Madoff’s long legacy

Author: | Published: 24 Jun 2010
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Following the Madoff scandal, financial centres, including Luxembourg, have had to face the consequences of the now world-famous fraud. These consequences were initially mostly bankruptcies.

In Luxembourg, several investors sued the custodian (UBS) of the LuxAlpha and LuxInvest funds, which were solely invested in Madoff funds, rather than going through the fund's liquidators, appointed by the court.

In a very recent decision, the court ruled that the investors were not entitled to individually seek compensation directly from the custodian, UBS. We will briefly review this decision and will also refer to other two LuxAlpha judgments of the same day.

The main issue of this ruling is the question of plaintiffs' capacity to sue, which was, according to the court, missing in the cases at hand. The condition of capacity was considered on several levels

The March 4 2010 decision raised the problem of judicial liquidation. First, the court examined the capacity to sue in light of the bankruptcy of the investment companies LuxAlpha and LuxInvest. The court starts by reminding us that to file a lawsuit, it is necessary to have the capacity and the interest to sue. However, the two notions should be kept separate.

Indeed, a person may have a direct and personal interest in bringing a lawsuit, but not the capacity to act. This is why it is necessary to distinguish the nominative lawsuit for which only certain categories of persons can sue, from the common lawsuit which are opened, in principle, to all.

This issue was raised as LuxAlpha was declared to be in judicial liquidation in April 2009, after the writ of summons was served (on March 2009). In case of judicial liquidation, the court-appointed liquidator represents the company as well as the investors and creditors; as this is expressly stated in the liquidation judgment of LuxAlpha.

Consequently, only the liquidators of a company may file lawsuits in case of bankruptcy, for damages sought for a collective harm (ie, a harm suffered by all shareholders collectively as a consequence of harm suffered by the corporation).

In such a situation, the question arising is whether the single investor or shareholder sue. Shouldn't only the liquidators be enabled to sue to recover damages suffered principally by the company in the name of all shareholders and investors?

To determine the admissibility of the lawsuit, the court took into consideration the date the writ of summons was served upon the defendants.

In this judgment, as the writ was served prior to LuxAlpha entering into judicial liquidation, the investors claim was declared admissible, as no collective suit was at possible at the time.

Nevertheless, the court held that plaintiffs had to justify that their lawsuit could be considered as independent from the one company, as represented by the liquidator being able to file (ie, proving that a separate personal and individual damage was suffered by the plaintiffs alone, which was not the same as the one suffered by all shareholders).

The other two mentioned decisions deal with a writ of summons served after the bankruptcy was filed.

For service of summons that occurred after a bankruptcy is filed, the court expressly indicates that lawsuits, filed in the aim of recovering the company's assets and related to a collective damage, are exclusively the responsibility of the liquidators, so that the shareholder can only file lawsuits which are external to the bankruptcy procedure and do not aim to recover damages suffered by all other shareholders in the same manner.

The plaintiffs, on their side, claimed they had a direct action on the basis of article 36 of the law of 20 December 2002, unrelated with Luxembourg corporate law, and which would therefore not be the object of a distinction between individual lawsuits and corporate lawsuits.

The decision

The decision of March 4 2010 and the December 2002 law on collective investment funds have far-reaching consequences. The court examined in the same judgment if the shareholder had a right to file a direct action based upon article 36 of the December 20 2002 law against the custodian. The direct action could be defined as the possibility for a creditor to request the payment of the debt of his debtor directly from the debtor of his debtor.

The first indication the court gave is that a direct action constitutes a sui generis mechanism, which must be expressly indicated by the legislator to be legitimate.

Because the law of December 2002 is adapted from the European directive 85/611/CE, the court examined the Luxembourg statute in light of the European Directive to see if there were any discrepancies. According to the latter, mutual funds should be distinguished from investment companies.

The European Directive for mutual funds states in article 9 that the custodian can be held liable, directly or indirectly, through the management company. The law of 2002 states that the management company is competent to question the custodian's liability. If, after an injunction of a shareholder, the company remains inactive, the shareholder may act against the custodian directly.

However, in regards to the investment company, such as a Sicav, article 36 of the law of 2002 indicates that the custodian is responsible, according to the laws of Luxembourg, to the shareholders of the damages they suffered due to the non-fulfillment or the wrongful execution of his obligations.

This law, (which refers to the laws of the country where the investment company has its head office) contains nearly the exact same words as the European Directive, even though the Luxembourg law is a little more restrictive as the bad execution must be wrongful.

According to the plaintiff's arguments, since the European Directive remains silent on whether the lawsuit should be direct or indirect, each European country has to give to the shareholders the possibility to file a direct action against the custodian.

The court disagreed, considering that the European Directive's omission should not be interpreted in such a way. The custodian is also liable towards the investment company according to the laws of the country of the latter. And the shareholder's lawsuit against the custodian is also subject to this law and especially to the corporate laws of this country.

But does Luxembourg law allocate such a direct action to shareholders of investment companies? For this issue, the court refers to the mechanism of the direct action which requires two conditions to be fulfilled for such a lawsuit to be admissible:

  • The holder of the action must be the creditor of the main debtor
  • The sub-debtor must be the debtor of the main debtor.

The court, making reference to a French ruling of the Highest Court of Appeal (Cour de Cassation, Civ Chamber 1, 2 October 2002), rules that a shareholder only has a financial right to receive dividends and is not a creditor of the investment company. Consequently, no direct action is possible against the custodian.

Ut singuli

The decision of 4 March 2010 and the problem of the ut singuli action is also critical. In such a situation are there available remedies to the shareholders against third parties?

As the court reminds us, general corporate law should apply to Sicavs as long as it is not derogated by the 2002 law. In the two other decisions of the same day, the court added that the restrictions brought to the shareholder's right to sue are linked either to his capacity as shareholder, or to the collective proceedings underway.

However, shareholders are not entitled to exercise a legal right vested with the company. Indeed, no one can plead for someone else without a valid power of attorney. Consequently, a difference should be made between a damage suffered individually by one or a few shareholders, and a corporate damage.

The latter should result in a lawsuit filed by the company itself, further to a favourable vote by the General Assembly.

Indeed, no law allows the single shareholder to file a suit by himself, for a damage suffered by the company, in case the managers remain inactive.

While drawing up the draft of the Luxembourg law, two respected Belgian scholars, Mr Nyssens and Corbiau specifically excluded such a possibility in limited liability companies. Such a possibility is on the contrary available in France and Belgium.

However, the shareholder still has the opportunity to file a lawsuit for an individual and personal damage suffered by him (ut singuli). According to certain scholars, the individual damage which can be compensated is the one that impacts the shareholder's assets directly and which at the same time doesn't affect the assets of the company, or impoverish it.

Consequently, the admissibility of such an ut singuli lawsuit is conditioned by the proof of a personal damage by the single shareholder, and case law even makes it compulsory to prove this separate damage.

In the present litigation, the damage suffered is the loss of value of the shares of the investment company. The court qualifies this damage as a damage suffered by the company itself, the prejudice suffered by the shareholder being only a corollary of the corporate damage. Consequently, the lawsuit is inadmissible as it should be the object of a corporate lawsuit filed by the company itself. The court here refers directly to French case law.

"Regarding the additional damage, ie, the damage inflicted to the applicant's image due to the publication in the press, the court considers that in addition to proving a personal and individual prejudice, the shareholder has to prove a causal link between the alleged damage and the alleged faults."

Luxembourg courts refer, in such a situation, to the theory of the appropriate causality: the damage should be the direct consequence, the necessary continuation of the fact and the harmful act. For this, the causal chaining should be examined: if an event interfered in the chaining, a breach intervened, and the damage could not be repaired, it becomes indirect.

According to the court, the announcements in the press and the revelation of the scandal caused the alleged additional damage to the applicant. However, the latter doesn't prove that this prejudice is individual and personal and, consequently, separate from the one suffered by the company. Moreover, the applicant doesn't prove that this prejudice has a direct causal link with the alleged faults of the defendants. Therefore, this particular claim has been declared inadmissible.

These judgments are issued by the commercial court. As such, they are by law subject to appeal, which would be heard by the Court of Appeals.

About the author

Fabio Trevisan qualified in Luxembourg in 1993, New York in 1993 and Milan in 2001. He has degress from MCJ, NYU School of Law, 1992 ; Laurea in Giurisprudenza, Università degli Studi, Milan, Italy.

Trevisan's specialist practice areas include construction and real estate, general commercial, litigation and arbitration.

Trevisan has been a partner at Bonn Schmitt Steichen since 2001. He was made an associate in 1993. He speaks fluent English, French and Italian.

The firm is a member of Lex Mundi.

Contact information

Fabio Trevisan
Bonn Schmitt Steichen

22-24, rives de Clausen L-2165 Luxembourg Mailing: BP522 L-2015 Luxembourg

Tel: +352 45 58 58