In light of the recent Madoff Scandal, an area of law commonly referred to as “Clawback Litigation” is becoming a hot topic among investors. Bernard Madoff masterminded the largest Ponzi scheme in American history. Madoff’s scheme has created a financial frenzy for some investors who had redeemed their initial investments and may have made a profit. The redeeming investors perhaps thought they were lucky to get out when they did after the truth came out. However, those same investors soon realized that they were not the lucky ones and that they would too become victims of Madoff’s fraud though clawback litigation.
In a clawback suit, the bankruptcy trustee or receiver will seek the recovery of initial investments and any false profits that were paid to investors in order to redistribute these funds to investors that lost the principal on their investment. Clawback litigation has roots in several sections of the United Stated Bankruptcy Code. Pursuant to Section 547 of the United Stated Bankruptcy, the trustee, may avoid, as preferences the full amount of transfers made within ninety (90) days preceding the filing of the bankruptcy petition, and if the transferee qualifies as an insider, within one year of the filing of the petition. Section 548 of the United States Bankruptcy code provides that a trustee may avoid fraudulent conveyances, whether based on actual or constructive fraud, that were made within two years of the filing of the petition. Finally, Section 544 of the United States Bankruptcy code, a trustee may avoid fraudulent conveyances based upon applicable state law. In Pennsylvania, the applicable statute of limitation for fraudulent conveyances is four (4) years. Some states have longer limitations periods, which allows the trustee to look back even further in time. For example, in New York, where the Madoff Ponzi scheme occurred, the applicable state statute of limitations period for fraud is six (6) years and in Pennsylvania it is four (4) years.
The courts have made a distinction between the redemption of initial investments and of false profits. In order for the trustee or receiver to be able to claw back payments that constituted and initial, there must be evidence of actual fraud. However, when the trustee or receiver is seeking the redemption of false profits, the standard only requires proof constructive fraud. Regardless if the case requires proof of actual or constructive fraud, generally the trustee or receiver can easily meet his or her burden. The very nature of a Ponzi scheme is fraudulent; therefore in almost all cases the trustee or receiver can show proof of the intent to defraud based upon the admission of a principal that they perpetrated a Ponzi scheme.
Once the actual or constructive fraud has been established an investor may use the “good faith” affirmative defense to defeat the fraud claims for the redemption of their initial investment. The good faith defense is not applicable to fictitious profits. The good faith affirmative defense has two parts: the “inquiry notice” prong; and the “diligent investigation” prong. With regard to the inquiry notice prong, the Court In re Bayou Group, LLC stated several instances where other courts have held that “inquiry notice” of the following precludes a finding of good faith: fraudulent purpose of the transfer; underlying fraud; unfavorable financial condition for the transferor; insolvency of the transferor; improper nature of he transaction and voidability of the transfer. The court stated however that the aforementioned circumstances are not conclusive and that “good faith must be evaluated on a case-by-case basis.” In other words, the inquiry notice prong focuses on whether there were red flags which caused investors to redeem their investments.
The Bayou court stated with regard to the “diligent investigation” requirement, “Once on inquiry notice, a transferee’s failure to conduct a diligent investigation is fatal to its good faith defense under 11 U.S.C.S. § 548(c). In order to prove good faith, that diligent investigation must ameliorate the issues that placed the transferee on inquiry notice in the first place. In other words, if the diligent investigation aggravates, rather than allays, the concerns placing the transferee on inquiry notice, then no good faith defense is supported. Moreover, a transferee cannot satisfy the diligent investigation prong of the good faith test merely by inquiring with the transferor itself, even were the transferor to provide a plausible explanation of the issues. A diligent investigation requires more than merely asking the transferor about the suspicious circumstances. In other words, a transferee cannot put his head in the sand in the face of unusual or suspicious circumstances and then take advantage of the “good faith” defense afforded by § 548(c). Once on inquiry notice, taking no steps at all would have amounted to willful ignorance, which would have defeated the good faith defense.”
There were a several instances where the good faith defense was upheld in the Bayou case. The following are examples of instances where the good faith defense was upheld: a Medical Group Pension Plan was able to show through independent objective evidence that on advice of independent auditors and counsel, the Plan liquidated its Bayou investment and similar investments to comply with ERISA and the Plan’s Trust Agreement; A Family Trust requested redemption for the sole purpose of funding the purchase of a home by the Trust’s beneficiary; A investor who was able to show through objective evidence that he requested the redemption of his investment to fund expenses of a newborn child and private school tuition expenses of an older child; Another investor was able to show that he made a redemption in order to obtain funds to purchase a new home.
The alleged $50 billion dollar Ponzi scheme perpetrated by Bernard Madoff will become the next big case in the area of claw back litigation. Madoff admitted that he operated a Ponzi scheme and gave details on how he operated the fund. Madoff’s admission is exactly what the trustee needs to show proof of actual fraud and meet his or her burden. Since the trustee has already per se established that there was actual fraud, the burden will shift to the redeeming investors to show why the funds they received should not be subject to a clawback based on variations of the good faith affirmative defense. In the Madoff case, clawback suits have not been formally filed yet, however investors who redeemed profits within the six year statute of limitations under New York state law have been advised through the media to be aware of the potential lawsuits and consequences.
11 U.S.C. § 547.
11 U.S.C. § 548
11 U.S.C. § 544
Pennsylvania Uniform Fraudulent Transfer Act, 12 Pa.C.S.A. § 5104 et seq. (“PUFTA”)
In re Bayou Group, LLC, 396 B.R. 810 (Bankr. S.D.N.Y 2008)
Id. at 846.
For additional information on perfection of security interests and the usage of other credit enhancements, please see the other articles in this Publications section.