Bernie Madoff’s Ponzi scheme and its unraveling is arguably one of the greatest personal tragedies in the history of American financial markets—lives were ruined as Madoff lost his investors roughly $18 billion, according to estimates from the Securities Investor Protection Corp. The fallout from Madoff’s scheme, however, has led to many interesting legal developments. For example, earlier this year—over a decade after Madoff’s arrest—the U.S. Court of Appeals for the Second Circuit ruled on yet another controversy arising from the collapse of Madoff’s house of cards. The ruling in In re Picard, 2019 U.S. App. LEXIS 5411 (2d Cir. Feb. 25, 2019), considered the reach of the Bankruptcy Code’s fraudulent transfer mechanism and whether a trustee could properly claw back funds from foreign transferees into a U.S. bankruptcy estate. The Second Circuit’s opinion has important implications for trustees and debtors-in-possession when dealing with overseas entities in a fraudulent transfer situation and highlights the importance of balancing respect for foreign jurisdictions against the effectiveness of U.S. laws.
The dispute in In re Picard was between the trustee responsible for administering the liquidation of Bernard L. Madoff Investment Securities LLC and certain victims of Madoff’s Ponzi scheme who invested in Madoff Securities via offshore feeder funds (the appellees). By way of background, shortly after Madoff’s arrest, the Securities Investor Protection Corp. petitioned the U.S. District Court for the Southern District of New York for a protective order placing Madoff Securities into liquidation, pursuant to the Securities Investor Protection Act of 1978. Under SIPA, a trustee is appointed to ensure that “customer property” (i.e., cash and securities held by a broker or fund for the benefit of investors) is properly returned to a fund’s investors. The district court entered the protective order, appointed Irving H. Picard as trustee, and referred the case to the Bankruptcy Court for the Southern District of New York.
During the liquidation process, it came to light that certain investors had managed to withdraw funds prior to Madoff Securities’ demise. These investors, the appellees, invested their money into offshore feeder funds, which, in turn, invested in Madoff Securities. To withdraw their cash from the feeder funds, the appellees, in effect, had to withdraw funds from Madoff Securities; Madoff Securities would transfer the cash to the feeder fund which would subsequently transfer the cash back to the investor. The dispute in In re Picard revolved around the trustee’s efforts to claw back those funds from the appellees.
Under SIPA, the trustee was empowered to recover funds transferred by Madoff Securities if they would have been, but for a transfer, customer property and only to the extent that such funds were recoverable by a trustee under the Bankruptcy Code. The Bankruptcy Code, in turn, permits a trustee to claw back fraudulent transfers from an initial transferee (here, the feeder funds) through Section 550(a)(1) and from a subsequent transferee (here, the appellees) through Section 550(a)(2). The trustee’s basis for finding these transfers to be fraudulent—and thus recoverable through Section 550(a)—was Section 548(a)(1)(A) of the Bankruptcy Code, which prohibits transfers made with the actual intent to hinder, delay or defraud. Thus, the trustee argued that Sections 548 and 550 of the Bankruptcy Code, working in concert, required that the appellees, as subsequent transferees of intentional fraudulent transfers, return the cash revived from the feeder funds. While making a case for intentional fraudulent transfer may seem like an easy win for a trustee liquidating the remains of a Ponzi scheme, the feeder funds added a complicating wrinkle. These feeder funds were based outside the United States and themselves had currently pending liquidation proceedings in the British Virgin Islands, Bermuda and the Cayman Islands. Thus, the district court (which withdrew reference from the Bankruptcy Court), ultimately ruled against the trustee, finding that the presumption against extraterritoriality limited the scope of Section 550(a)(2) from reaching transfers from one foreign entity to another and that, further, international comity principles limited Section 550(a)(2)’s scope on these facts. After remanding back to the Bankruptcy Court, the trustee’s avoidance actions were dismissed. The trustee appealed to the Second Circuit.
The Second Circuit disagreed with the district court’s analysis on both points and, in doing so, provided great insight on the topics of the Bankruptcy Code’s fraudulent transfer mechanism, the presumption against extraterritoriality and international comity.
First, the court addressed the presumption against extraterritoriality, which is a canon of statutory construction providing that without clearly expressed congressional intent to the contrary, federal laws shall be construed to have only domestic application. Actions may proceed if the statute indicates an international reach or the case involves domestic conduct. The court ultimately found that the trustee’s avoidance actions encompassed domestic conduct, notwithstanding the foreign feeder funds’ involvement. In making this determination, the court had to identify the “focus” of Section 550(a) of the Bankruptcy Code. Applying U.S. Supreme Court precedent, as set forth in WesternGeco v. ION Geophysical, 138 S. Ct. 2129 (U.S. 2018), the court explained that the location of the conduct relevant to the statute’s focus determines whether the statute seeks to regulate domestic or foreign conduct. Importantly, the court ruled that while Section 550(a) provided the actual ability of the trustee to recover funds, the underlying basis for such recovery was the fraudulent transfers themselves, which were governed by Section 548(a). Thus, the court determined that it had to read both sections in tandem to discover the proper focus of Section 550(a) and, thereby, whether the conduct at issue was foreign or domestic. Looking at Section 548(a)(1)(A), the Second Circuit ruled that the statute focused on protecting a debtor’s other creditors vis-à-vis a fraudulent transfer and its language focuses on a transfer made by a debtor—specifically, the focus is the initial transfer from debtor to transferee or, here, from Madoff Securities to the feeder funds. Section 550(a) only has teeth if there is an underlying fraudulent transfer or, as the court put it, “recovery is the business end of avoidance.” Thus, even though Section 550(a) permits recovery against subsequent transferees (here, the appellees), the statute’s focus is on the initial transfer. The court ruled “in recovery actions where a trustee alleges a debtor’s transfers are avoidable as fraudulent under Section 548(a)(1)(A), § 550(a) regulates the fraudulent transfer of property depleting the estate.” With that in mind, the court ruled that in the case at bar, the trustee was merely seeking to apply Section 550(a) to domestic conduct, i.e. Madoff Securities’ actions in making the initial transfers to the feeder funds. It was Madoff Securities’ conduct that was fraudulent under Section 548(a) and which made recovery possible under Section 550(a); the presumption against extraterritoriality does not extend to a trustee avoiding the transfer of a domestic debtor, regardless of where the initial or subsequent transferees are located.
Additionally, the court rejected the lower court’s conclusion that international comity prevented the trustee’s recovery in this case. The lower court found that prescriptive comity—the tenet that asks whether a court should presume Congress, out of respect for foreign sovereigns, limited the application of domestic law on a given set of facts—barred application of the Bankruptcy Code in the face of BVI, Bermudan and Cayman law (i.e., the jurisdictions of the feeder funds). A comity analysis required the court to balance the interests of the United States, the interests of the relevant foreign states, and the mutual interest in efficiently functioning rules of international law. The court highlighted the United States’ interest in ensuring that domestic estates could recover fraudulently transferred property as an important safeguard integral to the Bankruptcy Code’s avoidance and recovery scheme. The court also noted that the ability to recover such property benefits the U.S. economy, by making domestic entities attractive to investors and creditors, directly in accordance with the purposes of SIPA. In contrast, the court made the important distinction that, while the relevant foreign jurisdictions may have an interest in the administration of the feeder funds’ insolvencies, Madoff Securities was a domestic debtor and not a claimant in any of the foreign cases. While recovery of the money at issue could potentially affect recoveries in the feeder funds’ cases, comity analysis does not go so far as to bar application of U.S. law at the prospect of affecting foreign proceedings in which the debtor is not involved. Thus, with the United States having the greater interest, comity did not bar the application of the Bankruptcy Code’s avoidance and recovery provisions. The court ultimately overruled the lower court and remanded the case for further proceedings in accordance with the ruling—the trustee, it would seem, won the day.
In addition to the legal analysis discussed above, this ruling has several practical implications that the court calls out. First, as the court aptly notes, ruling that the appellees’ cash was outside the trustee’s reach merely because of the international nature of the feeder funds would lead to a perverse result; bad actors could easily protect fraudulently transferred funds simply by siphoning them through international conduits, thereby placing them outside of the reach of the trustee and, thus, other defrauded creditors or claimants. The Second Circuit’s ruling here—in particular the distinction that the Bankruptcy Code’s fraudulent conveyance scheme focuses on the initial transfer and, thus, almost certainly domestic conduct in a Chapter 7, 11, or 13 case—prevents fraudsters from easily moving their ill-gotten gains offshores for good. Additionally, the court took a pragmatic view of the facts surrounding Madoff Securities and investor expectations. While the feeder funds themselves were international, no rational investor could have a good faith expectation that U.S. law would not govern, or at least affect, his investment when over 90 percent of the cash in the feeder funds went directly to Madoff Securities—a U.S. entity. Finally, nowhere in the court’s analysis did it hinge its reasoning on the scale and import of the facts at bar. In particular, the court never mentioned in the comity analysis that the United States had a particular interest in the case given that the Madoff Ponzi scheme was the largest in its history by magnitudes. This suggests that the court’s reasoning will be applicable even in small cases, and equips trustees and debtors-in-possession to avoid and recover fraudulently transferred assets notwithstanding foreign transferees.
Francis J. Lawall, a partner in the Philadelphia office of Pepper Hamilton, concentrates his practice on national bankruptcy matters and workouts, including the representation of major energy and health care companies in bankruptcy proceedings and general litigation throughout the United States.
Kenneth A. Listwak is an associate in the corporate restructuring and bankruptcy practice group in the firm’s Wilmington office.