Bernie Madoff’s Ponzi scheme, the biggest fraud in U.S. history, has spawned a wealth of law about liability for actually fraudulent transfers, even among recipients who did not know there was fraud. At the end of last week, Bankruptcy Judge Stuart M. Bernstein of New York plunged deeper into the recesses of Section 548(a)(1)(A) by describing when an expert can provide admissible testimony shedding light on a defendant’s “good faith” defenses.
In a series of Madoff cases from the Second Circuit and the district court in New York, the rule has been established that recipients of actually fraudulent transfers from a Ponzi scheme will not have greater liability just for harboring suspicions and conducting investigations to determine if there was fraud.
Separately, the Second Circuit held that Madoff’s so-called net winners are liable to pay back fictitious profits, or money they received within two years of bankruptcy in excess of their cash deposits, regardless of whether or not they knew there was fraud. Net winners are liable for repayment of fictitious profits received within two years of bankruptcy, because the safe harbor in Section 546(e) does not apply to claims under Section 548(a)(1)(A).
Conversely, so-called net losers have no liability under Section 548(a)(1)(A) because they only recovered their principal investments and may therefore successfully raise the defense in Section 548(c), since they gave value in return for the transfer.
However, Madoff cases have established that net losers may nonetheless be liable if the trustee can show that they lacked “good faith” under Section 548(c).
With regard to recipients who did not have actual knowledge of fraud, the district court has ruled in Madoff cases that recipients lack “subjective good faith” and are liable if they have “turned a blind eye to facts that suggested a high probability of fraud.” For ABI’s discussion of a Madoff decision on that issue, click here.
In his Dec. 22 decision, Judge Bernstein was addressing a lawsuit where the Madoff trustee is seeking to recover $280 million in withdrawals received by a net loser within two years of bankruptcy. The net loser was a so-called feeder fund. The feeder fund has acknowledged that its liability turns on its fund manager’s knowledge.
The trustee alleges that the feeder fund’s manager had reason to believe Madoff was operating a Ponzi scheme and turned a blind eye. According to the Madoff trustee, the fund lacks good faith and is thus not entitled to the defense in Section 548(c).
Previously, the Madoff trustee’s complaint survived the defendants’ motion to dismiss. With a trial in the offing, the trustee and the defendants both submitted expert reports regarding the fund manager’s good faith, or lack of it. Both sides filed motions in limine to bar the other’s expert testimony and reports. Judge Bernstein ruled on the motions in his Dec. 22 opinion.
Judge Bernstein framed the ultimate question as whether the fund manager “willfully blinded himself to the fact that Madoff was not actually trading securities.” He said that willful blindness has two prongs: “(1) the defendant must subjectively believe that there is a high probability that a fact exists and (2) the defendant must take deliberate actions to avoid learning of that fact.” Inquiry notice is not enough to bar the good faith defense.
The trustee will submit evidence to show that the fund manager saw numerous red flags, including consistent returns that outperformed the major stock averages, impossibly high volumes of options trades, and prices outside of the daily trading ranges. The trustee will also attempt to show that the fund manager was warned by two other fund managers that Madoff might be a fraud.
With regard to the admissibility of the expert reports, Judge Bernstein scoured the law under Rule 702 of the Federal Rule of Evidence, governing expert testimony. Among other things, he said that “speculation about a person’s state of mind is improper expert testimony.”
Significantly, Judge Bernstein barred expert testimony about “what constitutes appropriate” due diligence. “These issues are immaterial,” he said, because this “is not a negligence case.” Therefore, what the fund manager “‘would have’ discovered but failed to discover because of shoddy due diligence is not before the court.”
Instead, Judge Bernstein said, the case turns on whether the fund manager “entertained the subjective belief that there was a high probability that [Madoff] was not actually trading securities.” [Emphasis in original.]
Judge Bernstein said that portions of the trustee’s expert’s report are admissible because they are germane to the second prong of the willful blindness test. He said it “is important to know” what someone “should have done, because if he did not respond appropriately to specific indications that Madoff was a fraud, it may support an inference that [the fund manager] consciously turned away from those facts and any further investigation.”
Applying the same standard, Judge Bernstein barred the defendant’s expert’s report because it dealt with “the general subject of appropriate due diligence.” He also struck the defendant’s report because the expert attempted to show what the fund manager knew. In addition, the defendant’s expert “did not explain his methodology and his opinions are conclusory and devoid of analysis,” the judge said.
The Madoff trustee, Irving Picard, will be the featured luncheon speaker on Jan. 18 at ABI’s 42nd Annual Alexander L. Paskay Memorial Bankruptcy Seminar in Tampa, Fla. (register here)Click here to read ABI’s discussion of Meoli v. Huntington National Bank, 848 F.3d 716 (6th Cir. Feb. 8, 2017), the Sixth Circuit’s somewhat different approach to the good faith defense and willful blindness.