In the wake of the collapse of Bernard L. Madoff's Ponzi scheme, Trustee Irving Picard brought hundreds of cases against investors under section 548(a) of the Bankruptcy Code to recover distributions received by the "net winners."  In Security Investor Protection Corp. v. Bernard L. Madoff Inv. Sec. LLC (the "SIPA Decision"), Judge Jed S. Rakoff held that where such claims are brought in a Securities Investor Protection Act ("SIPA") liquidation proceeding, the Trustee must specifically allege an investor's subjective lack of good faith, in other words that he "either knew of Madoff Securities' fraud or willfully blinded [himself] to it."1

By requiring the Trustee to allege specific facts negating an investor's good faith, Judge Rakoff's ruling will make it far more difficult for the Trustee to prevail in such cases.  This decision departs from decisions in non-SIPA fraudulent conveyance cases where courts have often required transferees to prove their good faith under an objective standard that defendants have had difficulty satisfying. The SIPA Decision breathes new life into the "good faith" defense to a fraudulent conveyance claim in SIPA cases and raises questions about its broader impact.

In Ponzi scheme cases, courts have wrestled with the proper balance of fairness between net losers and net winners.2 The issue, squarely presented by the Madoff case, is whether fraudulent conveyance claims (known as "clawback claims") can or should be pursued to recover funds from net winners in order to reduce the losses of the net losers.  Section 548(a)(1)(A) of the Bankruptcy Code requires that the transferor must have made the transfer with actual fraudulent intent, something ordinarily difficult to prove.  But under the so-called Ponzi scheme presumption, the transferor is deemed to possess the requisite scienter.3 Under section 548(c) of the Bankruptcy Code, defendants may establish an affirmative defense to such a claim by proving they acted in good faith. But the courts have struggled with what constitutes "good faith" -- a term not defined in the Bankruptcy Code -- and whether it should be measured by a subjective standard or by an objective standard of inquiry notice.4

In the SIPA Decision, the Trustee's position was that the defendants were sophisticated market participants who, even if they had no specific knowledge of Madoff's fraud, failed to act in good faith because they were aware of suspicious circumstances that should have led them to investigate the possibility of his fraud.  Thus, the Trustee argued, they lacked objective good faith irrespective of their actual knowledge.  But Judge Rakoff expressly rejected the duty to investigate that lay at the heart of the Trustee's theory, reasoning that in a SIPA proceeding the Bankruptcy Code must be harmonized with the federal securities laws.  He took note of SIPA's purpose of promoting investor protection and confidence in securities markets and he cited authority holding that under SIPA "'a securities investor has no inherent duty to inquire about his stockbroker and SIPA creates no such duty.'"  2014 WL 165192 at 3, quoting In re Manhattan Inv. Fund Ltd., 397 B.R. 1 (S.D.N.Y. 2007). While he acknowledged that the inquiry notice theory urged by the Trustee had been accepted in other cases, he ruled that "where the Bankruptcy Code and the securities law conflict, the Bankruptcy Code must yield."  The Trustee's duty to investigate, he said, would be completely at odds with the goal of investor confidence and marketplace stability that SIPA was designed to enhance.  Accordingly, he ruled that "the inquiry notice standard that the Trustee seeks to impose would be both unfair and unworkable."

Based on that logic, he then ruled that, in fraudulent conveyance actions brought in SIPA proceedings, it is the trustee's burden to allege the specific facts that would negate an investor's good faith, meaning that a trustee can no longer rely on the Ponzi presumption.  The practical significance is enormous: it will require a trustee to examine -- on a case by case basis -- the circumstances surrounding the transfers in such a case to determine if he has sufficient facts to allege that investors lacked good faith.  For defendants, it will become far easier to establish subjective good faith as an affirmative defense.

Beyond fraudulent conveyance cases brought in SIPA actions, Judge Rakoff's decision raises a broader question, whether it is fundamentally fair to burden defendants in a Ponzi scheme case with the duty of inquiry mandated by the objective standard.  Ponzi schemes last until their exposure; they are designed to avoid detection.  It's one thing to say that fraudulent conveyance defendants cannot willfully blind themselves to red flags; it's quite another to suggest that they are obligated to discover the existence of a well-hidden fraud.  What Judge Rakoff said about the inquiry standard remains true for all the Ponzi scheme cases; it is "unfair and unworkable," and effectively reads the good faith defense in section 548(c) out of the Bankruptcy Code.  It will be interesting to see whether other courts are persuaded by Judge Rakoff's analysis to extend his ruling.


1. Sec. Investor Prot. Corp. v. Bernard L. Madoff Inv. Sec. LLC, ___ F.Supp.2d ___ (2014), 2014 WL 1651952 (S.D.N.Y. Apr. 27, 2014). On June 5, 2014, Picard sought leave to pursue an interlocutory appeal, arguing that the SIPA Decision will disrupt the Madoff recovery efforts.

2. Net losers are investors who lose some or the entire principal of their investment.  Net winners are investors who recovered their principal investment plus some return.

3. See In re Bernard L. Madoff Inv. Sec. LLC, 454 B.R. 317, 331 (Bankr. S.D.N.Y. 2011) ("Because the foregoing interpretation "aligns the fraudulent intent pleading requirement under Bankruptcy Code § 548(a)(1)(A) and NYDCL § 276," the element of fraudulent intent under both statutes is met by virtue of the Ponzi scheme presumption.  Id. at *28.").

4. As the cases often note, "the Bankruptcy Code does not define `good faith'" and the "`legislative history related to section 548(c) never defines, and scarcely addresses, good faith.'" Jobin v McKay, 84 F.3d  1330 at 1338 (10th Cir. 1996)(internal citations omitted). The court in In re Bayou Group, LLC, 439 B.R. 284, 307 (S.D.N.Y. 2010) observed that, "courts have struggled in applying this term, and the case law discussing Section 548(c)'s good faith affirmative defense is marked by a lack of clarity if not outright confusion." But numerous cases have endorsed the objective good faith standard. In re Bayou Group, LLC, Id. (citing Jobin, Id. (holding that a transfer is not taken in good faith "if the circumstances would place a reasonable person on inquiry of the debtor's fraudulent purpose"); Banner v. Kassow, 1996 WL 680760, 1996 U.S.App. LEXIS 30734 (2d Cir. Nov. 22, 1996) ("`transferee does not act in good faith when he has sufficient knowledge to place him on inquiry notice of the debtor's possible [in]solvency.'" (quoting In re Sherman, 67 F.3d at 1355)); Terry v. June, 432 F.Supp.2d 635 (W.D.Va. 2006) ("transferee must show. . . that he did not have knowledge of facts that should have reasonably put him on notice that the transfer was made in order to delay, hinder, or defraud creditors of the debtor.").

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