Second Circuit Seems Primed to Give Extraterritorial Effect to Avoiding Powers

At oral argument in the Madoff liquidation, the Second Circuit seemed poised to reverse District Judge Jed Rakoff, who barred the trustee from recovering fraudulent transfers when the mastermind of the fraud had employed concepts borrowed from structured finance.

The Manhattan-based appeals court will decide whether Sections 548 and 550 can be used to recover fraudulent transfers where the subsequent transfer occurred abroad. In July 2014, Judge Rakoff ruled that Section 550 does not permit recovering from a subsequent foreign recipient of stolen funds, given the presumption against extraterritorial application of U.S. statutes. He also ruled that comity prevents the Madoff trustee from suing in the U.S.

If the appeals court reverses Judge Rakoff, the Madoff trustee can recover stolen property that was transferred abroad and then retransferred to someone else abroad. If, however, Judge Rakoff’s decision is upheld in the Second Circuit, there will be a split of circuits, and we expect the Madoff trustee will file a petition for certiorari in the Supreme Court.

The Fraudulent Transfers

The fraudulent transfers went like this: Bernard Madoff’s securities firm made payments to offshore feeder funds, ostensibly paying out profits on the funds’ investments or returning principal. The initial transfers to the offshore funds were actually fraudulent transfers under Section 548(a)(1)(A) because the money had been stolen from other customers.

In turn, the feeder funds made payments to their investors abroad by distributing the stolen money received from Madoff.

After discovery that Madoff had been conducting a Ponzi scheme for decades, the firm went into liquidation in New York in December 2008 under the Securities Investor Protection Act, or SIPA. A trustee was appointed under SIPA. In large part, SIPA incorporates the Bankruptcy Code together with the avoiding and recovery powers under Sections 548 and 550.

In bankruptcy court in New York, the Madoff trustee sued both the feeder funds and their investors for receipt of fraudulent transfers, because the money was stolen from other customers. In many cases, the trustee could not recover from the feeder funds themselves because they were bankrupt or had limited assets to pay a judgment. For that reason, the trustee also sued the feeder funds’ customers as subsequent recipients of fraudulent transfers under Section 550(a)(2).

Judge Rakoff’s Ruling

Before the bankruptcy judge could rule on the liability of the feeder funds’ investors as subsequent recipients of fraudulent transfers, they banded together and persuaded Judge Rakoff to withdraw the reference.

Next, the feeder fund investors argued to Judge Rakoff that U.S. fraudulent transfer law does not apply to them abroad. Judge Rakoff heard argument in September 2012 and handed down his opinion in July 2014. 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).

Judge Rakoff began his 2014 opinion by reciting 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 fraudulent transfers in the U.S. was insufficient to transform “these otherwise thoroughly foreign subsequent transfers” into a “domestic application” of bankruptcy law.

Having determined that an extraterritorial application of U.S. law was at issue, Rakoff then turned to the question of whether Congress “clearly expressed” an intent to allow application of the law abroad.

Judge Rakoff rejected the trustee’s argument based on Section 541(a), which gives the trustee control over property “wherever located.” He said that fraudulently transferred property is not “estate property” until it is recovered. Therefore, he said, congressional intent for the trustee to sue foreigners in the U.S. is not shown by the definition of “estate property.”

The trustee argued that foreigners could escape the reach of U.S. law by sending property abroad and then retransferring the property to another foreigner. Judge Rakoff rejected that policy argument.

Even if Congress intended to allow suits against foreigners, Judge Rakoff said he would still dismiss the suits on a second ground: international comity. He said that foreigners “had no reason to expect that U.S. law would apply to their relationships with the feeder funds.”

After issuing his ruling, Judge Rakoff sent the lawsuits back to bankruptcy court for further processing.

Implementing Judge Rakoff’s mandate, the bankruptcy court on remand dismissed the suits seeking $4 billion from feeder fund investors. Because Judge Rakoff had already ruled on the issues, the Second Circuit permitted the trustee to take a direct appeal.

Second Circuit Oral Argument

A panel of the Second Circuit — consisting of Circuit Judges Dennis Jacobs, Rosemary S. Pooler and Richard C. Wesley — heard oral argument for one hour on November 16.

Throughout oral argument, the panel repeatedly used a hypothetical where Madoff transferred a painting to Switzerland. Then, the initial recipient retransferred the painting to a third party, also abroad. If Judge Rakoff were correct, Judge Wesley said early in the argument that “you couldn’t avoid the transfer” to the third party.

“That makes no sense,” Judge Wesley said.

Judge Wesley ascertained that the Madoff trustee has recovered $13.3 billion, but still has a $6 billion shortfall because there are $19 billion in customer claims. On the question of comity, he said that “sounds like a substantial United States interest to me.”

Counsel for the feeder fund investors faced a dubious panel, especially Judge Wesley. He interpreted the feeder fund investors as saying that “anyone who wants to do a preference better get it offshore quick and into somebody else’s hands — so that U.S. courts can’t reach it.”

After the investors’ counsel admitted that the fraud occurred in the U.S., Judge Wesley said, “And that is the basis upon which the Trustee can vacate the transaction, is it not?”

Pressing further, Judge Wesley had the investors’ counsel admit that the trustee’s right of recovery stems from Section 548. He then said that the trustee’s right of recovery “begins and ends with 548.” Although the investors may have defenses under Section 550, he said, “I take it that 550 does have extraterritorial application.”

Later, Judge Wesley said that the stolen funds in the hands of the subsequent recipients were “encumbered” by the trustee’s fraudulent transfer claims. When counsel for the investors disagreed, Judge Wesley said, “How could that be? [The trustee] has a claim against the property, it most certainly encumbers it.” He added, “[Section] 541 clearly tells him it doesn’t matter where the property is located. It’s encumbered.”

Going back to the hypothetical about a stolen painting in Switzerland, Judge Wesley asked the investors’ counsel whether the transfer would be “traceable under 550.” When counsel said it would not be traceable, Judge Wesley disagreed, saying, “You bet your life it is.” He emphasized, “You don’t acquire anything when you steal something.”

Judge Rakoff had ruled against the trustee in large part on the idea that Section 550, permitting recovery from a subsequent recipient, cannot have extraterritorial application. Identifying the crux of the issue, Judge Wesley seemed to say that the trustee’s right of recovery does not emanate from Section 550. Instead, he said it “springs from Section 548.”

Because the bankrupt estate included fraudulent transfer claims, he said that Section “548 definitely has an extraterritorial effect” because the claim “is property of the estate.”

Judge Wesley thus closed the loop by saying that the trustee’s right of recovery emanates from Section 548, which, he said, has extraterritorial application. His two conclusions would seem to indicate that Judge Wesley is prepared to reverse and reinstate the Madoff’s trustee’s suit against subsequent transferees.

On the issue of comity, Judge Jacobs observed that “we would be much more interested if [foreign governments] were complaining that we were overstepping, and none of them are.”

Implications of the Second Circuit Decision

If the Second Circuit upholds Judge Rakoff, the Madoff trustee can petition the Supreme Court for certiorari, because there will be a split of circuits with the Fourth Circuit and lower courts that have given extraterritorial effect to Section 548.

On the other hand, if the circuit court rules in favor of the Madoff trustee, the opinion may distinguish or limit FDIC v. Hirsch (In re Colonial Realty), 980 F.2d 125 (2d Cir. 1992), on which Judge Rakoff placed significance. Colonial Realty stands for the proposition in the Second Circuit that fraudulently transferred property is not estate property until it has been recovered.

Because a SIPA trustee’s statutory powers are arguably more extensive than those of an ordinary bankruptcy trustee (or debtor in possession), it is possible that the Second Circuit could rule in favor of the Madoff trustee while basing the decision only on the powers of a SIPA trustee.