Reversing the bankruptcy court, a district judge in New York allowed a Kuwaiti public pension fund to escape liability for receipt of $20 million stolen from customers in the infamous Bernard L. Madoff Ponzi scheme.
In his September 20 opinion, District Judge Gregory H. Woods concluded that the pension fund was entitled to sovereign immunity from suit in the U.S. because the payment came from cash on hand held by one of Madoff’s so-called feeder funds, not from cash that the feeder fund withdrew from Madoff in response to the pension fund’s redemption request.
The appeal involved the Public Institution for Social Security, a Kuwaiti governmental agency. It began investing in Madoff in 1999 through an offshore feeder fund known as Fairfield Sentry. Substantially all investments in the feeder fund by the feeder fund’s customers were in turn invested in Madoff. The Kuwaiti fund allegedly knew that its investments were going to Madoff.
When the fraud surfaced, Madoff’s business was thrown into liquidation in New York in 2008 under the Securities Investor Protection Act, which incorporates large swaths of the Bankruptcy Code, including the ability to mount fraudulent transfer suits. The feeder fund went into its own liquidation abroad.
The Madoff trustee had fraudulent transfer claims against the feeder fund because the feeder fund received money stolen from customers. Because the feeder fund was largely a dry hole, the Madoff trustee sued investors in the feeder fund as subsequent transferees of fraudulent transfers.
The Kuwaiti fund was among the feeder fund customers that the Madoff trustee sued in 2012. The trustee was aiming to recover $20 million in a redemption that the Kuwaiti fund received from Fairfield Sentry in 2004. The Kuwaiti fund filed a motion to dismiss, claiming sovereign immunity under the Foreign Sovereign Immunities Act, or FSIA. The bankruptcy court denied the motion to dismiss, but Judge Woods granted leave for the Kuwaiti fund to pursue an interlocutory appeal.
The Madoff trustee conceded that the Kuwaiti fund was protected from suit in the U.S. unless the exception for “commercial activity” in FSIA were to apply under 26 U.S.C. § 1605(a)(2).
The Structure of the Redemption
The Kuwaiti agency did not receive the redemption directly from Madoff. Rather, the Kuwaiti fund sent a redemption request to the feeder fund that resulted in the $20 million payment. The redemption request came from abroad and was directed to a Fairfield Sentry agent also abroad. The $20 million emanated from a Fairfield Sentry bank account abroad and first went to a bank in New York for further credit to a bank account of the Kuwaiti fund in London.
The “critical fact,” Judge Woods said, is that the $20 million redemption request “did not lead Fairfield Sentry to request money from [Madoff] in the United States. At the time of the redemption request, Fairfield Sentry was sitting on a huge amount of cash that was sufficient to permit Fairfield Sentry to fund the redemption request without making a withdrawal from [Madoff].”
Judge Woods said that the $20 million transfer to the Kuwaiti fund came about six months after Fairfield Sentry’s “most recent transfer from” Madoff. Between the last transfer from Madoff and the transfer to the Kuwaiti fund, he said that “Fairfield Sentry received funds from third parties sufficient to deposit $120,000,000 with [Madoff], after giving effect to [the Kuwaiti fund’s] redemption request.”
The FSIA Exception
Judge Woods described the appeal as turning on the third clause in the exception to sovereign immunity contained in 26 U.S.C. § 1605(a)(2). The exception applies to a lawsuit “based . . . upon an act outside the territory of the United States in connection with a commercial activity of the foreign state elsewhere and that act causes a direct effect in the United States.”
The Kuwaiti fund conceded that the redemption was “commercial activity” but argued (successfully) that the act did not have “a direct effect in the United States.” Citing the Second Circuit, Judge Woods said that the “direct effect” must be “legally significant.”
Judge Woods rejected the Madoff trustee’s contention that the relevant act was the Kuwaiti fund’s initial investment in Madoff through the feeder fund. However, he cited the record as showing that the initial investment did have an effect in the U.S.
To identify the relevant “act,” Judge Woods noted that the feeder fund did not request money from Madoff to cover the Kuwaiti fund’s redemption request. Because the $20 million transfer from the feeder fund to the Kuwaiti fund came from one foreign entity to another, he said there was no direct effect on the U.S.
Again citing the Second Circuit, Judge Woods said:
The possibility that the transfer transited through a New York correspondent bank on its way between the foreign bank accounts of two foreign entities does not matter — the brief transit of funds through a U.S. correspondent account is not “legally significant.”
Judge Woods saw no “direct domestic effect.” He said that the payments by Madoff to the feeder fund “were made five months prior to the redemption request that triggered the January 2004 $20 million transfer . . . . [I]t cannot be the case that [the Kuwaiti fund’s] redemption request triggered any movement of funds from [Madoff] to Fairfield Sentry.” [Emphasis in original.]
Judge Woods therefore held that the Madoff trustee “has not sufficiently shown that either the redemption request from [the Kuwaiti fund] to Fairfield Sentry or the $20 million transfer from Fairfield Sentry to [the Kuwaiti fund] had any direct effect on the United States.”
Judge Woods reversed the bankruptcy court and granted the Kuwaiti fund’s motion to dismiss.
Observations
Does the opinion by Judge Woods elevate form over substance?
Fairfield Sentry made virtually no investments aside from Madoff. The feeder fund was an instrumentality through which foreign and U.S. investors invested with Madoff and did so for a variety of reasons, such as avoiding a direct presence in the U.S., avoiding a direct investment with Madoff or channeling their investment abroad.
Funds held by the feeder fund were either investments that the investors had earmarked for Madoff or were monies coming out of Madoff. In essence, the feeder fund could be seen as an instrumentality through which Madoff fostered his Ponzi scheme worldwide.
The “huge amount of cash” to which Judge Woods referred did not emanate from the feeder fund’s own astute investments elsewhere. Like any responsible fund, it maintained significant cash balances to respond quickly to redemption requests without having to await drawdowns from Madoff.
In the worst case for the Madoff trustee, the $20 million taken by the Kuwaiti fund was stolen from investors who intended to invest in Madoff. Isn’t that a “direct effect” on a Ponzi scheme in the U.S.?
There likely will be an appeal, because the Madoff trustee has another suit with a different foreign sovereign involving $200 million, or 10 times the amount at issue with the Kuwaiti fund. On appeal, the Madoff trustee may be arguing that Judge Woods went beyond the complaint to grant the motion to dismiss by finding that the redemption given to the Kuwaiti fund did not come from Madoff, according to the record.
Note
The suit with the Kuwaiti fund is just now at the motion-to-dismiss stage because the suit was dismissed as a result of a decision handed down in 2014 by District Judge Jed Rakoff. 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). The Madoff trustee persevered and won a reversal in the Second Circuit in 2019. In re Picard, Trustee for the Liquidation of Bernard L. Madoff Investment Securities LLC, 917 F.3d 85 (2d Cir. Feb. 25, 2019).
The Second Circuit held in 2019 that Sections 548 and 550 enable the trustee to sue foreign defendants for the recovery of fraudulent transfers, even if subsequent transfers occurred abroad. The reversal allowed the Madoff trustee to revive almost 90 avoidance actions where the trustee was pursuing the recovery of some $3.2 billion, before prejudgment interest. To read ABI’s report about the Second Circuit decision, click here.
The opinions are those of the writer, not ABI.
Reversing the bankruptcy court, a district judge in New York allowed a Kuwaiti public pension fund to escape liability for receipt of $20 million stolen from customers in the infamous Bernard L. Madoff Ponzi scheme.
In his September 20 opinion, District Judge Gregory H. Woods concluded that the pension fund was entitled to sovereign immunity from suit in the U.S. because the payment came from cash on hand held by one of Madoff’s so-called feeder funds, not from cash that the feeder fund withdrew from Madoff in response to the pension fund’s redemption request.