A recent Second Circuit decision has shed light on the framework of the “good faith” defense as it intersects with provisions of the Bankruptcy Code and the Securities Investor Protection Act (SIPA). Sections 548 and 550 of Bankruptcy Code[1] authorize trustees (and debtors-in-possession) to avoid fraudulent transfers and recover proceeds from transferees. SIPA also authorizes trustees liquidating broker-dealers to avail themselves of these same fraudulent transfer remedies.[2] These sections, however, contain a built-in limitation: Transferees may keep those transfers if they took them “in good faith.”[3]
The Bankruptcy Code does not define “good faith.” This silence has inspired interpretational questions such as (1) can transferees with inquiry notice of a debtor-transferor’s fraud be protected by the statutory “good faith” defense, and (2) who has the burden of pleading “good faith”? A national consensus has developed as to both of these questions in the bankruptcy context. First, courts have adopted an inquiry notice standard — i.e., a transferee does not act in good faith when it has sufficient actual knowledge to place it on inquiry notice of the transferor’s possible insolvency or that the transfer might be made with a fraudulent purpose.[4] Second, good faith is an affirmative defense that the transfereemust plead and prove.
But should the same be true in SIPA cases when a SIPA trustee asserts claims under §§ 548 and 550?
In In re Bernard L. Madoff Inv. Sec. LLC, 20-1333, 2021 WL 3854761 (2d Cir. Aug. 30, 2021) (“Madoff II”), the district court and the Second Circuit answered this question in fundamentally different ways. This article explores the nuances of these decisions and offers some practical takeaways from the Second Circuit’s controlling holdings.
Background[5]
Bernie Madoff claimed to have invested money he received from the customers of his investment company, Bernard L. Madoff Investment Securities LLC (BLMIS).[6] In actuality, Madoff and BLMIS used those funds in a Ponzi scheme that imploded in 2008.[7] BLMIS customers were a diverse collection of banks, hedge funds, individuals and charities. When a customer wanted to withdraw money, the customer received a transfer directly from BLMIS, making the customer an “initial transferee” for purposes of fraudulent transfer law. Sometimes, those initial transferee customers transferred funds they received from BLMIS to their own customers, creating “subsequent transferees.”[8]
The SIPA trustee, Irving Picard, sought to avoid and recover transfers made to certain initial and subsequent transferee BLMIS customers. The transferee defendants responded by relying on the statutory “good faith” defense available to them under §§ 548(c) and 550(b).[9] Initially, the bankruptcy court found that good faith is an affirmative defense that need not be pleaded by Picard in his complaints.[10]
On the request of certain Madoff transferees, the district court withdrew the reference to address “whether SIPA and other securities laws alter the standard the Trustee must meet in order to show that a defendant did not receive transfers in ‘good faith’ under [§§ 548(c) and 550(b)].”[11] Picard argued that they did not. SIPA, after all, expressly incorporates §§ 548 and 550, and a long line of cases in the bankruptcy context have found a lack of “good faith” where a transferee has inquiry notice of a transferor’s fraud and it does not diligently investigate. Picard argued that this standard should apply in BLMIS’s SIPA proceedings.[12]
The district court distinguished this line of cases and agreed with the transferees, finding that in SIPA cases, a transferee’s inquiry notice of potential fraud is not a lack of good faith. Instead, a transferee acts in good faith unless it willfully blinds itself to a high probability of fraud.[13]> The district court also held that the SIPA trustee bore the burden of pleading that a transferee lacked good faith.[14] In reaching a conclusion that cut against the national consensus in the bankruptcy context, the district court relied on scienter requirements located in federal securities (and not bankruptcy) law that were apparently inconsistent with an inquiry notice standard of good faith. The district court reasoned that SIPA is expressly subject to this federal securities law and that “the Bankruptcy Code must yield” to federal securities law.[15]
The Madoff II Decision
The Second Circuit found that the district court erred as to its central holdings. The Second Circuit first analyzed the dictionary definition of “good faith” alongside a review of the historical and statutory scheme applying that term.[16] The Madoff II court then found that “the plain meaning of good faith in [§§] 548 and 550 of the Bankruptcy Code embraces an inquiry notice standard,”[17] relying in part on its “sister courts” that have “unanimously accept[ed]” that standard.[18] The Madoff II court also rejected the appellees’ willful blindness theory as premised on the misconception that inquiry notice is “purely objective.” Inquiry notice instead is comprised of both subjective and objective components; it requires an examination of what the transferee actually knew and what the transferee should have known based on that actual knowledge.[19]
The Madoff II court next found that neither SIPA nor federal securities law compel an application of a willful blindness standard.[20] SIPA is an amendment to the Securities Exchange Act of 1934 that applies “if the 1934 Act is inapplicable or inconsistent with SIPA.”[21] SIPA was designed to fill a specific void left by the 1934 Act: remedying broker-dealer insolvencies.[22] SIPA does not regulate fraud on the securities markets.[23] The Madoff II court held that the fraudulent intent requirements of the 1934 Act, and the “willful blindness” standard implied by them, are “irrelevant to the specific context of a SIPA liquidation.”[24] In fact, “[t]he text of SIPA and the 1934 Act, the underlying goals of SIPA, and the practical implications of an inquiry notice standard provide no reason to depart from the meaning of the good faith defense . . . as it is applied” in bankruptcy proceedings.[25]
Finally, the Madoff II court again agreed with Picard on the burden issue, finding that “[n]othing in SIPA compels departure from the well-established rule that the defendant bears the burden of pleading an affirmative defense.”[26]
Takeaways
The Madoff II decision is significant for many reasons. First, it harmonizes SIPA proceedings and the avoidance powers available under §§ 548 and 550 of the Bankruptcy Code, ensuring that SIPA trustees actually do possess the “same powers” that a trustee in a bankruptcy proceeding possesses under the Bankruptcy Code. Second, the Madoff II decision meaningfully clarified the inquiry notice rubric applicable in SIPA and bankruptcy proceedings alike. It is a three-step inquiry: (1) The court examines what the defendant knew; (2) the court determines whether the facts the transferee knew would have led a reasonable person in the transferee’s position to conduct further inquiry into a transferor’s possible fraud; and (3) once the court has determined that a transferee had been put on inquiry notice, the court must inquire as to whether diligent inquiry would have discovered the fraudulent purpose. Third, Madoff II strikes down a less-stringent willful blindness standard that could encourage sophisticated transferees to avoid investigating suspicious activities about which they may be aware. That, in turn, would run counter to the equitable principles and aims underlying the Bankruptcy Code and SIPA. Finally, Madoff II puts the burden of pleading (and, logically, proving) a classic affirmative defense back where it belongs: on the defendant.
[1] 11 U.S.C. §§ 548, 550.
[2] A SIPA Trustee possesses “the same powers and title with the respect to the debtor and the property of the debtor” that a trustee in a bankruptcy proceeding possesses under the Bankruptcy Code. 15 U.S.C. § 78fff-1(a).
[3] 11 U.S.C. §§ 548(c), 550(b).
[4] See, e.g., In re Bayou Grp. LLC, 439 B.R. 284, 310-11 (S.D.N.Y. 2010); In re Nieves, 648 F.3d 232, 238 (4th Cir. 2011).
[5] For a more detailed discussion of the Madoff Ponzi scheme at great length, please see, e.g., In re Bernard L. Madoff Inv. Sec. LLC, 654 F.3d 229 (2d Cir. 2011); In re Bernard L. Madoff Inv. Sec. LLC, 976 F.3d 184 (2d Cir. 2020).
[6] Madoff II, 2021 WL 3854761 at *1-2.
[7] Id.
[8] Id.
[9] Id. at *1.
[10] See, e.g., Picard v. Cohmad Sec. Corp., 454 B.R. 317, 331 (Bankr. S.D.N.Y. 2011); Picard v. Merkin, 440 B.R. 243, 256 (Bankr. S.D.N.Y. 2010).
[11] Sec. Inv’r Prot. Corp. v. Bernard L. Madoff Inv. Sec. LLC, 516 B.R. 18, 20 (S.D.N.Y. 2014) (“Madoff I”).
[12] Id. at *21.
[13] Id. at *23-24.
[14] Id. at *21-24.
[15] This article will not discuss the years of litigation in the bankruptcy court on remand after the district court issued Madoff I. Suffice it to say, the bankruptcy court was bound to, and did, apply the district court’s rulings in Madoff I throughout that litigation.
[16]7-9.
[17] Id. at *9.
[18] Id. at *10.
[19] Id. at *11.
[20] Id. at *12-13.
[21] Id. at *12.
[22] Id. at *12-13.
[23] Id.
[24] Id.
[25] Id. at *15.
[26] Id. at *18-19.