Investors in the Bernard Madoff Ponzi scheme will not have more liability for having suspicions and conducting investigations to determine whether there was fraud, thanks to an opinion by Bankruptcy Judge Stuart M. Bernstein of Manhattan.
Based on a litany of decisions from District Judge Jed Rakoff and the Second Circuit since the Madoff liquidation began in 2008, customers are liable for paying back principal investments received within six years before bankruptcy if they had “actual knowledge” there was a Ponzi scheme. More specifically, Judge Bernstein said in his March 14 decision that actual knowledge means the customer knew “that there were no actual securities transactions being conducted.”
Although the trustee can recover fictitious profits paid within two years of bankruptcy even if the customer did not know there was fraud, the trustee can recover all payments of principal and fictional profits going back six years as a consequence of Section 548(c) if the customer lacked “subjective good faith.” In other words, the customer must have “turned a blind eye to facts that suggested a high probability of fraud,” the standard established by District Judge Rakoff.
Willful blindness, Judge Bernstein said, means that the customer “must subjectively believe that there is a high probability” of fraud and “must take deliberate actions to avoid learning” the truth.
Judge Bernstein’s 42-page opinion dealt with an investment fund that took out almost $213 million in the six years before bankruptcy, including some $86.5 million in fictitious profits and $126.7 million in principal.
Beginning in 2003, the fund had suspicions about Madoff and conducted due diligence. Judge Bernstein said the ensuing investigation raised “strong suspicions” that there was no actual trading in securities, “but no more.” Instead, the investigation concluded that “Madoff was most likely gambling,” facts that Judge Bernstein said fall short of the pleading standard requiring the trustee to make a “plausible claim that they actually knew that Madoff was not trading securities.”
It was not plausible to allege, Judge Bernstein said, that “the average financial professional owing fiduciary duties” would “knowingly invest their money in a Ponzi scheme that is doomed to collapse.”
Furthermore, hiring an outsider to perform an investigation implies that the fund did not know there was fraud. “The only plausible explanation is that like everyone else that Madoff fooled, [the outside investigator] did not uncover in real time what the trustee and everyone else discovered with the aid of hindsight,” the judge said.
Consequently, the trustee’s complaint failed to plausibly allege that the fund had actual knowledge of fraud. With regard to willful blindness, the complaint satisfied the first prong requiring a strong suspicion. The complaint failed to satisfy the second requirement, turning a blind eye, because the fund hired an outsider to conduct due diligence.
The fund is not entirely out of the woods, because Judge Bernstein did not dismiss counts in the complaint alleging receipt of $86.5 million in fictitious profits within two years of bankruptcy under Section 548(a)(1)(A).
Judge Bernstein’s decision to insulate a suspicious investor from greater liability is based on the notion, supported by authority, that people do not invest in what they know are Ponzi schemes. Following dictates in decisions by District Judge Rakoff, the March 14 opinion also draws a roadmap for someone who is profiting from a suspected Ponzi scheme but wants to avoid greater liability. The investor in that situation should conduct an investigation and leave behind a paper trail with no more than suspicions about fraud.
A suspicious investor in a Ponzi scheme who follows the roadmap must also be sure to withdraw everything more than two years before bankruptcy.