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Madoff: The Trojan Horse and The Lion

What do Madoff, the Trojan Horse and the Lion have in common? Answer: Irving H. Picard, the Trustee for Bernard L. Madoff Investment Securities, LLC ("Madoff Firm"). Mr. Picard as the Trustee appointed to liquidate the Madoff Firm pursuant to the Securities Investor Protection Act ("SIPA"). Last month, Mr. Picard delivered a Trojan Horse to investors of the Madoff Firm. He mailed claims packages to investors to ostensibly return securities and cash to investors from the Madoff Firm liquidation proceeds and Securities Investor Protection Corporation ("SIPC") 1. The claims procedure, however, requires investors, among other things, to "provide all documentation or information regarding all withdrawals you have ever made or payments received from [the Madoff Firm]" which the Lion will use to "claw back" funds paid to investors to pay the Trustee's fees, administration expenses and other investors. Thus, the question for many investors who received funds from the Madoff firm: Will the SIPA Trustee be able to require them to return money already paid out to them?

The Statutory Basis for Recovery

Mr. Picard's authority to "claw back" funds is derived from SIPA which incorporates by reference sections of the U.S. Bankruptcy Code (the "Bankruptcy Code"). Section 78eee(a)(3) of SIPA provides that when a broker-dealer "has failed or is in danger of failing to meet its obligations to customers," SIPIC shall file an application with a court of competent jurisdiction and the court shall, in response to that application, take various actions, including appointment of a trustee to oversee the liquidation of the broker-dealer. Section 78fff-1(a) of SIPA further provides that the trustee shall be vested with the same powers and title with respect to the debtor and the property of the debtor, including the same rights to avoid preferences, as a trustee in a case under Chapter 11 of the Bankruptcy Code. Those provisions give Mr. Picard the ability to recover funds formerly paid out by the insolvent entity. Generally, there are three sources of authority for such a recovery: Section 547(b) of the Bankruptcy Code, which provides for the avoidance of preferential transfers; Section 548 of the Bankruptcy Code, which provides for the avoidance of fraudulent conveyances; and various state fraudulent conveyance laws.

1 A maximum amount of $500,000.00 for each customer, including up to $100,000.00

Bankruptcy Code Section 547(b): Avoidance of Preferential Transfers

Section 547(b) of the Bankruptcy Code generally provides that a trustee may "avoid any transfer of an interest of the debtor in the property: (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent; [and] (4) made (A) on or within 90 days before the date of the filing of the petition. 2

The avoidance actions under Section 547(b) are "strict liability" actions, meaning that a recipient of a payment from the Madoff Firm may be liable for return of that payment regardless of his/her mental state. In other words, if any Madoff investor received any amount (not limited to profits) from the Madoff Firm after September 15, 2008 that sum is going to be "clawed back" by Mr. Picard if he discovers the transfer. The policy behind the provision is to prevent a debtor approaching insolvency from cherry picking among its creditors, and to preserve the estate so that distribution may be made in accordance with relevant bankruptcy law.

2 The Trustee can recover funds transferred to "insiders" within one year of filing the Petition. 11 U.S.C. §547(b)(4)(B).

Bankruptcy Code Section 548: Avoidance of Fraudulent Conveyances

Section 548(a) of the Bankruptcy Code will permit Mr. Picard to avoid a distribution to a Madoff investor that was made or incurred within two years of the date of the filing, if the Madoff Firm "made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted . . . ." When the existence of a Ponzi scheme is proven by a preponderance of the evidence, a presumption of actual fraudulent intent is applied. In re: Agricultural Research Tech Group, Inc., 916 F.2d 528, 535-36 (9 th Cir. 1990); Cuthill v. Greenmark, LLC (In re: World Vision Entertainment, Inc.), 275 B.R. 641, 656 (Bankr. M.D. Fla. 2002).

Section 548(c) provides an investor with a "good faith" defense to an action to avoid an allegedly fraudulent conveyance under Section 54 8(a), to the extent the "transferee or obligee" (1) took the transfer "for value and in good faith" and "gave value to the debtor in exchange for such transfer or obligation." Generally, in a Ponzi scheme, the good faith defense can protect an investor from having to return his/her invested principal. But, the defense will not protect against the return of any profits made to the investor. The burden of establishing "good faith" falls on the investor.

State Fraudulent Conveyance Law

The Trustees third source of authority is state fraudulent conveyance laws. Most states also have statutes provided for the avoidance of fraudulent conveyances or transfers. Most state fraudulent conveyance statutes require proof of intent on the part of the transferor to "hinder, delay or defraud" and also provide the transferee with a "good faith" defense. The time period for the "claw back" under state law is generally longer than under the Bankruptcy Code and governed by each state's statutes of limitation. The big question with Madoff's Ponzi scheme is what state law will apply. The six year statute of limitations under New York law or in the case of Florida investors, the shorter limitations period applicable to the Florida Uniform Fraudulent Transfer Act Section 726.101 et. seq., Fla. Stats. ("FUFTA"). Generally, the Trustee's cause of action under

FUFTA will extinguish within four (4) years of the transfer except where the Trustee alleges fraudulent intent which could extend the period to "claw back" funds under Florida law.

The "Good Faith" Defense

Generally, a "good faith" defense will protect a Madoff investor from the "claw back" of their invested capital by the Trustee under Section 548 of the Bankruptcy Code and the states fraudulent conveyance law. But what is "good faith?" The Courts appear to apply an "objective standard" in the context of Ponzi schemes. Joblin v. McKay, 84 F.3d 1330 (10 th Cir. 1993); In re: World Vision Entertainment, Inc., 275 B.R. at 659. The Joblin Court rejected any "good faith" defense because "a reasonable person would have noticed" the kind of suspicious circumstances that surrounded [the investment scheme] such as "promised rates of return greater exceeding the market rate [120% per year on one investment and 468% on others]." Do Madoff investors have a "good faith" defense? To date, the only red flag appears to be the "consistency of the annual returns" which apparently did not cause the SEC or NASD to be alarmed! The Madoff investors were not promised exorbitant returns and have a valid argument against the Lion's attempt to "claw back" withdrawals of their invested capital. The "good faith" defense will not protect the "claw back" of any profits.

The Lesson From History

To Madoff investors who withdrew funds from their accounts: Beware of the Trojan Horse and the Lion. Mr. Picard's claims procedure may seem an innocuous way to recover another $100,000 to which you believe you are entitled. But you could be providing a "road map" to the Trustee for recovery of assets from you for the Trustee's liquidation expenses and distribution to other investors. Take a lesson from history and think twice before you embrace the Trojan Horse and the Lion!

Free Consultation With Attorneys Who Can Handle Your Securities and Commodities Problems

Contact The Law Offices of Robert Wayne Pearce, P.A., in Boca Raton to discuss your fraud or misrepresentation claim. The firm can be reached by phone at 561-338-0037, toll free at 800-732-2889 or via e-mail.

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