Good-Faith Transferees and the Madoff Proceedings

In Picard v. Legacy Capital Ltd.,[1] the U.S. Bankruptcy Court for the Southern District of New York recently set forth the burden of pleading fraudulent transfers in bankruptcy cases decided under the Securities Investor Protection Act (SIPA). At issue were two complaints seeking the avoidance and recovery of various transfers under the fraudulent transfer provisions of the Code and New York Debtor and Creditor Law (NYDCL). After first turning to the § 546(e) safe harbor provision, the court dismissed one of the complaints in its entirety and left only part of one count in the other complaint, which sought to avoid and recover fictitious profits pursuant to actual fraud under the Code. The court made clear that the transferee’s good faith — which, under other facts not governed by both SIPA and the Code, would be the defendant’s burden as an affirmative defense — here became part of the trustee’s burden of pleading. Specifically, the court held that the trustee failed to sufficiently plead that the transferees either had actual knowledge of, or willfully blinded themselves to, the fact that the investment arm of Madoff’s enterprise, Bernard L. Madoff Investment Securities (BLMIS), was not engaged in trading securities.

The Good-Faith Transferee in the Southern District of New York

The consideration of good faith is an “indisputably thorny inquiry” and a concept that has held a precarious place in the jurisprudence of the Southern District of New York since the beginning of the Madoff proceedings.[2] As late as 2011, courts were split on whether to require a pleading of fraudulent intent by both the transferor and the transferee, particularly in the context of actual fraud claims under the NYDCL.[3] The late Judge Lifland, who originally presided over the BLMIS bankruptcy proceedings, in fact “[a]ssumed that a transferee’s intent must be pled” in an earlier decision in this case.[4] In a later opinion decided in the Dreier LLP Ponzi scheme bankruptcy, Judge Glenn clarified that the burden of pleading transferee intent under the NYDCL was rightly placed on the defendant as an affirmative defense.[5]

Notwithstanding the prior split of authority with respect to pleading NYDCL claims, it has been settled law in this jurisdiction that the burden of pleading a transferee’s good faith under Code § 548(c) falls on the defendant and that any determinations by the court on this issue are proper only upon a full evidentiary record at the close of discovery.[6]

SIPA, the Code and the Good-Faith Transferee

A transferee’s intent impacts the Legacy court’s holding in two distinct ways. First, as a threshold matter, the court iterated prior decisions of the district court that held that the § 546(e) safe harbor provision does not apply to those investors who had actual knowledge that BLMIS was not trading any securities.[7] Should transferees have such knowledge, then they would be susceptible to actual and constructive fraudulent transfer claims under the Code and state law, as well as be open to preference liability. Second, the court held that, in his claim for actual fraud under the Code seeking recovery of both fictitious profits and principal, the trustee needed to further plead the transferee’s lack of subjective good faith, or that “the transferee turned a blind eye to facts that suggested a high probability of fraud.”[8] The court found that, in light of the fact that securities laws do not impose a duty to inquire, the proper standard was to determine what the transferee actually knew, rather than what it ought to have known.[9]

What It Means

The words of the Second Circuit Court of Appeals continue to echo throughout the BLMIS proceedings, as we are constantly reminded of “the intersection of two important national legislative policies on a collision course — the policies of bankruptcy and securities law.”[10] As courts in the Southern District of New York — up to the Second Circuit Court of Appeals — have worked to determine how good faith plays into the substance of fraudulent transfer claims, they have also had to grapple with the various and sundry ways in which fraud is committed.[11] In settling the law in this area, they have been careful to remain clear on its context, from differentiating between claims for profits and principal, to distinguishing their holdings strictly within SIPA proceedings. Although the Legacy decision is a significant victory for defendants in the BLMIS case, it should not be read to protect fictitious profits, or to have significant force and effect outside of bankruptcy cases governed by SIPA and the Code.