Case Update: Second Circuit Breathes New Life Into Madoff Trustee's Efforts to Recover Ponzi Scheme Payments
In In re Bernard L. Madoff Investment Securities LLC, 12 F.4th 171 (2d Cir. 2021), the U.S. Court of Appeals for the Second Circuit revived litigation filed by the trustee administering the assets of defunct investment firm Bernard L. Madoff Inv. Sec. LLC ("MIS") seeking to recover hundreds of millions of dollars in allegedly fraudulent transfers made to former MIS customers and certain other defendants as part of the Madoff Ponzi scheme. The court of appeals vacated a 2019 bankruptcy court ruling dismissing the trustee's claims against certain defendants because he failed to allege that they had not received the transferred funds in "good faith."
The Second Circuit also reversed a 2014 district court decision in holding that: (i) "inquiry notice," rather than "willful blindness," is the proper standard for pleading a lack of good faith in fraudulent transfer actions commenced as part of a stockbroker liquidation case under the Securities Investor Protection Act, 15 U.S.C. §§ 78aaa et seq. ("SIPA"); and (ii) the defendants, rather than the SIPA trustee, bear the burden of pleading on the issue of good faith. The ruling, which involves test cases for approximately 90 dismissed actions, breathes new life into avoidance litigation seeking recovery of $3.75 billion from global financial institutions, hedge funds, and other participants in the global financial markets.
Good-Faith Defense to Avoidance of Fraudulent Transfers
Section 548(a)(1) of the Bankruptcy Code authorizes a bankruptcy trustee to avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor "on or within 2 years before the date of the filing of the petition" if: (i) the transfer was made, or the obligation was incurred, "with actual intent to hinder, delay, or defraud" any creditor; or (ii) the debtor received "less than a reasonably equivalent value in exchange for such transfer or obligation" and was, among other things, insolvent, undercapitalized, or unable to pay its debts as such debts matured.
Section 548(c) provides a defense to avoidance of a fraudulent transfer for a "good faith" transferee or obligee who gives value in exchange for the transfer or obligation at issue:
Except to the extent that a transfer or obligation voidable under this section is voidable under section 544, 545, or 547 of this title [dealing with a trustee's power to avoid, respectively, transfers that are voidable under state law, statutory liens, and preferential transfers], a transferee or obligee of such a transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation.
11 U.S.C. § 548(c).
Section 550(a) of the Bankruptcy Code provides that, after avoidance of a transfer, the trustee may recover the property transferred or its value from the initial transferee (or the entity for whose benefit such transfer was made) or any "immediate or mediate transferee" of the initial transferee. However, pursuant to section 550(b), the trustee may not recover the property transferred or its value from an initial or subsequent ("immediate" or "mediate") transferee "that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided."
The main difference between section 550(b) and section 548(c) is that section 550(b) provides "a complete defense to recovery of the property transferred," whereas under section 548(c), "the transaction is still avoided, but the transferee is given a lien to the extent value was given in good faith." Collier on Bankruptcy ¶ 548.09 (16th ed. 2021).
"Good faith" is not defined by the Bankruptcy Code. In determining whether it exists, some courts have applied a two-part analysis, examining: (i) whether the transferee was on "inquiry notice" of suspicious facts amounting to "red flags"; and (ii) if so, whether the transferee reasonably followed up with due diligence to determine whether a transaction may not have been bona fide. See, e.g., Horton v. O'Cheskey (In re Am. Hous. Found.), 544 Fed. App'x 516 (5th Cir. 2013); Christian Bros. High School Endowment v. Bayou No Leverage Fund LLC (In re Bayou Group, LLC), 439 B.R. 284 (S.D.N.Y. 2010).
Stockbroker Liquidations Under SIPA
Congress enacted SIPA in 1970 to deal with a crisis in customer and investor confidence and the prospect that capital markets might fail altogether after overexpansion in the securities brokerage industry led to a wave of failed brokers. The law was substantially revamped in 1978 in conjunction with the enactment of the Bankruptcy Code.
A SIPA proceeding is commenced when the Securities Investor Protection Corporation ("SIPC") files an application for a protective decree regarding one of its member broker-dealers in a federal district court. If the district court issues the decree, it appoints a trustee to oversee the broker-dealer's liquidation and refers the case to the bankruptcy court.
SIPA affords limited financial protection to the customers of registered broker-dealers. SIPC advances funds to the SIPA trustee as necessary to satisfy customer claims but limits them to $500,000 per customer, of which no more than $250,000 may be based on a customer claim for cash. SIPC is subrogated to customer claims paid to the extent of such advances. Those advances are repaid from funds in the general estate prior to payments on account of general unsecured claims.
If property in the customer estate is not sufficient to pay customer net equity claims in full, "the [SIPA] trustee may recover any property transferred by the debtor which, except for such transfer, would have been customer property if and to the extent that such transfer is voidable or void under the provisions of [the Bankruptcy Code]." SIPA § 78fff-2(c)(3).
As noted, the bankruptcy court presides over a SIPA case, and the case proceeds very much like a chapter 7 liquidation, with certain exceptions. SIPA expressly provides that "[t]o the extent consistent with the provisions of this chapter, a liquidation proceeding shall be conducted in accordance with, and as though it were being conducted under chapters 1, 3, and 5 and subchapters I and II of chapter 7 of [the Bankruptcy Code]." SIPA § 78fff(b).
This means, for example, that the automatic stay precludes the continuation of most collection efforts against the debtor or its property but not the exercise of the contractual rights of a qualifying entity (e.g., a stockbroker or a financial participant) under a financial or securities contract or a repurchase agreement. See 11 U.S.C. §§ 362(b)(6) and (7)). Similarly, the SIPA trustee has substantially all of a bankruptcy trustee's powers, including the avoidance powers. However, neither a SIPA trustee nor a bankruptcy trustee may avoid certain transfers made by, to, or for the benefit of stockbrokers, repurchase agreement participants, swap agreement participants, and certain other entities, unless the transfer was made with actual intent to hinder, delay, or defraud creditors in accordance with section 548(a)(1)(A). See 11 U.S.C. §§ 546(e), (f), and (g).
MIS was the brokerage firm that carried out Bernard Madoff's infamous Ponzi scheme by collecting customer funds that it never invested and making distributions of principal and fictitious "profits" to old customers with funds it received from new customers. After the scheme collapsed in December 2008, the U.S. District Court for the Southern District of New York issued a protective decree for MIS under SIPA.
Because the customer property held by MIS was inadequate to pay customer net equity claims, the SIPA trustee sought to recover funds that would have been customer property had MIS not transferred them to others. Certain customers had "net equity" claims, because they had withdrawn less than the full amount of their investments from their MIS accounts before entry of the protective decree. Other customers had no net equity claims, because they withdrew more money from their accounts than they had deposited. These customers received not only a return of their principal investment but also fictitious "profits" that were actually other customers' money.
In 2010, the SIPA trustee commenced hundreds of adversary proceedings in the bankruptcy court against former MIS customers and third parties seeking to avoid and recover many payments as actual and constructive fraudulent transfers under sections 548(a)(1)(A) and 548(a)(1)(B) of the Bankruptcy Code. That litigation included, among others, separate adversary proceedings against former MIS customer Legacy Capital Ltd. ("Legacy"), which received approximately $213 million in principal and net profits from MIS; two lenders ("Lenders") that received approximately $343 million in repayment of funds loaned to a "feeder fund" that invested with MIS; and Khronos LLC (together with the Lenders, "subsequent transferees"), which received approximately $6.6 million in investment management fees from Legacy.
Legacy and the subsequent transferees (collectively, "defendants") moved to withdraw the reference of the litigation to the bankruptcy court, asking the district court to decide whether SIPA and other securities laws alter the standard a trustee must meet in order to show that a defendant did not receive transfers in good faith under either section 548(c) or section 550(b). After withdrawing the reference, Judge Jed Rakoff of the U.S. District Court for the Southern District of New York held in Sec. Inv. Prot. Corp. v. Bernard L. Madoff Inv. Sec. LLC, 516 B.R. 18 (S.D.N.Y. 2014), that: (i) contrary to normal practice, a SIPA trustee bears the burden of pleading the affirmative defense of lack of good faith because placing the burden on the defendants would undercut SIPA's goal of encouraging investor confidence; and (ii) because SIPA is part of federal securities law, the trustee must plead the "willful blindness" standard applied to some securities law claims, which requires "a showing that the defendant acted with willful blindness to the truth, that is, he intentionally chose to blind himself to the red flags that suggest a high probability of fraud," rather than the "inquiry notice" standard, "under which a transferee may be found to lack good faith when the information the transferee learned would have caused a reasonable person in the transferee's position to investigate the matter further." Id. at 21 (citations and internal quotation marks omitted).
Applying that decision on remand, the bankruptcy court dismissed the trustee's actions against the defendants and denied the trustee's request for leave to amend his complaints, reasoning that the trustee could not plausibly show willful blindness. See Sec. Inv. Prot. Corp. v. Bernard L. Madoff Inv. Sec. LLC, 608 B.R. 181, 183 (Bankr. S.D.N.Y. 2019); Picard v. Legacy Capital Ltd. (In re BLMIS), 548 B.R. 13 (Bankr. S.D.N.Y. 2016). The Second Circuit accepted a direct appeal of the dismissal orders in both adversary proceedings.
The Second Circuit's Ruling
A three-judge panel of the Second Circuit vacated the bankruptcy court's orders and remanded the case below.
Writing for the panel, U.S. Circuit Judge Richard Wesley examined dictionary definitions, fraudulent transfer case law, the former Bankruptcy Act of 1898 (as amended in 1938), and "typical legal usage" at the time the Bankruptcy Code was enacted in 1978. He concluded, consistent with all other circuits that that have addressed the issue, that "the plain meaning of good faith in sections 548 and 550 of the Bankruptcy Code, embraces an inquiry notice standard," rather than the "willful blindness" standard adopted by Judge Rakoff in his 2014 ruling and applied by the bankruptcy court in dismissing the trustee's complaints. Madoff, 12 F.4th at 188.
The panel rejected the argument that federal securities laws impose a willful blindness standard for good faith in a SIPA liquidation. The panel reasoned that: (i) because SIPA is an amendment to the Securities Act of 1934 ("1934 Act"), lawmakers intended for SIPA to apply if the 1934 Act was "inapplicable or inconsistent with SIPA"; and (ii) because SIPA does not regulate fraud on the securities markets, but instead protects investors from the financial troubles of broker-dealers, "the general 'fraudulent intent' requirement in the 1934 Act is irrelevant to the specific context of a SIPA liquidation." Id. at 193.
The panel also rejected the argument that the inquiry notice standard is "'unworkable' and contrary to SIPA's goals" because inquiry notice does not "universally impose an affirmative duty to investigate." Id. at 195. According to Judge Wesley, "[T]he duty to conduct a diligent investigation arises only when a transferee is actually aware of suspicious facts that would lead a reasonable investor to inquire further into a debtor-transferor's potential fraud." The adequacy of an investigation, he wrote, "is of course, a fact-intensive inquiry to be determined on a case-by-case basis, which naturally takes into account the disparate circumstances of differently-situated transferees." Id.
In addition, the Second Circuit rejected the burden-shifting rule applied by Judge Rakoff and the bankruptcy court on remand, finding that sections 548 and 550 create affirmative defenses. Therefore, the panel explained, the defendant bears the burden of showing that it accepted a transfer in good faith, and the trustee need not plead or prove a lack of good faith.
The Second Circuit panel articulated a three-step inquiry for reviewing a good-faith defense at the pleading stage under both sections 548(c) and 550(b)(1):
First, a court must examine what facts the defendant knew; this is a subjective inquiry and not "a theory of constructive notice." … Second, a court determines whether these facts put the transferee on inquiry notice of the fraudulent purpose behind a transaction—that is, whether the facts the transferee knew would have led a reasonable person in the transferee's position to conduct further inquiry into a debtor-transferor's possible fraud. … Third, once the court has determined that a transferee had been put on inquiry notice, the court must inquire whether "diligent inquiry [by the transferee] would have discovered the fraudulent purpose" of the transfer.
Id. at 191-92 (citations omitted).
In a concurring opinion, Circuit Judge Steven Menashi questioned whether, under the circumstances of this particular case (i.e., subsequent transferees that unquestionably provided value in exchange, albeit not to MIS), the court properly applied the "Ponzi scheme presumption," under which transfers by a Ponzi scheme are deemed made with actual intent to hinder, delay or defraud solely by virtue of the existence of the scheme. According to Judge Menashi, the presumption "obscures the essential distinction between fraudulent transfers and preferences" and improperly uses fraudulent transfer law to provide equal distributions to creditors. Id. at 202 (concurring opinion).
He also observed that the presumption "necessarily" treats a creditor-transferee's inquiry notice as indicating a lack of good faith, contrary to the "normal" rule that creditors with knowledge of a debtor's fraudulent purpose are not charged with fraud as a result of that knowledge. "It may be that there are better arguments for the Ponzi scheme presumption," Judge Menashi wrote, "but consideration of that issue must await an appropriately contested case." Id. at 204.
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