For a second time, the Second Circuit has granted a direct appeal in the liquidation of the Bernard Madoff Ponzi scheme in New York under the Securities Investor Protection Act, or SIPA. If the trustee wins again, he may be able to recover all the cash stolen from victims.

The Madoff trustee in substance is appealing a decision made in 2014 by District Judge Jed Rakoff of Manhattan involving fraudulent transfers made with actual intent to defraud under Section 548(a)(1)(A) of the Bankruptcy Code. He imposed a higher standard of pleading and higher burden of proof on a trustee under SIPA than on an ordinary bankruptcy trustee.

According to Madoff trustee Irving Picard, Judge Rakoff made two mistakes of law by (1) requiring the trustee to plead facts with specificity in the complaint showing that the defendant lacked good faith, and (2) requiring proof that the defendant was “willfully blind” to the fraud, where “inquiry notice” is the standard in ordinary suits under Sections 548(a)(1)(A) and 550(b).

Reversing Judge Rakoff on a direct appeal last year, the Second Circuit held that Sections 548 and 550 can be applied extraterritorially to recover fraudulent transfers even if subsequent transfers occurred abroad. In re Picard, Trustee for the Liquidation of Bernard L. Madoff Investment Securities LLC, 917 F.3d 85 (2d Cir. Feb. 25, 2019). To read ABI’s report, click here.

The trustee’s successful appeal last year enabled him to resurrect about 80 lawsuits that were killed off by Judge Rakoff’s decision. The defendants in those suits have filed a petition for certiorari with the Supreme Court. The U.S. Solicitor General recommended that the high court deny certiorari and, in the process, opined that the decision by the Second Circuit was correct. To read ABI’s report, click here.

The Peculiar Ruling in SIPA Cases

The Madoff liquidation is being conducted under SIPA, which incorporates large swaths of the Bankruptcy Code, including Sections 548 and 550.

Courts have uniformly held that a Ponzi scheme by definition is a fraudulent transfer with “actual intent.” After establishing there was a Ponzi scheme, an ordinary bankruptcy trustee is only required to show under Section 548(a)(1)(A) and (c) that the defendant did not give “value” or that the defendant was not “in good faith.”

Most of the suits by the Madoff trustee were lodged against so-called “net winners,” meaning Madoff customers who took out fictitious profits. In reality, they were not receiving profits from investments. Rather, Madoff gave them money stolen from other investors because he never bought any securities with customers’ deposits.

Earlier in the Madoff liquidation, the Second Circuit held that net winners did not give value for receipt of fictitious profits and are therefore liable to pay back however much cash they took out in excess of the cash they invested. Because the return of a customer’s principal investments constitutes “value,” customers who took out less than they invested (so-called “net losers”) were not liable for receipt of a fraudulent transfer.

In test cases now going to the Second Circuit on direct appeal, the Madoff trustee had reason to believe that the defendants either knew there was fraud or ignored enough red flags to be put on so-called inquiry notice. For lack of good faith, the Madoff trustee contended in his suits that the defendants were liable even for principal they took out.

In his papers asking the Second Circuit to allow a direct appeal, the Madoff trustee argues that courts uniformly hold under Section 548(c) that good faith is an affirmative defense that the defendant must plead in an answer and prove at trial or through a motion for summary judgment. Those courts do not require an ordinary bankruptcy trustee to plead facts in the complaint showing lack of good faith.

Defendants in those and dozens of other suits prevailed on Judge Rakoff to withdraw the reference.

Judge Rakoff then ruled that a defendant’s lack of good faith is an element that a SIPA trustee must plead in the complaint with specificity as an element of fraud. In the same opinion, Judge Rakoff also held that the typical standard of inquiry notice is not sufficient. Instead, he required the SIPA trustee to plead the defendant’s “willful blindness” to fraud with specificity. SIPC v. BLMIS (In re Madoff Sec.), 516 B.R. 18 (S.D.N.Y. 2014).

Judge Rakoff reasoned that a SIPA trustee must plead lack of good faith in the complaint with particularity. Otherwise, he said, placing the burden on the defendant would undercut SIPA’s goal of encouraging investor confidence.

Informed by securities laws, Judge Rakoff required the higher standard of “willful blindness” in proving lack of good faith because a securities investor has no inherent duty to inquire about his stockbroker.

By requiring a SIPA trustee to plead and prove more than an ordinary bankruptcy trustee, the Madoff trustee argued to the Second Circuit in his petition for direct appeal that Judge Rakoff curtailed the ability of a SIPA trustee “to recover transfers for a broker’s defrauded customers [and] judicially alter[ed] the protections afforded by SIPA.” The trustee said that bankruptcy law “has never required a trustee to plead a defendant’s lack of good faith to survive a motion to dismiss.”

According to the Madoff trustee, “The district court cited no controlling authority for its conclusion that the Trustee bears the burden of pleading a transferee’s lack of good faith.” “For the first time since SIPA was enacted in 1970, and contrary to this entire body of case law,” the trustee contends that Judge Rakoff “enunciated new standards for fraudulent transfer actions in SIPA proceedings, judicially altering statutory pleading burdens and accepted standards for determining a transferee’s good faith.”

Since Judge Rakoff remanded the dozens of cases to the bankruptcy court, the bankruptcy court has now entered final judgments dismissing the trustee’s complaints in two test cases. In December, the Madoff trustee filed his petition for a direct appeal. The Second Circuit granted a direct appeal by order on April 23. The defendants consented to the direct appeal, although they do not agree with the trustee’s recitation of the law.

The Effect of Another Reversal

The Madoff trustee has already recovered $14.3 billion and made distributions representing about 69% of customers’ net equity claims. The trustee is holding $1 billion in cash toward future distributions.

If the trustee succeeds again in the Second Circuit like he did last year, he will have revived upwards of 100 lawsuits that otherwise were dead in the water. Success in the revivified adversary proceedings might conceivably enable the trustee to recover 100% of the cash that defrauded customers invested with Madoff.