Almost nine years after the collapse of the largest Ponzi scheme in history, Bernard Madoff continues to establish precedents for bankruptcy law and brokerage liquidations. The latest decision from the Second Circuit reaffirms the principle that courts must disregard fictitious profits in calculating customers’ claims.
The newest decision from the Second Circuit deals with transfers from one Madoff account to another and the question of whether the transferee can benefit from fictitious profits shown in the transferor’s account. Upholding the bankruptcy court and the district court, the circuit court said “no.”
Madoff’s customers believed he was using their cash investments to purchase securities. The Ponzi scheme endured since the early 1990s because Madoff’s account statements showed that customers were consistently making gains, in good markets and bad. In reality, Madoff was only using new investors’ money to pay old customers when they wanted to withdraw some or all of their supposed profits. As a result of the financial crisis in 2008, the Ponzi scheme was exposed because more customers wanted withdrawals than Madoff could supply by duping new investors.
In the Second Circuit’s so-called net equity decision in 2011, In re BLMIS, 654 F.3d 229 (2d. Cir. 2011), cert. denied, 133 S. Ct. 24 & 25 (2012), the appeals court upheld the trustee’s methodology and ruled that a customer’s proper claim must ignore the account statements. Instead, the appeals court held that each customer was only entitled to the net equity in the account, meaning the customer’s cash investments less amounts withdrawn. The Second Circuit therefore ruled that the court must ignore fictitious profits shown on customers’ account statements, even though securities laws generally mean that account statements are sacrosanct.
The 2011 decision did not specify the method to employ when one customer transferred money or securities from one Madoff account to another Madoff account. The transferee customers argued that they should be entitled to make claims in the liquidation based on the fictitious profits shown in the transferor’s account at the time of the transfer.
Bankruptcy Judge Stuart M. Bernstein held in December 2014 that the trustee under the Securities Investor Protection Act must employ the circuit’s net equity decision in calculating the amount of a transferee’s claim.
District Judge Paul A. Engelmayer upheld Judge Bernstein in January 2016. To read ABI’s discussion of Judge Engelmayer’s opinion, click here.
Consequently, a transferee would get credit for a transfer only to the extent that the transferor had cash deposits in excess of withdrawals.
The methodology could dramatically affect the amount of a transferee’s allowed claim. As an example, Judge Engelmayer alluded to one customer who would have had a valid claim for almost $300,000 if fictitious profits in the transferor’s account were included. Using net equity, the transferee had no allowable customer claim.
Judge Engelmayer was obliged to write a 53-page opinion knocking down a plethora of arguments proffered by the customers. The circuit court did not dignify the customers’ blizzard of theories with an equally lengthy opinion. Instead, the Second Circuit issued an unsigned, nonprecedential opinion on June 1 upholding the lower courts.
In its June 1 opinion, the Second Circuit said that its “Net Equity Decision requires this court to affirm the district court’s and bankruptcy court’s approvals of the Inter-Account Method adopted by the trustee here.” The appeals court said it could not recognize the amounts shown on the transferor’s account statements for the “simple reason” that the transfers “provided no true cash infusion.” Instead, they were only “paper profits” that were “properly excluded from a customer’s ‘net equity.’”
Nailing the coffin lid more tightly shut, the appeals court said it could not “treat the transfers as having consisted of actual money being moved” from one account to another since the inter-account transfers “did not reflect real value held by [Madoff] for its customers because [Madoff] had no value beyond its customers’ cash deposits.”