"Madoff Recovery's Next Steps After Justices' Petition Pass"
The COVID-19 virus has produced extraordinary human devastation around the globe, triggering health care and economic crises of historic proportion.
Small businesses and retail giants such as J.C. Penney Co., Hertz Global, J. Crew Group Inc. and Neiman Marcus Group have disappeared and/or filed for bankruptcy protection in some form. Virtually every industry has been negatively affected by the virus and the shutdown of the U.S. economy.
An ancillary, yet direct consequence of economic slowdowns, recessions and/or depressions — like the one America is currently enduring — is the eventual discovery, collapse and revelation of countless and, previously undiscovered Ponzi schemes, as well as other types of financial, investor and consumer frauds.[1]
Bernie Madoff was the platinum example of these phenomena. In 2008, when the subprime mortgage industry caused the housing market and many financial institutions, including then-icon Lehman Brothers Inc. to collapse, the largest Ponzi scheme in history — Madoff's $65 billion fraud — was exposed to the world as Madoff ran out of new money to fuel his Ponzi scheme and was ultimately arrested in December 2008.[2]
Incredibly, as COVID-19 decimates the economy, the Madoff recovery initiative marches on in its 12th year. The Madoff trustee and his team continue to wage crucial, legal battles to recover monies fraudulently transferred by Madoff that will undoubtedly shape the landscape of future Ponzi scheme recoveries,[3] Securities Investor Protection Act liquidation proceedings, broker-dealer collapses,[4] traditional bankruptcies, as well as international asset tracing recovery proceedings for decades to come.
A few recent developments set the stage for whether the trustee will be able to continue to achieve his prior extraordinary success.[5]
On June 1, 2020, the U.S. Supreme Court denied a petition for a writ of certiorari in HSBC Holdings et al. v. Irving H. Picard, brought by certain transferee defendants seeking the high court's appellate review of the U.S. Court of Appeals for the Second Circuit's landmark decision allowing the Madoff trustee to pursue the recovery of funds transferred by Madoff to subsequent transferees located outside the U.S.[6]
That ruling opens the door for the trustee to pursue recoveries in dozens of cases against subsequent transferees, who received transfers that originated from Bernard L. Madoff Securities.[7]
The trustee's ability to bring these many dozens of lawsuits is, however, only half the legal battle he now faces. The core legal question going forward is whether the trustee will be able to state viable claims that survive dispositive motion practice given the strict pleading and proof standards that have evolved during the course of 12 years of Madoff-related litigation.
In April, after years of procedural wrangling — and before the Supreme Court's decision denying certiorari — the trustee was granted permission by the Second Circuit to, at long last, pursue direct appeals of cases previously dismissed pursuant to a critical 2014 district court opinion articulating the good faith standard.[8]
Specifically, the trustee shall now get to appeal the very heightened pleading standards that require him to plead as part of his prima facie case specific facts with particularity that a recipient of Madoff's fraudulent transfers received monies lacking good faith, even though the Bankruptcy Code identifies good faith as an affirmative defense for which a defendant bears the burden of proof.[9]
Perhaps more importantly, the trustee has for years been saddled with having to allege, and nearly prove, at the pleading stage that a transferee defendant subjectively believed and/or was, willfully blind to the fact that Madoff was running a Ponzi scheme,[10] with no legitimate securities trading occurring.
The stark reality of this decision cannot be overstated legally: The trustee, a court-appointed actor serving a bankruptcy in equity, is being held to a higher pleading standard when seeking to recover stolen monies from a Ponzi scheme, than a private plaintiff bringing suit for monetary damages and/or punitive or treble damages under the federal securities laws.
The transferee defendants at issue in the trustee's recovery actions under the Bankruptcy Code, all claim to have acted in good faith and contend that they too were victims of Madoff's fraud, having received the disputed, fraudulent transfers without any actual or subjective knowledge or suspicion of Madoff's fraud and misconduct.
By comparison, a plaintiff in any securities fraud litigation seeking monetary damages also alleges that he or she was duped by a defendant's myriad fraudulent activity.
A plaintiff's own conduct and behavior in a federal securities fraud case is routinely measured at the pleading and proof stage against an objective, "reasonable person" standard; i.e., as to whether a plaintiff was on notice of any red flags or facts that put her on notice of possible fraud, so as to compel the plaintiff to an affirmative and legal duty of inquiry.
For example, the statute of limitations defense often raised by a securities fraud defendant traditionally focuses on whether the plaintiff was reasonably and objectively aware of public facts putting said plaintiff on notice of possible fraud, thereby triggering the beginning of the limitations period in which to assert such claims.[11]
The trustee will reasonably be expected to argue that contrary to the holding in the 2014 opinion, the fact that the trustee's action are Securities Investor Protection Act-related bankruptcy proceedings under the federal securities laws only serves to reinforce why a transferee's purported good faith should be evaluated at the pleading stage under a lesser, objective standard akin to those of securities class action and other plaintiff victims of financial fraud.
To be sure, the Madoff trustee in a Ponzi scheme seeking to recover stolen monies, for equitable ratable distribution, will argue that he is not claiming that the transferee defendant committed fraud herself and thus he should therefore not be required to plead scienter of the transferee defendant.
Rather he will almost certainly argue that a transferee defendant should not be allowed to keep other people's money if he or she had objective reasons to suspect Madoff was not legitimate and that this item is a fact inquiry not ripe for disposition on a motion to dismiss where defendant should carry the burden of proof.
As such, the trustee will also undoubtedly argue that the district court erred mightily by rejecting an objective, inquiry notice standard applied in a long line of precedents seen in bankruptcy decisions for over a century prior to the 2014 decision being appealed.[12]
The myriad and totality of dozens of objective red flags and badges of fraud relating to Madoff's scheme would form an integral part of the notice pleadings the trustee would file against foreign, subsequent transferees — red flags that under the current pleading standards are insufficient to state an actionable claim.[13]
At bottom, the Madoff trustee's chance to recover billions more for victims will depend, in large part, on winning the appeal now before the Second Circuit on the pleading burden and legal standards for evaluating the claims against transferees.
It is also a legal battle with significant implications for the many Ponzi schemes and broker-dealer collapses that are likely to unfold as a result of the COVID-19 recession.
In the absence of a reversal or adjustment to the 2014 opinion, the Madoff trustee's prior victory on his ability to sue foreign transferees may prove to be a pyrrhic one, as he will be severely hamstrung in his ability to sustain billions in claims.
If the 2014 opinion stands, it will present a challenging precedent for future recovery and cross-border asset tracing proceedings for many years to come.
Disclosure: From October 2009 through June 2018, Kornfeld served the trustee and lead counsel as first chair of the settlement and expert committees of the Madoff recovery initiative.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] Grag Bartalos, "Madoff is Behind Bars. But With Markets Infected by COVID-19, More Ponzi schemes may be unmasked." RIAIntel (April 7, 2020) ("Like we have seen with previous market-moving events, the sharp downturn in financial markets emanating from the coronavirus pandemic is likely to cause an uptick in the collapse and/or discovery of Ponzi schemes.")).
[2] On Feb. 5, 2020, Madoff sought an early release, "sentencing reduction" in the United States District Court for the Southern District of New York pursuant to 18 U.S.C. §3582 and the First Step Act for purportedly humanitarian and health reasons. https://www.ponzitracker.com/home/bernard-madoff-wants-early-compassionate-release-based-on-failing-health. Madoff's request, not surprisingly, was ultimately denied by Judge Chin (who had sentenced Madoff to 150 years, with the expectation that he would die in prison). USA v. Madoff, Case No. 09-cr-213, Doc. 230 (S.D.N.Y. June 4, 2020).
[3] See Kornfeld, Vander Velde, D'Amico, "Shockwaves from a Global Scandal: The Madoff Recovery Effort and the Legal and Economic Landscape." 24 Westlaw Journal of Bank and Lender Liability 3 (May 13, 2019).
[4] See 15 U.S.C. § 78aaa et seq.
[5] By all objective and subjective measures the Madoff Recovery Initiative has been the most successful recovery effort of all time. As of May 2020 that effort has resulted in over $14.3 billion in recoveries and settlement agreements, and an astonishing $13.3 billion in distributions back to those with approved claims. The Madoff Trustee Recovery Initiative, available at https://www.madofftrustee.com/.
[6] In re: Picard 
, 917 F.3d 85 (2d Cir. 2019). This appellate decision overturned an earlier district court opinion preventing the Trustee from seeking recovery from foreign transferees due to the principles of presumption against extra-territoriality and international comity. See Sec. Inv'r Prot. Corp. v. Bernard L. Madoff Inv. Sec. LLC (In re: Madoff Sec.), 513 B.R. 222, 226 (S.D.N.Y. 2014).
[7] Madoff would often initially transfer funds to his "customer," such as a "feeder fund," who in turn would distribute or transfer funds to the foreign fund investor/shareholder, i.e., the "subsequent transferee."
[8] Securities Investor Protection Corporation v. Bernard L. Madoff Investment Securities LLC, 2014 WL 1651952 (S.D.N.Y. Apr. 27, 2014).
[9] 11 U.S.C. 548(c) ("[A] transferee or obligee of [a fraudulent] 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.").
[10] In this context willful blindness has been described as red flags that the defendant was aware of the fact in dispute and consciously avoided confirming that fact. See, e.g., SIPC v. Bernard L. Madoff Inv. Securities ("Good Faith Decision"), 516 B.R. 18, 21 (S.D.N.Y. 2014) ("'good faith' requires a showing that a given 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'") (citing Picard v. Katz , 462 B.R. 447 (S.D.N.Y. 2011)); SIPC v. Citibank, N.A. , et al.,608 B.R. 181, 196 (Bankr. S.D.N.Y. 2019); Picard v. Legacy Capital Ltd ., et al., 548 B.R. 13, 38 (Bankr. S.D.N.Y. 2016).
[11] See, e.g., FHFA v. Nomura Holding America, Inc. , 873 F. 3d 85, at 120-22 (2d Cir. 2017) (applying an objective inquiry notice standard to determine when the statute of limitations begins to run for a securities fraud plaintiff); Schiro v. Cemex, S.A.B. de C.V., 2020 WL 635705, at *4-5 (applying an objective inquiry notice standard in a securities fraud suit and holding that the statute of limitations began to run against the plaintiffs when an SEC Press Release regarding a probe into the issuer put the plaintiffs on inquiry notice with respect to the potential fraud of the issuer and its management).
[12] In his Memorandum of Law to the Southern District of New York in Katz, the Trustee cited a litany of cases going back centuries, and covering courts from New York to Ohio to Florida stating essentially the same rule with respect to the good faith: If a transferee is presented with facts that would put a reasonable investor on notice that a potential fraud is amiss, that transferee has a duty to diligently investigate. The Trustee continues, stating, "[a]n objective, reasonable investor standard applies to both the inquiry notice and the diligent investigation components of the good faith test." It would seem that this objective standard of inquiry notice, as it applies to a good faith transferee of a fraudulent transfer, was as settled as any legal doctrine can be. See Trustee's Supplemental Memorandum of law in Further Opposition to the Sterling Defendants' Motion to Dismiss the Amended Complaint or, in the Alternative, for Summary Judgment, filed on July 22, 2011 in Picard v. Katz, 462 B.R. 447 (S.D.N.Y. 2011).
[13] The application of the subjective, pleading burden requiring the Trustee to plead with heightened specificity and particularity that a transferee defendant was willfully blind to Madoff's fraud has been met with harsh results. See, e.g., SIPC v. Citibank, N.A., et al.,608 B.R. 181, 200 (Bankr. S.D.N.Y. 2019) (holding that, despite the Trustee's allegations that the defendants were "reckless and deliberately indifferent to" the risk that Madoff was not actually trading securities, the Trustee failed to meet his burden of subjective willful blindness to the fraud); Picard v. Legacy Capital Ltd, et al., 548 B.R. 13, 18, 29-35 (Bankr. S.D.N.Y. 2016) (holding that the Trustee failed to carry his burden despite alleging that the defendants had investigated Madoff's trading patterns and concluded that Madoff's purported trading volume and timing was unsupportable by market evidence); Picard v. BNP Paribas S.A., et al., 594 B.R. 167, 180-85 (Bankr. S.D.N.Y. 2018) (granting motion to dismiss notwithstanding allegations that certain BNP Paribas, S.A. affiliates continued to lend to Madoff even after cutting off its feeder fund relationship with Madoff as a result of fraud concerns); but see In re: BLMIS ;("Kingate"), 2015 WL 4734749, at *4-10 (S.D.N.Y August 11, 2015) (denying motion to dismiss given allegations that defendants eschewed their strict due diligence standards in the face of evidence that Madoff's returns were nearly statistically impossible).