IRA Withdrawals Aren’t Protected from Madoff Fraudulent Transfer Judgments

Bankruptcy Judge Cecelia G. Morris of New York slammed the door on every argument made by the holder of a self-directed individual retirement account. Because his account was held in an IRA, the defendant argued that he was somehow immune from being sued for receiving fictitious profits from the Bernard Madoff Ponzi scheme.

The defendant was one of the fortunate Madoff investors who managed to take out more than he invested before the fraud blew up 13 years ago. On motion for summary judgment by the Madoff trustee, Judge Morris granted judgment against him for about $670,000.

Judge Morris added prejudgment interest at 4% per annum, because the defendant forced the Madoff trustee to spend “time and energy having to defend against legal arguments that have already been decided in these . . . cases” under the Securities Investor Protection Act, or SIPA.

Prejudgment interest will increase the judgment to about $950,000, raising the question of whether the defendant should have been advised to settle years ago when he might have avoided the additional sting of prejudgment interest. On top of prejudgment interest, the defendant presumably has been paying attorneys’ fees for a decade in a lost cause.

Defendant’s Withdrawal of ‘Fictitious Profits’

Madoff’s fraud was disclosed in 2008, followed quickly by a liquidation in the Manhattan Bankruptcy Court under SIPA, which incorporates large swaths of the Bankruptcy Code, including avoidance actions for the recovery of fraudulent transfers with “actual intent” under Section 548.

In litigation all the way to the Second Circuit, courts established years ago that customers were the recipients of fraudulent transfers with “actual intent” when Madoff had paid them more cash than the cash they had invested. Customers who took out more than they invested have become known as net winners. The cash they took out in excess of their cash investments is known as fictitious profits.

Under Second Circuit authority, customers branded as net winners are obliged to return fictitious profits received within two years of the Madoff bankruptcy. The profits were fictitious because Madoff never bought a single share of stock with customers’ investments.

The defendant in Judge Morris’s July 2 opinion had invested about $4 million in cash with Madoff. In the 10 years before bankruptcy, the defendant had withdrawn almost $4.7 million.

It has been established in the Madoff case that the trustee’s recovery is limited to fictitious profits paid out within two years of bankruptcy, under Section 548(a)(1) of the Bankruptcy Code. In 2010, the Madoff trustee therefore sued to recover the $670,000 that the defendant had withdrawn in the two years before bankruptcy.

The IRA Defenses

Most Madoff customers invested directly in what turned out to be a Ponzi scheme. They thought their investments were being used to buy securities, but Madoff never purchased a single share of stock. Instead, he used new investments to pay off old investors.

The defendant had a self-directed IRA where he instructed the custodian to invest only with Madoff. The defendant raised several defenses. For instance, he argued that Madoff’s books and records were unreliable. That argument and others have “been overruled numerous times,” Judge Morris said.

The defendant raised other defenses based on the idea that he invested through an IRA, not directly. Judge Morris knocked them down, one by one.

The defendant claimed that his IRA withdrawals were protected by the Employee Retirement Income Security Act. ERISA provides that pension plans “may not be assigned or alienated.”

To begin with, Judge Morris ruled that ERISA does not apply generally to IRAs. Even if ERISA did protect IRAs, she cited authorities for the proposition that “distributions from a retirement account are not.” Because the defendant had received the distribution, she held that the “funds are not protected by ERISA.”

Next, the defendant made arguments based on New York law. Generally speaking, New York law protects spendthrift trusts and the like. The Madoff trustee conceded that collecting a judgment from the IRA may be difficult, but he saw nothing in state law to prevent entry of judgment against the defendant, who was the beneficiary of the IRA.

In a similar case, Judge Morris said that District Judge Jed Rakoff had “made short shrift of the investor’s state law arguments.” In other words, state law only protects funds remaining in the IRA.

Next, the defendant contended that he was not the initial recipient of the fraudulent transfers and was thus entitled to the so-called good faith defense in Section 550(b), because he did not know Madoff was running a Ponzi scheme. He argued that the custodian of the IRA was the initial recipient.

While the Bankruptcy Code does not define “initial transferee,” Judge Morris cited the Second Circuit for adopting the “mere conduit” test. In other words, a “mere conduit” is not the initial recipient.

In short order, Judge Morris held that the IRA custodian was a “mere conduit,” not the initial transferee, because the custodian never had dominion or control over the payments from Madoff.

Judge Morris nixed the Section 550(b) defense for a second reason: An IRA is not a separate legal entity from its owner. She added that the “overwhelming majority of federal courts have decided that self-directed IRA’s are not trusts under state law.”

Judge Morris therefore held that the defendant was the initial transferee and thus not entitled to the good faith defense in Section 550(b).

After deciding that the Madoff trustee was entitled to judgment for the $670,000 withdrawn within two years of bankruptcy, Judge Morris noted how she had already granted the trustee 4% prejudgment interest against defendants “who litigate issues that have already been decided by the Court.”

Judge Morris said that the Madoff trustee “cannot be made whole” without prejudgment interest because the trustee was compelled to spend “time and energy having to defend against legal arguments that have already been decided in these SIPA cases.” Prejudgment interest will likely turn out to be some $280,000.

Judge Morris ended her opinion by expressing her sympathy for the defendant, but, she said, “he has recovered his principal investments. Other victims have not been so fortunate.”