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On December 8, 2014, the Second Circuit U.S. Court of Appeals read the Bankruptcy Code to shield the profits paid by a Bernard Madoff company to “net winners” (those paid in excess of their initial investments into the Ponzi scheme) from claw back, as constructively fraudulent transfers, by a trustee seeking to distribute those profits to the scheme’s victims. See In re Bernard Madoff Inv. Sec. LLC, 773 F.3d 411, 414 (2d Cir. Dec. 8, 2014), petition for cert. filed, 14-1128 (U.S. Mar. 17, 2015). On March 17, 2015, the trustee filed a petition for a writ of certiorari seeking U.S. Supreme Court review of this decision. While the decision's holding results from a straightforward application of statutory definitions, the effect on previous and future settlements in the case, and the Second Circuit’s characterization of the Congressional intent behind those definitions – i.e., minimizing market disruption – bear comment.

Madoff orchestrated a massive and unprecedented Ponzi scheme which purported to purchase securities on behalf of customers (many of which were institutional investors and feeder funds), but in reality deposited customer investments into a single commingled checking account and, for years, fabricated statements showing trading activity and returns between 10-17% annually. After the scheme collapsed, the management of Madoff’s company was left to a trustee appointed under the Securities Investors Protection Act, 15 U.S.C. § 78aaa, which empowers a trustee appointed pursuant to it to “recover” (claw back) money paid out by the company if the money would otherwise have been available for ratable distribution and could have been clawed back under the Bankruptcy Code. 773 F.3d at 414.

The trustee sued hundreds of Madoff customers who had withdrawn more than their investments and thus, as the Court put it, “profited (whether knowingly or not) from Madoff’s scheme.” As is common in Ponzi scheme cases, the trustee argued that, under both the Bankruptcy Code and New York law, the net winner payments were “fraudulent transfers” either made by Madoff’s company with actual intent to defraud creditors or constructively fraudulent because they were made without receiving reasonably equivalent value in exchange. 773 F.3d at 416 (citing 11 U.S.C. §§ 544(b), 548(a)(1)(A)-(B)). Several defendants moved to dismiss these lawsuits by arguing that a different Bankruptcy Code provision, 11 U.S.C. § 546(e), precluded avoidance of the constructively fraudulent transfers made by stockbrokers either as “settlement payments” or “in connection with a securities contract.”

The Second Circuit held that the net winner payments could not be clawed back as constructively fraudulent transfers because they were both “settlement payments” and “in connection with a securities contract” under the Bankruptcy Code. 773 F.3d at 417. Simply put, the opinion concluded that Congress had legislated that the potential market chill from a claw back made the Ponzi scheme payments too big to claw back (and arguably that this would be the case regardless of the magnitude of the potential chill, as § 546(e) contains no dollar threshold). A few examples include:

  • “Section 546(e) is a very broadly-worded safe-harbor provision that was enacted ‘to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries.’”
  • “The theory underlying this section is that, ‘[i]f a firm is required to repay amounts received in settled securities transactions, it could have insufficient capital or liquidity to meet its current securities trading obligations, placing other market participants and the securities markets themselves at risk.’”
  • “The statutory definition and Enron compel the conclusion that, for example, if I instruct my broker to sell my shares of ABC Corporation and remit the cash, that payment is a ‘settlement’ even if the broker may have failed to execute the trade and sent me cash stolen from another client.”

The opinion merits at least three observations. First, there may be a new breed of “net losers” in the Madoff case: those who settled on a claw back action before this opinion. This category may include nearly half of the total dollars filed as claims in the case, and a strong majority of the dollars recovered by the SIPA trustee. As of February 6, 2015, the SIPA trustee is reported to have recovered or entered into agreements to recover $10.5 billion (approximately 60 percent) of the estimated $17.5 billion in principal lost by Madoff customers who filed claims, which “far exceeds prior restitution effort related to Ponzi schemes both in terms of dollar value and percentage of stolen funds recovered.”1 Of the $9.8 billion received by the SIPA trustee as of September 30, 2014, $8.7 billion resulted from settlements.2 Unless the settlements so provide, there is likely no direct appellate recourse for those who settled before the December 8, 2014 opinion.

Second, the Madoff decision may reduce the trustee’s prospects for recovering the remaining 40% of the unrecovered dollars in claims filed – amounting to about $7 billion – in this case, which in turn will reduce the amount for distribution to the scheme’s victims. Because neither the Madoff opinion nor § 546(e) apply to the trustee’s attempts to claw back on a theory of actual fraudulent intent under § 548(a)(1)(A), all hope is not lost for the trustee’s future recoveries. The trustee may still rely upon the Ponzi scheme presumption of actual fraudulent intent for those transfers made in furtherance of the Ponzi scheme.3

Third, the Madoff opinion reads certain Bankruptcy Code provisions as essentially prioritizing market stability (or at least the perception thereof) over recovery to the Ponzi scheme victims who could benefit from a claw back. While Second Circuit opinions have previously interpreted § 546(e) expansively, this case involved a particularly in-depth analysis as to Congressional intent and dictionary definitions of the terms evincing that intent. Applying the statutory definitions to the Madoff facts resulted in those definitions dovetailing neatly with the Second Circuit’s interpretation of the policy behind them. So understood, Madoff may have been an easy case for the Second Circuit. The dollars and institutional investors laid a clear factual predicate for potential market disruption. But in most instances, the potential for market disruption will be less obvious, and bankruptcy lawyers and investors may speculate how these definitions will be applied by courts (which have not yet weighed in on the issue) in more run-of-the-mill fraudulent transfer cases, including those involving privately held companies.4


1The Madoff Recovery Initiative, (last visited February 27, 2015).
2See supra note 1.
3See, e.g., Bear, Stearns Sec. Corp. v. Gredd (In re Manhattan Inv. Fund Ltd.), 397 B.R. 1, 13 (S.D.N.Y. 2007).
4The Third, Sixth, and Eighth Circuit U.S. Courts of Appeal have held that § 546(e) protects beneficial owners of privately issued securities. See, e.g., Contemporary Indus. Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009); QSI Holdings, Inc. v. Alford (In re QSI Holdings), 571 F.3d 545 (6th Cir. 2009), cert. denied, 558 U.S. 1148 (2010); Brandt v. B.A. Capital Co. (In re Plassein In’l Corp.), 590 F.3d 252 (3d Cir. 2009), cert. denied, 559 U.S. 1093 (2010). The American Bankruptcy Institute Commission to Study the Reform of Chapter 11, in its 2012-2014 Final Report and Recommendations, has proposed an amendment to the Bankruptcy Code to limit the scope of section 546(e) to prevent it from applying to beneficial owners of privately issued securities in connection with prepetition transactions using some or all of the debtor’s assets to facilitate the transaction.