persuasive in the face of substantial contrary authority. Berger, No. 00 Civ. 2498, 2001 WL 1112548, at *4 (S.D.N.Y. Sept.19, 2001), Caboara v. Babylon Cove Given the amount of legal authority in this district Dev., LLC, 54 A.D.3d 79, 862 N.Y.S.2d 535, 538-39 favoring Martin Act-preemption for non-fraud com- (2d Dep't 2008), and Scalp & Blade, Inc. v. Advest, mon law claims based on deceptive acts committed in Inc., 281 A.D.2d 882, 722 N.Y.S.2d 639, 640 (4th connection with the sale of securities within or from Dep't 2001), to bolster their argument that the nu- New York, dismissal of these claims (Counts VIII, X, merous opinions issued by New York state and federal and XI) is warranted. courts were wrongly decided. Because it is unnecessary to do so, the court declines Plaintiffs' non-fraud claims plainly fall within the to address defendants' remaining arguments in support ambit of the Martin Act. First, plaintiffs' claims in- of dismissal of the common law claims. volve a “security” under the Martin Act based on their ownership of limited partnership interests in the CONCLUSION Funds. Second, as plaintiffs themselves acknowledge, substantial acts in furtherance of the alleged wrong- For the reasons set forth herein, E & Y's and KPMG's doing occurred within the district, thus satisfying the motions to dismiss are granted (Docket Nos. 35 and 45 Martin Act's geographic prong. Third, the Complaint on 08 Civ. 11212; Docket No. 103 on 08 Civ. 11117). is centered on plaintiffs' allegations of various misrepresentations and omissions with respect to the diligence performed on the funds, including ignoring FN1. Since plaintiffs' substantive allegations countless “red flags” warning that Madoff was oper- do not distinguish between E & Y and ating a Ponzi scheme. Finally, the fact that the Com- KPMG and the Auditors advance largely plaint specifically references the New York Attorney similar arguments in favor of dismissal, the General's action under the Martin Act against Ezra court will discuss the claims against the Au- Merkin and feeder fund Gabriel Capital Corp. for ditors together. funneling fund assets to Madoff only underscores the appropriateness of Martin Act-preemption here. FN2. The “split-strike conversion” strategy purportedly entailed the purchase of 30 to 40 *8 And the line of cases that plaintiffs advance has large capitalization S & P 500 stocks and the been rejected repeatedly by courts in this district. See, simultaneous sale of out-of-the-money calls e.g., Kassover v. UBS AG, 619 F.Supp.2d 28, 39 on the S & P 100 Index and the purchase of (S.D.N.Y.2008) (“Plaintiffs reliance on Caboara is out-of-the-money puts on the S & P 100 In- unavailing ... Caboara appears to overlook a dex. long-standing distinction between courts' treatment of common law fraud claims and that of other state law S.D.N.Y.,2010. claims based on deceptive practices.”); Nanopierce In re Tremont Securities Law, State Law and Insur- Techs., Inc. v. Southridge Capital Mgmt., LLC, No. 02 ance Litigation Civ. 0767(LBS), 2003 WL 22052894, at *4 (S.D.N.Y. --- F.Supp.2d ----, 2010 WL 1257580 (S.D.N.Y.), Fed. Sept.2, 2003) (“Both Scalp & Blade and Cromer Sec. L. Rep. P 95,666 Finance stand as solitary islands in a stream of contrary opinion”). Indeed, although “there is some dis- END OF DOCUMENT agreement among New York's appellate courts as to whether the Martin Act preempts common law claims,

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ciency of service, UBP indicated its intention Only the Westlaw citation is currently available. to join this motion to dismiss.

United States District Court, BACKGROUND S.D. New York. Andrea BARRON, on behalf of herself and all others The Complaint similarly situated, Plaintiff, v. Except where otherwise indicated, the following facts Roman IGOLNIKOV, Sheldon S. Gordon, Matthew are taken from the complaint. For the purpose of this Stadtmauer, Union Bancaire Privée, Union Bancaire motion, plaintiff's allegations are assumed to be true. Privée Asset Management LLC, UBPI Holdings, Inc., Daniel de Picciotto, Michael de Picciotto, Guy de The basic facts surrounding Madoff's fraudulent Picciotto, and Christophe Bernard, Defendants. Ponzi scheme are well-known. Madoff told his cus- No. 09 Civ. 4471(TPG). tomers that he was investing their assets through a strategy called “split-strike conversion,” which in- March 10, 2010. volved the supposed purchase and sale of stocks in the S & P 100 Index as well as options on that index. OPINION Madoff sent account statements and trade tickets to his customers purporting to reflect this trading. THOMAS P. GRIESA, District Judge. On December 11, 2008, news broke that Madoff had *1 Andrea Barron brings this putative class action been operating an enormous Ponzi scheme for nearly under Fed.R.Civ.P. 23(a) and (b)(3) seeking to hold 20 years. Rather than using his customers' money to Union Baincaire Privée Asset Management, LLC purchase publicly traded securities, Madoff used (“UBPAM”), its Swiss parent Union Bancaire Privée investments from new customers to pay returns to (“UBP”), and several of their officers and directors other customers. In fact, he never purchased a single liable for all losses incurred by 11 “fund of funds” security. And the account statements and trade tickets (“UBP Funds”) resulting from Bernard Madoff's that Madoff had been sending to customers were massive Ponzi scheme. Defendants are Roman Igol- complete fabrications. Upon the revelation of this nikov, Sheldon S. Gordon, Matthew Stadtmauer, fraud, the U.S. Attorney for the Southern District of UBP, UBPAM, UBPI Holdings, Inc., Daniel de Pic- New York charged Madoff with violations of the ciotto, Michael de Picciotto, Guy de Picciotto, and federal securities laws. On March 13, 2009, Madoff Christophe Bernard. Plaintiff asserts common law pleaded guilty to these charges. Bernard Madoff has claims for breach of fiduciary duty, aiding and abet- since been sentenced to 150 years in prison for his ting breach of fiduciary duty, gross negligence, and crimes. While the conviction is not pled in this com- unjust enrichment. plaint, which was filed about two months before the sentencing, the court takes judicial notice of this fact as a matter of public record extensively and globally Defendants move to dismiss the complaint for lack of covered in news. subject matter jurisdiction under Fed.R.Civ.P. 12(b)(1) and for failure to state a claim upon which relief can be granted under Fed.R.Civ.P. 12(b)(6).FN1 On April 6, 2009, the New York Attorney General Plaintiff opposes. The motion is granted. brought civil fraud charges under New York's Martin Act against hedge fund operator J. Ezra Merkin based on his feeder funds' role in supplying money to Ma- FN1. UBP, a foreign corporation, separately doff. The Attorney General alleges that Merkin filed a motion to quash service of process steered his clients' money to Madoff without permis- under Fed.R.Civ.P. 12(b)(5) on June 9, 2009. sion in exchange for management and incentive fees Notwithstanding its challenge to the suffi-

Slip Copy, 2010 WL 882890 (S.D.N.Y.), Fed. Sec. L. Rep. P 95,637 (Cite as: 2010 WL 882890 (S.D.N.Y.)) funds and ignored glaring “red flags” related to Ma- FN2. Defendants assert that plaintiff invested doff's investments. The court takes judicial notice of in this fund under another name, Andrea the fact that Merkin managed several feeder funds Brenninkmeyer. Plaintiff does not contest with ties to Madoff, including Ascot Fund Ltd. this.

*2 Plaintiff brings this action on behalf of all investors To the fullest extent permitted by law, the General who acquired and/or held limited partnership interests Partner [an affiliate of UBPAM], its Affiliates and or other investment interests in the UBP Funds as of any of their respective partners, directors, officers, December 11, 2008. The UBP Funds are “funds of employees or shareholders shall not be liable to the funds,” which invested with Madoff indirectly by Partnership or any other Partner for (i) any act or allocating a portion of their assets to four feeder funds, omission by the General Partner in connection with including Ascot Fund Ltd., which had direct accounts the conduct of the business of the Partnership that is with Madoff and invested substantially all of their determined by the General partner in good faith to assets with him. The complaint refers to 11 separate be in or not opposed to the best interests of the UBP Funds managed by UBPAM or UBP that plain- Partnership, unless the act or omission constitutes tiff purports to represent: Selectinvest ARV LP, Se- fraud, willful misconduct or gross negligence ... lectinvest ARV II Ltd., Selectinvest Alternative Ba- lanced Fund Ltd ., UBP Multi-strategy Alpha Fund, The limited partnership agreement also contains a Dinvest-Total Return, Dinvest-Concentrated Oppor- provision specifying the application of Delaware law. tunities, Dinvest-Select I, Dinvest-Select II, Dinv- est-Select III, Dinvest-Concentrated Opportunities III The other 10 funds comprising the UBP Funds have Equity, and Trendsquare I. Plaintiff alleges that the separate investors or shareholders, boards of directors, UBP Funds' investments in Madoff feeder funds and governing documents. According to defendants, ranged from 2.31% to 6.92% of total assets. As a result these other funds are domiciled outside the United of these investments, the UBP Funds lost a portion of States, in either the Cayman Islands or Luxembourg. their value upon revelation of Madoff's extensive securities fraud. On December 17, 2008, UBP disclosed that investors in the UBP Funds in fact lost Plaintiff's Claims $700 million attributable to investments with Madoff. *3 Plaintiff asserts four state-law claims in this diver- Back in 2007, the research division of UBP apparently sity class action under the Class Action Fairness Act, discovered and questioned some of the “red flags” 28 U.S.C. § 1332(d)(2) (A) & (C): (1) breach of fidu- associated with Madoff. Plaintiffs allege that defen- ciary duty against all defendants, (2) aiding and abet- dants nonetheless failed to warn their clients against ting breach of fiduciary duty against UBP, Daniel de investing with Madoff and instead continued to funnel Picciotto, Guy de Picciotto, Michael de Piciotto, money to Madoff-related feeder funds while collect- Christophe Bernard, Sheldon S. Gordon, Roman ing management fees from its investors. And defen- Igolnikov, and Matthew Stadtmauer, (3) gross negli- dants allegedly failed to provide proper account gence against all defendants, and (4) unjust enrich- statements that accurately reflected plaintiff's and the ment against UBP and UBPAM. class's account values. Plaintiff seeks to recover money damages from all While the complaint does not identify which of the 11 defendants. UBP Funds plaintiff invested in, defendants believe, based on a review of their records, that she invested in Standard On A Motion To Dismiss a single, domestic fund-Selectinvest ARV LP-managed by UBPAM out of its New York head- In reviewing a motion to dismiss pursuant to quarters.FN2 Defendants have provided the court with a Fed.R.Civ.P. 12(b)(6), the court must accept the fac- copy of the limited partnership agreement for Selec- tual allegations set forth in the complaint as true and tinvest ARV LP, which contains an exculpation pro- draw all reasonable inferences in favor of the plaintiff. vision stating as follows: See Cleveland v. Caplaw Enters., 448 F.3d 518, 521 (2d Cir.2006). “To survive a motion to dismiss, a

Slip Copy, 2010 WL 882890 (S.D.N.Y.), Fed. Sec. L. Rep. P 95,637 (Cite as: 2010 WL 882890 (S.D.N.Y.)) complaint must contain sufficient factual matter, ac- any private party alleging- cepted as true, to state a claim to relief that is plausible on its face.” Ashcroft v. Iqbal, 129 S.Ct. 1937, 1949 (A) a misrepresentation or omission of a material (2009). “A claim has facial plausibility when the fact in connection with the purchase or sale of a plaintiff pleads factual content that allows the court to covered security; or draw the reasonable inference that the defendant is liable for the misconduct alleged.” Id. While a com- (B) that the defendant used or employed any ma- plaint need not supply “detailed factual allegations,” it nipulative or deceptive device or contrivance in must consist of more than “labels and conclusions” or connection with the purchase or sale of a covered a “formulaic recitation of the elements of a cause of security. action.” Bell Atl. Corp. v. Twombly, 550 U.S. 544, 555 (2007). Unless a plaintiff's well-pleaded allegations have “nudged [its] claims across the line from con- 15 U.S.C. §§ 78bb(f)(1), 77p(b). Thus, SLUSA ceivable to plausible,” the complaint must be dis- mandates dismissal when the following four-part test missed. Id. at 570. is met: (1) the ... suit must be a “covered class action”; (2) the action must be based on state or local law; (3) the action must concern a “covered security” FN3; and DISCUSSION (4) the defendant must have misrepresented or omitted a material fact or employed a manipulative device or Defendants move to dismiss the complaint for lack of contrivance “in connection with the purchase or sale” subject matter jurisdiction and failure to state a claim of that security. See Felton v. Morgan Stanley Dean on the grounds that (1) the action is preempted by the Witter & Co., 429 F.Supp.2d 684, 690-91 Securities Litigation Uniform Standards Act (S.D.N.Y.2006). SLUSA's preemptive reach extends (“SLUSA”), 15 U.S.C. §§ 78bb(f), 77p(b); (2) the to complaints framed in terms of causes of action other action is preempted by the Martin Act, N.Y. Gen. Bus. than fraud. See In re Salomon Smith Barney Mut. Fund Law § 352 et seq.; (3) plaintiff lacks standing under Fees Litig., 441 F.Supp.2d 579, 603-04 Article III of the United States Constitution to assert (S.D.N.Y.2006); In re Oppenheimer Funds Fess Li- claims on behalf of investors in the UBP Funds in tig., 419 F.Supp.2d 593, 596 (S.D.N.Y.2006). which she did not invest; and (4) plaintiff's claims are barred by the exculpation provision in the limited FN3. A “covered security” includes any se- partnership agreement of the Selectinvest ARV LP curity that is listed or authorized for listing on fund. the New York Stock Exchange or another national exchange. See 15 U.S.C. §§ 77r(b) SLUSA Preemption and 78bb(f)(5)(E).

Congress enacted SLUSA in 1998 in response to It is undisputed that this action a “covered class ac- concerns that state-law class actions were being uti- tion” within the meaning of SLUSA and that the lized to circumvent the heightened pleading require- complaint contains no claims brought under federal ments for securities fraud lawsuits under the Private law. At issue is whether plaintiff has alleged a “mi- Securities Litigation Reform Act of 1995. Indeed, srepresentation or omission ... in connection with the SLUSA's purpose is to ensure that federal courts re- purchase or sale of a covered security.” main “the exclusive venue of, and federal law the exclusive source of, certain class actions alleging The Supreme Court has instructed that SLUSA's securities claims.” Dacey v. Morgan Stanley Dean operative language must be read broadly to cover not Witter & Co., 263 F.Supp.2d 706, 709 only purchasers and sellers of covered securities but (S.D.N.Y.2003). To achieve this aim, SLUSA im- also claims where the fraud alleged coincides with a poses certain limitations on putative state-law class covered securities transaction by someone else. See actions: Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71, 85 (2006). The requisite showing is de- *4 No covered class action based upon the statutory ception in connection with the purchase or sale of any or common law of any State or subdivision thereof security, not deception practiced against a particular may be maintained in any State or Federal court by purchaser or seller. See id. at 85. This “purchase or

Slip Copy, 2010 WL 882890 (S.D.N.Y.), Fed. Sec. L. Rep. P 95,637 (Cite as: 2010 WL 882890 (S.D.N.Y.)) sale” requirement is to be “construed not technically deception in connection with the purchase or sale of a and restrictively, but flexibly.” S.E.C. v. Zandford, covered security, not the deception of plaintiff herself. 535 U.S. 813, 819 (2002). The court concludes that plaintiff's various claims Most importantly, it is not necessary that the purchase allege “a misrepresentation or omission ... in connec- or sale actually transpired; claims based on the alleged tion with the purchase or sale of a covered security” failure to buy or sell covered securities fall squarely within the meaning of SLUSA. They are alleged as within SLUSA's ambit. See, e.g., Instituto de Previ- state law claims, but are preempted by SLUSA. sion Militar v. Merrill Lynch, 546 F.3d 1340, 1352 (11th Cir.2008) (finding SLUSA precluded action Martin Act Preemption seeking to hold defendant liable for fraud where third-party investment manager stole investors' money Apart from the bar of SLUSA, plaintiff's claims are rather than purchasing securities); Falkowski v. Ima- preempted by the Martin Act, N.Y. Gen. Bus. Law §§ tion Corp., 309 F.3d 1123, 1129-30 (9th Cir.2002) 352 et seq. This statute, commonly known as the (preempting class action under SLUSA relating to Martin Act, “prohibits various fraudulent and deceit- unexercised stock options because “if a person con- ful practices in the distribution, exchange, sale, and tracts to sell a security, that contract is a ‘sale’ even if purchase of securities but does not require proof of the same is never consummated”). And SLUSA has intent to defraud or scienter.” Kassover v. UBS AG, precluded state-law claims where defendants placed 619 F.Supp.2d 28, 36 (S.D.N.Y.2008). plaintiffs' retirement proceeds into a collective fund that invested with Madoff and BMIS and subsequently ignored several “red flags” that should have New York courts construe the Martin Act liberally and alerted them to Madoff's Ponzi scheme. See Levinson have held that the statute vests the New York Attorney v. PSCC Servs., Inc., No. 3:09-CV-00269 (PCD), General with the sole authority to prosecute state-law 2009 WL 5184363, at * *11-12 (D.Conn. Dec. 23, securities violations sounding in fraud. See Castellano 2009): see also Schnorr v. Schubert, No. v. Young & Rubicam, Inc., 257 F.3d 171, 190 (2d CIV-05-303-M, 2005 WL 2019878, at *5 (W.D.Okla. Cir.2001); First Energy Leasing Corp. v. Attor- Aug. 18, 2005) (preempting claims under SLUSA ney-General, 68 N.Y.2d 59, 64 (1986). There is no where defendant engaged in a Ponzi scheme by implied private right of action for any claim covered promising to invest plaintiff's and the putative class's by the Martin Act. See CPC Intl. Inc. v. McKesson money in nationally listed and traded securities but Corp., 70 N.Y.2d 268, 275 (1987). never actually executed any trades). Courts routinely dismiss common-law securities *5 Here, Madoff told investors that he would pur- claims under the Martin Act based on conduct that is chase and sell securities in the S & P 100 Index but “within or from” New York sounding in fraud or never consummated any trades. Central to his fraud, deception that do not require pleading or proof or Madoff used prices from the public markets on the intent. See Owens v. Gaffken & Barriger Fund, LLC, trade documentation he sent to customers. In light of No. 08 Civ. 8414(PKC), 2009 WL 3073338, at *13 the Supreme Court's command that SLUSA be con- (S.D.N.Y. Sept. 21, 2009). Limited partnership inter- strued expansively, it is enough that this fraudulent ests are considered securities for purposes of the scheme was in connection with the trading in the Martin Act. See N.Y. Gen. Bus. Law § 352(1); Mayer nationally listed securities in which Madoff claimed v. Oil Field Sys. Corp., 721 F.2d 59, 65 (2d Cir.1993). to be engaged. It is not essential that Madoff actually And a transaction qualifies as “within or from” New performed any trades or acquired any securities. And York for purposes of the Martin Act if a plaintiff al- while plaintiff and members of the putative class leges that a substantial portion of the events giving rise purchased limited partnership interests in the UBP to a claim occurred in New York. See, e.g., Sedona Funds-which in turn invested in covered securi- Corp. v. Ladenburg Thalmann & Co., Inc., No. 03 ties-rather than covered securities directly from Ma- Civ. 3120(LTS)(THK), 2005 WL 1902780, at *22 doff, SLUSA preemption is justified because the se- (S.D.N.Y. Aug. 9, 2005) (applying Martin Act where curities transaction need not have been performed by complaint alleged proper venue in New York based on plaintiff. Rather, it is only necessary to demonstrate substantial part of the events or omissions giving rise to the claims occurred in the Southern District of New

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York). END OF DOCUMENT

*6 Plaintiff's claims plainly fall within the scope of the Martin Act. First, plaintiff's and the class's claims involve a security within the meaning of the Act, based on their ownership of limited partnership interests in the UBP Funds. Second, the Martin Act's geographic prong is easily satisfied. Substantial acts in furtherance of the alleged wrongdoing indisputably occurred “within or from” New York, and plaintiff is a New York resident, Madoff's fraud was centered in New York, and the Selectinvest ARV LP fund in which plaintiff invested is a domestic fund managed by UBPAM from its New York headquarters. As such, the securities at issue here have a significant nexus with New York.

Most importantly, the factual allegations here greatly resemble those in In re Bayou Hedge Fund Litig., 534 F.Supp.2d 405 (S.D .N.Y.2007), where the court dismissed plaintiff's breach of fiduciary duty claim against its investment advisor under the Martin Act for allegedly conducting inadequate diligence before recommending investment in a hedge fund, which ultimately was revealed to be a Ponzi scheme. See id. at 421. Similarly, the core of the complaint here is the allegation that defendants failed to perform adequate due diligence before investing the UBP Funds' assets with Madoff, whose operations were later exposed to be a fraudulent Ponzi scheme. Moreover, the fact that the New York Attorney General has brought claims under the Martin Act against Ascot Fund Ltd., one of the feeder funds through which plaintiff had exposure to Madoff, only underscores the appropriateness of Martin Act-preemption here.

Plaintiff's claims are precluded by the Martin Act.

CONCLUSION

Defendants' motion to dismiss is granted, and the case is dismissed in its entirety.

SO ORDERED.

S.D.N.Y.,2010. Barron v. Igolnikov Slip Copy, 2010 WL 882890 (S.D.N.Y.), Fed. Sec. L. Rep. P 95,637

Slip Copy, 26 Misc.3d 1237(A), 2010 WL 936208 (N.Y.Sup.), Blue Sky L. Rep. P 74,821, 2010 N.Y. Slip Op. 50430(U) (Table, Text in WESTLAW), Unreported Disposition (Cite as: 2010 WL 936208 (N.Y.Sup.))

petrated by Bernard L. Madoff through the investment advisory segment of Bernard L. Madoff Investment Securities LLC (“BMIS”). It alleges that Madoff used defendant Cohmad Securities Corporation (“Coh- United States District Court, mad”), a registered broker-dealer, to market his in- S.D. New York. vestment advisory business. BMIS allegedly paid SECURITIES and EXCHANGE COMMISSION, Cohmad and its representatives fees for recruiting Plaintiff, prospective clients to BMIS, from which Cohmad v. derived the majority of its revenue. The individual COHMAD SECURITIES CORPORATION, Maurice defendants are Maurice J. Cohn, Cohmad's Chairman J. Cohn, Marcia B. Cohn, and Robert M. Jaffe, De- and Chief Executive Officer; Marcia B. Cohn, its fendants. President, Chief Operating Officer, and Chief Com- No. 09 Civ. 5680(LLS). pliance Officer; and Robert M. Jaffe, its Vice Presi- dent. They are also each partial owners of Cohmad. Feb. 2, 2010. Invoking Rules 12(b)(6) and 9(b) of the Federal Rules West KeySummary of Civil Procedure, defendants move to dismiss parts Securities Regulation 349B 60.45(3) of the SEC's complaint. Specifically, they move to dismiss the securities fraud claims, which assert vi- 349B Securities Regulation olations, and aiding and abetting violations, of Section 349BI Federal Regulation 10(b) of the Securities Exchange Act of 1934 (“Ex- 349BI(C) Trading and Markets change Act”), 15 U.S.C. § 78j(b), and Rule 10b-5 349BI(C)7 Fraud and Manipulation thereunder, 17 C.F.R. § 240.10b-5; violations of Sec- 349Bk60.43 Grounds of and Defenses to tion 17(a) of the Securities Act of 1933 (“Securities Liability Act”), 15 U.S.C. § 77q(a); and aiding and abetting 349Bk60.45 Scienter, Intent, Know- violations of Sections 206(1) and (2) of the Investment ledge, Negligence or Recklessness Advisers Act of 1940 (“Advisers Act”), 15 U.S.C. §§ 349Bk60.45(3) k. Accountants, 80b-6(1) and (2). Cohmad and the Cohns also move to Attorneys, Underwriters and Brokers. Most Cited dismiss the claims for aiding and abetting violations of Cases technical registration, compensation, and filing regu- The Securities and Exchange Commission (SEC) lations under Section 15(b)(7) of the Exchange Act, 15 failed to state securities fraud claims under the Secur- U .S.C. § 78o(b)(7), and Rule 15b7-1 thereunder, 17 ities Exchange Act against a broker-dealer for its C.F.R. § 240.15b7-1; Section 206(4) of the Advisers alleged participation in a Ponzi scheme. Although the Act, 15 U.S.C. § 80b-6(4), and Rule 206(4)-3 the- SEC alleged that the broker-dealer referred customers reunder, 17 C.F.R. § 275.206(4)-3; and, as against to an investment adviser heading the scheme, it failed Maurice Cohn only, Section 15(b)(1) of the Exchange to demonstrate that the broker-dealer knew of, or Act, 15 U.S.C. § 78o(b)(1), and Rule 15b3-1 the- recklessly disregarded, the fraud. Securities Exchange reunder, 17 C.F.R. § 240.15b3-1.FN1 They also move Act of 1934, § 10(b), 15 U.S.C.A. § 78j(b); Fed.Rules to strike the SEC's request for civil penalties for aiding Civ.Proc.Rules 12(b)(6), 9(b), 28 U.S.C.A. and abetting violations of the Advisers Act.

Opinion and Order FN1. The SEC also asserts claims for violations, and aiding and abetting violations, of LOUIS L. STANTON, District Judge. Section 17(a) of the Exchange Act, 15 U.S.C. § 78q(a), and Rule 17a-3 thereunder, 17 C.F.R. § 240.17a-3, which defendants do not *1 The Securities and Exchange Commission sues move to dismiss. defendants for participating in the Ponzi scheme per-

Slip Copy, 2010 WL 363844 (S.D.N.Y.), Fed. Sec. L. Rep. P 95,595 (Cite as: 2010 WL 363844 (S.D.N.Y.))

“permits scienter [guilty knowledge] to be demon- There is nothing inherently fraudulent about referring strated by inference, [but] this must not be mistaken customers to an investment adviser for fees, and the for license to base claims of fraud on speculation and complaint does not allege statements or omissions by conclusory allegations. An ample factual basis must defendants that are fraudulent absent awareness or be supplied to support the charges.” Wood ex rel. U.S. notice that Madoff's investment advisory business v. Applied Research Assocs., Inc., 328 F. App'x 744, was a sham. Thus, to state its securities fraud claims, 747 (2d Cir.2009) (internal quotation marks omitted). the SEC must show that defendants knew of, or recklessly disregarded, Madoff's fraud. In other words, SECURITIES FRAUD one who conducts normal business activities while ignorant that those activities are furthering a fraud is Madoff's fraud was the use of elaborate machinery, not liable for securities fraud. including falsifying account statements and trade confirmations, to promote the illusion that he was In contrast, there is no need for the SEC to show de- making securities transactions with investors' money, fendants' knowledge of Madoff's fraud to state valid when the reality was that “when earlier investors claims for technical rule violations. sought to collect their ‘profits,’ Madoff simply paid them out of the capital received from newer inves- RULES 12(b)(6) AND 9(b) tors.” Anwar v. Fairfield Greenwich Ltd., --- F.Supp.2d ----, No. 09 Civ. 0118, 2009 WL 5103234, On a motion to dismiss under Rules 12(b)(6) and 9(b) at *4 (S.D.N.Y. Dec.23, 2009). However, nowhere of the Federal Rules of Civil Procedure, the Court does the complaint allege any fact that would have put must accept as true the factual allegations in the defendants on notice of Madoff's fraud. complaint, and draw all reasonable inferences in the plaintiff's favor. Mills v. Polar Molecular Corp. ., 12 Rather, the complaint supports the reasonable infe- F.3d 1170, 1174 (2d Cir.1993). rence that Madoff fooled the defendants as he did individual investors, financial institutions, and regu- *2 To survive a motion to dismiss under Rule lators. As it alleges, Madoff is a former Chairman of 12(b)(6), the NASDAQ stock market. BMIS has existed since 1960. Maurice Cohn is Madoff's former neighbor. They formed Cohmad in 1985, and Marcia Cohn a complaint must contain sufficient factual matter, joined in 1988, before Madoff allegedly began oper- accepted as true, to state a claim to relief that is ating BMIS's investment advisory business as a fraud plausible on its face. A claim has facial plausibility in 1991. The Cohns worked in Cohmad's New York when the plaintiff pleads factual content that allows office on the 18th and 19th floors of BMIS's New the court to draw the reasonable inference that the York premises, from which BMIS operated legitimate defendant is liable for the misconduct alleged. The market-making and proprietary trading businesses. plausibility standard is not akin to a probability re- BMIS's fraudulent investment advisory business was quirement, but it asks for more than a sheer possi- on the 17th floor. Jaffe was farther removed from the bility that a defendant has acted unlawfully. Where site of the fraud, operating Cohmad's Boston office. a complaint pleads facts that are merely consistent Defendants' are claimed to have referred prospective with a defendant's liability, it stops short of the line clients to BMIS. They are not alleged to have had a between possibility and plausibility of entitlement role in managing clients' funds. When clients called to relief. Cohmad with questions about their BMIS accounts, the Cohns checked “with Madoff or employees on Ashcroft v. Iqbal, --- U.S. ----, 129 S.Ct. 1937, 1949, BMIS' 17th floor to find out the answers.” Compl. ¶ 173 L.Ed.2d 868 (2009) (internal citations and quota- 35. The individual defendants maintained their own tion marks omitted). BMIS accounts. Outside of its referral business, “Cohmad had some 600 retail brokerage accounts Allegations of fraud must also comply with Rule 9(b), which, for many years, Cohmad cleared through the which requires that the plaintiff “state with particu- broker-dealer Bear Sterns Securities Corp.,” id. ¶ 14, larity the circumstances constituting fraud.” This rule and it executed trades on the New York Stock Ex-

Slip Copy, 2010 WL 363844 (S.D.N.Y.), Fed. Sec. L. Rep. P 95,595 (Cite as: 2010 WL 363844 (S.D.N.Y.)) change for BMIS's legitimate market-making busi- allegation of motive, we assume that the defendant is ness. Cohmad is not alleged to have engaged in acting in his or her informed economic self-interest.”). wrongdoing in those activities. No inference of fraudulent motive can be drawn from the change in compensation for Maurice Cohn in *3 The allegations of defendants' scienter can be 2002, because there are no allegations that it resulted grouped into four categories, but whether considered in higher pay than he was earning before, and the individually or collectively, they do not show that change is not tied to any suspicious event. Compare defendants knew of, or recklessly disregarded, Ma- Kalnit v. Eichler, 264 F.3d 131, 139 (2d Cir.2001) doff's fraud: (providing example of fraudulent motive “where plaintiff alleged that defendants misrepresented cor- 1. Cohmad's Compensation Arrangement with porate performance to inflate stock prices while they BMIS sold their own shares”).

The SEC argues that the Cohns' fraudulent intent can Since defendants' fraudulent motive is not apparent, be inferred from Cohmad's compensation arrangement “the strength of the circumstantial allegations must be with BMIS, id. ¶ 27: correspondingly greater.” Id. at 142.

The incentive for Cohmad representatives was a 2. Madoff's Requests for Secrecy rich compensation structure. Madoff compensated Cohmad each year (in monthly installments) with a The SEC argues that defendants' fraudulent intent can percentage (declining from 1% to .25% over the be inferred from allegations that Madoff requested years) of the original capital investment brought secrecy in marketing BMIS, and that defendants into BMIS' advisory business by Cohmad repre- complied. According to the complaint, “Madoff di- sentatives for as long as the account was open. rected Cohmad and the Cohns to maintain a cloud of However, to the extent that any withdrawals were secrecy about how BMIS was marketed, banning all made from the investor's account, the amount of written marketing materials, cold calls, and emails.” capital subject to the fee calculation was reduced. Compl. ¶ 53. Madoff also “communicated to the De- The vast majority of these payments was passed on fendants that he would not accept investments from to the representatives in quarterly installments. anyone who worked in the finance or banking industry” because “sophisticated investors would ask ‘too In 2002, the arrangement changed for Maurice Cohn, many questions.’ “ Id. ¶ 48. Thus, to recruit customers, and he received a flat fee of $2 million a year. id. ¶ 26,

Cohmad's compensation arrangement with BMIS *4 Cohmad's representatives strategically circu- provided incentives to induce customers to invest with lated among wealthy individuals in exclusive mi- BMIS and “discourage investors from withdrawing lieus-New Jersey golf clubs, Palm Beach Country any funds that might exceed the amount of the indi- Club, and the like-and offhandedly mentioned that vidual investments.” Id. ¶ 57. That does not indicate they were affiliated with Madoff. The representa- fraud. The compensation structure was consistent with tives projected themselves as individuals who be- Cohmad's business, which existed before Madoff's came wealthy through BMIS, had no need to work, fraud began. Cohmad referred customers to a pur- and merely frequented country clubs. When pros- ported investment adviser and provided customer pective investors asked if the representatives could service, but it had no role in investment decisions, so it make an introduction to Madoff so they could in- is logical that Cohmad did not earn fees on “profits” vest with BMIS, the Cohmad representatives would from investment. The decrease in the fees over time agree to try to put in a good word with Madoff and from 1% to .25% is inconsistent with any inference see if they could get the investors in. Cohmad and its that Madoff was inducing defendants to participate in representatives would then assist and arrange the a fraud and thereby “put the Defendants ['] licenses, opening of accounts with BMIS. and the individual defendants' livelihoods, at risk,” id. ¶ 6. See Shields v. Citytrust Bancorp, Inc., 25 F.3d That Madoff's secrecy warned defendants of fraud 1124, 1130 (2d Cir.1994) ( “In looking for a sufficient amounts to an argument of “fraud by hindsight,”

Slip Copy, 2010 WL 363844 (S.D.N.Y.), Fed. Sec. L. Rep. P 95,595 (Cite as: 2010 WL 363844 (S.D.N.Y.)) which the Second Circuit “has rejected as a basis for a the question, but instead identified its business as securities fraud complaint.” Stevelman v. Alias Re- “Development of Trading, Hedging and Investment search, Inc., 174 F.3d 79, 85 (2d Cir.1999). The Strategies.” complaint itself offers what defendants may reasonably have perceived was a neutral explanation for *5 In its 2007 Annual Audit Report filed with the Madoff's secrecy: that “Madoff had a clever mar- SEC, Cohmad disclosed the amount of its fees from keting strategy” by which “He cultivated an aura of BMIS, but it classified them as “brokerage service success and secrecy surrounding BMIS, projecting to fees,” id. ¶ 42, and in its quarterly FOCUS reports a social network of wealthy friends and investors that filed with the Financial Industry Regulatory Authori- he was highly successful and did not need to market or ty, it classified them as “Fees for account supervision, solicit to obtain investments.” Compl. ¶ 23. That investment advisory and administrative services,” id. ¶ strategy was successful in that, “By creating an air of 43. Cohmad also maintained “no meaningful records” prestige and exclusivity, many of BMIS' victims felt of its referral business “Other than an ongoing tally of privileged to be allowed to invest with Madoff and amounts invested (less withdrawals of principal).” Id. BMIS and many prospective investors angled for ¶ 44. ways to get in.” Id. ¶ 24. It did not give notice of fraud because, as Cohmad and the Cohns explain, “anyone Absent facts showing that defendants were on notice who watches TV commercials or reads magazine ads of Madoff's fraud, the chain of inferences that Coh- can attest” that “the projection of an ‘aura of exclu- mad's recent regulatory disclosures' failure “to accu- sivity’ is a common marketing tactic.” Cohmad & rately identify the nature and scope of the business Cohn Mem. 25. arrangement between Cohmad and BMIS,” id. ¶ 41, showed an intention to conceal that relationship, and 3. Regulatory Violations further that the concealment was because any defendant knew that Madoff was committing fraud, is The SEC argues that defendants' fraudulent intent can speculative and flimsy. be inferred from allegations that Cohmad failed to disclose the full extent of its relationship with BMIS in 4. Irregularities in Jaffe's Personal BMIS Accounts its regulatory filings and books and records, and that defendants were aware that BMIS failed to register As to Jaffe, the SEC also relies on paragraphs 60 and them as associated with BMIS. 62 of the complaint regarding his personal BMIS accounts: The SEC points to Cohmad's Form BD and amendments filed with the SEC the past six years, Compl. ¶ 60. BMIS directly compensated Jaffe for the 39: numerous investors he brought to BMIS. Unlike the other Cohmad representatives, Jaffe's compensation • Question 7 on the Form BD asks: “Does applicant did not come via Cohmad. Instead, Jaffe received refer or introduce customers to any broker or deal- compensation directly from BMIS, through his er?” Cohmad answered “Yes,” but only disclosed personal BMIS accounts. Through these accounts, Bear Sterns, its clearing firm for the retail brokerage BMIS provided Jaffe with outsized returns: Jaffe business and failed to disclose any reference to received annual returns of up to 46% while the in- BMIS, to which it referred over 800 customers. vestors that Jaffe brought into BMIS received an- [emphasis in complaint] nual returns of only 12-18%. Based on these outsized returns, Jaffe made large withdrawals from his .... BMIS accounts, totaling at least $150 million between 1996 and 2008. • Question 12 asks the filer to identify “Types of Business” engaged in and Cohmad did not identify .... its primary business of obtaining investors for BMIS. Although the catchall box for “Other” was 62. Jaffe frequently made specific requests to checked, Cohmad did not disclose its predominant BMIS seeking a specific dollar amount of gains for business referring customers to BMIS in response to

Slip Copy, 2010 WL 363844 (S.D.N.Y.), Fed. Sec. L. Rep. P 95,595 (Cite as: 2010 WL 363844 (S.D.N.Y.))

a given period. Some of these were requests for arising from Madoff's fraud, there is a justi- specific dollar amounts of “long term gains” on fiable concern for anyone who did business specific days. A BMIS employee would then insert with BMIS's investment advisory unit, as did a backdated trade going back days, weeks or even Jaffe, that he or she will be hauled into the months that afforded Jaffe's account that particular criminal probe. gain and then mailed confirmations and account statements to Jaffe reflecting those trades. This was REGISTRATION, COMPENSATION, AND FIL- a highly unusual arrangement, particularly given ING VIOLATIONS that the instructions requested specific dollar amounts and were not for the sale of any particular Cohmad and the Cohns also move to dismiss claims securities, but were followed by confirmations re- for aiding and abetting technical registration, com- flecting trades that antedated the requests. pensation, and filing violations of the federal securities laws. These claims do not require awareness or The basis for the assertion that he was part of the fraud notice of Madoff's fraud. Nor are they subject to Rule is that “Jaffe received annual returns of up to 46% 9(b)'s standards for alleging fraud. The SEC has while the investors that Jaffe brought into BMIS re- pleaded those claims apart from its fraud allegations. ceived annual returns of only 12-18%,” id. ¶ 60, but the complaint does not allege when or how often Jaffe Because the SEC asserts aiding and abetting liability, received “outsized returns” to support the inference however, it must plead (i) the existence of the tech- that they were unusual or suspicious. In light of Ma- nical violation by the primary party; (ii) knowledge of doff's established reputation as a successful and res- this violation on the part of defendants; and (iii) sub- pected investment adviser, the high returns he pro- stantial assistance by defendants in the achievement of duced were not generally perceived (even by profes- the violation. See SEC v. DiBella, 587 F.3d 553, 566 sionals) as a badge of fraud. (2d Cir.2009).

*6 Similarly, the complaint does not allege how often 1. Aiding and Abetting Violations of Section Jaffe's account reflected a backdated trade. An irre- 15(b)(7) of the Exchange Act, and Rule 15b7-1 gular trade date over the twelve years that Jaffe Thereunder, and Section 206(4) of the Advisers maintained an account with BMIS does not show Act, and Rule 206(4)-3 Thereunder reckless disregard of Madoff's fraud. Jaffe reasonably might believe that his account reflected an innocent bookkeeping or typographical error. Rule 15b7-1, pursuant to Section 15(b)(7) of the Ex- change Act, makes it unlawful for a registered broker-dealer to “effect any transaction in, or induce the Thus, the SEC has failed to allege facts giving rise to a purchase or sale of, any security unless any natural plausible inference of the Cohns' or Jaffe's fraudulent person associated with such broker or dealer who intent, and the securities fraud claims against them are FN2 effects or is involved in effecting such transaction is dismissed. Since the SEC has failed to plead the registered.” Rule 206(4)-3, pursuant to Section 206(4) Cohns' or Jaffe's fraudulent intent (and it does not of the Advisers Act, prohibits an investment adviser argue that Madoff's intent can be imputed to Coh- from paying a referral fee unless certain pre-requisites mad), the securities fraud claims against Cohmad are have been met. The SEC alleges that Cohmad and the dismissed as well. Cohns aided and abetted BMIS's violations. In essence, it argues that they knew BMIS was in violation FN2. The SEC argues that Jaffe's assertion of of the rules but nevertheless continued to conduct their his Fifth Amendment privilege during his referral business with BMIS. SEC investigative testimony “provides a sufficient and independent reason for deny- That fails to allege that Cohmad or the Cohns aided ing his motion to dismiss in its entirety.” Pl.'s and abetted BMIS's violations. The sole authority Opp. to Jaffe Mot. 23. The adverse inference cited by the SEC in which aiding and abetting liability that may be drawn from Jaffe's invocation of was imposed under either rule is instructive. In Dennis his Fifth Amendment privilege is weak. Ward, Initial Decision Release No. 226, 80 SEC Given the numerous criminal investigations Docket 453 (May 8, 2003), an SEC Administrative

Slip Copy, 2010 WL 363844 (S.D.N.Y.), Fed. Sec. L. Rep. P 95,595 (Cite as: 2010 WL 363844 (S.D.N.Y.))

Proceeding, a registered broker aided and abetted his juror could conclude that Maurice Cohn had the duty brokerage firm's violation of Rule 15b7-1, as well as and authority to see that the filings were corrected, and Rule 17a-3 which requires accurate records, where he that his failure to do so over the six years that Coh- “signed subscription documents, new account forms, mad's filings were allegedly inaccurate substantially order tickets, and other documents falsely assisted Cohmad's violation. representing that he was the registered representative” for securities sales made by his business associate CIVIL PENALTIES UNDER THE ADVISERS whom he knew was not registered. In contrast, here ACT the SEC does not allege misconduct by Cohmad or the Cohns aimed at enabling BMIS's rule violations, but Cohmad and the Cohns move to dismiss the SEC's only that they continued their routine business with claim for civil penalties for aiding and abetting viola- BMIS. Cf. IIT v. Cornfeld, 619 F.2d 909, 922 (2d tions of the Advisers Act. They argue that the Advis- Cir.1980) (“in order to be held as an aider and abettor, ers Act does not grant authority to impose penalties for a person must ‘in some sort associate himself with the aiding and abetting violations. After briefing on their venture, that he participate in it as something that he motion closed, the Second Circuit in DiBella, 587 wishes to bring about, that he seek by his action to F.3d at 571-72, held that “the civil penalty provision make it succeed’ ”), quoting United States v. Peoni, encompasses both primary and secondary violators of 100 F.2d 401, 402 (2d Cir.1938). The complaint does the Advisers Act.” This Court is bound by that deci- not allege that the Cohns held themselves out as BMIS sion. Thus, this aspect of Cohmad and the Cohns' registered representatives or hid their involvement motion is denied. from clients they solicited, in order to enable BMIS's Rule 15b7-1 violations. Indeed, their participation was transparent because they allegedly assisted with LEAVE TO REPLEAD opening BMIS accounts and fielded customer inquiries. The SEC requests leave to replead if any of its claims are dismissed. It has not previously amended its *7 Accordingly, the SEC's claims against Cohmad and complaint, and defendants offer no persuasive reason the Cohns for aiding and abetting violations of Section why amendment would be futile. Accordingly, the 15(b)(7) of the Exchange Act, and Rule 15b7-1 the- SEC is granted leave to replead its defective claims by reunder; and Section 206(4) of the Advisers Act, and filing an amended complaint within 30 days from the Rule 206(4)-3 thereunder, are dismissed. date of this opinion and order.

2. Aiding and Abetting Violations of Section CONCLUSION 15(b)(1) of the Exchange Act, and Rule 15b3-1 Thereunder, as Against Maurice Cohn Jaffe's motion (Docket No. 12) is granted, and Coh- mad and the Cohns' motion (Docket No. 17) is granted Rule 15b3-1, pursuant to Section 15(b)(1) of the Ex- in part and denied in part. In particular, the claims for change Act, requires a broker-dealer to correct its securities fraud (Claims One through Four) are dis- Form BD and amendments if they are inaccurate. The missed as against all defendants. The claims for aiding SEC alleges that Cohmad was the primary violator, and abetting violations of Section 206(4) of the Ad- and that the Cohns aided and abetted its violation. visers Act, and Rule 206(4)-3 thereunder, (Claim Maurice Cohn disputes whether the SEC has pleaded Five) and Section 15(b) (7) of the Exchange Act, and his substantial assistance because the complaint al- Rule 15b7-1 thereunder, (Claim Seven) are dismissed leges that Marcia Cohn signed each of the filings at as against Cohmad and the Cohns. Cohmad and the issue. Cohns' motion is otherwise denied.

Maurice Cohn cannot escape aiding and abetting lia- The SEC is granted leave to replead its defective bility under Rule 15b3-1 even though only Marcia claims by filing an amended complaint within 30 days Cohn may have signed Cohmad's filings. He is alle- from the date of this opinion and order. gedly Cohmad's largest owner (48%), and its founder, Chairman, and Chief Executive Officer. A reasonable *8 So ordered.

Slip Copy, 2010 WL 363844 (S.D.N.Y.), Fed. Sec. L. Rep. P 95,595 (Cite as: 2010 WL 363844 (S.D.N.Y.))

S.D.N.Y.,2010. S.E.C. v. Cohmad Securities Corp. Slip Copy, 2010 WL 363844 (S.D.N.Y.), Fed. Sec. L. Rep. P 95,595

END OF DOCUMENT

Slip Copy, 2009 WL 5184360 (D.Conn.) (Cite as: 2009 WL 5184360 (D.Conn.))

Investors' claims for theft and violation of the Con- Only the Westlaw citation is currently available. necticut Unfair Trade Practices Act against a bank were precluded by the Securities Litigation Uniform Standards Act because the complaint alleged a frau- United States District Court, dulent scheme coinciding with the purchase or sale of D. Connecticut. securities. Investors alleged a scheme of false repre- Ben R. BACKUS, et al, Plaintiffs, sentations concerning the purported purchase and sale v. of securities by the bank. Investors alleged that the CONNECTICUT COMMUNITY BANK, N.A., bank knowingly sent false account statements detail- owner of Westport National Bank, Defendant. ing the purchase, sale, and value of securities. Inves- Civ. No. 3:09-CV-1256. tors alleged that the bank charged fees based on the value of securities which it purportedly, but did not Dec. 23, 2009. actually, hold. Securities Litigation Uniform Stan- dards Act of 1998, § 101, 15 U.S.C.A. § 77p. West KeySummary Antitrust and Trade Regulation 29T 132 Andrew W. Skolnick, David A. Slossberg, J. Daniel Sagarin, Hurwitz Sagarin Slossberg & Knuff LLC, 29T Antitrust and Trade Regulation Milford, CT, Craig Yankwitt, David S. Golub, Jona- 29TIII Statutory Unfair Trade Practices and than M. Levine, Silver, Golub & Teitell, Stamford, Consumer Protection CT, for Plaintiffs. 29TIII(A) In General 29Tk132 k. Preemption. Most Cited Cases Jonathan M. Freiman, Joseph C. Merschman, Wiggin & Dana, New Haven, CT, Scott D. Corrigan, Wiggin States 360 18.15 & Dana, LLP, New York, NY, for Defendant.

360 States RULING ON MOTIONS TO DISMISS AND RE- 360I Political Status and Relations MAND 360I(B) Federal Supremacy; Preemption 360k18.15 k. Particular Cases, Preemption PETER C. DORSEY, District Judge. or Supersession. Most Cited Cases *1 This action arises out of the infamous Ponzi States 360 18.84 scheme conducted by Bernie Madoff. Plaintiffs Ben R. Backus and twenty-six other individuals (“named 360 States Plaintiffs”) bring suit against Defendant Connecticut 360I Political Status and Relations Community Bank, as owner of Westport National 360I(B) Federal Supremacy; Preemption Bank. The Complaint alleges breach of contract, theft, 360k18.83 Trade Regulation; Monopolies and fraud, as well as violations of the Connecticut 360k18.84 k. In General. Most Cited Unfair Trade Practices Act, CONN. GEN. STATS. § Cases 42-110(a) et seq. Plaintiffs also allege breach of contract, theft, and violations of the Connecticut Unfair Trover and Conversion 389 13 Trade Practices Act, CONN. GEN. STATS. § 42-110(a) et seq., on behalf of a putative class. The action was originally filed in Connecticut Superior 389 Trover and Conversion Court on July 8, 2009. On August 6, 2009, the case 389II Actions was removed to the District of Connecticut. On Au- 389II(A) Right of Action and Defenses gust 31, 2009, Plaintiffs filed a Motion to Remand 389k13 k. Nature and Scope of Remedy in Named Plaintiffs' Individual Claims [Doc. No. 15] as General. Most Cited Cases

Slip Copy, 2009 WL 5184360 (D.Conn.) (Cite as: 2009 WL 5184360 (D.Conn.)) well as an Amended Complaint. Also on August 31, into custodian agreements with each PSCC depositor. 2009, Defendant filed a Motion to Dismiss pursuant to FED.R.CIV.P. 12(b)(6) and the Securities Litigation Each custodian agreement states in part: Uniform Standards Act of 1998, 15 U.S.C. §§ 77p & 78bb(f) [Doc. No. 14], followed by a Motion to Dis- • WNB would invest all cash and cash equivalents miss the Amended Complaint on September 21, 2009 received from the Principal “in [WNB's] deposit [Doc. No. 37]. Plaintiffs filed a Motion to Remand the money market account until [WNB] transfers the Entire Action on September 8, 2009 [Doc. No. 24]. funds to Bernard L. Madoff Investment Securities (“BLMIS”) ...” For the reasons stated herein, Plaintiffs' Motion to Remand the Entire Action [Doc. No. 24] is denied. • The Principal “authorize[d][WNB] to transmit to Plaintiffs' Motion to Remand Named Plaintiffs' Indi- BLMIS all funds received by [WNB] from the vidual Claims [Doc. No. 15] is granted. Defendant's Principal ...” WNB would “enter into an agreement Motions to Dismiss [Doc. Nos. 14, 37] are granted in with BLMIS under which BLMIS will have full part and denied in part. discretionary authority as to the manner in which funds are invested.” The Principal's funds would be I. BACKGROUND aggregated with other funds for transmission to BLMIS, and the omnibus account maintained with The following facts are recited according to the com- BLMIS would be named “Westport National plaint. See Ashcroft v. Iqbal, --- U.S. ----, ----, 129 Bank.” S.Ct. 1937, 1949, 173 L.Ed.2d 868, 884 (2009). The 27 named Plaintiffs are residents of Connecticut who • WNB would “follow such reasonable written di- deposited their retirement funds into accounts at rections which the Principal may deliver to [WNB] Westport National Bank (“WNB”), pursuant to cus- at any time, ... including to request that BLMIS re- todian agreements. All named Plaintiffs maintained turn assets of the Principal to [WNB] and for these accounts as of December 11, 2008. Defendant [WNB] to remit cash or cash equivalents to the Connecticut Community Bank (“Defendant”) is a Principal.” nationally chartered bank that owns and operates offices in Fairfield County. WNB is a division of Con- • WNB “shall maintain adequate records indicating necticut Community Bank. Defendant's principal ownership by the Principal; of investments with place of business is Westport, CT, where the WNB BLMIS and held by [WNB] as custodian ...” division also operates. • WNB “shall render at least annually statements As of 1999, Plaintiffs were clients of PSCC Services, reflecting the property held by it as custodian ...” Inc. (“PSCC”), a Connecticut corporation in the business of providing retirement fund investment consulting services. In or about July 1999, PSCC • “The custodial services fees of [WNB] ... shall be recommended that its clients, including named Plain- an annual charge of .006 of the average assets ...” tiffs, invest their retirement funds with Bernard L. FN1 Madoff Investment Securities, LLC (“BLMIS”). (Pls.' Mot. to Remand Indiv., Ex. A.) (Amend.Compl.¶ 35.) On the advice of PSCC, Plain- tiffs established accounts at WNB for the purpose of FN1. Although the custodial agreements pooling their retirement funds together in a collective have not been included in the Complaint, the investment account (in the name of WNB), to be Court may consider them on a motion to placed under BLMIS' investment management and dismiss because they are integral to the “used for the purchase and sale of securities by Ma- claims alleged. “Even when a document is doff for the benefit of the account holders.” (Id. ¶ 36.) not incorporated by reference [in the complaint], the court may nevertheless consider it *2 Pursuant to this plan, WNB established an in- where the complaint relies heavily upon its vestment account in its name at BLMIS, funded with terms and effect, which renders the document deposits made by PSCC's clients. (Id.) WNB entered integral to the complaint.” Mangiafico v.

Slip Copy, 2009 WL 5184360 (D.Conn.) (Cite as: 2009 WL 5184360 (D.Conn.))

Blumenthal, 471 F.3d 391, 398 (2d *3 According to Plaintiffs, “WNB purported to pur- Cir.2006). chase shares of BLM 1 or BLM 2 (as the case may be) with PSCC depositors' contributions to the accounts” Plaintiffs allege that these agreements required WNB and “purported to sell shares of BLM 1 or BLM 2 in to maintain records detailing BLMIS' investments, act each PSCC depositor account (as the case may be) to as custodian for each account by holding these in- fund PSCC depositors' redemption requests and ac- vestments, and render annual statements reflecting count fees.” (Id. ¶ 41.) From July 1999 to December investments made by Madoff and held by WNB as 11, 2008, WNB issued annual account statements custodian. (Amend.Compl.¶ 36.) The agreements setting forth the amount of any deposits into each further provide that WNB was to receive an annual fee account, the purchase of purported shares in BLM 1 or from each PSCC depositor, paid quarterly from each BLM 2, the sale and redemption of purported shares in account and based on the average value of the in- these funds, fee charges, the number of purported vestments WNB held in such account. (Id.) The fees shares in BLM 1 or BLM 2 held in each account and were collected directly out of each depositor's ac- “the unit market value of the purported shares.” (Id. ¶ count. PSCC also charged fees that WNB collected 42.) However, because these reported holdings did not directly out of the individual accounts. actually exist, Plaintiffs argue that the statements were fraudulent. Plaintiffs further allege that WNB charged Plaintiffs agreed that WNB would place their retire- and collected millions of dollars in false and unjusti- ment funds under the management of Madoff, pur- fied fees. (Id. ¶ 42.) Plaintiffs submit that WNB's suant to the custodian agreements. (Id. ¶ 37.) WNB fraudulent conduct caused the loss of their retirement thereby invested the collective account in shares of funds. The suit seeks the return as damages of 1) lost BLM 1, a BLMIS entity supposedly holding securities retirement funds; and 2) improperly charged fees. for tax-qualified retirement plans, and BLM 2, a BLMIS entity supposedly holding securities for IRA II. STANDARD OF REVIEW accounts. Although Madoff was operating a now infamous Ponzi scheme and BLMIS' security offer- The purpose of a motion to dismiss pursuant to Fed- ings were fraudulent (Id. ¶ 47), Plaintiffs continued to eral Rule of Civil Procedure 12(b)(6) “is merely to receive annual statements “from WNB purporting to assess the legal feasibility of the complaint, not to detail the activity, holdings and value of their ac- assay the weight of evidence which might be offered counts.” (Id. ¶ 38.) in support thereof.” Ryder Energy Distrib. Corp. v. Merrill Lynch Commodities Inc., 748 F.2d 774, 779 In essence, the Amended Complaint alleges that (2d Cir.1984) (quoting Geisler v. Petrocelli, 616 F.2d “WNB falsely represented that it was fulfilling its role 636, 639 (2d Cir.1980)). In ruling on a motion under as custodian for Plaintiffs and its other retirement FED. R. CIV. P. 12(b)(6), the court may consider only account holders.” (Amend. Compl. at 1.) Plaintiffs “the facts as asserted within the four corners of the argue that the custodial agreements required WNB to complaint, the documents attached to the complaint as maintain Plaintiffs' assets in its possession except for exhibits, and any documents incorporated in the short term transmissions to BLMIS for the purpose of complaint by reference.” McCarthy v. Dun & Brad- trades and WNB therefore breached the agreements street Corp., 482 F.3d 184, 191 (2d Cir.2007). when it failed to require Madoff to “transmit or otherwise arrange to hold the purported investment made The district court may dismiss a claim under by Madoff.” This failure allowed Madoff to perpe- FED.R.CIV.P. 12(b)(6) only if the plaintiff's factual trate his infamous Ponzi scheme. (Id. ¶ 39.) Plaintiffs allegations are not sufficient “to state a claim to relief argue that WNB's false representations that it was that is plausible on its face.” Bell Atlantic Corp. v. holding shares of BLM 1 and BLM 2 on their behalf, Twombly, 550 U.S. 544, 570, 127 S.Ct. 1955, 167 that it was purchasing and selling shares of these ent- L.Ed.2d 929 (2007). “The plausibility standard is not ities, and that the shares had a stated unit market value, akin to a probability requirement, but it asks for more enabled WNB to intentionally and wrongly misap- than a sheer possibility that a defendant has acted propriate depositors' funds from depositors by charg- unlawfully.” Ashcroft, 129 S.Ct. at 1949. ing unjustified fees. (Id. ¶¶ 62-64.) For the purposes of a motion to dismiss, the court must

Slip Copy, 2009 WL 5184360 (D.Conn.) (Cite as: 2009 WL 5184360 (D.Conn.)) take all of the factual allegations in the complaint as true. However, this tenet “is inapplicable to legal (B) that the defendant used or employed any ma- conclusions. Threadbare recitals of the elements of a nipulative or deceptive device or contrivance in cause of action, supported by mere conclusory state- connection with the purchase or sale of a covered ments, do not suffice.” Id. Although detailed factual security. allegations are not required, a plaintiff must provide the grounds of its entitlement to relief beyond mere 15 U.S.C. §§ 77p(b). In other words, SLUSA “labels and conclusions.” Bell Atlantic, 550 U.S. at mandates dismissal of any action that meets the 555. following criteria: 1) a covered class action; 2) brought under state statutory or common law; 3) Despite the four pending motions in this case, there is alleging misrepresentation or omission of a material only one issue at hand. Defendant's Motion to Dismiss fact; 4) in connection with the purchase or sale; 5) of argues that each of the state law claims is precluded by a covered security. the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”), 15 U.S.C. §§ 77p & 78bb(f). The Supreme Court found that SLUSA should be Plaintiffs argue in their Motions to Remand, however, interpreted broadly. “A narrow reading of the statute that SLUSA does not apply, removal was improper, would undercut the effectiveness of the 1995 Reform and remand is necessary. Therefore, the question to be Act and thus run contrary to SLUSA's stated purpose, determined is whether SLUSA is applicable to the viz., to prevent certain State private securities class seven counts in Amended Complaint. If SLUSA ap- action lawsuits alleging fraud from being used to plies, the count must be dismissed. If SLUSA does not frustrate the objectives of the 1995 Act.” Merrill apply, the count must be remanded to the Superior Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. Court. 71, 86, 126 S.Ct. 1503, 164 L.Ed.2d 179 (2006); see Anderson v. Merrill Lynch Pierce Fenner & Smith, *4 In response to perceived abuse of the class action 521 F.3d 1278, 1284 (10th Cir .2008). However, device in litigation involving nationally traded secur- “while plaintiffs may not avoid SLUSA preemption ities, Congress enacted the Private Securities Litiga- simply by artful pleading that avoids the actual words tion Reform Act (“PSLRA”), 15 U.S.C. §§ 77z-1; ‘misrepresentation’ or ‘fraud,’ neither may defendants 78u-4. Among other reforms, PSLRA imposes avoid every possible claim by recasting any lawsuit in heightened pleading requirements and authorizes a which a securities broker is a defendant into a securi- stay of discovery pending resolution of a motion to ties fraud action.” Norman v. Salomon Smith Barney, dismiss in actions brought pursuant to Section 10(b) Inc., 350 F.Supp.2d 382, 386 (S.D.N.Y.2004). and Rule 10b-5. Congress' enactment of the PSLRA, however, had the unintended consequence of en- Additionally, the law of the Second Circuit requires a couraging plaintiffs to bring class actions involving claim-by-claim analysis as to SLUSA preemption. securities fraud under state law to circumvent these Dabit v. Merrill Lynch, Pierce, Fenner & Smith Inc., stringent requirements. In response, Congress enacted 395 F.3d 25, 47 (2d Cir.2005), rev'd as to other SLUSA to prevent plaintiffs from seeking to evade the grounds, 547 U.S. 71, 126 S.Ct. 1503, 164 L.Ed.2d protections against abusive securities litigation codi- 179 (2006); Gray v. Seaboard Securities, 126 F. fied in the PSLRA. SLUSA provides: App'x. 14, 16 (2d Cir.2005); LaSala v. Bank of Cyprus Public Co. Ltd., 510 F.Supp.2d 246, 273 n. 10 CLASS ACTION LIMITATIONS (S.D.N.Y.2007). The presence of one or more preempted claims in a complaint does not require No covered class action based upon the statutory or dismissal of the entire action under SLUSA. common law of any State or subdivision thereof may be maintained in any State or Federal court by III. DISCUSSION any private party alleging- *5 The Court is mindful of its previous ruling denying (A) an untrue statement or omission of a material a motion to stay discovery in a parallel state court case fact in connection with the purchase or sale of a under SLUSA and the PSLRA. However, the question covered security; or of SLUSA preemption pursuant to the pending mo-

Slip Copy, 2009 WL 5184360 (D.Conn.) (Cite as: 2009 WL 5184360 (D.Conn.)) tions requires a more detailed and de novo analysis. SLUSA only applies to “covered class actions,” de- A. State Law fined as an action in which:

There is no dispute that this action meets the first (I) damages are sought on behalf of more than 50 SLUSA criteria, that the action is “based upon the persons or prospective class members, and ques- statutory or common law of any State.” tions of law or fact common to those persons or members of the prospective class, without reference B. Covered Security to issues of individualized reliance on an alleged misstatement or omission, predominate over any Under SLUSA, a “covered security” is a security “that questions affecting only individual persons or satisfies the standards for a covered security specified members; or in paragraph (1) or (2) of section 77r(b).” 15 U.S.C. § 77p(f)(3). In turn, § 77r(b)(1) defines “covered secu- (II) one or more named parties seek to recover rity” as a security: damages on a representative basis on behalf of themselves and other unnamed parties similarly si- (A) listed, or authorized for listing, on the New tuated, and questions of law or fact common to York Stock Exchange or the American Stock Ex- those persons or members of the prospective class change, or listed, or authorized for listing, on the predominate over any questions affecting only in- National Market System of the NASDAQ Stock dividual persons or members.” Market (or any successor to such entities).” 15 U.S.C. § 77p(f)(2)(A)(I). Counts I-IV of the (B) listed, or authorized for listing, on a national Amended Complaint are not class actions. They are securities exchange (or tier or segment thereof) that brought on behalf of only the named Plaintiffs. has listing standards that the Commission deter- Therefore, Plaintiffs' Motion to Remand Named mines by rule (on its own initiative or on the basis of Plaintiffs' Individual Claims [Doc. No. 15] is granted. a petition) are substantially similar to the listing Defendant's Motion to Dismiss [Doc. No. 37] is de- standards applicable to securities described in sub- nied as to Counts I-IV. However, there is no dispute paragraph (A); or that Counts V, VI, and VII of the Amended Complaint are covered class actions. © is a security of the same issuer that is equal in seniority or that is a senior security to a security D. In Connection With the Purchase or Sale of a described in subparagraph (A) or (B). Covered Security

Plaintiffs make a passing argument that the securities *6 The most difficult question before the Court is at issue are not ‘covered’ because BLM 1 and BLM whether the remaining claims are “in connection with 2,FN2 the entities in which WNB invested Plaintiffs the purchase or sale of a covered security.” In Dabit, accounts, do not fall within this definition. (Pls.' Mot. 547 U.S. at 85-86, the Supreme Court held that ac- to Remand Entire at 11.) However, this argument is cording to ordinary principals of statutory interpreta- without merit as Plaintiffs admit that the individual tion, as well as the particular concerns that resulted in securities fraudulently represented to be bought, sold, SLUSA's enactment, this phrase should be read and held by the BLM 1 and 2 entities are covered broadly. The Court held that “it is enough that the securities. These securities, not the BLM entities, are fraud alleged ‘coincide’ with a securities transac- at the heart of this case. tion-whether by the plaintiff or by someone else.” Id. at 85. The Court further instructed that SLUSA be read with the “presumption that Congress envisioned a FN2. BLM 1 supposedly held securities for broad construction” of the statute so that the most tax-qualified retirement plans, while BLM 2 troublesome class actions would be subject to the supposedly held securities for IRA accounts. PSLRA. Id. at 86.

C. Covered Class Action

Slip Copy, 2009 WL 5184360 (D.Conn.) (Cite as: 2009 WL 5184360 (D.Conn.))

Courts have deemed that whether the fraud ‘coincides' The Court must therefore examine whether the with the purchase or sale of a covered security is the Amended Complaint sufficiently alleges that WNB's critical question when determining whether SLUSA own misrepresentations and omissions coincide with precludes a state law allegation.FN3 The Ninth Circuit the purchase and sale of securities. Courts have found held that in order to satisfy this requirement, the fraud SLUSA preemption even in cases where the defendant need not relate “to the investment value of the securi- accused of fraud did not itself buy and sell securities. ties themselves,” but “must relate to the nature of the In Gray v. Seaboard Securities, 126 F. App'x. 14 (2d securities, the risks associated with their purchase or Cir.2005), the Second Circuit held that misrepresen- sale, or some other factor with similar connection.” tations concerning the source of investment advice Falkowski, 309 F.3d at 1131. were in connection with the purchase and sale of securities. In Cordova v. Lehman Bros. Inc., 413 FN3. S.E.C. v. Zandford, 535 U.S. 813, 825, F.Supp.2d 1309 (S.D.Fla.2006), the court found 122 S.Ct. 1899, 153 L.Ed.2d 1 (2002); Fal- SLUSA preemption in a relationship similar to the one kowski v. Imation Corp., 309 F.3d 1123, at hand. In that case, plaintiffs agreed to invest with 1131 (9th Cir.2002) (holding that claim that PFA, a fraudulent pension fund, because major fi- defendant concealed impending accounting nancial institutions agreed to serve as post-investment write-off coincided with the value and timing custodians and/or trustees. The investors alleged that of a securities transaction and therefore sa- the major financial institutions aided and abetted the tisfied SLUSA's ‘in connection with’ re- fraud by, inter alia, allowing their names, logos, and quirement). reputations to be used in the pension fund's marketing materials, failing to alert investors of false statements Defendant argues that because the Complaint coin- made by the pension fund, and falsely reassuring the cides with a Ponzi scheme, it satisfies this require- investors of the safety of their investments. The court ment. However, whether WNB's misrepresentations held that plaintiffs' claims were in connection with were in connection with the purchase or sale of se- PFA's securities fraud and therefore preempted by curities is more difficult than Defendant suggests. SLUSA. The court rejected investors' arguments that While there is no question that Madoff's Ponzi SLUSA did not apply because their state law claims scheme was in connection with the purchase and sale were based on post-investment retention of funds. Id. of securities, Plaintiffs do not allege that Defendant at 1318-20. As in Cordova, WNB's allegedly fraudu- knowingly participated. The Court must determine lent statements led Plaintiffs to believe that their se- whether WNB's independent misrepresentations also curity holdings were safeguarded by a trusted bank. coincided with securities transactions. While Plaintiffs in this case do use the term inducement, it is easy to see how WNB's allegedly fraudulent account statements persuaded Plaintiffs to maintain Plaintiffs allege that WNB committed fraud by mi- their investments in fraudulent securities, further srepresenting its fulfillment of the custodial role and connecting the allegations to securities transactions. by collecting fraudulent fees. The crux of Plaintiffs' allegations is that WNB reported that it held securities of a certain value and charged fees on this basis, when *7 In their Motion to Remand, Plaintiffs claim they do in truth WNB held no such securities. Specifically, not allege that WNB made intentional misstatements Plaintiffs submit that: 1) WNB's annual account in connection with investment activity. However, statements setting forth each account's “holdings, looking closely at the Complaint's language, it appears activity and total value” were fraudulent; 2) WNB that Plaintiffs argue not that WNB simply endorsed calculated and charged fees based on fraudulent val- Maddoff's misrepresentations, but that WNB's state- ues of “purported shares of BLM 1 or BLM 2;” and 3) ments were misrepresentations of their own know- “the transactions involving BLM 1 and BLM 2 re- ledge concerning securities transactions. Plaintiffs do ported to the named Plaintiffs and other PSCC depo- not allege that WNB knew of Madoff's Ponzi scheme. sitors by WNB did not occur.” (Amend.Compl.¶¶ They do argue, however, that WNB intentionally 42-44.) Plaintiffs allege not fraud in the inducement of misreported its own securities holdings. Specifically, investments, but fraud in the reporting of investments Plaintiffs allege that “at all times mentioned herein, previously made. WNB knew that it had no securities or other assets in its possession as custodian for the members of the plaintiff class.” (Amend.Compl.¶ 60) (emphasis

Slip Copy, 2009 WL 5184360 (D.Conn.) (Cite as: 2009 WL 5184360 (D.Conn.)) added). The Complaint continues: WNB “knew it had chase or sale of securities. Here, Plaintiffs allege a no permissible basis ... for charging the members of scheme of false representations concerning the ‘pur- the Plaintiff class annual percentage fees” and De- ported’ purchase and sale of securities. Plaintiffs al- fendant intended to misappropriate to itself funds lege that WNB knowingly sent false account state- rightfully belonging to the members of the Plaintiff ments detailing the purchase, sale, and value of se- Class. (Id. ¶¶ 61, 62)(emphasis added). curities. Furthermore, Plaintiffs allege that WNB charged fees based on the value of securities which it The Complaint language such as “WNB falsely purportedly, but did not actually, hold. This scheme represented that it was holding shares of BLM 1 or not only coincides with, but centers on, the purchase BLM 2,” (Id. ¶ 63) (emphasis added) connects WNB's and sale of securities. alleged misconduct to the purchase and sale of securities. Furthermore, the custodian agreement between However, the fraud was not disseminated to the public each Plaintiff and WNB states: “it is the Principal's and did not concern investment advice, on which an intent to transfer cash or cash equivalents to the Bank investor would rely. Thus, although the second gui- [WNB], as provided herein for investment.” (Pls.' Mot. depost is not met, our analysis is not finished. The four to Remand Indiv., Ex. A ¶ 1.) In sum, the Amended factors are not requirements but considerations to be Complaint alleges that WNB made knowing misre- taken into account. presentations concerning the value of securities and intentionally charged fees based on purported but false The third factor is met here, as the very purpose of the security holdings. The merits of these contentions are relationship between Plaintiffs and WNB was to trade not at issue. Whether Plaintiffs can prove these alle- in securities. The custodian agreement governing the gations is not yet relevant, the issue at hand is solely parties' dealings states that the relationship was the facts as alleged. created for the purpose of investment in securities: “it is the Principal's intent to transfer cash or cash equi- The Third Circuit has set out helpful guideposts for valents to the Bank [WNB], as provided herein for deciding whether the ‘in connection with’ element of investment.” (Pls.' Mot. to Remand Indiv., Ex. A ¶ 1.) SLUSA is satisfied. In Rowinski v. Salomon Smith The Amended Complaint clearly states that the spe- Barney Inc., 398 F.3d 294 (3d Cir.2005), plaintiffs cific investment contemplated by the agreement was alleged that defendant provided biased investment the securities traded by BLMIS and that WNB was to advice and charged fees based on this advice. In buy and sell shares of BLM 1 and BLM 2 on behalf of holding that breach of contract and unjust enrichment the depositors. (Amend.Compl.¶ 36(b).) Other courts claims were barred by SLUSA, the Third Circuit have found that when “the purpose of the investment provided four factors to help distinguish between agreements was to utilize [the plaintiff's] assets and preempted claims and those remaining within the expand upon those assets, presumably with the pur- ambit of state law: “first, whether the covered class chase and sale of securities, the ‘in connection with’ action alleges a ‘fraudulent scheme’ that ‘coincides' prong [is] met.” Dommert v. Raymond James Finan- with the purchase or sale of securities, second, cial Serv. Inc., No. 1:06 civ. 102, 2007 WL 1018234, whether the complaint alleges a material misrepre- at *11 (E.D.Tex. Mar.29, 2007) (rejecting plaintiffs' sentation or omission ‘disseminated to the public in a argument that the alleged violations related to her medium upon which a reasonable investor would rely, relationship with defendants and not the purchase and third, whether the nature of the parties' relationship is sale of securities, as the investment agreement “was such that it necessarily involves the purchase or sale of formed and the fiduciary relationship was created securities, and fourth, whether the prayer for relief because plaintiff contracted with defendant for the ‘connects' the state law claims to the purchase or sale management of her assets, which encompassed the of securities.” Id. at 302 (internal citations omitted). purchase and sale of stock”).

*8 The Third Circuit identifies these factors as “gui- Fourth, the prayer for relief requests restitution not deposts in a flexible preemption inquiry” and this only of WNB's fees, but the retirement funds lost due Court finds them instructive in a difficult analysis. See to the purchase of fraudulent securities. Plaintiffs id. at n. 7. The first factor is whether the complaint themselves thereby connect the state law claims di- alleges a fraudulent scheme coinciding with the pur- rectly to the purchase and sale of securities. Deciding

Slip Copy, 2009 WL 5184360 (D.Conn.) (Cite as: 2009 WL 5184360 (D.Conn.)) whether Plaintiffs are entitled to this relief will involve was in fact delayed by more than an hour. Although determining WNB's role in a massive securities fraud. the court held the state law claims not precluded by Analysis of these guideposts illustrates a strong con- SLUSA, this case is distinguishable as the Green court nection between Plaintiff's state law claims and the found that plaintiffs were merely not receiving a con- purchase and sale of securities, bringing them within tracted for service. the bounds of SLUSA. Finally, Plaintiffs cite to Gavin v. AT & T Corp., 464 *9 Other courts have found SLUSA preemption for F.3d 634, 639 (7th Cir.2006), which holds that more schemes, such as the one alleged by Plaintiffs, where a than ‘but-for’ causation between the injury and a se- defendant charged fees based on a misrepresentation curities transaction is needed to satisfy SLUSA's ‘in concerning the value of a security. Araujo v. John connection with’ requirement. However, the Hancock Life Ins. Co., 206 F.Supp.2d 377, 382-83 Amended Complaint alleges much more than ‘but-for’ (E.D.N.Y.2002) (finding that a scheme to charge in- causation between Plaintiffs' lost funds and fraudulent surance premiums for a period of time when no policy transactions in the securities supposedly underlying coverage existed met the ‘in connection with’ element the BLM entities. Plaintiffs allege intentional misap- of SLUSA). WNB annually reported the value of the propriation of these funds carried out via a scheme of securities it purportedly held in each depositor's WNB knowing misrepresentations of the value of securities account and charged fees on the basis of this value. holdings. Given the nature of the allegations in the However, according to Plaintiffs, WNB knew this Complaint, the relationship between the parties, and value was fraudulent. Courts have repeatedly found the broad application of SLUSA espoused by the the ‘in connection with’ prong satisfied when misre- Supreme Court in Dabit, the Court finds that all counts presentations concern the value of a security. See Id. against Defendant are “in connection with the pur- (citing Lander v. Hartford Life & Annuity Ins. Co., chase or sale of a covered security.” 251 F.3d 101, 106-11 (2d Cir.2001) (finding that alleged misrepresentations as to the value of variable E. Misrepresentation or Omission annuities were in connection with its purchase); Kor- sinsky v. Salomon Smith Barney Inc., No. 01 civ. 6085, *10 The final question in the SLUSA preemption 2002 WL 27775, at *5 (S.D.N.Y. Jan.10, 2002) analysis is whether Plaintiffs allege misrepresenta- (finding that alleged misrepresentations as to the value tions or fraud. Preemption does not turn on whether of a stock were in connection with the purchase and misrepresentation is an essential legal element of the sale of securities); Hardy v. Merrill Lynch, Pierce, state law claims. Under SLUSA, “preemption does not Fenner & Smith, Inc., 189 F.Supp.2d 14, 18 turn on whether allegations are characterized as facts (S.D.N.Y.2001) (same)); Broadhead L.P. v. Goldman, or as essential legal elements of a claim, but rather on Sachs & Co., No. 2:06 civ. 009, 2007 U.S. Dist. whether the SLUSA prerequisites are ‘alleged’ in one LEXIS 21302, at *12-13 (E.D.Tex. Mar. 26, 2007) form or another. A contrary approach, under which (holding failure to disclose mark ups and mark downs only essential legal elements of a state law claim on bond trades to be in connection with the purchase trigger preemption, is inconsistent with the plain and sale of securities); Falkowski, 309 F.3d at 1131. meaning of the statute. Furthermore, it would allow artful pleading to undermine SLUSA's goal of un- In opposition, Plaintiffs argue that the fraudulent ac- iformity.” Rowinski 398 F.3d at 300 (holding that count statements and charges were unrelated to Ma- allegations of materially misleading research reports doff's fraud in the purchase and sale of securities. and biased investment analysis readily satisfied the However, WNB's alleged misrepresentations clearly misrepresentation requirement). ‘coincide’ with the Ponzi scheme. Even more importantly, Plaintiffs allege that WNB knew that some of Courts in this circuit “must look beyond the face of the its own statements concerning securities transactions complaint to the substance of plaintiff's allegations to were untrue. (Amend.Compl.¶ 42). Plaintiffs cite to determine whether SLUSA preemption applies.” Paru Green v. Ameritrade, Inc., 279 F.3d 590, 598-99 (8th v. Mutual of America Life Insurance Co., No. 04 civ. Cir.2002), where investors alleged that fees charged in 6907, 2006 WL 1292828, at *3 (S.D.N.Y. May 11, connection with a ‘real-time’ stock information ser- 2006). The court must “look beyond the explicit al- vice were fraudulent because the provided information legations of the complaint and the state law labels the

Slip Copy, 2009 WL 5184360 (D.Conn.) (Cite as: 2009 WL 5184360 (D.Conn.)) plaintiffs employ to the ‘gravamen’ or ‘essence’ of the *11 Plaintiffs argue that this count is based solely on claims.” Xpedior Creditor Trust v. Credit Suisse First the express provisions of the custodian agreements Boston (USA) Inc., 341 F.Supp.2d 258, 265 and contain no allegations of fraud or misrepresenta- (S.D.N.Y.2004). The Xpedior court applied the in- tion. Plaintiffs are correct that the legal elements for structive ‘necessary component’ test, “wherein a court breach of contract do not include proof of a misre- must determine whether the state law claim relies on presentation or untrue statement. However, this Court misstatements or omissions as a necessary component is unpersuaded that this count is a straightforward of the claim. In this context, ‘necessary component’ breach of contract claim. It cannot be separated from encompasses both technical elements of a claim as the rest of the complaint, which alleges a coherent well as factual allegations intrinsic to the claim as scheme. Furthermore, count V explicitly incorporates alleged. Thus, under the ‘necessary component’ test, a paragraphs 1-54 of the Amended Complaint (Amend. complaint is preempted under SLUSA only when it Comp. at Count V), which are replete with allegations asserts 1) an explicit claim of fraud, e.g., common law of untrue and misleading statements. Incorporating fraud or fraudulent inducement; or 2) other gar- allegations of fraud made in support of other claims is den-variety state law claims that ‘sound in fraud.’ ” Id. grounds for dismissal of this count. In re Mutual at 266; LaSala v. Bank of Cyprus Public Co. Ltd., 510 Funds Inv. Litig.2005, 384 F.Supp.2d 845, 871-72 F.Supp.2d 246, 272 (S.D.N.Y.2007). (D.Md.2005) (dismissing state law counts of a consolidated amended complaint because plaintiffs in- i. Counts VI and VII: CUTPA and Theft corporated by reference all of the allegations of fraud and misrepresentation made in support of other Plaintiffs admit that counts VI and VII, which assert claims); Rowinski 398 F.3d at 300; see also Hines v. claims on behalf of the class for theft and CUTPA ESC Strategic Funds, Inc., No. 3:99 civ. 0530, 1999 violations, allege untrue statements and false repre- WL 1705503, at *6-7 (M.D.Tenn. Sept.17, 1999) sentations. Plaintiffs argue, however, that these claims (dismissing breach of contract allegations because are not precluded by SLUSA because the misrepre- representations referred to in that count had been sentations were not in connection with the purchase or described as fraudulent earlier in the complaint). The sale of securities. (Pls.' Mem. in Support of Remand gravamen of the Amended Complaint is a fraudulent and in Opp. to Mot. to Dismiss at 28-34.) These ar- scheme in connection with the purchase and sale of guments have been discussed and dismissed in the securities. The breach of contract allegations are an previous section. The alleged fraudulent scheme integral part of that scheme and therefore cannot es- coincides with securities transactions. cape SLUSA preemption. Count five of the Amended Complaint is therefore dismissed. Furthermore, it is unmistakable that these two counts meet the ‘necessary component’ test, as they both IV. CONCLUSION make explicit claims of fraud. Count six alleges that “WNB falsely represented that it was holding shares” For the foregoing reasons, Plaintiffs' Motion to Re- (Amend.Compl.¶ 63) and that “through its false remand [Doc. No. 24] is denied. Plaintiffs' Motion to presentations as aforesaid, WNB was able to wrongly Remand Named Plaintiffs' Individual Claims [Doc. misappropriate funds from the accounts of the mem- No. 15] is granted. Defendant's Motions to Dismiss bers of the Plaintiff class through false pretenses.” (Id. [Doc. Nos. 14, 37] are granted in part and denied in ¶ 64). Likewise, count seven alleges that “Defendant part. In sum, Counts I-IV of the Amended Complaint is liable to the members of the Plaintiff class for the are remanded to the Superior Court and Counts V-VII funds misappropriated and obtained by false pretenses of the Amended Complaint are dismissed. by WNB.” (Id. ¶ 64.) These explicit accusations meet the SLUSA requirement of “misrepresentations or SO ORDERED. omissions in connection with the purchase or sale of a covered security” and counts six and seven of the D.Conn.,2009. Amended Complaint are therefore dismissed. Backus v. Connecticut Community Bank, N.A. Slip Copy, 2009 WL 5184360 (D.Conn.) ii. Count V: Breach of Contract END OF DOCUMENT

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Jonathan M. Freiman, Joseph C. Merschman, Wiggin United States District Court, & Dana, Glenn William Dowd, Howard Fetner, Day D. Connecticut. Pitney LLP, New Haven, CT, Scott D. Corrigan, Stephen R. LEVINSON; Richard E. Layton; and Dr. Wiggin & Dana, LLP, New York, NY, for Defen- R. Layton PA 401(K) Plan, Plaintiffs, dants. v. PSCC SERVICES, INC.; Westport National Bank; RULING ON DEFENDANTS' MOTION TO DIS- TD Banknorth NA; Dennis P. Clark; and Robert L. MISS Silverman, Defendants. No. 3:09-CV-00269 (PCD). PETER C. DORSEY, District Judge.

Dec. 23, 2009. *1 This action arises out of the Ponzi scheme conducted by Bernie Madoff. Two individuals and a West KeySummary pension and profit-sharing plan (collectively “Plain- Racketeer Influenced and Corrupt Organizations tiffs”) have brought a class action complaint against 319H 11 Westport National Bank (“Westport”) and TD Bank- north NA (“TD Banknorth”), the custodians of their 319H Racketeer Influenced and Corrupt Organiza- retirement accounts; Dennis P. Clark (“Clark”), the tions Vice President of Westport; PSCC Services, Inc. 319HI Federal Regulation (“PSCCSI”), Plaintiffs' pension consulting and actu- 319HI(A) In General arial firm; and Robert L. Silverman (“Silverman”), the 319Hk4 Racketeering or Criminal Activity President of PSCCSI (collectively “Defendants”). 319Hk11 k. Securities or Commodities Plaintiffs and the class they seek to represent main- Law Violations. Most Cited Cases tained custodial accounts with Westport and Westport Investors failed to establish a claim under the Rack- B & T (TD Banknorth's predecessor) for their retire- eteer Influenced and Corrupt Organizations Act ment funds. Westport and Westport B & T operated a against the custodians of retirement accounts where collective investment fund that was invested with the conduct was actionable as securities fraud. The Bernard L. Madoff (“Madoff”). After Madoff ad- custodial agreement authorized the custodians to mitted his fraud and Plaintiffs realized that their re- bundle the investors' funds and transmit them to a tirement savings were lost, they commenced this class company for investment at the company's discretion. action. The crux of Plaintiffs' allegations is that De- The investors alleged that the custodians induced the fendants misled them into believing that their funds investors to invest in the common investment fund by were safe and conservatively invested and that De- making false representations in the custodial agree- fendants ignored several red flags that should have ments, account statements, and other correspondence alerted them of Madoff's Ponzi scheme. Plaintiffs for the purpose of collecting fees. Where the custodial assert twelve causes of actions: 1) violation of the agreement was clearly for the purpose of allowing Racketeer Influenced and Corrupt Organizations Act company to purchase and sell securities using the (“RICO”), 18 U.S.C. § 1962(c); 2) conspiracy to vi- investors' funds, the investors were barred from olate RICO, 18 U.S.C. § 1962(d); 3) breach of the bringing a RICO claim. 18 U.S.C.A. § 1962(c). custodial agreements (against Westport and TD Banknorth only); 4) breach of fiduciary duty; 5) fraud; 6) negligent misrepresentation; 7) negligence; 8) vi- Deborah Clark-Weintraub, Edith M. Kallas, Joe R. olation of the Connecticut Unfair Trade Practices Act, Whatley, Jr., Max R. Schwartz, Whatley Drake & (“CUTPA”), CONN. GEN.STAT. § 42-110b(a); 9) Kallas, New York, NY, James E. Hartley, Jr., Drubner aiding and abetting conversion and statutory theft; 10) & Hartley, Waterbury, CT, Richard P. Rouco, What- unjust enrichment; 11) money had and received; and ley Drake & Kallas, Birmingham, AL, for Plaintiffs. 12) constructive trust.

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3. Transmit all funds received from the Principal to On April 13, 2009 and April 15, 2009, Defendants Bernard L. Madoff, an investment firm registered filed motions to dismiss pursuant to Fed.R.Civ.P. under Section 3(39)(B) of the Employee Retirement 12(b)(6). For the reasons stated herein, Defendants' And Income Securities Act of 1974 (ERISA) for Motions to Dismiss [Doc. Nos. 45, 48, 58] are investment under a full discretionary basis. [West- granted. port B & T] is acting solely in a ministerial capacity and assumes no responsibility for the investment performance of Bernard L. Madoff and will not be I. BACKGROUND liable in case of any diminution in assets; The following allegations are set forth in the Com- plaint unless otherwise noted. Westport, Westport B & 4. Deliver to the Principal or legal representative T and PSCCSI established a collective investment upon its request in writing at any time any property fund for the purpose of investing with Bernard L. held under the terms of the Agreement; Madoff Investment Securities LLC (“BLMIS”), and worked with BLMIS to find potential investors for the 5. Render statements of property held annually or fund. (Compl.¶ 31.) Because the minimum investment upon request; ... amount accepted by BLMIS was quite high, feeder funds and aggregators such as Westport and Westport (TD Banknorth Mot. Ex. A-B).FN1 B & T pooled the investments of numerous individuals, who could only invest smaller amounts, into a FN1. Although the custodial agreements collective fund for transmission to BLMIS. (Id. ¶ 29.) have not been included in the Complaint, the Thus, Defendants' conduct “allowed Madoff to Court may consider them on a motion to broaden his scheme to capture smaller investors ...” dismiss because they are integral to the (Id. ¶ 31.) claims alleged. “Even when a document is not incorporated by reference [in the com- Dr. Levinson and Dr. Layton, the two individuals plaint], the court may nevertheless consider it named as plaintiffs, initially entered into custodial where the complaint relies heavily upon its agreements with Westport B & T with respect to their terms and effect, which renders the document individual retirement accounts (“IRAs”) in the 1990s. integral to the complaint.” Mangiafico v. Compl. ¶¶ 10-12. Defendant Clark, an officer at Blumenthal, 471 F.3d 391, 398 (2d Cir.2006) Westport B & T, handled the accounts and commu- (internal citations and quotations omitted). nicated with Plaintiffs and class members about them. In 1999, Westport B & T exited the institutional cus- *2 The agreements provided in the following or very tody business and Westport was designated the suc- similar language: cessor custodian. (Compl.¶ 32.) When their accounts were transferred, Plaintiffs entered into new custodial [Westport B & T] will hold as Custodian the secur- agreements with Westport, which were substantially ities, monies and other property which it may re- similar to their previous agreements with Westport B ceive belonging to the Principal and will: & T. The agreements with Westport provided in relevant part: 1. Receive interest, dividends, and income from such property for reinvestment or disbursement as • Westport would invest all cash and cash equiva- the Principal may direct in writing; lents received from the Principal “in [Westport's] deposit money market account until [Westport] 2. Collect the proceeds from securities which may transfers the funds to Bernard L. Madoff Invest- mature or be called, attend to the deposit or ex- ment Securities (“BLMIS”) ...” change of securities and rights of companies in re- organization, make purchases and sales of securities • The Principal “authorize[d] [Westport] to transmit as the Principal may direct; to BLMIS all funds received by [Westport] from the Principal ...” Westport would “enter into an agree-

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ment with BLMIS under which BLMIS will have • Westport “has no authority or ability to full discretionary authority as to the manner in direct or oversee in any manner the dis- which funds are invested.” The Principal's funds cretionary investments made by would be aggregated with other funds for transmis- BLMIS[.]” sion to BLMIS, and the omnibus account maintained with BLMIS would be named “Westport • Westport “is acting solely in a ministerial National Bank.” capacity[.]”

• Westport would “follow such reasonable written • “[T]he Principal will hold [Westport] directions which the Principal may deliver to harmless from any liability to BLMIS in- [Westport] at any time, ... including to request that curred by [Westport] resulting from the BLMIS return assets of the Principal to [Westport] performance of investments made on be- and for [Westport] to remit cash or cash equivalents half of the Principal pursuant hereto by to the Principal.” [Westport] or BLMIS.”

• Westport “shall maintain adequate records indi- (Westport Mem. Ex. A-C.) cating ownership by the Principal; of investments with BLMIS and held by [Westport] as custodian Plaintiffs assert that the compensation scheme de- ...” scribed in the custodial agreements created a conflict of interest for Defendants. As the reported value of the • Westport “shall render at least annually statements assets held in their omnibus account at BLMIS grew, reflecting the property held by it as custodian ...” Defendants earned more and more fees. (Compl.¶ 33.) Therefore, although Defendants were required to sa- • “The custodial services fees of [Westport] ... shall feguard Plaintiffs' investments, “asking tough ques- be an annual charge of .006 of the average assets ...” tions of Madoff posed the risk that Madoff would terminate the relationship thereby jeopardizing the *3 (Westport Mot. Ex. A-C; Compl. ¶ 33.) The significant custodial and other fees Defendants were Westport agreements also acknowledged that “the earning.” (Id. ¶ 35.) Principal has entered into an agreement with [PSCCSI] for services to be provided by PSCCSI with Consequently, Defendants ignored several red flags respect to Principal's investments made by BLMIS” that should have alerted them of the Ponzi scheme. and that Westport “is authorized and directed to The detailed statements provided by Madoff to De- coordinate its record keeping with that provided by fendants, which were never sent to Plaintiffs, pur- PSCCSI.” Westport was also authorized to pay ported to show the trading activity in the omnibus PSCCSI annually based on a formula that included the accounts but in fact contained glaring inconsistencies. percentage of the average assets held by Westport for For instance, one account statement provided to the Principal and the amount of each transaction ef- Plaintiffs after the Ponzi scheme was revealed re- fected by BLMIS on behalf of the Principal. (Westport flected that tens of thousands of shares of more than Mot. Ex. A-C.) FN2 50 Fortune 300 companies were bought in the month of November, but the confirmation slip provided along FN2. The custodial agreements also con- with this statement reflected that tens of thousands of tained numerous disclaimers of Westport's shares were sold, not bought. (Id. ¶ 39.) The trade liability, such as: confirmations also revealed that the trades were purportedly executed by BLMIS' broker-dealer arm rather • “The Principal has chosen BLMIS to re- than through an independent third party, which Plain- ceive and to invest the Principal's funds, tiffs allege greatly increased the risk of loss. (Id. ¶ 40.) and has not relied on [Westport] in choosing to give BLMIS full discretionary On December 12, 2008, the day after Madoff was authority.” arrested, Plaintiffs and class members received a letter from Westport. The letter acknowledged the “recent allegations involving Bernie Madoff” and reminded

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Plaintiffs that, pursuant to their custodial agreements, Treasuries for the past month. (Id. ¶¶ 41, 89.) Despite they could request return of their assets by delivering these allegations of fraudulent conduct, Plaintiffs the request to Westport. (Compl.¶ 42.) This letter was never assert that Defendants acted in concert with the first indication that Plaintiffs' retirement savings Madoff to maintain the Ponzi scheme or otherwise might be in jeopardy. (Id. ¶ 43.) On January 16, 2009, had knowledge of the Ponzi scheme. Plaintiffs received another letter from Westport en- closing a notice it had received from the Securities II. STANDARD OF REVIEW Investor Protection Corporation Trustee setting forth the requirements for filing claims in bankruptcy court. The purpose of a motion to dismiss pursuant to Fed- (Id. ¶ 44 .) The letter also enclosed a BLMIS account eral Rule of Civil Procedure 12(b)(6) “is merely to statement dated November 30, 2008 and BLMIS assess the legal feasibility of the complaint, not to purchase and sale confirmations for the Westport assay the weight of evidence which might be offered National Bank account. Prior to receiving these main support thereof.” Ryder Energy Distrib. Corp. v. terials, Plaintiffs had never received copies of BLMIS Merrill Lynch Commodities Inc., 748 F.2d 774, 779 account statements or trade confirmations and “had (2d Cir.1984)(quoting Geisler v. Petrocelli, 616 F.2d not understood that the investments made by Madoff 636, 639 (2d Cir.1980)). In ruling on a motion under with their funds were being held at all times by Ma- FED.R.CIV.P. 12(b)(6), the court may consider only doff rather than the Custodians.” (Id.) “the facts as asserted within the four corners of the complaint, the documents attached to the complaint as *4 On February 13, 2009, Plaintiffs filed this Com- exhibits, and any documents incorporated in the plaint. In addition to alleging that Defendants complaint by reference.” McCarthy v. Dun & Brad- breached the custodial agreements and their fiduciary street Corp., 482 F.3d 184, 191 (2d Cir.2007). duties to Plaintiffs by ignoring the red flags, Plaintiffs allege that Defendants made a number of misrepre- The district court may dismiss a claim under sentations as to the nature of the custodial accounts FED.R.CIV.P. 12(b)(6) only if the plaintiff's factual and the safety of their investments. (Compl.¶¶ 55, 89.) allegations are not sufficient “to state a claim to relief The custodial agreements falsely stated that Plaintiffs' that is plausible on its face.” Bell Atlantic Corp. v. funds would be transmitted to BLMIS for short-term Twombly, 550 U.S. 544, 570, 127 S.Ct. 1955, 167 trading only but at all other times would be held in L.Ed.2d 929 (2007). “The plausibility standard is not Plaintiffs' accounts at Westport B & T or Westport, akin to a probability requirement, but it asks for more misleading Plaintiffs as to the activities to be under- than a sheer possibility that a defendant has acted taken by the custodians and PSCCSI to safeguard their unlawfully.” Ashcroft v. Iqbal, --- U.S. ----, ----, 129 retirement funds. Since Plaintiffs' funds had been S.Ct. 1937, 1949, 173 L.Ed.2d 868 (2009). transferred to BLMIS, the annual account statements from the custodians and correspondence with PSCCSI misrepresented the balances in Plaintiffs' accounts and III. DISCUSSION the fees owed to Westport B & T, Westport and PSCCSI. (Id. ¶ 55.) Furthermore, the annual account A. RICO Counts (Counts I and II) statements, which only reflected deposits into the individual custodial accounts and withdrawals made *5 The Complaint asserts that Defendants, “together to pay Defendants' fees, did not disclose the securities with Madoff and BLMIS, formed an associa- positions in the omnibus account at BLMIS. (Id. ¶ 36.) tion-in-fact for the common and continuing purpose described herein ... and constitute an enterprise within Additional misrepresentations also reassured Plain- the meaning of 18 U.S.C. § 1961(4) (the ‘Omnibus tiffs that their investments were safe. Defendants Investment Account Enterprise’).” (Compl.¶ 46.) falsely stated that the custodians were audited by Through the Omnibus Investment Account Enterprise, Arthur Andersen and Deloitte & Touche to provide Defendants established and operated the common Plaintiffs with an additional measure of security. And, investment fund, concealed from Plaintiffs the de- in an October 2008 letter, PSCCSI falsely reassured tailed monthly account statements and trade confir- Plaintiffs that their retirement savings were safe from mations received from Madoff, and “[c]oncealed the market turmoil because they had been invested in U.S. true nature of the relationship” between Defendants and Madoff.FN3 (Id. ¶ 50.) In support of the predicate

Slip Copy, 2009 WL 5184363 (D.Conn.), RICO Bus.Disp.Guide 11,800 (Cite as: 2009 WL 5184363 (D.Conn.)) acts of mail fraud and wire fraud, Plaintiffs assert that civil RICO if such offenses are based on conduct Defendants engaged in a scheme to defraud or obtain that would have been actionable as securities fraud. money by means of false pretenses, as evidenced by the false statements contained in the custodial agree- Thomas H. Lee Equity Fund V, L.P. v. Mayer Brown, ments, account statements, and other correspondence Rowe & Maw LLP, 612 F.Supp.2d 267, 281 with Plaintiffs. (Id. ¶¶ 52-55.) These misrepresenta- (S.D.N.Y.2009) (internal citations omitted). tions and concealments were “made for the purpose of deceiving Plaintiffs and the Class and obtaining their *6 Under Section 10(b) of the Securities Exchange property for Defendants' gain.” (Id. ¶ 57.) Act of 1934, the determination of whether conduct is actionable as securities fraud focuses on whether the FN3. Since Plaintiffs never allege that De- fraudulent conduct is “in connection with the purchase fendants had knowledge of Madoff's Ponzi or sale of any security.” 15 U.S.C. § 78j(b). The Su- scheme, it is unclear what “true nature of the preme Court has defined the scope of “in connection relationship” Plaintiffs are referring to. with” very broadly to encompass a “fraudulent scheme in which the securities transactions and Defendants jointly make the following arguments in breaches of fiduciary duty coincide.” S.E.C. v. Zand- support of dismissing the RICO counts: 1) the claims ford, 535 U.S. 813, 825, 122 S.Ct. 1899, 153 L.Ed.2d are barred because they rely on conduct that is ac- 1 (2002); see also Ling v. Deutsche Bank, AG, No. 04 tionable as securities fraud; 2) Plaintiffs lack standing CV 4566(HB), 2005 WL 1244689, at *3 (S.D.N.Y. because they were not injured “by reason of” Defen- May 26, 2005) (“[T]he requirement is satisfied when dants' acts; 3) Plaintiffs have not pled the predicate the securities transactions and breaches complained of acts of mail fraud and wire fraud with particularity; 4) coincide and are not independent events.”). Plaintiffs have not adequately alleged a continuing enterprise; and 5) Plaintiffs have not adequately al- Defendants argue that the RICO claims are barred leged a conspiracy under 18 U.S.C. § 1962(d). because they rely on Madoff's securities fraud to establish their liability. See e.g., Compl. ¶ 5 (describ- The Court first considers whether the RICO claims are ing Plaintiffs as “the perfect ‘mark’ for the Ponzi barred because they rely on conduct that is actionable scheme” because “[i]ndividuals [sic] saving for re- as securities fraud. The Private Securities Litigation tirement supplied a steady stream of funds for Madoff Reform Act, Pub.L. No. 104-67, 109 Stat. 737 (1995) each year and, by law, these funds could not be with- (codified as amendments to 15 U.S.C. §§ 78-78 and 18 drawn until retirement without paying significant U.S.C. § 1964) (“PSLRA”), amended RICO by nar- penalties” and “the steady if unremarkable returns rowing the types of conduct that could qualify as a reported to Plaintiffs and Class Members by Defen- predicate act. Section 107 of the PSLRA, the “RICO dants, who were paid substantial fees for their ‘ser- Amendment,” states in relevant part: vices' thereby reducing the reported yield on the custodial accounts, misled Plaintiffs and Class Members Any person injured in his business or property by to believe that their funds were safe and conserva- reason of a violation of section 1962 of this chapter tively invested”); id. ¶ 31 (“Plaintiffs and the other may sue therefor in any appropriate United States Class members' retirement savings would not have District Court ... except that no person may rely been ‘invested’ with Madoff absent Defendants' cre- upon any conduct that would have been actionable ation and decades-long operation of a collective in- as fraud in the purchase or sale of securities to es- vestment fund for the purpose of investing with Ma- tablish a violation of section 1962. doff.”). Indeed, the conduct actionable as securities fraud need not have been committed by Defendants 18 U.S.C. § 1964(c) (emphasis added). for the amendment to apply. The Conference Committee Report for § 107 makes clear that the RICO Amendment was intended by The statute does not say ‘no person may rely on a Congress to ‘eliminate securities fraud as a predi- defendant's conduct actionable as securities fraud to cate offense in a civil RICO action’ and to bar a establish a RICO violation against the defendant.’ plaintiff from ‘plead[ing] other specified offenses, Rather, it is written broadly to bar reliance on any such as mail or wire fraud, as predicate acts under conduct, no matter whose conduct it is.

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consider the allegedly fraudulent scheme as a whole. Fezzani v. Bear Stearns & Co., No. 99CIV0793RCC, For instance, in Stechler v. Sidley, Austin Brown & 2005 WL 500377, at *4 (S.D.N.Y. Mar.2, 2005) Wood, L.L.P, 382 F.Supp.2d 580 (S.D.N.Y.2005), (denying leave to amend defective complaint because investors alleged that several legal and financial ser- the proposed amendments, which relied on a third vices firms conspired to market, sell and implement a party's securities fraud to establish defendants' liabil- tax shelter, which they knew or should have known ity under RICO, were still barred by the RICO would be considered unlawful by the IRS. One part of Amendment). the tax shelter strategy required investors to acquire and sell common stock. In response to Plaintiffs' ar- While Madoff's Ponzi scheme is the principal cause guments that the connection between the common of Plaintiffs' losses and is therefore central to this stock transactions and the alleged fraud was tenuous, action, Plaintiffs do not rely on Madoff's Ponzi the court held that the strategy as a whole, not the scheme to establish Defendants' liability. Rather, individual steps required to carry it out, must be ana- Plaintiffs allege a different fraudulent scheme between lyzed. Since the tax strategy involved the purchase and Defendants and BLMIS, in which Defendants induced sale of securities, the RICO claims were barred. Id. at Plaintiffs to invest in the common investment fund by 597-98. See also Bald Eagle Area Sch. Dist., 189 F.3d making false representations in the custodial agree- at 330 (plaintiffs' “surgical presentation of the cause of ments, account statements and other correspondence action” could not avoid the determination that the for the purpose of collecting fees. Thus, the Court conduct giving rise to the predicate offenses amounted must determine whether Defendants' own misrepre- to securities fraud); Ling, 2005 WL 1244689, at *4 sentations concerning the safety of Plaintiffs' invest- (“If one predicate act alleges breaches of duty coin- ments are in connection with the purchase or sale of cident with securities transactions then the whole securities.FN4 scheme is subject to the PSLRA bar. Because here the Plaintiffs contend the wrongful acts were committed as part of a single fraudulent scheme, all of the com- FN4. Defendants also rely heavily on Bald ponents must be considered together for securities Eagle Area Sch. Dist. v. Keystone Fin., Inc., fraud purposes .”); Seippel v. Jenkens & Gilchrist, 189 F.3d 321(3d Cir.1999), in which the P.C., 341 F.Supp.2d 363, 373 (S.D.N.Y.2004) (Plain- Third Circuit held that investors' RICO tiff's RICO claims based on Defendants' allegedly claims against their custodians based on a fraudulent tax shelter, which was supposed to reduce Ponzi scheme run by an investment firm plaintiff's tax liability when exercising his stock op- were barred by the RICO Amendment. In tions, were barred because the “sale of [plaintiff's] that case, however, the plaintiffs alleged that stock was an integral part of the scheme”). the custodians violated RICO by knowingly participating in and furthering the Ponzi scheme through numerous acts of mail, wire In this case, an integral part of the fraudulent scheme and bank fraud, such as preparing false trust was the purchase and sale of securities. While Plain- statements to conceal the scheme and failing tiffs steer clear of mentioning the word securities in to maintain adequate collateral. Id. at 326. most of their allegations, the omnibus account created Here, by contrast, the motive of Defendants' by Defendants was clearly for the purpose of allowing allegedly fraudulent conduct was not to Madoff to purchase and sell securities using Plaintiffs' perpetuate a Ponzi scheme but to continue to funds. And, as Plaintiffs readily acknowledge in their reap the benefits of the fees from Plaintiffs' Complaint, but for their custodial agreements with investments with Madoff. Thus, the Court Westport B & T and Westport, which authorized the must consider whether, despite Defendants' custodians to bundle Plaintiffs' funds and transmit lack of knowledge of Madoff's Ponzi them to BLMIS for investment at BLMIS' discretion, scheme, their misrepresentations concerning their funds would never have been invested with Plaintiffs' investments involved securities Madoff. fraud. Moreover, Defendants' alleged misrepresentations and *7 In determining whether misrepresentations coin- omissions relate to Madoff's purported purchase and cided with the purchase or sale of securities, courts sale of securities with Plaintiffs' funds. Defendants

Slip Copy, 2009 WL 5184363 (D.Conn.), RICO Bus.Disp.Guide 11,800 (Cite as: 2009 WL 5184363 (D.Conn.)) essentially induced Plaintiffs to invest their assets in 77p(b), 78bb(f). In response to perceived abuses of the the common investment fund (and induced them to class action device in litigation involving nationally keep their assets there in the long run) based on false traded securities, Congress enacted the Private Secur- reassurances that their assets would be safe. Many of ities Litigation Reform Act (“PSLRA”), 15 U.S.C. §§ these false reassurances-misrepresentations that 77z-1; 78u-4. Among other reforms, PSLRA imposes Plaintiffs' assets were being “held” by the custodians heightened pleading requirements and authorizes a and were submitted to BLMIS for short-term trading stay of discovery pending the resolution of a motion to only, nondisclosure of the individual securities posi- dismiss in securities fraud cases. The enactment of tions in the BLMIS omnibus accounts, and false as- PSLRA, however, had the unintended consequence of sertions that Plaintiffs' assets were invested in U.S. encouraging plaintiffs to bring class actions involving Securities-relate to Madoff's purchase and sale of securities fraud under state law to circumvent securities. Even misrepresentations about Defendants' PSLRA's stringent requirements. See Merrill Lynch, fees relate to securities transactions because the cal- Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71, 82, culation of Defendant PSCCSI's fees was determined 126 S.Ct. 1503, 164 L.Ed.2d 179 (2006). In response, in part by how many trades Madoff made with Plain- Congress enacted SLUSA to prevent plaintiffs from tiff's funds.FN5 evading the protections against abusive securities litigation codified in PSLRA. SLUSA provides: FN5. The cases cited by Plaintiffs are not to the contrary. (See Pls.' Opp. Mem at 11.) No covered class action based upon the statutory Plaintiffs cite OSRecovery, Inc. v. One common law of any State or subdivision thereof Groupe Int'l, Inc., 354 F.Supp.2d 357 may be maintained in any State or Federal court by (S.D.N.Y.2005) and Renner v. Chase Man- any private party alleging- hattan Bank, No. 98-926, 1999 WL 47239, at*6-*7 (S.D.N.Y. Feb. 3, 1999), cases where (A) an untrue statement or omission of a material the defendants were not alleged to have made fact in connection with the purchase or sale of a a misleading statement or misrepresentation covered security; or to the plaintiffs. Since the claims against them amounted to aiding and abetting (B) that the defendant used or employed any ma- another parties' fraud, they were not action- nipulative or deceptive device or contrivance in able under the federal securities laws; thus connection with the purchase or sale of a covered the RICO claims were not barred. Here, security. however, Defendants are alleged to have made numerous false statements to Plaintiffs, not merely aided Madoff in his commission Thus, the five requirements for SLUSA preemption of false statements, so the claims against are: 1) a covered class action 2) based on state law 3) Defendants are actionable as securities fraud. alleging untrue statements or omissions of material fact 4) in connection with the purchase or sale of 5) a covered security. *8 The Court finds that Plaintiffs' RICO claims are barred by the RICO Amendment because they rely on Plaintiffs do not dispute that this lawsuit is a “covered conduct that is actionable as securities fraud. There- FN6 fore, the Court declines to address Defendants' re- class action” based on state law (with the exception of the two RICO claims addressed supra ) or that maining arguments in support of dismissal of the FN7 RICO claims. For the reasons stated above, Defen- Madoff purported to trade in covered securities. dants' motions to dismiss Counts I and II are granted. They do, however, dispute that the Complaint involves a misrepresentation or omission of a material fact and that the required misrepresentation or omis- B. State Law Claims (Counts III-XI) sion was in connection with the purchase or sale of securities. The Court addresses the “misrepresentation Defendants also assert a number of bases for dis- or omission” and “in connection with” requirements to missing the ten state law claims, one of which is that SLUSA preemption below. the claims are preempted by the Securities Litigation Uniform Standards Act (“SLUSA”), 15 U.S.C. §§ FN6. A covered class action is a lawsuit in

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which damages are sought on behalf of more SLUSA is applicable.” (Pls.' Supp. Opp. Mem. at 3.) than 50 prospective class members and According to Plaintiffs, Defendants' alleged misre- common questions of law or fact predomi- presentations-contracts that falsely represented that nate over questions affecting only individual the custodians would hold Plaintiffs' investments and members of the class. 15 U.S.C. § annual account statements that falsely represented the 78bb(f)(5)(B)(i)(I). balances in Plaintiffs' accounts-did not coincide with Madoff's securities transactions. Rather, they concern FN7. A covered security is a security “listed, whether Defendants were “holding Plaintiffs' invest- or authorized for listing, on the New York ments and the alleged value of Plaintiffs' accounts at Stock Exchange or the American Stock Ex- year end after the alleged securities transactions had change, or listed, or authorized for listing, on occurred.” Id. at 3 (emphasis in original). Moreover, the National Market System of the NASDAQ the contracts and annual account statements did not Stock Market (or any successor to such enti- mention any specific securities, make representations ties).” 15 U.S.C. § 77r(b)(1)(A). about expected returns, or otherwise offer investment advice. Id. at 11-12. Instead, the annual account (I) “In Connection With” statements “recorded such mundane events as deposits into and withdrawals from Plaintiffs' custodial accounts, and were provided to Plaintiffs well after the Defendants allege that, since the Complaint focuses on securities transactions that BLMIS purportedly en- Madoff's Ponzi scheme and Defendants' aiding and gaged in took place.” Id. at 11. abetting of that scheme, the allegations are clearly in connection with the purchase or sale of securities. The Supreme Court has defined “in connection with” very Despite Plaintiffs' arguments to the contrary, the al- broadly to encompass circumstances where “the leged misrepresentations are not required to contain scheme to defraud and the sale of securities coincide.” specific securities information or investment advice in S.E.C. v. Zanford, 535 U.S. 813, 822, 122 S.Ct. 1899, order to coincide with securities transactions. In 153 L.Ed.2d 1 (2002). In Dabit, 547 U.S. at 85, the Fisher v. Kanas, 288 F. App'x 721, 723 (2d Cir.2008), Supreme Court applied this definition of “in connec- the Second Circuit affirmed a lower court's holding tion with” to SLUSA, holding that “it is enough that that proxy statements that misrepresented executive the fraud alleged ‘coincide’ with a securities transac- compensation policies were in connection with the tion-whether by the plaintiff or by someone else.” The purchase or sale of securities because they allegedly Court also instructed that SLUSA be read with the deprived shareholders of their full equity in the cor- “presumption that Congress envisioned a broad con- poration. Thus, the plaintiff's breach of fiduciary duty struction” of the statute so that the most troublesome claim was preempted by SLUSA. Id. See also Sofonia class actions would be subject to the PSLRA. Id. at 86. v. Principal Life Ins. Co., 465 F.3d 873, 877 (8th Cir.2006) (misrepresentations in a Policyholder In- formation Booklet, which were intended to induce *9 Despite the broad application of “in connection policyholders to approve insurance company's de- with” espoused by the Supreme Court, this Court finds mutualization process, involved the purchase or sale the question of whether Defendants' misrepresenta- of securities). tions were “in connection with” the purchase or sale of securities to be more difficult than Defendants suggest. While there is no question that Madoff's Ponzi Moreover, Plaintiffs' argument that Defendants' mi- scheme was “in connection with” the purchase and srepresentations only concern the post-transaction sale of securities, Defendants are not alleged to have value of their assets is belied by the allegations in the been knowing participants in that scheme. The rele- Complaint. The Complaint alleges that Defendants vant inquiry is whether Defendants' own misrepre- and BLMIS engaged in a scheme to operate a common sentations that unintentionally facilitated Madoff's investment fund, and that Defendants induced Plain- fraud coincided with the purchase and sale of securi- tiffs into investing their assets in the fund by misre- ties. presenting the extent to which Defendants would safeguard their assets. Thus, some of the misrepresentations occurred prior to-and were necessary con- Plaintiffs argue correctly that “the alleged misconduct ditions for-Madoff's purported purchase and sale of of the defendant is central in determining whether

Slip Copy, 2009 WL 5184363 (D.Conn.), RICO Bus.Disp.Guide 11,800 (Cite as: 2009 WL 5184363 (D.Conn.)) securities with Plaintiffs' funds. claims were not in connection with the purchase or sale of securities because they were based solely on *10 Misrepresentations that induce an investment of the post-investment retention of their retirement trusts. funds to the investor's detriment are often sufficient to The “in connection with” requirement was met be- meet the “in connection with” requirement. In Gray v. cause the “allegations make clear that Plaintiffs were Seaboard Sec. Inc., 126 F. App'x 14, 16 (2d Cir.2005), fraudulently induced to purchase the trusts/securities the plaintiffs argued that their common law fraud [from the pension fund] based on allegedly false as- claim was not preempted by SLUSA because the surances that their funds would be protected by De- defendant brokerage firm's misrepresentations about fendants.” Id. at 1319-20 (emphasis in original). its affiliation with another brokerage firm only induced them to open accounts with the defendant, not *11 Here, as well, the crux of Plaintiffs' allegations is purchase or sell specific securities. The Second Circuit that Defendants' fraudulent statements caused Plain- disagreed, holding that the “in connection with” re- tiffs to make poor investment decisions. Defendants' quirement was met because the misrepresentations misrepresentations regarding the safety of Plaintiffs' caused plaintiffs to pay premium brokerage commis- investments induced Plaintiffs to chose Defendants as sions, which accrued upon the purchase or sale of their investment advisor and the custodian of their securities. Id. See also Professional Mgmt. Assocs., funds, to authorize Defendants to invest their funds Inc. v. Employees' Profit Sharing Plan, 335 F.3d 800, with Madoff, and to continue this arrangement until 803 (8th Cir.2004) (“[M]isconduct [that] caused a Madoff's fraud was uncovered. plaintiff to invest in inappropriate securities is a claim in connection with the purchase or sale of a covered Courts also consider the nature of the parties' rela- security for purposes of SLUSA preemption.”). tionship, and whether it necessarily involved the purchase and sale of securities, in determining Similarly, in Instituto de Prevision Militar v. Merrill whether the “in connection with” requirement is met. Lynch, 546 F.3d 1340 (11th Cir.2008), an investor Rowinski v. Salomon Smith Barney, Inc., 398 F.3d sued Merrill Lynch for allowing the investor's pension 294, 302 (3d Cir.2005). For instance, in Dommert v. fund-which stole the investor's funds rather than in- Raymond James Fin. Serv., Inc., No. CIV A. vesting them-to falsely hold itself out as Merrill 1:06-CV-102, 2007 WL 1018234 (E.D.Tex. Mar.29, Lynch's agent and for failing to prevent the misap- 2007), the court held that investors' breach of contract propriation of funds. The Eleventh Circuit found that and breach of fiduciary duty claims based on a finan- the misrepresentations were in connection with the cial investment services firm's nondisclosure of ma- purchase or sale of securities because they facilitated terial information about the terms of its investment the post-investment theft of plaintiff's funds. Because agreements were preempted by SLUSA. Since the the complaint essentially alleged that Merrill Lynch purpose of the investment agreements was to “utilize fraudulently induced the plaintiff to invest with the [the plaintiff's] assets and expand upon those assets, pension fund, the claims were preempted by SLUSA. presumably with the purchase and sale of securities,” Id. at 1349-50. In Cordova v. Lehman Bros., Inc., 413 the court held that the “in connection with” require- F.Supp.2d 1309 (S.D.Fla.2006), another case stem- ment was met. Id. at * 11. Moreover, the investment ming from the same pension fund fraud as Instituto de agreement “was formed and the fiduciary relationship Prevision Militar, the investors alleged that they was created because Plaintiff contracted with Defen- agreed to invest with the fraudulent pension fund dant for the management of her assets, which en- because major financial institutions agreed to serve as compassed the purchase and sale of stock.” Id. custodians and/or trustees of their funds. Id. at 1311-12. The investors alleged that the major financial Here, as well, the relationship between Plaintiffs and institutions rendered substantial assistance to the fraud their custodians, as delineated in the custodial by, inter alia, allowing their names, logos, and repu- agreements, was formed for the purpose of investing tations to be used in the pension fund's marketing Plaintiffs' funds in securities. Both the Westport B & T materials, failing to alert investors of false statements and Westport agreements authorized the custodians to made by the pension fund, and falsely reassuring the transmit Plaintiffs' funds to BLMIS for investment on investors of the safety of their investments. The court a discretionary basis. The Westport B & T agreement rejected the investors' argument that their state law also expressly authorized the custodian to “make

Slip Copy, 2009 WL 5184363 (D.Conn.), RICO Bus.Disp.Guide 11,800 (Cite as: 2009 WL 5184363 (D.Conn.)) purchases and sales of securities as the Principal may Supreme Court in Dabit ”); Dommert, 2007 WL direct ...” And, as Plaintiffs acknowledge several 1018234, at *9-* 10 (noting that the plaintiff's reliance times in their Complaint, their funds would never have on Norman v. Salomon Smith Barney Inc., 350 been invested with Madoff but for their custodial F.Supp.2d 382 (S.D.N.Y.2004), was not persuasive in relationship with Westport B & T and Westport and part because the case preceded Dabit ). their investment advisor relationship with PSCCSI. FN8. Plaintiffs cite McPhatter v. Sweitzer, Moreover, a close reading of the Complaint reveals No. Civ. 103CV00170, 2003 WL 22113455 that the nature and purpose of the allegedly fraudulent (M.D.N.C. Sept.8, 2003); Adaba v. Charles scheme is connected to the purchase and sale of se- Schwab & Co., 127 F.Supp.2d 1103 curities. The purpose of Defendants' scheme was “to (S.D.Cal.2000); French v. First Union Sec. create and operate a common investment fund for the Inc., 209 F.Supp.2d 818 (M.D.Tenn.2002); purpose of investing with Madoff and BLMIS and to and Norman v. Salomon Smith Barney Inc., induce Plaintiffs and Class members to invest their 350 F.Supp.2d 382 (S.D.N.Y.2004). retirement savings in this common fund.” (Compl.¶ 18.) Each of the misrepresentations in support of the Given the nature of the allegations in the Complaint, scheme relates either to the safety of Plaintiffs' funds the relationship between the parties, and the broad and conservativeness of the investments or the fees application of SLUSA espoused by the Supreme Court charged to Defendants for their services which, for in Dabit, the Court finds that the allegations against PSCCSI, depended in part on the amount of each trade Defendants are in connection with the purchase or sale effected by BLMIS. See Broadhead Ltd. Partnership of securities. v. Goldman, Sachs & Co., No. 2:06CV009, 2007 WL 951623, at *5 (E.D.Tex. Mar. 26, 2007) (state law (II) Mis representation or Omission claims based on financial services firm's failure to disclose fees associated with bond purchases and sales in its advisory service agreements were in connection In determining whether each claim alleges a misre- with the purchase or sale of securities). presentation or omission, the Court must determine whether the individual claim depends on allegations of fraud. “Under SLUSA, regardless of the words used *12 In support of their argument that Defendants' acts by a plaintiff in framing her allegations and regardless are too far removed from securities transactions to be of the labels she pastes on each cause of action, a court preempted by SLUSA, Plaintiffs cite cases that pre- must determine whether fraud is a necessary compo- ceded the Supreme Court decision in Merrill Lynch, nent of the claim. Under this test, a complaint is Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71, FN8 preempted under SLUSA when it asserts (1) an ex- 126 S.Ct. 1503, 164 L.Ed.2d 179 (2006). However, plicit claim of fraud or misrepresentation (e.g., com- as many courts have acknowledged, the Dabit deci- mon law fraud, negligent misrepresentations, or sion greatly expanded the scope of SLUSA. See, e.g., fraudulent inducement), or (2) other garden-variety Fisher v. Kanas, 487 F.Supp.2d 270, 277 state law claims that ‘sound in fraud.’ “ Xpedior (S.D.N.Y.2007) (“Although the proxy statements [that Creditor Trust v. Credit Suisse First Boston (USA) misrepresented executive compensation policies] did Inc., 341 F.Supp.2d 258, 261 (S.D.N.Y.2004) (em- not make a misrepresentation regarding the purchase phasis in original). A claim sounds in fraud when or sale of a security, the [SLUSA] statute has been “although not an essential element of the claim, the interpreted broadly by the Supreme Court in Dabit to plaintiff alleges fraud as an integral part of the conduct include any misrepresentation touching upon the giving rise to the claim.” Id. at 269. purchase or sale of securities.”); Horattas v. Citigroup Financial Markets, Inc., 532 F.Supp.2d 891, 901 (W.D.Mich.2007) (holding that state law claims According to this test, Plaintiffs' claims of common against trustees for failing to safeguard trust funds law fraud, negligent misrepresentation, and aiding and were barred by SLUSA because “no matter how per- abetting conversion and statutory theft are preempted suasive [the plaintiff's] arguments might have been a by SLUSA because a misrepresentation or other few years ago, they are now undermined by the broad fraudulent conduct is a necessary element of these reading of ‘in connection with’ announced by the causes of action. The more difficult question is whether Plaintiffs' non-fraud-based causes of action

Slip Copy, 2009 WL 5184363 (D.Conn.), RICO Bus.Disp.Guide 11,800 (Cite as: 2009 WL 5184363 (D.Conn.)) are preempted as well because they “sound in fraud,” statements. Courts have held that non-fraud-based i.e., they rely on allegations of fraud as the basis for claims are preempted by SLUSA if they incorporate their claims of breach of contract, breach of fiduciary by reference allegations of false or misleading state- duty, etc. For instance, in Felton v. Morgan Stanley ments. The “counts which alleged fraud or misrepre- Dean Witter, 429 F.Supp.2d 684 (S.D.N.Y.2006), the sentation ... taint[ ] subsequent counts in the com- court held that investors' breach of contract action plaint.” Breakaway Solutions, Inc. v. Morgan Stanley against their broker for failing to disclose conflicts of & Co., No. Civ. A. 19522, 2004 WL 1949300 interest was preempted by SLUSA. (Del.Ch. Aug.27, 2004). See, e.g., Miller v. Nation- wide Life Ins. Co., 391 F.3d 698, 702 (5th Cir.2004) *13 Plaintiffs describe this conduct as a breach [of (holding that breach of contract claim, which incor- contract] ... and so it may have been, but it is also a porated by reference allegations of materially false quintessential example of a fraudulent omission of a and misleading statements in seller's prospectus, was material fact under the federal securities laws.... To preempted by SLUSA); In re Mutual Funds Invest- regard the Amended Complaint as alleging nothing ment Litig., 384 F.Supp.2d 845, 871-72 (D.Md.2005) more than common law breaches of contract would (dismissing state law counts because they incorpo- reward artful pleading that the law does not permit. rated by reference allegations of fraud made in support of other claims); Professional Mgmt. Assocs., Inc., Id. at 693. See also Dacey v. Morgan Stanley Dean 335 F.3d at 803 (dismissing negligence claim because, Witter & Co., 263 F.Supp.2d 706, 710 (S.D.N.Y.2003) although it contained no allegations of a misrepre- (holding that breach of contract claim was preempted sentation or omission, it incorporated by reference the by SLUSA because the defendants' alleged scheme to misrepresentation allegations made elsewhere in the induce individuals to buy or hold securities by issuing complaint). Therefore, the non-fraud-based claims artificially positive ratings on the stock of certain rely on fraud as an integral part of the conduct giving companies clearly concerned misrepresentations or rise to the claims. omissions). *14 Since all of the state law claims allege a misre- In their breach of contract and breach of fiduciary duty presentation or omission in connection with the pur- counts, Plaintiffs allege that Defendants failed to sa- chase or sale of securities, the Court finds that they are feguard Plaintiffs' assets by not maintaining posses- preempted by SLUSA. Thus, Defendants' motions to sion of Plaintiffs' funds, neglecting to independently dismiss the state law claims are granted. verify the investment returns reported by BLMIS, and ignoring evidence of Madoff's Ponzi scheme. While C. Leave to Replead none of these allegations sound in fraud, the Com- plaint states elsewhere that Defendants intended to Plaintiffs have requested leave to replead their state misrepresent their obligations in the Custodial law claims in the event that this Court finds that they Agreements to induce Plaintiffs to enter into the are preempted by SLUSA. The Court finds that agreements. (Compl.¶ 55(a)). “The failure to carry out Plaintiffs' non-fraud-based claims for breach of con- a promise made in connection with a securities tract, breach of fiduciary duty, negligence, violation of transaction is normally a breach of contract. It does CUTPA, unjust enrichment, money had and received, not become fraud unless, when the promise is made, and unjust enrichment may be pled without reference the defendant secretly intended not to perform or knew to a misrepresentation or fraudulent scheme to avoid that he could not perform.” Gurary v. Winehouse, 190 SLUSA preemption. See, e.g., Beckett v. Mellon Inv. F.3d 37, 44 (2d Cir.1999) (quoting Mills v. Polar Serv., LLC, No. 06-36044, 2009 WL 1336735, at *2 Molecular Corp., 12 F.3d 1170, 1176 (2d Cir.1993)). (9th Cir. May 14, 2009) (granting leave to amend Defendants' intent not to perform turns a simple complaint that alleged breach of contract, breach of breach of contract into allegations of fraud. fiduciary duty, unjust enrichment, and violation of Washington's consumer protection and unfair trade Moreover, the non-fraud-based causes of action in- practices law because plaintiff could conceivably corporate by reference all preceding allegations in the allege these claims in a way that would avoid SLUSA Complaint, such as the allegations of misrepresenta- preemption); In re Mutual Funds Investment Litig., tions in the custodial agreements and annual account 384 F.Supp.2d at 871-72 (dismissing state law counts

Slip Copy, 2009 WL 5184363 (D.Conn.), RICO Bus.Disp.Guide 11,800 (Cite as: 2009 WL 5184363 (D.Conn.)) but granting leave to file an amended complaint without reference to any allegations of a misrepresentation or fraudulent scheme). Thus, Plaintiffs' request to replead is granted.

IV. CONCLUSION

For the foregoing reasons, Defendants' motions to dismiss [Doc. Nos. 45, 48, 58] are hereby granted. Plaintiffs' request to replead is granted.

SO ORDERED.

D.Conn.,2009. Levinson v. PSCC Services, Inc. Slip Copy, 2009 WL 5184363 (D.Conn.), RICO Bus.Disp.Guide 11,800

END OF DOCUMENT