MADOFF INTERNATIONAL FEEDER FUND LITIGATION: CLAWBACK CLAIMS AGAINST FOREIGN FEEDER FUNDS

Prepared by: Michael Kosnitzky, Esq., and Matthew Kaden, Esq.

Boies, Schiller & Flexner LLP, Miami

Madoff International Feeder Fund Litigation Teleconference

August 27, 2009

I. Introduction: Avoidance (“Clawback”) Claims.

A. Preference Claims.

1. Prima Facie Case - Section 547(b).1 Trustee may avoid any transfer of an interest of the debtor in property a) to, or for the benefit of, a creditor, b) for an antecedent debt, c) made while debtor was insolvent, d) on or within 90 days before the filing of the petition, e) and that enables the creditor to receive more than it would have received in Chp. 7 Liquidation.

2. Presumption of Insolvency. Trustee has burden of proof in preference case, but also has the benefit of a presumption of insolvency of the debtor for the 90-day period prior to the bankruptcy filing. § 547(f).

3. Insiders. Preferences to certain insiders extend beyond the 90-day window to reach back to one year. Section 101(31) defines insider to include the following relationships.

(a) If the debtor is a corporation—

(i) Director of the debtor;

(ii) Officer of the debtor;

(iii)Person in control of the debtor;

(iv) Partnership in which the debtor is a general partner;                                                             

1 Unless otherwise indicated, all section references are to Title 11 of the United States Code, Sec. 101 et seq.

(v) General partner of the debtor; or

(vi) Relative of a general partner, director, officer, or person in control of the debtor;

(b) If the debtor is a partnership—

(i) General partner in the debtor;

(ii) Relative of a general partner in, general partner of, or person in control of the debtor;

(iii)Partnership in which the debtor is a general partner;

(iv) General partner of the debtor; or

(v) Person in control of the debtor.

(c) Madoff feeder funds likely are not “insiders” for Bankruptcy purposes.

4. Exceptions: Trustee cannot avoid certain transfers including the following:

(a) “Substantially contemporaneous exchange.” § 547(c)(1).

(b) Trustee can’t void transfer to the extent of new value given by the transferee.

(c) Transfers in ordinary course of business. § 547(c)(2).

(d) Transfers that create a purchase money security interest in debtor’s property. § 547(c)(3).

(e) Transfers followed by subsequent advances within preference period § 547(c)(4).

(f) Statutory liens § 547(c)(6).

5. With respect to Ponzi schemes, payments of fictitious “profits” are not likely subject to avoidance under section 547, because such payments would not be on account of an antecedent debt within the meaning of section 547(b)(2). See In re Cohen, 875 F.2d 508, 510-511 (5th Cir. 1989) (transfer of fictitious profits from Ponzi scheme not voidable under section 547 because “[transferee] was not contractually entitled to receive “profits” on sales of stock that did not occur”).

B. Fraudulent Transfer Claims.

1. Clawback Period (“Reachback” Period).

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(a) Trustee can bring action under section 548(a) to avoid transfers made within 2 years prior to petition date. § 548(a)(1).

(b) Trustee can also bring action under state law pursuant to section 544(b), which provides that the Trustee may avoid any transfer voidable under applicable law by a creditor holding an unsecured claim.

(i) State fraudulent transfer statutes generally provide that transfers made within 4-6 years prior to petition date can be avoided.

(A) New York (Madoff) – Generally, 6 years.

(B) New York “Discovery Rule” – Longer of (i) 6 years or (ii) 2 years from date plaintiff discovered fraud or, with reasonable diligence, could have discovered the fraud. N.Y. C.P.L.R. § 213(8).

C. Preferences and Fraudulent Transfers Can Be Recovered from both “Initial Transferees” and “Subsequent Transferees.”

1. Prima facia claim that against a subsequent transferee requires the pleading of an initial transfer that is avoidable, and that the initial transfer was later made to – or for the benefit of – the subsequent transferee. § 550(a); Silverman v. K.E.R.U. Realty Corp., 379 B.R. 5, 28-30 (Bankr. E.D.N.Y. 2007).

II. Jurisdiction and Venue.

A. Jurisdiction.

1. Subject Matter Jurisdiction.

(a) U.S. District Courts have subject matter jurisdiction over bankruptcy matters. 28 U.S.C. § 1334(a).

(i) District courts generally refer bankruptcy matters to the U.S. bankruptcy court for that district. See 28 U.S.C. § 157(a).

(ii) Bankruptcy court jurisdiction extends to all “core proceedings”, including avoidance actions (clawbacks). 28 U.S.C. § 157(b).

2. Personal Jurisdiction.

(a) Personal jurisdiction requires: (1) reasonable notice to the defendant that an action seeking to impose a personal obligation has been commenced (i.e., the “Notice” requirement) and (2) sufficient contacts, between the defendant and the state where the action is pending, to make it reasonable and fair to require the defendant to raise a defense in that state (i.e., the “Due Process” requirement). Kulko v. California Superior Court , 436 U.S. 84, 91 (1978).

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(b) Two methods for establishing personal jurisdiction over foreign defendants in bankruptcy court:

(i) Service of process (or filing of waiver) pursuant to Fed. R. Civ. P. 4(f) (for individuals) and 4(h)(2) (for partnerships and corporations) on person who is subject to the jurisdiction of the court of the state in which the district court sits. Fed. R. Civ. P. 4(k)(1)(A), Fed. R. Bankr. P. 7004(a);

(ii) Service of process (or filing of waiver) pursuant to Fed. R. Civ. P. 4(f) (for individuals) and 4(h)(2) (for partnerships and corporations) on person who is not subject to the jurisdiction of any state court, and over whom the exercise of jurisdiction is consistent with the U.S. Constitution (i.e., where defendant has insufficient contacts with any one state, but sufficient contacts with the United States as a whole). Fed. R. Civ. P. 4(k)(2); Fed. R. Bankr. P. 7004(a), (f).

(c) To date, it appears that the Trustee is relying on the first method to establish personal jurisdiction.2 The first method requires analysis of (i) whether New York’s long-arm statute confers personal jurisdiction over the fund; and (ii) whether the “Due Process” requirement is met. R.M.R. Corp. v. Clare Bros., Ltd. (In re R.M.R. Corp.), 133 B.R. 759, 764 (Bankr. D. Md. 1991).

(i) New York Long Arm Statute – N.Y. C.P.L.R. § 302(a)(1).

(A) Confers jurisdiction where (i) the non-domiciliary “transacts any business within the state” (either directly or through an agent) and (ii) the plaintiff’s cause of action arises from the business transacted or, in other words, there is an “articulable nexus” between the business transacted and the cause of action sued upon. N.Y. C.P.L.R. § 302(a); McGowan v. Smith, 419 N.E. 2d 321, 322 (N.Y. 1981).

1. “A nondomiciliary ‘transacts business’ under CPLR § 302(a)(1) when he “purposefully avails [himself] of the privilege of conducting activities within [New York], thus invoking the benefits and protections of its laws.” CutCo Indus., Inc. v. Naughton, 806 F.2d 361, 365 (2d Cir.1986).

                                                            

2 Some complaints explicitly state the jurisdictional predicates as N.Y. C.P.L.R. § 302(a)(1) and Bankruptcy Rule 7004 (E.g., the complaint against Kingate Management Limited). Others do not explicitly state the basis, however it can be inferred that the Trustee is relying on the long-arm statute (See Complaint, Picard v. Fairfield Sentry Limited, Greenwich Sentry, L.P., and Greenwich Sentry Partners, L.P., ¶ 38).

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2. “[O]ne transaction in New York is sufficient to invoke jurisdiction, even though the defendant never enters New York, so long as the defendant’s activities here were purposeful and there is a substantial relationship between the transaction and the claim asserted.” Kreutter v. McFadden Oil Corp., 522 N.E.2d 40, 43 (1988).

3. In deciding whether assertion of long-arm jurisdiction is appropriate, New York courts consider the interest New York has in the litigation. See Picard v. Elbaum, 707 F. Supp. 144, 148-149 (S.D. N.Y. 1989) (“[D]efendants benefitted substantially from [broker’s] self-admitted fraudulent activities in New York, conduct which has injured many New York residents. Even though there is no allegation that defendants knew of Bloom’s scheme, they benefitted from his tortious activities here. In such a situation, New York has a strong interest in recouping sums fraudulently taken from its residents. Cf. Retail Software Servs., Inc. v. Lashlee, 854 F.2d 18, 24 (2d Cir.1988) (noting New York’s strong interest in providing forum for defrauded residents in determining constitutionality of asserting long-arm jurisdiction over non-resident corporate officers who benefitted by corporation’s in-state fraudulent activities).”

(B) Examples of activities sufficient to meet the “transacting business” prong include:

1. Participation in a short business meeting in New York by the defendant or his agent, if that person is also maintaining an investment account and directing the sale of securities in New York. Picard v. Elbaum, 707 F. Supp. 144, 147 (S.D. N.Y. 1989).

2. Maintaining an investment account and conducting 22 transactions in that account. Bluestone Capital Partners, L.P. v. MGR Funds Ltd., 1999 WL 322658 (S.D. N.Y. May 20, 1999).

3. Making telephone calls and sending letters to New York for the purpose of selling securities; receiving multiple letters and faxes from New York; several face-to-face meetings in New York, and designating a New York resident as a “contact” regarding certain securities. Newbro v. Freed, 337 F. Supp. 2d 428 (S.D. N.Y. 2004).

4. Long-arm jurisdiction proper because “sophisticated institutional trader knowingly enter(ed) our state ... to negotiate

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and conclude a substantial transaction.” Deutsche Bank Sec., Inc. v. Montana Bd. of Invs., 850 N.E.2d 1140 (N.Y. 2006).

5. Preliminary negotiations with parties located in New York, a contract that provided that it was “made in the State of New York and governed by the laws thereof”, and several visits to New York following execution to deal with problems in the performance of the contract. Longines-Wittnauer Watch Co. v. Barnes & Reinecke, Inc., 209 N.E. 2d 68, 74 (N.Y. 1965).

(C) Trustee’s clawback complaints allege activities similar to those described above to meet the “transacting business” requirement. For example, in its complaint against Fairfield Greenwich Group , the Trustee alleges the following activities:

1. Maintaining accounts with Madoff;

2. Entering into account agreements where performance was contemplated in New York;

3. Entering into customer agreements governed by New York law;

4. Making numerous wire transfers to a New York bank for the conducting of securities trading in New York.

See Complaint, Picard v. Fairfield Sentry Limited, Greenwich Sentry, L.P., and Greenwich Sentry Partners, L.P., ¶¶ 36-38.

(D) “Articulable Nexus” requirement: a “totality of the circumstances” test. Hoffritz for Cutlery, Inc. v. Amajac, 763 F. 2d 55, 60 (2d. Circuit 1985).

1. “While there has been much discussion of what amounts to transacting business under section 302(a)(1), there has been little analysis of when a cause of action ‘arises’ out of business so transacted.” Sole Resort Sa De Cv v. Allure Resorts Management LLC, 450 F. 3d 100 (2d. Cir. 2005).

2. Cases where no articulable nexus is found generally involve attenuated relationships between the transaction and the cause of action. E.g., Johnson v. Ward, 829 N.E. 2d 1201 (N.Y. 2005). (“Plaintiffs’ cause of action arose out of Defendant’s allegedly negligent driving in New Jersey, not from the issuance of a New York driver’s license or vehicle registration.”); Holness v. Mar. Overseas Corp., 251 A.D.2d 220, 676 N.Y.S.2d 540 (N.Y. 1998) (despite the fact that Virginia corporation entered into contract with New York

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corporation to repair its ships, injury sustained by worker repairing those ships in Virginia did not arise from the contract, and thus, Virginia corporation was not subject to personal jurisdiction in New York).

3. There appears to be some authority on which Trustee can rely in establishing an “articulable nexus”:

a. Newbro v. Freed, 337 F. Supp. 2d 428 (S.D. N.Y. 2004). Investor whose funds were used, by his investment broker, in Ponzi-like manner to cover losses sustained by other investors brought suit against these other investors on fraudulent transfer, unjust enrichment and conversion theories. Court found articulable nexus between investors’ maintenance of accounts with the broker and plaintiff’s cause of action. See also Picard v. Elbaum, 707 F. Supp. 144 (S.D. N.Y. 1989) (articulable nexus found in similar circumstances).

(E) Exercise of Personal Jurisdiction must also meet Due Process requirement.

1. In order for due process requirement to be met, the Trustee must show that the foreign defendant had certain “minimum contacts” with the forum state so that requiring the foreign defendant to defend the suit would not violate “traditional notions of fair play and substantial justice.” International Shoe Co. v. Washington, 326 U.S. 310, 316 (1945).

2. Such minimum contacts exist when the foreign defendant’s conduct in the forum state is such that he can reasonably foresee being haled into court there, Kulko v. California Superior Court, 436 U.S. 84, 97-98 (1978), or where the contacts with the state are such “that the maintenance of the suit does not offend “traditional notions of fair play and substantial justice.” International Shoe Co. v. Washington, supra, 326 U.S. at 316. Minimum contacts also exist where the defendant “purposefully avails itself of the privilege of conducting activities within the forum State, thus invoking the benefits and protections of its laws.” Hanson v. Denckla, 357 U.S. 235 (1958).

3. New York’s long-arm statute was designed to comport with the Due Process requirement, so, generally, a finding that there is personal jurisdiction under the statute means that the Due Process requirement will also be met. See Longines-Wittnauer

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Watch Co. v. Barnes & Reinecke, Inc., 209 N.E. 2d 68, 71-72 (N.Y. 1965).

(i) Analysis under long-arm statute and under Due Process clause unnecessary where transferee files proof of claim in bankruptcy court.

(A) A foreign person filing a proof of claim submits to the personal jurisdiction of the bankruptcy court because a proof of claim is analogous to a complaint whereby a plaintiff submits to the court’s jurisdiction for all counterclaims. Kline v. Ed. Zueblin (In re Am. Exp. Group Int'l Servs.), 167 B.R. 311 (Bankr. D.D.C. 1994).

(B) As such, prior to filing its SIPC claim, the feeder fund should have obtained Trustee’s agreement that the filing of a SIPC claim would not form the basis for the Trustee’s assertion of personal jurisdiction over the fund.

(ii) Query: In the absence of sufficient contacts, whether fund’s legal action against advisors or other parties in New York courts would open it up to clawback claims.

(A) Use of the New York courts is a traditional justification for the exercise of personal jurisdiction over a nonresident. Matter of Sayeh R., 693 N.E. 2d 924 (N.Y. 1997).

1. However, the mere filing of a lawsuit is grounds for asserting personal jurisdiction only where the lawsuit’s claims arise from the same transaction or out of the “same nucleus of operative facts” as the action in which it is the defendant. See Gulf Ins. Co. v. Caldor Corp., Not reported in F. Supp. 2d, 2006 WL 1586571 (S.D. N.Y. June 9, 2006), aff’d, 273 Fed.Appx. 90 (2d Cir. 2008).

a. In Gulf Ins. Co., individuals brought claims against a chapter 11 debtor for personal injuries, which resulted in a judgment against Gulf Insurance Company. Gulf then brought a declaratory judgment action seeking a declaration that it was not liable under the judgment. The court held that the individuals did not waive their defense to personal jurisdiction based on their bankruptcy claims, because the operative facts there related to personal injury, while the operative facts in the declaratory judgment action brought by Gulf related to the obtaining of the judgment and an alleged failure to give Gulf proper notice of claims. The court further supported its holding by noting the parties were not the same in the two actions. Gulf Ins. Co. at *3.

b. Gulf presents two issues for the Trustee:

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i. Same nucleus of operative facts. Would the Trustee’s claims against a fund be considered to arise out of the same set of operative facts as the fund’s claims against other defendants?

ii. Identity of the parties. The court in Gulf seemed to indicate it was necessary that the parties in the two actions be identical, although this may have only been one factor in the court’s analysis.

B. Venue. For clawback claims, venue is proper in the district court where the bankruptcy case is pending. 28 U.S.C. § 1409.

III. Intentional Fraudulent Transfers.

A. Transfer “made…with actual intent to hinder, delay or defraud. § 548(a)(1)(A).

1. Debtor’s (Madoff) intent is subject of inquiry, not transferee’s. In re: Bayou Group, LLC, 362 B.R. 624, 631 (Bkrtcy. S.D. N.Y. 2007).

2. “Badges of fraud” are evidence of actual intent:

(a) insolvency or indebtedness of the transferor;

(b) lack of consideration for the conveyance;

(c) relationship between the transferor and the transferee;

(d) pendency or threat of litigation;

(e) secrecy or concealment;

(f) departure from the usual method of business;

(g) transfer of the debtor’s entire estate;

(h) reservation of benefit to the transferor;

(i) retention by the debtor of possession of the property.

B. Intentional fraudulent transfers can be avoided in their entirety.

1. Irrelevant whether reasonably equivalent value received in exchange. See AFI Holding, Inc. v. Mackenzie, 525 F.3d 700, 707 (9th Cir. 2008).

(a) Burden is on transferee to show value and good faith in intentional fraudulent transfer cases (i.e., it is an affirmative defense – see iv., below). Id.

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IV. Constructive Fraudulent Transfers.

A. Transfers for which debtor received less than reasonably equivalent value AND debtor was (1) insolvent at the time of the transfer or became insolvent as a result of the transfer; (2) or was engaged (or about to engage) in a business or transaction, for which property remaining was unreasonably small capital, or (3) intended to incur, or believed that it would incur, debts beyond its ability to pay as they matured. § 548(a)(1)(B).

B. Constructive fraudulent transfers can be avoided in their entirety if less than reasonably equivalent value is received. See e.g., In Re: Madrid, 10 B.R. 795 (D. Nev. 1984).

1. Burden is on trustee to show that reasonably equivalent value is not received. See AFI Holding, Inc. v. Mackenzie, 525 F.3d 700, 707 (9th Cir. 2008).

V. Defenses to Fraudulent Transfer Actions.

A. “Value” and “good faith” defense (described below in Part VIII, section C).

B. Attacking any elements of a fraudulent transfer action:

1. Debtor had no interest in the property transferred

2. There was no “transfer” of property by the debtor

3. No intent to hinder, delay, etc.

4. For constructive fraud cases: (attacking elements of prima facie case)

(a) Reasonably equivalent value was given for the exchange.

(b) Showing that the debtor was solvent at the time of the transfer, that it did not plan to undertake any transactions that would leave it with unreasonably small capital, and that it did not intend to incur debts beyond its ability to pay.

C. Transferee was not “initial transferee” or “subsequent transferee” (i.e., transferee was a middleman).

1. Trustee can only bring back into the estate transfers to “initial transferees” and their immediate and mediate transferees. § 550.

(a) Transferee from debtor argues that it was “mere conduit” and exerted no dominion or control over the transfer, therefore it is not liable to restore the transfer to the bankruptcy estate. See Hooker Atlanta (7) Corp. v. Hocker (In re Hooker Investments, Inc.), 155 B.R. 332, 337 (Bankr.S.D.N.Y.1993) (“Parties that act as conduits and simply facilitate

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the transfer of funds or property from the debtor to a third party generally are not deemed initial transferees....”).

(i) Typically asserted by banks and brokers with no direct relationship with debtor – may not be appropriate defense for feeder funds who were direct investors in Madoff.

(ii) However, funds’ custodian banks may be able to successfully assert defense (the Trustee typically has named the fund’s custodian bank as a defendant in the clawback actions).

D. Certain payments by or to certain financial participants.

1. The Trustee may not avoid a “margin payment,” as defined in section 101, 741, or 761 of the Bankruptcy Code, or “settlement payment,” as defined in section 101 or 741 of the Bankruptcy Code, made by or to a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency. § 546(e).

(a) Settlement payment means “a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, or any other similar payment commonly used in the securities trade.” § 741(8).

2. May literally apply to payments made by Madoff to investors, although may be outside “spirit” of the rule.

3. Defense to constructive fraudulent transfer actions only. § 546(e). Not a defense to actual constructive fraudulent transfer actions. Id.

VI. Limitations Period on Avoidance Actions.

A. Avoidance action may not be brought after the earlier of (1) the time the bankruptcy case is dismissed; and (2) the later of (x) 2 years after the bankruptcy filing and (y) 1 year after the election of the first trustee, if elected prior to the expiration of the 2 year period described in (x). § 546(a).

VII. Collecting from Foreign Transferee Funds.

A. Foreign funds may have U.S. assets which can be attached by the Trustee in the event the Trustee obtains a judgment against a fund, however these funds also hold significant assets offshore.

B. Generally, U.S. courts cannot order foreign banks to turn over a judgment debtor fund’s offshore assets, even where the court has personal jurisdiction over the foreign bank.

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1. However, New York’s highest court has held that a judgment creditor (e.g., the Trustee) may obtain an order requiring the turnover of the judgment debtor’s (e.g., the fund’s) offshore assets if New York courts have personal jurisdiction over the foreign bank in which those assets are held. See Koehler v. Bank of Bermuda, Ltd., 12 N.Y. 3d 533, 2009 WL 1543698 (June 4, 2009).

(a) The import of the Koehler decision is significant – Many foreign banks have a New York branch – either one that is not separately incorporated, or a subsidiary with which the parent’s relationship is close enough to subject the parent to New York jurisdiction. United States Brands Corp. v. V.C. Bonerb, Inc., No. Civ-90-371E, 1990 WL 201593 at *4 (W.D.N.Y. Dec. 7, 1990).

2. On May 22, 2009, the Trustee reached a settlement with Optimal Strategic U.S. Equity Limited and Optional Arbitrage Limited to settle the Trustee’s avoidance claims against them. These funds are indirectly owned by Banco Santander, S.A., a Spanish banking corporation. The settlement was in the amount of $235 million, or 85% of the amount claimed by the trustee to be a voidable preference.

(a) The Trustee viewed this as a significant achievement given the thorny jurisdiction and collection issues the suit would have entailed. See SIPC v. Bernard L. Madoff Investment Securities LLC, Trustee’s First Interim Report, ¶ 127. However, in light of Koehler, the Trustee may have additional leverage in other negotiations, including its ongoing settlement talks with the Fairfield Greenwich Group and Kingate Management, Ltd.

VIII. The Bayou Case: Payments to Investors as Fraudulent Transfers

A. Ponzi Scheme Payments as Intentional Fraudulent Transfers.

1. “Ponzi Scheme Presumption”:

(a) Debtor is presumed to make transfer related to Ponzi scheme with actual intent to hinder, delay, etc. See, e.g., In re: Bayou Group, LLC, 362 B.R. 624, 634 (Bkrtcy. S.D. N.Y. 2007); Cuthill v. Greenmark, LLC (In re World Vision Entm't, Inc.), 275 B.R. 641, 656 (Bkrtcy. M.D. Fla. 2002).

B. Ponzi Scheme Payments as Constructive Fraudulent Transfers.

1. Prima facie case for constructive fraudulent transfer action likely not met to the extent payments did not exceed principal (i.e., transferee is a “Net Loser”), because such payments treated as transferred in exchange for reduction in transferee’s restitution and rescission claims, and therefore constitute “reasonably equivalent value.” See In re M & L Business Mach. Co., 84 F.3d 1330, 1335 (10th Cir.), cert. denied, 117 S. Ct. 608 (1996); Wyle v. Rider (In

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re United Energy Corp.), 944 F.2d 589, 596 (9th Cir. 1991); Merrill v. Abbott (In re Indep. Clearing House Co.), 77 Bankr. 843 (D. Utah 1987).

2. Prima facie case would likely be met with respect to payments of fictitious “profits” i.e., to the extent the transferee is a “Net Winner”) See In re: Bayou Group, LLC, 362 B.R. 624, 636 (Bkrtcy. S.D. N.Y. 2007); Sender v. Buchanan (In re Hedged-Investments Assocs.), 84 F.3d 1286, 1290 (10th Cir. 1996); Wyle v. C.H. Rider & Family (In re United Energy Corp.), 944 F.2d 589, 595 n.6 (9th Cir. 1994); Terry v. June, 432 F. Supp. 2d 635, 642-43 (W.D. Va. 2006); and Rieser v. Hayslip, et al. (In re Canyon Sys. Corp.), 343 B.R. 615, 643-45 (Bankr. S.D. Ohio 2006).

(a) Generally, courts have held that reasonably equivalent value cannot be given for fictitious “profits” in a Ponzi scheme.

(i) The view that reasonably equivalent value cannot be given is espoused in the following cases: In re Hedged-Investments Associates, Inc., 84 F.3d 1286, 1290 (10th Cir. 1996) In re Independent Clearing House, 77 B.R. 843, 848, 858-59 (D. Utah 1987); In re Randy, 189 B.R. 425, 441 (Bankr. N.D. Ill. 1995); In re Taubman, 160 B.R. 964, 985-86 (Bankr. S.D. Ohio 1993); In re International Loan Network, Inc., 160 B.R. 1, 12, 15 (Bankr. D.D.C. 1993).

(A) Some courts have carved out an exception where the investors had a contractual right to interest. See Daly v. Deptula (In re Carrozzella & Richardson), 286 B.R. 480 (D. Conn. 2002); Lustig v. Weisz & Assocs., Inc. (In re Unified Commer. Capital, Inc.), 260 B.R. 343 (W.D.N.Y. 2002) (each case finding reasonably equivalent value for interest paid to Ponzi scheme investors).

(B) In re: Bayou Group, LLC, 362 B.R. 624, 635-636 (Bkrtcy. S.D. N.Y. 2007) distinguished these cases on the grounds that the investment agreements in both cases provided for the payment of a stated interest rate.

C. Section 548(c): Payments May Be Retained to the Extent Received for Value AND in Good Faith.

1. “Value”

(a) Defined:

(i) “Value” means property, or satisfaction or securing of a present or antecedent debt of the debtor, but does not include an unperformed promise to furnish support to the debtor or to a relative of the debtor. § 548(d)(2)(A).

(b) Distinguished from “reasonably equivalent value”:

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(i) In Jimmy Swaggert Ministries v. Hayes (in Re Hannover Corp.), 310 F.3d 796 (5th Cir. 2002), the court noted that the “reasonably equivalent value” component of the prima facie case of a constructive fraudulent transfer focuses on whether the transferor “receive[d] enough.” “Value” inquiry under section 548(c) focuses on “how much the transferee gave” and is designed to protect the transferee from clawbacks “to the extent” he gave value.

(c) Contractual rights.

(i) Investors in fraudulent schemes may have contractual right to return of principal, such that repayments of principal are in satisfaction of a current or antecedent debt, thus meeting the definition of “value” in section 548(d)(2)(A).

(d) Fraud claim.

(i) Even where investors in fraudulent schemes have no contractual right to return of principal, the reduction in investor’s restitution and rescission claims represent the satisfaction of current or antecedent debt within the meaning of section 548(d)(2)(A). Wyle v. Rider (In re United Energy Corp.), 944 F.2d 589, 596 (9th Cir. 1991).

(e) Principal vs. profits.

(i) Courts have generally held that “value” can never be given for payment of fictitious “profits” by fraudulent scheme to investors. See Section VIII, B, 2, (a), (i), above. See also In re: Bayou Group, LLC, 362 B.R. 624, 636 (Bkrtcy. S.D. N.Y. 2007); Sender v. Buchanan (In re Hedged-Investments Assocs.), 84 F.3d 1286, 1290 (10th Cir. 1996); Wyle v. C.H. Rider & Family (In re United Energy Corp.), 944 F.2d 589, 595 n.6 (9th Cir. 1994); Terry v. June, 432 F. Supp. 2d 635, 642-43 (W.D. Va. 2006); and Rieser v. Hayslip, et al. (In re Canyon Sys. Corp.), 343 B.R. 615, 643-45 (Bankr. S.D. Ohio 2006).

(A) Exception: Some courts have held that “value” can be given for fictitious “interest” payments from Ponzi scheme where there was contractual provision for interest payments. See Daly v. Deptula (In re Carrozzella & Richardson), 286 B.R. 480 (D. Conn. 2002); Lustig v. Weisz & Assocs., Inc. (In re Unified Commer. Capital, Inc.), 260 B.R. 343 (W.D.N.Y. 2002) (each case finding reasonably equivalent value for interest paid to Ponzi scheme investors.

1. In re: Bayou Group, LLC, 362 B.R. 624, 635-636 (Bkrtcy. S.D. N.Y. 2007) distinguished these cases on the grounds that the investment agreements in both cases provided for the payment of a stated interest rate.

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2. “Good Faith”:

(a) No definition.

(i) The Bankruptcy Code does not define “good faith” as used in section 548(c). Jobin v. McKay (In re M & L Bus. Machine Co., Inc.), 84 F.3d 1330, 1335 (10th Cir. 1996).

(b) Interpreted differently than in other contexts.

(i) An absence of “good faith” in the section 548(c) context does not mean the transferee engaged in any misconduct whatsoever, or acted in “bad faith.” In re Bayou Group, LLC, 396 B.R. 810, 866 (S.D.N.Y. 2008).

(ii) The good faith requirement was not designed by Congress nor has it been interpreted by the courts to deter or sanction misconduct. Like section 547, which requires innocent creditors to refund payments of money owed to them within ninety days of a bankruptcy filing, section 548 seeks to promote a limited degree of equality of treatment among creditors by requiring redeeming investors to return transfers found to be fraudulent on the part of debtor management under subsection (a) unless the redeemers can establish that they received such transfers in “good faith” under subsection (c), i.e., without being on inquiry notice of some infirmity on the part of the transferor. Id. at 866-867.

(c) Objective standard.

(i) “Good faith” as used in section 548(c) must be determined according to an “objective” or “reasonable person” standard, and not on the subjective knowledge or belief of the transferee. In re Manhattan Inv. Fund, 397 B.R. 1, 23 (S.D.N.Y. 2007); Enron Corp. v. Avenue Special Situations Fund II, L.P. (In re Enron Corp.), 340 B.R. 180, 207 (Bankr. S.D.N.Y. 2006), rev’d on other grounds, 379 B.R. 425 (S.D.N.Y. 2007); Jobin v. McKay, 84 F.3d at 1337-38 (10th Cir. 1996).

(ii) Courts look to what the transferee objectively “knew or should have known” in questions of good faith, rather than examining what the transferee actually knew from a subjective standpoint. In re Enron Corp., 340 B.R. 180, 208 n.25 (Bankr. S.D.N.Y. 2006), rev’d on other grounds, 379 B.R. 425 (S.D.N.Y. 2007).

(iii)Transferee cannot be found to have taken a transfer in good faith “if the circumstances would place a reasonable person on inquiry of a debtor’s fraudulent purpose, and a diligent inquiry would have discovered the fraudulent purpose.” Jobin v. McKay, 84 F.3d at 1338.

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(d) Two-prong test.

(i) In In re Manhattan Inv. Fund, 397 B.R. 1, 23 (S.D.N.Y. 2007) the court held that a showing of “good faith” requires either that: (1) the transferee was not on “inquiry notice” of the debtor’s insolvency or (2) if on notice, the transferee was “diligent in its investigation” of the transferor. See also In re Bayou Group, LLC, 396 B.R. 810 (S.D.N.Y. 2008) (“Once on inquiry notice, a transferee’s failure to conduct a ‘diligent investigation’ is fatal to its ‘good faith’ defense. In order to prove ‘good faith,’ that ‘diligent investigation’ must ameliorate the issues that placed the transferee on inquiry notice in the first place. Jobin v. McKay, 84 F.3d at 1335-36 (‘the presence of any circumstance placing the transferee on inquiry as to the financial condition of the transferor may be a contributing factor in depriving the former of any claim to good faith unless investigation actually disclosed no reason to suspect financial embarrassment’).”

(A) A transferee is on “inquiry notice” if it knew or should have known of information placing it objectively “on alert that there was a potential problem with the [debtor]” such that the transferee “should have attempted to learn more.” In re Manhattan Inv. Fund, 397 B.R. 1, 23 (S.D.N.Y. 2007).

(B) “Support for a finding of inquiry notice is found in [the transferee’s] own reaction” to the information it learned. Id. Whether a transferee was on “inquiry notice” may also be informed by, inter alia, the experience or sophistication of the transferee. See Jobin v. McKay, 84 F.3d at 1338.

(C) A “diligent investigation” requires more than merely asking the transferor about the suspicious circumstances. In re Bayou Group, LLC, 396 B.R. 810, 846 (S.D.N.Y. 2008).

1. It is no defense to argue that a diligent investigation would not have uncovered the fraud (e.g., because regulators and investors did not discover the fraud over a number of many years) – the diligent investigation must be carried out in any event. In re Bayou Group, LLC, 396 B.R. 810, 849-850 (S.D.N.Y. 2008).

2. Exception to diligent investigation requirement: Where the transferee argues that the redemption request was motivated by a purpose independent of a red flag warning signal, the transferee can make a showing of good faith, even if he was on inquiry notice and did not make inquiry before redeeming, by showing, by a preponderance of the “credible objective evidence”, that his request for redemption was in fact the result

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of a good faith reason other than his knowledge of “red flags.” In re Bayou Group, LLC, 396 B.R. 810, 848-849 (S.D.N.Y. 2008).

(e) Which investors “reasonably should have known” of the fraud?

(i) Investors aware of “red flags” so as to be put on inquiry notice.

(A) “Red flags”: The test is whether the defendant requested redemption after learning of a “red flag” which, under an “objective” standard, should have put the defendant on “inquiry notice” of some infirmity in the transferor or the integrity of its management. The rule does not require that the “red flag” be of such specificity as to put the recipient on “inquiry notice” of the actual fraud, or embezzlement, or looting, or whatever ultimately proves to be the cause of loss. It is sufficient if the red flag puts the investor on notice of some potential infirmity in the investment such that a reasonable investor would recognize the need to conduct some investigation. In re Bayou Group, LLC, 396 B.R. 810, 848 (S.D.N.Y. 2008).

(B) Examples of red flags:

1. Fund principal was preparing NAV for offshore fund instead of offshore administrator. This “red flag” led feeder fund to investigate and learn that “independent auditor” who was only party reviewing NAV, was controlled by Fund principal. In re Bayou Group, LLC, 396 B.R. 810, 865 (S.D.N.Y. 2008).

2. Complaint had been filed against Fund principals, which alleged that they denied investors access to financial information to which they were entitled, and violated SEC regulations. In re Bayou Group, LLC, 396 B.R. 810, 867-868 (S.D.N.Y. 2008).

3. Promised rates of return greatly exceeding the market rate (120% per year on two investments and 468% on the two other investments); an implausible explanation by [debtor] officials as to how the company could pay these extremely high rates; [debtor’s use] of postdated checks to pay investors; and the fact that the [debtor’s] first check to [transferee] was returned. Jobin v. McKay (In re M & L Bus. Mach. Co.), 84 F.3d 1330, 1338-1339 (10th Cir. 1996).

4. Actions Brought by Madoff Trustee Allege Defendant Investors Were Aware of a Number of Red Flags. Clawback actions brought by the Trustee against foreign feeder funds, among others, allege that defendant investors were aware of a number

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of red flags that put them on inquiry notice of the fraud, including implausibly high and consistent rates of return and lack of independent oversight – which the case law above has recognized as red flags – and, also the following:

a. Inclusion of securities transactions on the account statement months after the purported trades settled.

b. Account statements showed trading of securities consistently occurring at each security’s monthly high and low.

c. Financial industry press reports which reported industry skepticism of Madoff’s ability to produce such consistently high returns.

d. Madoff asked investment managers not to disclose to their investors that they were invested in Madoff.

e. Departing from industry standard, Madoff did not provide online real-time access to accounts.

f. Madoff, purportedly the world’s largest hedge fund, was audited by a three person accounting firm located in a strip mall.

g. The fact that Madoff did not receive administrative fees or a share of the profits of its trades was atypical of an investment management arrangement.

h. Many banks and investment advisors refused to invest with Madoff because they had serious concerns that Madoff’s activities were legitimate.

i. Madoff avoided questions, or was vague in his reponse to questions.

j. Madoff paid out far higher returns to investment managers than he would have had to pay banks for investment capital.

k. Account statements reflected trades that were made outside the daily price range of a particular security.

l. On some days, Madoff purportedly made more option trades than were made on the Chicago Board Option Exchange in total.

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m. At no time did fund principals conduct a performance audit or confirm that the purported trades were actually made on the public exchanges.

n. Madoff purported to convert its entire holdings into cash before each quarterly report, which produced no benefit other than to shield its activities from scrutiny.

(f) Do subjective factors play any role in this objective “reasonable person” test? E.g., independent reasons for redeeming? Partial, rather than full, redemptions?

(i) Yes. The transferee can make a showing of good faith, even if he was on inquiry notice and did not make inquiry before redeeming, by showing, by a preponderance of the “credible objective evidence”, that his request for redemption was in fact the result of a good faith reason other than his knowledge of “red flags.” In re Bayou Group, LLC, 396 B.R. 810, 848-849 (S.D.N.Y. 2008).

(ii) Partial redemptions may be objective evidence of good faith. See In re Bayou Group, LLC, 396 B.R. 810, 852 (S.D.N.Y. 2008).

[SEE TABLE ON NEXT PAGE

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Summary of Clawback Exposure For Each Category of Ponzi Scheme Investor. INVESTOR CATEGORY

PREFERENCE (SECTION 547))

INTENTIONAL FRAUDULENT TRANSFER (SECTION 548(a)(1)(A))

CONSTUCTIVE FRAUDULENT TRANSFER (SECTION 548(a)(1)(B))

“Net Loser”* without special knowledge of any debtor infirmity

Liable to return all repayments of principal within preference period (90 days for noninsiders, 1 year for insiders).

Not liable because good faith and value defense of section 548(c) is met.

Not liable because “no reasonably equivalent value” element of Trustee’s prima facia case has not been met.

“Net Winner” without special knowledge of any debtor infirmity

Liable to return all repayments of principal within preference period (90 days for noninsiders, 1 year for insiders).

Liable only to the extent of “fictitious” profits because good faith and value defense satisfied with respect to repayments of principal.†

Liable only to the extent of “fictitious” profits because good faith and value defense satisfied with respect to repayments of principal.†

“Net Winner” with special knowledge of some debtor infirmity

Liable to return all repayments of principal within preference period (90 days for noninsiders, 1 year for insiders).).

Liable for all payments (principal and “fictitious” profits) because good faith element of good faith and value defense not satisfied.

Liable for all payments (principal and “fictitious” profits) because good faith element of good faith and value defense not satisfied.†

“Net Loser” with special knowledge of some debtor infirmity

Liable to return all repayments of principal within preference period (90 days for noninsiders, 1 year for insiders).

Liable for all payments because good faith element of good faith and value defense not satisfied.

Not liable because “no reasonably equivalent value” element of Trustee’s prima facie case has not been met.

 

                                                            

* Trustee has not pursued, and claims he will not pursue clawbacks from “net losers” in Madoff.

† Transferee may not be liable for any payments to the extent the investment agreement provided for payment of interest. See Sections VIII, B, 2, (a), (i), (A), and VIII, C, 1, (c), (i), above.

 

 

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IX. “Turnover” Claims: A Way Around Limitation on “Reachback” Periods?

A. Section 542: Provides for turnover of debtor’s property in possession of others.

1. In actions seeking recovery of payments made by Madoff (i.e., Bernard Madoff Investment Securities, LLC), Trustee has pled that such payments should be turned over to estate pursuant to section 542, because such payments constitute “property of the estate” under section 541.

(a) Under this theory, Trustee can seek recovery of all payments, even those made more than 6 years before the filing date (the period during which transfers can be avoided under New York fraudulent transfer law).

(b) From Trustee’s perspective, this is a very advantageous theory:

(i) Unlimited “reachback” period.

(ii) No “good faith and value” defense or equivalent.

2. Trustee’s Turnover Claims Face Significant Obstacles.

(a) Argument is untested in Ponzi scheme context.

(b) Transferees may be able to argue that Madoff was mere conduit through which investor money flowed, and Madoff never had any right in the invested funds that were later transferred.

(c) Generally, turnover claims require the transferee to be in possession of the transferred property at the commencement of the turnover proceedings. In re De Berry, 59 B.R. 891, 896 (E.D.N.Y. 1986). It may be difficult for Trustee to trace Madoff payments to show possession.