Unless the Supreme Court reverses, the Second Circuit has now rejected the last nonfrivolous arguments preventing the trustee for the Bernard Madoff Ponzi scheme from recovering fictitious profits paid to customers within two years of bankruptcy.

The pertinent facts were simple, but the legal analysis was complex in the September 24 decision by Circuit Judge Robert D. Sack for the New York-based Court of Appeals.

“The Second Circuit’s well-crafted decision makes clear that provisions of the Bankruptcy Code that undermine the goal of customer protection under the Securities Investor Protection Act will not apply,” Josephine Wang told ABI. Wang is the president and chief executive of the Securities Investor Protection Corp. She commended “the Trustee and his team for their tireless pursuit of recoveries for the benefit of customers.”

The Theory for Recovery of Fictitious Profits

Madoff never bought a single share of stock with customers’ investments. Instead, he created fictitious account statements showing that his customers were earning handsome profits. When a customer sought a withdrawal, Madoff paid with money stolen from other customers, a classic Ponzi scheme.

The Ponzi scheme crashed in 2008, followed by a liquidation in bankruptcy court in New York under the Securities Investor Protection Act, 15 U.S.C. § 78aaa et seq. SIPA incorporates large swaths of the Bankruptcy Code to the extent not inconsistent with SIPA.

The Second Circuit recognizes the so-called Ponzi scheme presumption, which automatically turns customers into recipients of fraudulent transfers with “actual intent” except to the extent they have cognizable defenses. Customers who were only paid part of their principal investments in good faith received repayments of antecedent debts and therefore had defenses under Section 550(b)(1).

Customers who had recovered only part of their investments before bankruptcy were called net losers.

The Second Circuit appeal, on the other hand, involved so-called net winners, meaning customers who took more cash out of the Ponzi scheme than they had invested. The Madoff trustee sued net winners.

Through a multitude of complex litigations and appeals, the Second Circuit previously upheld the ability of the Madoff trustee to sue net winners for receipt of fraudulent transfers made with “actual intent” under Section 548(a)(1)(A). However, the trustee’s recoveries were limited to transfers made within two years of bankruptcy.

Previously, the Second Circuit had also ruled that the trustee was correctly calculating net losers’ so-called net equity claims: All of a customer’s deposits since inception of the account were weighed against all of the customer’s withdrawals. To the extent a customer took out less that he or she had invested, the customer had a net equity claim against what SIPA calls the fund of customer property. In substance, valid customer claims are paid ahead of the claims of general unsecured creditors from the fund of customer property and from advances by the Securities Investor Protection Corp.

The trustee used the same calculation to determine his fraudulent transfer recovery: He sued to recover fictitious profits taken out within two years of bankruptcy. Because Madoff never purchased any securities, the trustee calculated fictitious profits as the amount by which a customer’s withdrawals since inception exceeded the customer’s investments since inception. In other words, the trustee did not sue only to recover the excess of withdrawals made within two years of bankruptcy over cash taken out within two years of bankruptcy.

The district court granted summary judgment in favor of the trustee and allowed the calculation of fictitious profits to consider deposits and withdrawals going back to inception of the account, not just deposits and withdrawals within two years of bankruptcy. For customers in good faith because they did not know there was fraud, the trustee’s recovery was limited to withdrawals within two years of bankruptcy.

The ‘Value’ Issue in the Second Circuit

Several customers appealed to the Second Circuit. Primarily, they made two arguments: (1) With regard to the defenses under Section 548(c), the customers contended they had a defense because they gave “value” and in good faith. For these particular customers, the trustee did not challenge their good faith. That is, they did not know a Ponzi scheme was afoot. (2) The customers argued that the trustee was improperly suing to recover transfers that occurred more than two years before bankruptcy, because their contractual rights to the payments accrued more than two years before bankruptcy.

Judge Sack devoted 26 pages of his 42-page opinion to explaining the prior district and circuit court Madoff rulings that were pertinent to the new appeal. In that respect, the opinion reads like a memorandum to the Supreme Court putting the new decision in context in case the customers file a petition for certiorari.

The Customers Gave No ‘Value’

The customers argued that a prior holding by the Second Circuit means that they had given value arising from “securities entitlements” on account of the account statements they had received showing handsome but fictitious profits. Judge Katz said that his court had made no such ruling.
Even if the customers did have securities entitlements, he said “they did not have property rights to the values in excess of principal reflected there,” based on the Uniform Commercial Code.

Next, the customers argued they had contract rights based on Section 29(b) of the Exchange Act of 1934, which allows a defrauded customer to void or enforce the contract. The theory, however, would conflict with the special priority system created under SIPA, where customers are paid from the fund of customer property ahead of unsecured creditors.

The customers’ value defense, Judge Sack said, “would conflict with SIPA,” because customers with no net equity claims would come out ahead of those who had valid net equity claims.

Judge Sack went on to explain how the value defense “operates differently in a SIPA liquidation.” In an ordinary bankruptcy, he said, the value defense applies to any transfer made in exchange for value.

In a SIPA liquidation, on the other hand, a customer only has a claim against the fund of customer property related to net equity claims based on cash investments into the account. Since the transfers were not a return of customers’ principal, Judge Sack said “they were transfers of fictitious profits in excess of principal that depleted the resources of the customer property fund without an offsetting satisfaction of a debt or liability of that fund.”

Judge Sack therefore held that the customers did not give value to justify the defense in Section 548(c).

The Two-Year Limitation Didn’t Apply

A valid fraudulent transfer claim under Section 548 only allows recovery of transfers within two years of bankruptcy. By basing the claim against net winners on withdrawals since the inception of the account, the customers therefore argued that the trustee was recovering withdrawals more than two years before the filing date.

Judge Sack said that Madoff never actually purchased any securities. Thus, he said, Madoff “never generated any legitimate profits. The [customers] therefore had no rights to the transfers let alone rights that arose prior to the two-year limitation period.”

Judge Sack pointed out that the two-year limitation appears in Section 548(a)(1), but not in Section 548(c), which creates the value defense.

The customers gave no value because the trustee was suing only to recover fictitious profits, not principal investments, Judge Sack said. He then held that “the trustee’s claims under the actual fraud provision do not violate the statutory provision limiting recovery to transfers made within the two years prior to the filing of the petition.”

‘Cert’ and ‘PJI’

The customers might file a petition in the Supreme Court for certiorari. Granting the petition is unlikely because there is no circuit split, and the issue principally relates to SIPA liquidations of Ponzi schemes, which are infrequent.

The loss puts the customers at a turning point. The lawsuits against them began 10 years ago. If they do not settle now with the trustee, they face claims for prejudgment interest that could double the judgments in favor of the trustee.