By November 21, 2022 No Comments

In recent months, the bankruptcy judge presiding over the wreckage of the mammoth Bernard Madoff Ponzi scheme has been routinely denying motions to dismiss by investors in so-called offshore feeder funds who were subsequent transferees of fraudulent transfers by Madoff. Principally, investors in feeder funds contended unsuccessfully in bankruptcy court that the transfers to them were immune from attack under the so-called safe harbor in Section 546(e).

In an opinion on November 3, District Judge Jed S. Rakoff of New York denied motions by several feeder fund customers for the allowance of an interlocutory appeal. The decision hastens trials in 58 lawsuits where the trustee is aiming to recover $1.8 billion.

The Feeder Fund Investors

Offshore feeder funds were among Madoff’s larger investors. The feeder funds took in money from their own investors, which they turned over to Madoff. Typically, the feeder funds invested almost everything with Madoff.

When the fraud surfaced, Madoff’s business was thrown into a liquidation in New York in 2008 under the Securities Investor Protection Act, which incorporates large swaths of the Bankruptcy Code, including the ability to mount fraudulent transfer suits. The feeder funds went into liquidations abroad.

The Madoff trustee had fraudulent transfer claims against the feeder funds because they received money stolen from other customers. But because the feeder funds were largely dry holes, the Madoff trustee sued investors in the feeder funds as subsequent transferees of fraudulent transfers. Many of the feeder fund customers were banks and financial institutions. Significantly, the Madoff trustee alleged in bankruptcy court in New York that some of the feeder funds knew or should have known that Madoff was operating a fraud.

The fraud availed the Madoff trustee of the so-called Ponzi scheme presumption, which essentially allows the avoidance of initial transfers to the feeder funds as fraudulent transfers with “actual intent” under Section 548(a)(1)(A).

Even when the initial transferee is a financial institution, the commission of fraud with actual intent negates the initial transferee’s ability to raise the safe harbor as a defense to transfers that occurred within two years of bankruptcy. Section 546(e) says that “the trustee may not avoid a transfer that is a . . . settlement payment . . . made by or to (or for the benefit of) a . . . financial institution . . . in connection with a securities contract, . . . except under section 548(a)(1)(A) of this title.” [Emphasis added.]

Originally, the feeder fund customers hit a home run when Judge Rakoff ruled years ago that inquiry notice was insufficient to invoke the good faith defense to a fraudulent transfer. He also held that the Madoff trustee was obliged to allege facts in the complaints to negate the good faith defense.

The Second Circuit reversed in August 2021. Picard v. Citibank, N.A. (In re Bernard L. Madoff Investment Securities LLC), 12 F. 4th 171 (2d Cir. 2021). To read ABI’s report, click here.

By virtue of the reversal, the Second Circuit reinstated about 90 lawsuits against global financial institutions, hedge funds and other participants in the global financial markets. The decision allowed the Madoff trustee to pursue the recovery of an additional $3.75 billion in stolen customer property.

With lawsuits revived in bankruptcy court, feeder fund customers began filing motions to dismiss once again, raising other issues. Routinely, Bankruptcy Judge Cecelia Morris denied the dismissal motions. She ruled that the feeder fund customers, even though they might be financial institutions, were not protected by the safe harbor. She also rejected the notion that the feeder fund customers were protected by the safe harbor because they received payments from the feeder funds under “securities contracts.”

Several of the feeder funds filed motions to permit interlocutory appeals under 28 U.S.C. § 158(a)(3). Courts have ruled that the section permits appeals from orders that are not final if the decision involves a controlling issue of law as to which there is substantial ground for difference of opinion. Permitting an interlocutory appeal must also advance the ultimate termination of the litigation.

District Judge Rakoff denied the motions on November 3, dispensing pages of dicta on issues not yet decided by the bankruptcy.

The ‘Primary Argument’

Judge Rakoff said that the feeder fund customers’ “primary argument” advanced the idea that the safe harbor protected them because the trustee did not allege that they were aware of the fraud. He said that the argument was “easily dispensed with.”

Like Bankruptcy Judge Morris, Judge Rakoff said that the safe harbor is a defense to the initial transfer. If the safe harbor does not apply to the initial transfer, he said that “the subjective knowledge of a subsequent transferee cannot retroactively render it applicable.”

Among other things, he said there was no “atextual” or “equitable exception” to the safe harbor defense and that some of the defendants’ arguments were “bizarre.” Naturally, Judge Rakoff said that the defendants were only liable for payments from Madoff that represented fictitious profits rather than principal investments.

Securities Contracts Between the Feeder Funds and Their Customers

The feeder fund customers wanted Judge Rakoff to grant an interlocutory appeal and rule on another argument: The defendants contended that the safe harbor applied because they were receiving payments from the feeder funds under securities contracts between them and the feeder funds.

Judge Rakoff said that the “plain terms” of the safe harbor did not say that it applied only to the initial transfer. He therefore said that the safe harbor “might” apply if “it was made ‘in connection with’ a securities contract between [the feeder fund] and a third party, even though Madoff Securities was not a party to that contract.”

Judge Rakoff proceeded to write pages of dicta about the question that was not being presented to him for decision on the merits. For that matter, he said that the argument had not been presented to the bankruptcy court.

Nonetheless, Judge Rakoff said that a payment to a feeder fund customer “could” qualify as “related to” if it was “caused by” a feeder fund’s “payment obligation” to its customer. On the other hand, he said that a “withdrawal that just happens to be used in relation to a securities contract a few levels removed from the initial transfer might not suffice.”

Even if the issue was properly presented, Judge Rakoff said it did not justify an interlocutory appeal. To begin with, it did not present a controlling issue of law because the underlying facts had not been established and indeed were “fact-intensive.”

In dicta, Judge Rakoff said that the safe harbor might apply if the feeder fund’s payment from Madoff was “precipitated” by a “specific withdrawal request” by the feeder fund’s customer. He said it would be a “harder” case “if, for example, that initial transfer came as part of a regularly scheduled distribution from Madoff Securities to [the feeder fund] that occurred irrespective of any specific agreements between [the feeder fund] and its clients.”

The argument also did not represent grounds for an interlocutory appeal, Judge Rakoff said, because it would delay rather than expedite the litigation.

Denying the motions for interlocutory appeal, Judge Rakoff said that the bankruptcy court “may need, at some point, to address this argument.”