Second Circuit Shields $6B Madoff Redemptions from Clawback Under Bankruptcy Safe Harbor

Relevant Document:
Opinion

An Aug. 5 opinion issued by a three-judge panel of Second Circuit judges holds that the joint liquidators of the Fairfield Sentry funds – funds that invested heavily in the Madoff Ponzi scheme – cannot recover redemptions paid to investors shortly before the collapse of the scheme even though the defendants allegedly “knew or had reason to know that the Net Asset Value calculations were inflated due to the Madoff fraud.”

The court reasons that the liquidators’ claims are barred by section 546(e) of the Bankruptcy Code, the “safe harbor” provision, which protects from clawback “settlement payment[s]” made to “financial institution[s] … in connection with a securities contract.”

The opinion, penned by Circuit Judge Steven Menashi, reverses a Southern District of New York Bankruptcy Court decision, affirmed by the U.S. District Court on appeal, which held that the liquidators’ avoidance claims could proceed because they were based in foreign law, beyond the ambit of the safe harbor.

“[F]oreign common law avoidance claims fall within the scope of the safe harbor,” Judge Menashi writes, dashing the liquidators’ hopes to recover over $6 billion of redemption payments and indicating that the circuit continues to espouse a broad interpretation of the safe harbor.

In the Second Circuit appeal, the liquidators were looking to overturn two 2018 decisions by the bankruptcy court, affirmed on appeal to the district court, that resulted in the dismissal of all their claims except those based on a British Virgin Islands constructive trust theory. By finding that the constructive trust suits should have been dismissed, the Second Circuit hands a definitive win to the defendants; the liquidators now face a choice of whether to ask the Second Circuit to rehear the case or seek further appeal to the Supreme Court.

The Safe Harbor Applies, Overcoming the Presumption Against Extraterritoriality

The liquidators made several arguments that the constructive trust claims do not fall into the safe harbor. The threshold argument is that the safe harbor – a U.S.-law creation – should not apply outside of the U.S. under a principle known as the “presumption against extraterritoriality.”

Like the district court, the Second Circuit reasons that Congress “manifests an unmistakable intent” through section 561(d) of the Bankruptcy Code that the safe harbor should apply extraterritorially.

Section 561(d), which makes section 546(e) applicable to chapter 15 cases, “must apply extraterritorially if it is to have any effect at all,” Judge Menashi writes, noting that chapter 15 only allows foreign representatives – such as the liquidators – to assert foreign-law avoidance claims.

The Claims Do Not Meet the High Threshold for the Intentional Fraudulent Transfer Exception

Besides their threshold argument, the liquidators also argued that their claims are for “intentional fraudulent transfers” under section 548(a)(1)(A) of the Bankruptcy Code, carved out from the safe harbor. The judges reject that argument, explaining that the liquidators failed to meet the high bar for showing their claims are for intentional fraudulent transfers. The facts are relevant for context.

The liquidators alleged that Citco Funds (Europe) BV had the task of certifying to the Fairfield Funds administrators the net asset value of the funds. The certifications were based on statements provided by Bernard L. Madoff Investment Securities, or BLMIS. The statements were fictitious, and the liquidators alleged that Citco knew the statements contained incorrect information.

The liquidators also allege that Citco attempted three times to verify the existence of the funds’ assets at BLMIS between May 2000 and December 2002 but “never again tried to gain evidence” of the Madoff fraud and instead “accepted dramatically higher fees” tied to the net asset values certified by Citco.

According to the Second Circuit panel, however, those facts “establish that Citco was negligent or reckless with respect to the risk of fraud at BLMIS but do not establish that Citco intended to hinder, delay, or defraud creditors.”

“To establish an intent to hinder, delay, or defraud creditors, a plaintiff ‘must show that the debtor had an intent to interfere with creditors’ normal collection processes or with other affiliated creditor rights for personal or malign ends,” the opinion states.

The court concludes that “the allegations here do not show that Citco was ‘substantially certain’ that BLMIS was a Ponzi scheme and that investors who redeemed shares late would be defrauded. At most, Citco was reckless in continuing to issue the NAV certificates despite its suspicions regarding BLMIS.”

The panel takes care to distinguish a Second Circuit opinion from 2000 that found Ernst & Young liable for securities fraud – a tort requiring intent – when E&Y “had actual knowledge that the financial statements were inaccurate” but “nonetheless certified to the contrary.”

“In this case,” the opinion states, “Citco suspected – but did not know – that BLMIS was engaging in fraud,” and “[w]hile that suspicion might establish recklessness or negligence, it does not establish that Citco intended to hinder, delay, or defraud investors.”

The Safe Harbor Applies to Foreign Common Law Claims

The liquidators provided an additional path for the Second Circuit to find that the constructive trust claims – made under British Virgin Island law – do not fall within the safe harbor’s ambit. They argued that the safe harbor applies only to “statutory avoidance claims under the Bankruptcy Code” or “under foreign law that exist solely in bankruptcy.”

On that point, the liquidators pointed to section 546(e)’s use of the term “avoid,” which they contended was a “term of art referring to the statutory avoidance powers conferred by the Bankruptcy Code,” not common law. The district court agreed with the argument. The Second Circuit, however, was not persuaded.

“The premise of the liquidators’ argument – that the safe harbor applies only to the statutory avoidance powers conferred by the Bankruptcy Code – contradicts the statutory text,” Judge Menashi writes, explaining that the liquidators do not employ a “natural reading of the text.”

“In this case, the notwithstanding clause of § 546(e) establishes that the safe harbor provision overrides §§ 544, 545, 547, 548(a)(1)(B), and 548(b),” according to the panel. “It does not imply that the operative language of the safe harbor, which provides that the trustee ‘may not avoid’ a ‘settlement payment,’ limits only the use of the enumerated statutory avoidance powers.”

The Second Circuit panel also reasons that the term “avoiding powers” is not a “term of art” referring to Bankruptcy Code avoidance powers. “If Congress intended to restrict the ordinary meaning of “avoid” when it enacted the Bankruptcy Code, it would have provided a statutory definition identifying that technical sense,” the opinion says.

The opinion emphasizes, “[o]ur precedent does not foreclose the straightforward conclusion that § 546(e) directly bars the trustee from avoiding a covered transfer through either a statutory or a common-law claim.”

The BVI Constructive Trust Claims are Avoidance Claims

Lastly, the liquidators argued that their constructive trust claims do not fall into the safe harbor because they “proceed on different theories and different proof” than avoidance claims under the Bankruptcy Code. While the Second Circuit panel agrees that the constructive trust claims “do not require a showing of insolvency” or “bad faith,” this does not mean that the constructive trust claims are not avoidance claims, according to the opinion.

“Whether a claim is an avoidance claim for purposes of the safe harbor depends on the remedy sought – that is, whether it would avoid a covered transaction – rather than the legal elements of the claim,” the court states, citing its Nine West decision.

The constructive trust claims are avoidance claims, the panel finds, because “[t]he liquidators concede that the constructive trust claims seek a ‘similar remedy’ as an avoidance action using the Bankruptcy Code’s avoidance powers,” and “[t]hat is dispositive.”

Second Circuit Restates Broad Safe Harbor Jurisprudence

The opinion concludes with quotes from the Second Circuit’s 2019 Tribune decision that underscore a broad reading of the safe harbor: “[b]y adopting the ‘broad language’ of the safe harbor provision, Congress sought to prevent ‘settled securities transactions’ from being unwound in a way that ‘would seriously undermine … markets in which certainty, speed, finality, and stability are necessary to attract capital.”

Judge Menashi adds that “[c]ontrary to arguments advanced on appeal, there is ‘no conflict between Section 546(e)’s language and its purpose.’”