Suit Claims S.E.C. Failed to Detect Madoff Scheme

Two victims of Bernard L. Madoff’s huge Ponzi scheme sued the Securities and Exchange Commission on Wednesday, saying that the agency’s failure to detect the fraud years ago contributed to their financial losses. Echoing complaints that other victims have made for months, the two plaintiffs argued in the lawsuit that they would not have fallen prey to the fraud if the government had “simply done its job”

and if the commission had not “closed its eyes to Madoff’s obvious crimes.”

The lawsuit, filed in federal court in Manhattan, is aimed at forcing the commission to repay $2.4 million lost by the two plaintiffs — Phyllis Molchatsky, a disabled retiree, and Stephen Schneider, a doctor nearing retirement, both residents of New York. They had previously demanded compensation through administrative complaints to the commission, which have been denied.

“Based on our initial understanding, we believe there is no merit to the complaint,” said John Heine, a spokesman for the commission.

The lawsuit, filed by lawyers with Herrick, Feinstein in New York, faces a significant fight because the legal doctrine of sovereign immunity makes it extremely difficult to sue a government agency for the consequences of its official activity.

Lawyers for the two victims acknowledged that the doctrine might prevent litigation arising from the commission’s discretionary decisions, formal policies and rule-making. But they assert that the doctrine does not shield the S.E.C. from the consequences of “serial, gross negligence” in carrying out its day-to-day duties.

“The S.E.C. staff who investigated Madoff from time to time were not crafting policy or making rules,” the complaint asserted. Rather, it said, the staff members were carrying out their routine obligations to investigate numerous tips and warnings about Mr. Madoff and simply “botched all of them.”

The complaint draws heavily on a report by the commission’s inspector general, released in August. That report identified dozens of hapless errors, faulty procedures, inaccurate legal interpretations and inept staff work that marred the commission’s numerous failed investigations of Mr. Madoff over a 16-year period beginning in 1992.

Mary L. Schapiro, who became chairwoman of the S.E.C. about six weeks after Mr. Madoff’s arrest, acknowledged those shortcomings last month but promised to undertake broad structural reforms aimed at preventing such failures in the future.

Difficult as it may be to collect damages for Madoff victims from the S.E.C., success by the plaintiffs would establish new ground rules for investors and regulators.

But any ruling against the commission will certainly be appealed to the utmost, given its potential impact in the Madoff case alone, where out-of-pocket losses are estimated to exceed $13 billion and paper losses exceed $65 billion.

The sovereign immunity challenge filed Wednesday is one of several lawsuits to arise in the Madoff scandal that have the potential to rewrite laws that have long governed Wall Street’s relationship with its customers and its regulators.

In February, a federal bankruptcy judge in Manhattan will review whether the trustee liquidating Mr. Madoff’s estate for the benefit of his victims is correctly applying the 1970 law that established the Securities Investors Protection Corporation, an industry-financed fund that provides up to $500,000 in upfront reimbursement for losses incurred in the bankruptcy of a brokerage firm.

The trustee, citing a common legal practice in Ponzi scheme cases, calculates an investor’s loss as the difference between the amount invested and the amount withdrawn over time. Victims whose withdrawals exceed their initial investments — who have no valid claim, under the trustee’s formula — are arguing in court that their losses should be based on their final account statement from Mr. Madoff.

The trustee, Irving H. Picard, has also sued several large investors in the Madoff fund to recover money they withdrew over the years, asserting in each case that the investors “knew or should have known” that their profits were implausible and most likely fictional.

Several securities law specialists say those cases, if successful, might force professional investors to revise their assessment of the risks they would face if an apparently profitable opportunity turned out to be fraudulent.