The Second Circuit's recent decision in the Madoff clawback
actions effectively limited the exposure period that "innocent
investor" defendants face for the return of transfers they
received in connection with the Bernie Madoff Ponzi scheme to two
years prior to the date of its collapse. In re BLMIS, Nos.
12-2557-bk(L), (2d Cir. Dec. 8, 2014) (hereinafter, Second
Circuit Decision).
For many individual investors who were sued by Irving H. Picard
(the "Trustee"), the trustee for Bernard L. Madoff
Investment Securities LLC ("BLMIS"), as "net
winners,"1 and thus subject to clawback actions,
that designation only heightened their misery -- and potentially
left them liable for up to six years of "fictitious
profits."2 So when District Court Judge
Rakoff in the Southern District of New York (the "District
Court") dismissed the Trustee's constructive fraudulent
conveyance claims in 2011 in Picard v. Katz, 462
B.R. 447 (S.D.N.Y. 2011) (Rakoff, J.), many "innocent
investor" defendants found some relief in the potential (and
often significant) reduction in their litigation exposure.
The District Court's dismissal of those claims was based on the
safe-harbor provisions of section 546(e) of the Bankruptcy Code,
which shields a trustee from recovering certain securities-related
payments.3
Following the Katz decision, Judge Rakoff applied
section 546(e) to dismiss the Trustee's constructive fraudulent
transfer claims in numerous other clawback actions, and the appeals
of those decisions had been consolidated at the Second Circuit
since 2012. With the issuance of the Second Circuit
Decision, clawback defendants now have certainty that the
Trustee will be limited to reaching back only two years prior to
the BLMIS liquidation to recover transfers made to recipients.
Background
The BLMIS liquidation was commenced in December
2008 when Bernie Madoff's Ponzi scheme was discovered and he
was arrested. As part of his mandate to recover assets to
distribute to BLMIS customers who suffered losses as a result of
the Ponzi scheme, the Trustee commenced nearly 1,000 lawsuits
against investors to recover fictitious profits from the "net
winners" in order to satisfy claims of "net
losers." The Trustee's claims generally were based
on constructive fraudulent transfers4 made by BLMIS as
far back as six years preceding the BLMIS liquidation, and actual
fraudulent transfers5 in the two years preceding the
liquidation. The defendants in the Katz lawsuit
withdrew the bankruptcy court reference and sought dismissal of the
Trustee's claims in the District Court, including dismissal of
claims for transfers that were protected by section 546(e).
The District Court held that the safe harbor provisions of section
546(e) applied to protect the six-year constructive fraudulent
transfer claims from recovery by the Trustee and dismissed those
claims. The District Court found that the payments at issue
were settlement payments made by a stockbroker, or otherwise
transfers made in connection with a securities contract. The
significant consequence of the Katz holding was to limit
the transfers from BLMIS that the Trustee could recover from
recipients to a two-year reach back period for actual fraudulent
transfers rather than a six-year period for constructive fraudulent
transfers.6
Following the Katz decision, hundreds of clawback
defendants withdrew the bankruptcy references and sought dismissal
of the Trustee's claims for clawback of transfers that were
made prior to the two-year period preceding the Madoff SIPA
proceeding. The District Court granted dismissal of the
constructive fraudulent transfer claims in those lawsuits as
well. The Trustee appealed the District Court decisions, and
the numerous appeals were consolidated at the Second Circuit Court
of Appeals.
The Second Circuit Decision
On appeal, the Second Circuit affirmed Judge
Rakoff's rulings under section 546(e). The Second Circuit
agreed that the safe-harbor provisions of section 546(e) applied in
these cases. Because there was no dispute that BLMIS was a
"stockbroker," the Second Circuit framed the dispositive
issue as whether the transfers the Trustee sought to claw back
either were "made in connection with a securities
contract" or were "settlement payments."
Second Circuit Decision at 13.
The court noted that section 741(7) of the Bankruptcy Code defined
"securities contact" in with "extraordinary
breadth." Id. The court then identified
the BLMIS contracts that created a securities contract for the
purposes of section 543(e): (i) customer agreements with
BLMIS, in which customers authorized BLMIS to open or maintain
accounts for the customers' benefit, (ii) trading
authorizations, in which customers appointed BLMIS to be their
agent to effect securities transactions, and (iii) option
agreements authorizing BLMIS to engage in options trading for the
customer's account. Id. at 15.
Having found the existence of a securities contract, the court
affirmed that the payments made by BLMIS were made "in
connection with" the securities contracts between the
parties. The court rejected SIPC's argument that the
payments were not made "in connection" with the
securities contracts because there was no true connection between
the payment and the contracts. Instead, the Court noted that
section 546(e) "sets a low bar for the required
relationship" and does not require the payments to be made
"pursuant to," or "in accordance with" the
securities contract. Id. at 21-22.
The court also rejected the Trustee's argument that section
546(e) should not apply because BLMIS never actually made the
securities transactions contemplated by the customer
agreements. The court correctly noted that neither sections
741(7) nor 546(e) contains a purchase or sale requirement,
rendering it irrelevant whether BLMIS actually completed securities
transactions. Id. at 17-18.
Finally, the Second Circuit affirmed on an independent basis that
the transfers were "settlement payments" under the
statute, and similarly rejected the Trustee's argument that
they could not be settlement payments because BLMIS never actually
did any securities trading.
Conclusion
The Second Circuit Decision means the Trustee's claims against "innocent investor" defendants are limited to avoidance of transfers in a two-year reachback period, rather than six years. In many cases, this represents a significant reduction in the amount that the Trustee can seek to avoid and recover.7 The Second Circuit Decision also provides extensive discussion of the court's reasoning and thus affords a degree of certainty about what the law on this matter for Madoff litigants likely will be going forward.
1 Applying the "net equity" methodology for calculating claims, the Trustee determined which investors were "net winners" and which were "net losers" based on whether those investors withdrew from their BLMIS account(s) more funds than the principal amount that was deposited into such account(s). The "net equity" methodology thus ignores fictitious profits that may have been reflected in an investor's BLMIS account statements. This methodology was approved by the Second Circuit in In re BLMIS, 654 F.3d 229 (2d Cir. 2011), cert. denied, 133 S. Ct. 24 (2012), and its application was recently confirmed by the Bankruptcy Court on December 8, 2014, with respect to transfers between multiple BLMIS accounts. In re BLMIS, Adv. Pro. No. 08-01789, Docket No. 8680 (Bankr. S.D.N.Y. Dec. 8, 2014).
2 Under section 544(a) of the Bankruptcy Code, the Trustee may utilize a state law statute of limitations for bringing avoidance actions. In New York, the statute of limitations under the Debtor and Creditor Law is six years (CPLR §213(1).
3 Section 546(e) of the Bankruptcy Code provides that a trustee "may not avoid a transfer that is a ... settlement payment ... made by [a] stockbroker ..., or that is a transfer made by [a] ... stockbroker ... in connection with a securities contract ... except under section 548(a)(1)(A) of this title." 11 U.S.C. § 546(e).
4 Constructive fraudulent transfers may be avoided and recovered under the Bankruptcy Code and the corresponding New York statutes where the recipient received the transfer without giving equivalent value. In the BLMIS lawsuits, the Trustee's theory was that fictitious profits received by investors were not made for value.
5 Actual fraudulent transfers may be avoided and recovered where the transferor made the transfers with actual intent to defraud creditors. There is a presumption of fraudulent intent for transfers made by perpetrators of a Ponzi schemes. Section 548(c) of the Bankruptcy Code, however, provides a "good faith" defense to recovery of actual fraudulent transfers where the recipient received the transfer for value and in good faith.
6 In addition, with respect to the actual fraudulent transfer claims, the Katz decision shifted to the Trustee the initial burden to allege that the defendant was willfully blind to the fraud in order to recover payments of principal. The District Court reasoned that, because payments of fictitious profits could not be made for value, defendants could not satisfy the good faith defense (discussed above at footnote 3) to actual fraudulent transfers to shield payments of fictitious profits. On the other hand, because payments of principal were made for value, the Trustee would have to allege that the defendant was willfully blind to Madoff's fraud in order to bring the transfer outside of the good faith defense and recover such transfer.
7 In status reports on pending clawback actions, the Trustee has indicated that about one-third of the lawsuits involve mostly recovery of transfers made earlier than the two-year reachback period. Thus, a substantial number of clawback defendants will benefit from the Second Circuit Decision.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.