United States: Second Circuit Affirms Judge Rakoff's Section 546(E) Ruling In Madoff Appeal: Clawback Actions Against "Innocent Investor" Defendants Limited To Transfers Made Two Years Prior To The SIPA Proceeding

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.


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.


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.

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