David J. Onorato & David Y. Livshiz.
David J. Onorato & David Y. Livshiz. ()

Irving Picard, the trustee ap-pointed under the Securities Investor Protection Act (SIPA) to liquidate Bernard Madoff’s firm, Bernard L. Madoff Investment Securities LLC (BLMIS), has brought more than 100 lawsuits1 seeking, in the aggregate, billions of dollars in transfers from defendants whom the trustee alleges received transfers of funds that originated with BLMIS.In their motion to dismiss, filed before Judge Jed Rakoff of the Southern District of New York, defendants raised three arguments—two of which involved issues of first impression—with respect to the good-faith defense2 provided by the Bankruptcy Code:

1. In a SIPA liquidation, what is the appropriate standard governing the good faith of an initial transferee?

2. In a SIPA liquidation, what is the appropriate standard governing the good faith of a subsequent transferee? (issue of first impression).

3. In a SIPA liquidation, does the trustee have the burden of pleading facts sufficient to plausibly establish a defendant’s lack of good faith in order to survive a motion to dismiss? (issue of first impression).

In an opinion issued on April 27, 2014, in In re Madoff Securities, 12-MC-115 (JSR), Rakoff concluded that in a SIPA proceeding, the transferees’ good faith is measured by a subjective willful blindness standard. Moreover, Rakoff held that the trustee must allege facts to plausibly support the inference that the defendant took the challenged transfers with a lack of good faith. Accordingly, a defendant can succeed on a dismissal motion if the trustee fails to so allege.3


Seeking to recover funds for Madoff’s customers, the trustee sued numerous defendants who allegedly received transfers from BLMIS (the so-called “initial transferees”). In an effort to further augment potential recoveries, the trustee also sued numerous financial institutions that received transfers not from BLMIS, but from entities that invested with BLMIS (the so-called “subsequent transferees”).

Recognizing that both sets of defendants would assert the good-faith defense provided by Sections 548(c) (initial transferees) and 550(b) (subsequent transferees), many of the trustee’s complaints alleged that defendants acted with a lack of good faith. The gravamen of the trustee’s complaints was the theory that defendants lacked good faith because they had failed to investigate publicly available information that a reasonable person in their circumstances would have investigated, and which, if investigated, may have uncovered Madoff’s fraud.

Rakoff withdrew the reference from the Bankruptcy Court and requested briefing on what standard should govern the good-faith defense in a liquidation proceeding under a federal securities law—SIPA. In the briefing that followed, the trustee argued that defendants’ good faith should be evaluated under an objective inquiry notice standard otherwise used in bankruptcy proceedings. Defendants countered that their good faith should be evaluated under the subjective willful blindness standard that applies in many areas of federal securities law. Thus, defendants argued that absent a showing that they actually knew of Madoff’s fraud or intentionally blinded themselves to the alleged red flags that suggested Madoff’s fraud, they should be deemed to have acted in good faith.

A group of defendants also argued that the trustee should bear the burden of pleading that defendants had acted with a lack of good faith. In response, the trustee relied heavily on the plain language of the Bankruptcy Code, arguing that a transferee’s good faith is an affirmative defense and the trustee was therefore not obligated to allege a lack of good faith to survive a motion to dismiss.

The Decision

As an initial matter, Rakoff reaffirmed his previous ruling in Picard v. Katz,4 that, in a SIPA liquidation, the good faith of an initial transferee is measured by a willful blindness standard. In Katz, Rakoff reasoned that while an inquiry notice approach may have applicability in an ordinary bankruptcy case, “it has much less applicability…in a context of a SIPA trusteeship, where bankruptcy law is informed by federal securities laws.”

Borrowing from securities laws, Rakoff concluded that in the context of a SIPA liquidation, the good faith of an initial transferee is measured by a willful blindness standard. Rakoff noted that this was especially appropriate as an investor has “no inherent duty to inquire about his stockbroker” and “SIPA imposes no such duty.”5 Reaffirming Katz, Rakoff concluded that absent a duty to investigate, a failure to do so cannot, as a matter of law, equate to a lack of good faith.

Rakoff then considered what standard should govern the good faith of subsequent transferees—i.e. those transferees who received their transfer not from BLMIS directly but from an entity that allegedly received a transfer from BLMIS, e.g. Fairfield Sentry. Rakoff held that the good faith of subsequent transferees is also governed by a willful blindness standard. This made sense, Rakoff noted, both “as a matter of statutory construction” and because it “reflects the impracticability of imposing a heightened duty of investigation on a securities market participant” that is further removed from the failed broker than is the initial transferee.6

Finally, Rakoff considered the question of “which party bears the burden of pleading a defendant’s good faith or lack thereof.” Rakoff acknowledged, pointing to the Bankruptcy Code’s language, the trustee’s argument that “if one looks at the question simply in terms of the Bankruptcy Code…good faith appears to be an affirmative defense.” Nevertheless, he concluded that “just as SIPA affects the meaning of ‘good faith,’” “so too it affects the burden of pleading good faith or its absence.”

Rakoff then concluded that “it would totally undercut SIPA’s twin goals of maintaining marketplace stability and encouraging investor confidence if a trustee could seek to recover the investors’ investments while alleging no more than that they withdrew proceeds from their facially innocent securities account.” Accordingly, “in a SIPA proceeding,” “a defendant may succeed on a motion to dismiss by showing that the complaint does not plausibly allege that the defendant did not act in good faith.”7

Having established the standard by which defendants’ good faith will be measured, Rakoff ordered the cases returned to Bankruptcy Court to determine whether the trustee’s allegations are sufficient to avoid dismissal.


At its core, Rakoff’s decision offers defendants facing fraudulent conveyance clawback claims in SIPA proceedings a viable, logical defense. This is true whether the defendants received transfers from a broker-dealer that failed because of fraud (BLMIS) or ordinary insolvency (Lehman Brothers or MF Global).

Moreover, Rakoff’s reasoning may offer an avenue for subsequent transferee defendants in ordinary bankruptcy proceedings to seek to have their good faith measured by the willful blindness standard. Both in his recent ruling and in Katz, Rakoff noted that it made little sense to measure investors’ good faith by an inquiry notice standard because under ordinary circumstances an investor will be unable to “launch an investigation of the broker’s internal processes.”8 Rakoff noted that this logic applied even stronger to “market participants even further removed” from Madoff.9

While Rakoff’s decisions are limited to the context of a SIPA liquidation, their fundamental logic applies with equal force to clawback actions brought against subsequent transferees in ordinary bankruptcies. As Judge Frank Easterbrook recognized more than 25 years ago, subsequent transferees are not well positioned to monitor the potential debtor’s conduct and so should face a lesser burden than should initial transferees.10

It seems likely that in the future subsequent transferees sued in clawback actions will argue that—in light of their distance from the debtor—their good faith should be measured by a willful blindness standard. Whether the bankruptcy courts agree, only time will tell.

David J. Onorato is a partner in Freshfields Bruckhaus Deringer’s U.S. litigation practice, based in New York. David Y. Livhsiz is a senior associate at the firm, also based in New York.


1. In his role prior to joining Freshfields, co-author David Livshiz led the briefing and argued these issues on behalf of eight financial institution defendants.

2. The defense requires the defendant to establish that he or she received the transfer in good faith and for value. The value component of the defense was not at issue in Rakoff’s opinion.

3. Sec. Investor Prot. Corp. v. Bernard L. Madoff Inv. Sec. LLC, 2014 WL 1651952 (S.D.N.Y. April 27, 2014).

4. 462 B.R. 447 (S.D.N.Y. 2011).

5. Id. at 455.

6. BLMIS, , 2014 WL 1651952, at *4.

7. Id. at *5.

8.Katz, 462 B.R. at 455; BLMIS, 2014 WL 1651952, at *3.

9. BLMIS, 2014 WL 1651952, at *3, at * 4.

10. Bonded Financial Services v. European Am. Bank, 838 F.2d 890, 892-93 (7th Cir. 1988).