Second Circuit Allows Extraterritorial Application of Sections 548 and 550

In a broadly worded opinion in the Madoff liquidation, the Second Circuit held that Sections 548 and 550 can be applied extraterritorially to recover fraudulent transfers even if subsequent transfers occurred abroad.

The appeals court reversed District Judge Rakoff, who had ruled in July 2014 that Section 550 does not permit recovering from a subsequent foreign recipient of stolen funds, given comity and the presumption against extraterritorial application of U.S. statutes.

As Circuit Judge Richard C. Wesley was careful to say in his February 25 opinion, the ruling by the appeals court closed a “loophole,” because the district court’s decision would have enabled a fraudster to transfer property to a “foreign entity,” thereby rendering the “property recovery-proof.”

The opinion avoided a split of circuits with the Fourth Circuit and lower courts that have given extraterritorial effect to Section 548.

The opinion has practical significance for the victims of Bernie Madoff’s Ponzi scheme, who have already received distributions representing about 67% of what they invested. The revival of the trustee’s lawsuits means the victims have a realistic shot at recovering 100%. Reinstatement of the lawsuits may convince some defendants to settle, because they face the possibility of liability for 10 years of prejudgment interest on top of a judgment for the stolen money they received.

“The opinion has a broad application, and we think the court got it 100% right,” Stephen P. Harbeck, the president and chief executive of the Securities Investor Protection Corp., told ABI.

The Fraudulent Transfers

Some of the largest investors in the Madoff Ponzi scheme were so-called offshore feeder funds, located in places like the Cayman Islands. Many of the feeder fund investors were foreigners, or at least nominally so.

Some of the feeder funds reinvested virtually everything with Madoff. The feeder fund investors seemingly made out very well until the fraud came crashing down. When it did, some of the feeder funds had taken more cash out of the Madoff firm than the cash they had invested.

The feeder funds were called “net winners” if they had taken out more cash than they invested. Under prior Second Circuit decisions in the Madoff case, net winners are recipients of fraudulent transfers with “actual intent,” making them liable to disgorge fictitious profits received within two years of bankruptcy under Sections 548(a)(1)(A) and 550(a)(1).

Madoff’s bankruptcy in 2008 put many of the feeder funds into liquidation abroad. The feeder funds’ bankruptcies left the Madoff trustee unable to claw back fraudulent transfers made to the feeder funds themselves. Undeterred, the Madoff trustee sued feeder fund investors as subsequent transferees under Section 550(a)(2), because the feeder funds had paid out their fictitious Madoff profits to the feeder funds’ investors. The payments were fictitious profits because they represented money stolen from other investors, not legitimate income from investments.

The Madoff firm is being liquidated under the Securities Investor Protection Act, which incorporates large swaths of the Bankruptcy Code, including the avoiding and recovery powers under Sections 548 and 550.

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.

The feeder fund investors contended 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).

Reciting black letter law, Judge Rakoff said that U.S. statutes do not apply extraterritorially absent contrary intent by Congress. For him, 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. He also found no “clearly expressed” congressional intent to allow application of the law abroad.

Even if Congress had 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 ruling, Judge Rakoff sent the lawsuits back to bankruptcy court. Implementing Judge Rakoff’s mandate, the bankruptcy court on remand dismissed 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 in 88 consolidated appeals.

The Second Circuit Opinion

Reversing Judge Rakoff, the Second Circuit could have rested its decision on the unique provisions of SIPA giving special powers to trustees liquidating brokerage firms. Instead, Judge Wesley found the result entirely within the four corners of the Bankruptcy Code, meaning that the decision is equally applicable to ordinary bankruptcies, not merely brokerage liquidations under SIPA.

Judge Wesley agreed with Judge Rakoff about the presumption against extraterritoriality, saying that the lawsuits could go ahead “if either the statute indicates its extraterritorial reach or the case involves a domestic application of the statute.” From there on, however, Judge Wesley knocked the props out from under Judge Rakoff’s theories.

Extraterritoriality

Following Supreme Court authority, Judge Wesley said the court looks to the statute’s “focus” to decide “whether a case involves a domestic application of that statute.”

Where the district court focused on Section 550, Judge Wesley said the proper focus was Section 548, because Section 550 merely provides a remedy for a fraudulent transfer.

Judge Wesley said the harm to the estate resulted from the initial transfer, which was made in the U.S. He said that Section 550 is a “utility provision” helping to execute the policy in Section 548. Paraphrasing the Supreme Court, he said that Section 550 is merely the means by which the statute achieves its ends of “regulating and remedying the fraudulent transfer of property.”

Judge Wesley thus held that a fraudulent transfer emanating from the U.S. “is a domestic activity for the purposes of Sections 548(a)(1)(A) and 550(a).” Consequently, “the presumption against extraterritoriality therefore does not prohibit the debtor’s trustee from recovering, . . . regardless of where any initial or subsequent transferee is located.” Mimicking the Supreme Court’s terminology, he said the “relevant conduct in these actions is the debtor’s fraudulent transfer of property, not the transferee’s receipt of property.” [Emphasis in original.]

Comity

Having decided that the presumption against extraterritoriality did not bar the lawsuits, Judge Wesley next dealt with international comity as grounds for dismissal. His opinion is a ringing endorsement of a trustee’s ability to chase defendants around the world when the fraudulent transfer initiated in the U.S.

Comity, Judge Wesley said, comes into play only when there is a “true conflict” between American law and that of a foreign jurisdiction. Assuming without deciding that there was such a conflict, he said that the U.S. nevertheless “has a compelling interest in allowing domestic estates to recover fraudulently transferred property.”

There would be a better argument for comity were Madoff also in liquidation abroad. The absence of any parallel Madoff proceeding abroad “seriously diminishes the interest of any foreign state in our resolution of the Trustee’s claims,” Judge Wesley said. Even where the initial recipient of the fraudulent transfer is in liquidation abroad, he said, the foreign “interests are not compelling.”

Even if the foreign liquidators were trying to recover the same funds from the same subsequent recipients, Judge Wesley said “those are not comity concerns,” nor are they “compelling enough to limit the reach of a federal statute that would otherwise apply here.”

Judge Wesley saw no reason to believe that “Congress would have decided that trustees looking to recover property in domestic proceedings are out of luck when trustees in foreign proceedings may be interested in recovering the same property.” Indeed, he saw the “opposite”: “Congress wanted the claims resolved in the U.S., rather than through piecemeal proceedings around the world.”

Judge Wesley said the district court erroneously focused on the subsequent transfer. He held that “[p]roscriptive comity poses no bar to recovery when the trustee of a domestic debtor uses Section 550(a) to recover property from a foreign subsequent transferee on the theory that the debtor’s initial transfer of that property from within the U.S. is avoidable under Section 548(a)(1)(A).”

Judge Wesley ended by debunking the district court’s theory that the feeder fund investors had no reason to believe that U.S. law would apply to their relationship with the offshore feeder funds. “When these investors chose to buy into feeder funds that placed all or substantially all of their assets with Madoff Securities,” he said, “they knew where their money was going.”

An Important Footnote and an Omission

The conclusion on extraterritoriality was based on two factors: The Madoff firm was a domestic entity, and the fraud occurred when Madoff transferred funds from a U.S. bank account. 

In a footnote, Judge Wesley expressed “no opinion on whether either factor standing alone would support a finding that a transfer was domestic.” Thus, the Second Circuit left the door open for the trustee of a domestic corporation to pursue a fraudulent transfer made from a bank account abroad.

Judge Rakoff found significance in FDIC v. Hirsch (In re Colonial Realty), 980 F.2d 125 (2d Cir. 1992), where the Second Circuit said that fraudulently transferred property is not estate property until it has been recovered. The Second Circuit’s Madoff opinion did not mention Colonial Realty, implying that the pursuit of estate property is not a necessary factor to overcome the presumption against extraterritoriality involving a fraudulent transfer emanating from the U.S.