Corporate Governance

SEC v. Chais: SEC's Own Failures as an Affirmative Defense to Alleged Violations of Federal Securities Laws

By Benjamin Hager

In a complaint filed on June 22, 2009 ('Complaint'), the SEC alleged Stanley Chais, a money manager who managed three funds ('Funds') that invested substantially all assets with Bernard Madoff, committed securities fraud by (1) misrepresenting involvement in managing investors' assets and (2) disseminating account statements containing false information.  The collapse of Madoff's Ponzi scheme resulted in a loss of nearly all of the Funds' assets, totaling approximately $917 million.  In an answer filed on October 21, 2009 ('Answer'), Chais denied allegations of securities fraud.  Interestingly, Chais asserted, among others affirmative defenses, the SEC's conduct provided credibility to Madoff, and thus barred the SEC's claims against Chais.

The Complaint alleged Chais committed securities fraud beginning in 1970, when he formed and managed the Funds.  Chais represented to investors that he was an 'investing wizard' executing a complex trading strategy.  The Complaint asserted, however, that Chais was a close friend of Madoff and was an 'unsophisticated investor' who turned over substantially all of the Funds' assets to Madoff.  Nonetheless, Chais received approximately $270 million in fees for his 'services' between the years of 1995 and 2008.  

According to the Complaint, Chais concealed from investors the fact that he turned the Funds' assets over to Madoff.  When asked questions regarding his trading strategy, Chais allegedly offered nebulous and false responses.  Moreover, Chais specifically told his accountant not to disclose Madoff's name to investors.  Consequently, investors were unaware that Chais deposited the Funds' assets with Madoff until after Madoff's Ponzi scheme collapsed.  

The Complaint further alleges that Chais and his accountant prepared and distributed investors' account statements based on information received from Madoff regarding the Funds' investment performances.  Around 1995, Chais told Madoff, 'he did not want there to be any losses in any of the Fund's trades.'  Between 1999 and 2008, Madoff did not report any trading losses on behalf of the Funds.  As a result, the Funds reported returns of at least 10% per annum since 1995.  Nevertheless, Chais and his accountant continued to prepare and distribute investors' account statements using information provided by Madoff.

Based on the foregoing allegations, the SEC asserted Chais committed securities fraud for two reasons.  First, Chais made misstatements and omissions to investors regarding his role in managing the Funds.  Second, Chais was at least negligent in distributing investors' account statements that he should have known contained false information.  As a result, the SEC claimed Chais violated Section 17(a) of the Securities Act; Section 10(b) of the Exchange Act and Rule 10b-5 thereunder; and Section 206(4) of the Advisers Act and Rule 206(4)-8 thereunder.

The SEC sought, among other relief, a judgment (1) enjoining Chais from committing future violations of securities fraud, (2) ordering disgorgement of ill-gotten gains, and (3) ordering payment of civil money penalties.  In his Answer, Chais denied committing securities fraud and argued he was not an investment advisor to the Funds.  Although Chais denied his alleged friendship with Madoff, he admitted turning over substantially all of the Funds' assets to Madoff.  In addition, Chais claimed insufficient knowledge to form a belief as to the amount of fees he received from the Funds, but he admitted receiving some amount of fees for his services.

Chais admitted he did not want Madoff's name disclosed to investors.  He denied, however, making representations to investors that he was managing the Funds' investing and trading strategies.  Chais told investors, 'if they were uncomfortable with the lack of information they were receiving, they could withdraw their investment or decline to invest.'  Also, Chais admitted preparing investors' account statements based on information received from Madoff.  Furthermore, Chais denied requesting that Madoff not show trading losses on behalf of the Funds.  Because Chais did not request that Madoff not show trading losses, the reported returns on the Funds' investments would not have alerted Chais to the fact Madoff was providing false information. 

In addition to denying violation of federal securities laws, Chais stated three affirmative defenses.  First, the SEC's 'claims . . . [were] barred by virtue of . . . [the SEC's] own conduct, which provided credibility to Madoff.'  Second, the doctrines of waiver, estoppel, and unclean hands barred the SEC's claims.  Third, Chais' receipts from Madoff were irrelevant to the SEC's claims.  He sought, among other relief, dismissal of the SEC's claims and attorneys' fees. 

The second asserted affirmative defense is peculiar: the SEC's failure to thwart the Madoff Ponzi scheme 'provided credibility to Madoff,' and thus, barred the SEC's claims against Chais.  In other words, Chais claimed the SEC's failure to discover the Madoff fraud provided assurance to investors, including Chais, that Madoff was running a legitimate investing business.  At first glance, this defense may seem tenuous.  Contingent upon the ultimate factual determinations in the case, however, this defense may inoculate Chais' actions from liability that, absent the SEC's bungle, would otherwise violate federal securities laws.  In sum, SEC's own missteps in the Madoff case may provide Chais with a defense to the SEC's charges and raise the SEC's own failures as an issue in the case at bar.  

The primary materials for the post are available on the DU Corporate Governance website. 

Full post as published by The Race to the Bottom on December 10, 2009 (boomark / email).