The US government can be sued on account of the fantastic negligence of the SEC

June 16, 2010

Information, as expected, has been coming out, even if slowly. Inparticular, excellent sources of information and ideas seem to include the SEC Inspector General's two Reports on the Madoff case; the IG's two reports on the all too analogous Stanford scam; and complaints, among others, filed against J.P. Morgan Chase, against a money manager, now owned by the Bank of New York, called Ivy Asset Management, against Banco Santander, Price Waterhouse and subsidiaries or components of each, and against the SEC. There have also been two legal opinions of consequence (aside from Judge Lifland's opinion on net equity, which can be ignored for present purposes). Both involve governmental immunity under the Federal Tort Claims Act: one is in a California case asserting the SEC's negligence in Madoff, and the other is in a case involving the negligence of the Army Corps of Engineers that led to the destruction of New Orleans during Hurricane Katrina.

One can have high confidence in the information and ideas in the SEC Inspector General's reports, of course. Necessarily, one should not have as high a degree of confidence in the complaints, because they are adversary documents and are comprised of allegations rather than of truths shown by evidence at trial. Yet most -- even nearly all -- of what they say has the ring of truth (and some of it, even much of it, is known to be true on the basis of priorinformation).

As for what is said in the two opinions, one is an intelligent assessment of what is necessitated by modern conditions. The other is simply imbecilic.

These various informational sources are relevant to several issues I would like to discuss in a two-installment post. The issues are important because they already are involved in major suits or are likely to be involved in suits that will be filed in future. One could write huge amounts about the involvements, about the relationships. Ishall, however, try to confine myself by and large to only the most crucial points, which tend to get buried in the clouds of words appearing in the formal documents written by lawyers and judges.

Let us begin with the issue of the government's liability arising from the unbelievable negligence of the SEC. This is an issue on which, as is common in the legal profession, many lawyers waxed definitive when the Madoff case broke. Lawyers were quick to confidently say, on the basis of very little if any knowledge, that the government cannot be sued. The accuracy of this highly confident but knowledge-free reaction is open to serious doubt.

The problem arises because there is a medieval doctrine called sovereign immunity, under which the government cannot be sued. Though the doctrine is a relic of the days of kings and is wholly inconsistent with the rule of law, it is still followed in many instances. And, at bottom, it is this doctrine that accounts for the lawyerish knee-jerk reactions against the possibility of suit based on the SEC's horrendous conduct.

However, the doctrine of sovereign immunity has been waived by Congress in the Federal Tort Claims Act for matters that fall within that Act. Governmental negligence is one such matter, so under the waiver the government can be sued on account of the fantastic negligence of the SEC.

The waiver does not apply, however, if the matter involved is based on thepolicy of a given statute or statutes (like the various federal securities acts) and/or is a matter in which a government agency had discretion. The two ideas are often run together; there is no waiver, for example, if a governmental action, though it ultimately proved unsuccessful or even negligent, was within an agency's discretion in seeking to carry out the policy of a statute (such as the securities acts). So the question here is going to come down to whether, in conducting itself with horrible negligence, the SEC was acting within the policy of the securities laws and/or was exercising legitimate, permissible discretion in its enforcement of those laws.

One would think that, as the old saying goes, to put this question is to answer it. A powerful policy of the securities laws is to protect investors against fraud. It is utterly bizarre to argue that SEC personnel could be acting inaccordance with the policy of the securities laws, rather than against such policy, by conducting themselves with such fantastic negligencet hat thousands or maybe even tens of thousands of people were defrauded out of their money instead of the fraud readily being caught and stopped by investigatory methods so simple that they are highly conventional -- methods such as (among many others) contacting counterparties to see if transactions had in fact occurred, contacting the Depository Trust Company to find out what securities Madoff held in his account there, contacting the NASD to see what trades he hadengaged in, and determining (as various large funds did), whether therewere enough options to cover his alleged strategy. It is correlatively and equally bizarre to say that SEC personnel had discretion to negligently fail to take even the most conventional investigatory steps and to thereby negligently thwart the deep seated securities lawpolicy of stopping fraud.

...More than enough said. The Katrina decision makes clear that there should be no immunity for the government in the Madoff and Stanford cases on the ground that the SEC's horrible negligence in the two cases was an exercise of permissible discretion in accordance with the anti fraud policy of the securities laws. As in the Katrina case, the government violated professional standards. As well, instead of protecting citizens as it was supposed to do under the statutory policy, the SEC opened the door to terrible injury to untold numbers of citizens. The government's argument would vitiate the FTCA's waiver of sovereign immunity in negligence cases because every investigatory and prosecutorial action and decision of the SEC, no matter how abysmal and negligent, would be turned into an exercise of permissible discretion. The SEC's negligent actions were not the kind of actions Congress intended to protect -- they were the exact opposite (as further shown, I note, by the furious Congressional outcry against the SEC when its misconduct regarding the disastrous Ponzi schemes came to light). And the government's arguments are merely ex post putative rationalizations to try to escape liability for a degree of negligence that boggles the mind.


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