Safe Harbor Given Extraterritorial Effect to Benefit Madoff Feeder Funds Customers

The safe harbor in Section 546(e) applies extraterritorially, according to Bankruptcy Judge Stuart M. Bernstein of New York, even if the plaintiffs are foreign liquidators suing to recover under foreign law on account of transfers that occurred abroad.

In view of Merit Management Group LP v. FTI Consulting Inc., 138 S. Ct. 883 (Feb. 27, 2018), Judge Bernstein stopped short of invoking the safe harbor until he determines whether the transferor was a “financial participant.”

The Madoff Connection

Judge Bernstein’s 65-page opinion on December 6 was another spinoff from the $19 billion Ponzi scheme perpetrated by Bernard Madoff.

The case involved so-called feeder funds organized in the British Virgin Islands that took in money from investors and reinvested almost everything with Madoff. When the Madoff fraud was exposed, the feeder funds themselves went bankrupt in the BVI, where liquidators were appointed.

The bankruptcy court in New York recognized the liquidations in the BVI as the feeder funds’ foreign main proceedings under chapter 15.

In the U.S. court, the liquidators mounted 305 adversary proceedings to recover redemptions that some feeder fund investors had received in the years before the Madoff firm went into liquidation in New York under the Securities Investor Protection Act. Asserting several legal theories under BVI law, the liquidators based their clawback actions on the notion that the investors’ shares were really worthless when they redeemed their investments.

In a decision in August, Judge Bernstein concluded that the bankruptcy court had subject matter jurisdiction but that personal jurisdiction required more than signing a subscription agreement with the feeder funds. He did not reach the merits, he said, because the ruling did not “completely resolve” the defendants’ motion to dismiss for lack of jurisdiction.

Addressing the merits in his decision this month, Judge Bernstein dismissed most — but not all — of the liquidators’ claims for failure to state a claim under BVI law. However, he declined to dismiss the liquidators’ constructive trust claims based on a feeder fund customer’s knowledge that the investments in Madoff were inflated in value.

The Safe Harbor Defense

With regard to the surviving claims based on knowledge, the defendants argued that the remaining suits should be dismissed in view of the so-called safe harbor in Section 546(e). With the exception of a transfer made with actual intent to hinder, delay or defraud, the safe harbor prohibits voiding a transfer that was “made by or to (or for the benefit of) a . . . financial participant . . . in connection with a securities contract . . . .”

Because the district court in New York had held in the Madoff liquidation that the avoiding powers do not have extraterritorial application, the liquidators contended that the safe harbor likewise should not be applied to transactions occurring abroad. See 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), appeal pending in In re Picard, 17-2992 (2d Cir.).

N.B.: The district court’s decision on extraterritoriality was argued in the Second Circuit in mid-November. To read ABI’s report on oral argument, click here.

The Safe Harbor Applies Extraterritoriality, Judge Bernstein Says

To contend that the safe harbor applies extraterritorially, the defendants relied in large part on the plain meaning of Section 561(d), which was adopted along with the latest iteration of the safe harbor as part of the BAPCPA amendments in 2005.

Pertinent to the case at hand, the section says, in substance, that the safe harbor “shall apply in a case under chapter 15 . . . to limit avoidance powers to the same extent as in a proceeding under chapter 7 or 11 . . . (such enforcement not to be limited based on the presence or absence of assets of the debtor in the United States).”

“Asking whether section 546(e) applies extraterritorially is the wrong question,” Judge Bernstein said. The “correct question,” he said, “is whether section 561(d) makes the safe harbor applicable to proceedings brought by foreign representatives in a chapter 15 case seeking to avoid purely foreign transfers under foreign insolvency law.”

Since Section 1521(a)(7) prohibits a foreign representative from exercising U.S. avoiding powers, Judge Bernstein concluded that Section 561(d) “necessarily [refers] to avoidance powers under non-U.S. law.” With a qualification we shall discuss later, he held that the BVI liquidators therefore cannot avoid transfers that resulted from the feeder fund investors’ rights to redeem their investments.

Judge Bernstein buttressed his conclusion with citations to legislative history accompanying Section 561(d). In substance, he conceded that both the section and its legislative history were drafted by two securities industry associations. He also quoted legislative history that is broader, arguably, than the statutory language. In addition, he quoted a House report as referring to “new section 304,” which does not exist.

Ruling that the safe harbor is not limited to U.S. creditors and U.S. markets, Judge Bernstein held that the liquidators “cannot invoke non-U.S. law to avoid and recover those transfers that have already occurred.”

The Implications of Merit Management

Simply holding that the safe harbor applies to transactions abroad does not mean it always applies in light of Merit Management, where the Supreme Court significantly narrowed the safe harbor by holding that it only immunizes transfers where the ultimate transferor or transferee was a bank, broker or “financial participant.”

Although Judge Bernstein had found that the safe harbor was theoretically applicable, he still needs to determine whether the feeder funds were financial participants.

Since Merit Management was handed down after the defendants’ motion to dismiss was argued, Judge Bernstein called for additional briefing with regard to the definition of “financial participant” in Section 101(22A)(A). The term means an entity with $1 billion or more in specified securities contracts “on any day during the 15-month period preceding the date of the filing of the petition . . . .”

The defendants argued that the principal feeder fund qualified as a financial participant because it had more than $6 billion in assets in October 2008, when the Madoff liquidation began. However, Judge Bernstein said, the feeder fund’s bankruptcy did not begin until mid-2010, 19 months after Madoff went bust.

Because the feeder funds’ holdings at the earlier date were more than 15 months before their liquidations in the BVI, Judge Bernstein denied the motion to dismiss based on the safe harbor, without prejudice to demonstrating that the feeder funds were “financial participants” invoking the safe harbor to dismiss the remaining claims.

The Interplay with the Madoff Liquidation

Earlier in the Madoff liquidation, the Madoff trustee and the feeder fund liquidators reached a settlement where they agreed to share recoveries. Consequently, the dismissal of the liquidators’ suits will adversely affect the Madoff trustee’s recoveries and distributions to customers.

If the Second Circuit reverses and rules that the avoiding powers have extraterritorial application, the Madoff trustee can prosecute $4 billion in lawsuits involving offshore transfers, such as those already being pursued by the BVI liquidators.

Even if Judge Bernstein’s decisions result in dismissal of the suits by the BVI liquidators, the Madoff trustee can pursue the same recoveries against many of the same defendants if he wins in the Second Circuit. If the Madoff trustee prevails, the BVI liquidators will share some of the recoveries, even though their suits in the U.S. may have been dismissed.

Implications of the Forthcoming Madoff Decision

The Madoff appeal, now sub judice in the Second Circuit, will decide whether the avoiding powers apply extraterritorially. If the appeals court agrees with the district court, limiting the avoiding powers to the U.S. might suggest that Judge Bernstein was incorrect in giving extraterritorial effect to the safe harbor.

If, as seems likely, the Second Circuit reverses the district court, Judge Bernstein’s decision will be on sounder footing, because logic suggests that the avoiding powers and limitations on the avoiding powers should be coextensive.

However, it’s not that simple. Extraterritorial application of the safe harbor has a leg up.

The Supreme Court has held that statutes apply only domestically absent a clear expression of congressional intent to apply extraterritorially. While there arguably is no explicit expression of extraterritorial intent regarding the avoiding powers, Section 561(d) explicitly gives some extraterritorial effect to the safe harbor. Still, it’s a bold step to interpose a U.S. defense to kill off a lawsuit between foreign parties, based on foreign law, concerning transactions occurring abroad. That’s why the courts may employ principles of comity to narrowly read that portion of Section 561(d) limiting the avoiding powers “to the same extent as in a proceeding under chapter 7 or 11 . . . .”

There is also an outside chance that Merit Management may have something to say on the matter. The Supreme Court tells us to find the “real” transferor and the “real” transferee, ignoring intermediate transferees and transferors. If the Madoff firm were viewed as the “real” transferor, the status of the feeder fund as a financial participant would not matter. However, injecting the Madoff firm into the picture is not the basis for the liquidators’ lawsuits.