Madoff and the Sophisticated Investor

Coverage of Bernard Madoff's scam in the New York Times has focused on how Madoff used his status in the Jewish community in Palm Beach as a lever to get money and avoid due diligence. Scams which abuse ties of trust in close-knit communities are called “affinity fraud.”

To paraphrase one prominent securities regulator, "You can trust me because I'm like you" is a siren song that has been used in recent years to defraud many investors.

Fairfax, "WITH FRIENDS LIKE THESE . . .": TOWARD A MORE EFFICACIOUS RESPONSE TO AFFINITY-BASED SECURITIES AND INVESTMENT FRAUD, 36 Ga. L. Rev. 63, 64 (2001)

Affinity fraud has been the subject of investor alerts from the SEC and the NASAA. Because this type of fraud often targets poor and minority investors there have been calls to recognize that affinity fraud causes special harm. One such proposal would increase penalties (Fairfax, 36 Ga. L. Rev. 63,(2001)) another would adopt an alternative materiality threshold to make such cases easier to maintain (Sachs, MATERIALITY AND SOCIAL CHANGE: THE CASE FOR REPLACING " THE REASONABLE INVESTOR" WITH "THE LEAST SOPHISTICATED INVESTOR" IN INEFFICIENT MARKETS 81 Tul. L. Rev. 473, 473 (2006)).

However, as the Wall Street Journal pointed out, abuse of trust cuts across lines of wealth, and class. Lisa M. Farifax, Professor of Law and Director of the Business Law Program at the University of Maryland, argues that "even generally savvy individuals will succumb to such fraud because it preys on one's ... instinct to trust members within their own affinity group." Professor Margaret V. Sachs, Robert Cotton Alston Chair in Corporate Law at the Georgia University Law School, agrees that Madoff's victims may have been "more vulnerable than they would have been under other cirucumstances." Many of Madoff’s “investors” were just as easily taken in as those with limited investment smarts.

Madoff's victims are likely to be classified as "sophisticated investors" - the least protected class of individual investors. To determine if an individual investor is sophisticated, a court will consider "wealth[,] … age, education, professional status, investment experience, and business background." (4 Bromberg & Lowenfels on Securities Fraud § 7:444 (2d ed.)) Sophisticated investors have a "duty to investigate the facts surrounding a securities transaction which [...]is greater than the corresponding duty of a novice." (Fletcher, SOPHISTICATED INVESTORS UNDER THE FEDERAL SECURITIES LAWS, 1988 Duke L.J. 1081, 1092)

Does it make sense to use wealth and age as the tests of investor sophistication? Should protections developed for the least privileged be extended to the most? Professor Sachs thinks so "concievably, in an action brought by the SEC or the DOJ, but not in a private action." Professor Fairfax concedes that "some may view such victims as less sympathetic because they appear to be more sophisticated or well off," but "they too may need protection because they are - at least in this context - especially vulnerable and thus less likely to be vigilant."