As an outgrowth of the mammoth Bernard Madoff Ponzi scheme, the Second Circuit will decide whether crafty lawyers can engraft foreign elements into questionable transactions to prevent trustees from recovering fraudulent transfers.
Believing that the avoiding powers under Section 548 and 550 do not have extraterritorial application, the district court in New York held that the Madoff trustee could not sue subsequent recipients of fraudulent transfers when the initial transfer was made to a transferee abroad and the initial transferee in turn forwarded the funds to someone else also abroad.
There will be a split of circuits if the Second Circuit decides that the avoiding powers do not have extraterritorial application because the Fourth Circuit has held to the contrary. Beyond the significance of the legal issues, the outcome is important because a victory by the Madoff trustee may enable him to recover several billion dollars more and inch the bankrupt estate closer to a full recovery for fraud victims.
The Feeder Fund Suits
Many Madoff investors were so-called feeder funds, and many of them were theoretically offshore. The feeder funds received investments from their customers and in turn invested with Madoff. In the cases on appeal to the Second Circuit, both the feeder funds and their investors were offshore.
Many of Madoff’s feeder funds were so-called net winners, meaning they took more cash out than they invested. Under established law in the Madoff case, customers who took out more cash than they invested are liable to return the excess as fraudulent transfers “with actual intent.”
The trustee sued the feeder funds who were net winners. The feeder funds could not satisfy judgments because they had distributed their withdrawals to their offshore investors. The trustee therefore sued the feeder fund investors as subsequent recipients of fraudulent transfers under Section 550(a)(2).
Before the bankruptcy court could rule, the foreign feeder fund investors prevailed on District Judge Jed Rakoff to withdraw the reference. Judge Rakoff proceeded to rule that the avoiding powers do not have extraterritorial application. Securities Investor Protection Corp. v. Bernard L. Madoff Investment Securities LLC (In re Bernard L. Madoff Investment Securities LLC), 513 B.R. 222 (S.D.N.Y. 2014).
Although the initial transfers to the offshore feeder funds were domestic and subject to the avoiding powers, Judge Rakoff said that the subsequent transfers from the foreign feeder funds to their foreign investors were not domestic.
To decide whether the avoiding powers reach transfers that take place abroad, Judge Rakoff began with the “longstanding principle of American law” that U.S. statutes do not apply extraterritorially absent contrary intent by Congress. He said that the origination of the funds in the U.S. did not transform “these otherwise thoroughly foreign subsequent transfers” into a “domestic application” of bankruptcy law.
After deciding there was an attempted extraterritorial application of U.S. law, Judge Rakoff inquired as to whether Congress “clearly expressed” an intent to allow application of the law abroad.
Judge Rakoff rejected the Madoff trustee’s argument based on Section 541(a) of the Bankruptcy Code and 28 U.S.C. § 1334(e)(1), which refer to property “wherever located.” He said fraudulently transferred property does not become estate property until after it is recovered. Therefore, he said, the definition of “estate property” does not show an intent by Congress to allow the trustee to sue foreigners in U.S. courts.
Even if he were wrong about extraterritoriality, Judge Rakoff also said that the suits should be dismissed on international comity. He said that foreigners “had no reason to expect that U.S. law would apply to their relationships with the feeder funds.”
Judge Rakoff remanded the suits for the bankruptcy court to process in light of his rulings. Having no alternative, the bankruptcy court dismissed the suits. The Madoff trustee appealed.
Since Judge Rakoff had already ruled, the parties agreed to a direct appeal to the Second Circuit under 28 U.S.C. § 158(d)(2). The Second Circuit accepted the direct appeal.
The Madoff Trustee’s Appeal
Madoff trustee Irving Picard filed his brief in the Second Circuit on Jan. 10.
The trustee argues that the Fourth Circuit correctly decided the extraterritoriality issue. In French v. Liebmann (In re French), 440 F.3d 145 (4th Cir. 2006), the trustee contends that the Fourth Circuit determined that “the interplay among provisions of Chapter 5 of the Bankruptcy Code shows that Congress empowered trustees to avoid transfers of property, wherever located, that would have been property of the estate but for the transfer.”
If it were otherwise, the trustee says, the avoiding powers could be “easily circumvented” by structuring transactions with foreign elements.
Even if he wins on extraterritoriality, the trustee must also convince the Second Circuit that comity does not apply.
If the Second Circuit is unwilling to create a split of circuits but is reluctant to agree with French, the appeals court has an escape hatch.
The trustee contends that the foreign feeder fund investors all knew their money was being funneled into Madoff. Conceivably, the investors’ knowledge or direction about their indirect investments with Madoff could be enough to persuade the Second Circuit that the avoiding powers are being applied domestically.
As an outgrowth of the mammoth Bernard Madoff Ponzi scheme, the Second Circuit will decide whether crafty lawyers can engraft foreign elements into questionable transactions to prevent trustees from recovering fraudulent transfers.