The latest in a line of fraudulent transfer decisions in the Madoff case has added to the case-law regarding what level of knowledge is needed to plead actual fraud in securities Ponzi scheme cases.

In dismissing most of the claims brought against certain investors by court-appointed trustee Irving Picard, Judge Stuart Bernstein of the United States Bankruptcy Court for the Southern District of New York found that the level of knowledge pled by the trustee did not satisfy the prevailing standard that has been established in the Madoff cases, as discussed below.

In this case, Picard asserted several counts of actual and constructive fraud against Legacy Capital Ltd. (“Legacy”), a single purpose vehicle used to invest in Bernard L. Madoff Securities LLC (“BLIMIS”), and Khronos LLC, a provider of accounting and other services to Legacy and certain other funds that invested in BLIMIS. Taken together, Picard’s complaint sought to avoid and recover approximately $213 million in initial transfers made to Legacy and approximately $6.6 million in subsequent transfers made to Khronos.

Standards

First, a quick recap on fraudulent transfers. There are two types of fraud in the world of fraudulent transfers – actual and constructive. Actual fraud requires a showing of “actual intent to hinder, delay or defraud” creditors, while constructive fraud permits a trustee or debtor in possession to avoid transfers made for “less than reasonably equivalent value” when certain other factors are present, e.g., insolvency or unreasonably small capital (among others). The Bankruptcy Code generally gives the trustee the right to pursue these claims under either the Bankruptcy Code-created fraudulent transfer provisions (section 548 of the Bankruptcy Code), which have a two year look-back period, or through state law fraudulent transfer laws (using section 544(b) of the Bankruptcy Code), which often provide a longer statute of limitations.

Section 548(c) provides a defense to fraudulent transfers where the transferee took for value and good faith; in that case, the transferee may retain any interest transferred to the extent of such value given. This section provides that

[A] transferee or obligee of [an avoidable transfer or obligation of the debtor] that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation.

Moreover, in securities transactions, potential fraudulent transfers may fall within the safe harbor of section 546(e), which protects a transfer that is a “settlement payment … made by or to (or for the benefit of) a … financial institution [or] financial participant,” or a transfer that is “made by or to (or for the benefit of) a … financial institution [or] financial participant … in connection with a securities contract.” As we reported in our previous post, District Court’s Dismissal of Madoff Trustee’s Constructively Fraudulent Claims Against Customers Reaffirms a “Settled” Principle, the United States District Court for the Southern District of New York has previously found that many transfers to Madoff customers fall within the safe harbor.

There is an explicit exception to the safe harbor, however, for actual fraudulent transfers under section 548(a)(1)(A) of the Bankruptcy Code. Actual intent can be difficult to prove. But in the Second Circuit, fraudulent intent may be inferred by the mere presence of a Ponzi scheme. The District Court has also previously held that it is “patent” that all of Madoff’s securities transfers during the two-year period preceding the liquidation proceedings were made with actual intent to defraud present and future creditors. Picard v. Katz, 462 B.R. 447, 453 (S.D.N.Y. 2011) abrogated by Sec. Inv’r Prot. Corp. v. Bernard L. Madoff Inv. Sec. LLC, 513 B.R. 437 (S.D.N.Y. 2014).

The interesting twist on Judge Bernstein’s most recent decision is that it was the actual knowledge of the transferees that mattered more. This is for two reasons.

First, prior fraudulent transfer decisions of the District Court have held that the section 546(e) safe harbor is not available even in constructive fraudulent transfer cases if the transferee had “actual knowledge that there were no actual securities transactions being conducted.” This is because

The safe harbor was intended, among other things, to promote the reasonable expectations of legitimate investors. If an investor knew that BLMIS was not actually trading securities, he had no reasonable expectation that he was signing a contract with BLMIS for the purpose of trading securities for his account. In that event, the Trustee can avoid and recover preferences and actual and constructive fraudulent transfers to the full extent permitted under state and federal law.

The transferee’s knowledge and intent was necessary, therefore, to avoid the safe harbors. Actual knowledge “implies a high level of certainty and absence of any substantial doubt regarding the existence of a fact.”

Second, the transferees’ knowledge and intent were relevant for determination of the defendants’ good-faith transferee defense under section 548(c) of the Bankruptcy Code. The defense essentially shifts the intent inquiry to the transferee – rather than focus on the intent of the transferor, the defense requires the trustee and the court to focus on the transferee’s good faith. This, in turn, leads to an inquiry of the transferee’s intent and knowledge. Judge Bernstein explained:

Where, as here, the Trustee seeks to recover the transfer of principal in addition to fictitious profits, he must plead the transferee’s lack of subjective good faith which, in this SIPA case, means the transferee turned a blind eye to facts that suggested a high probability of fraud.

Willful blindness involves (i) a subjective belief that there is a high probability that a fact exists and (ii) taking deliberate actions to avoid learning of that fact; in other words “strong suspicion but some level of doubt or uncertainty of the existence of a fact and the deliberate failure to acquire knowledge of its existence.”

Taken together, for Picard to meet his pleading burden against Legacy, he needed to plead (i) that Legacy had actual knowledge that BLMIS was not engaged in the trading of securities (this would negate the section 546(e) safe harbor for the fraudulent transfer claims not based on section 548(a)(1)(A) of the Bankruptcy Code) or, (ii) at least, willful blindness (which would negate the section 548(c) good faith defense for the actual fraudulent transfer claims relating to repayment of principal based on section 548(a)(1)(A) of the Bankruptcy Code).

Application to Facts

Judge Bernstein’s decision illustrates why it is difficult to plead actual knowledge or willful blindness. The decision describes in detail the court’s findings about what the defendants knew. For example, the court found that they knew that BLIMIS’ purported options trading was impossible; that the timing of BLMIS’ trades was impossible; that BLMIS’ fee structure was unusual and differed from industry standards in that it only charged trading commission instead of a 1% to 2% management fee and 10% to 20% performance fee; that BLMIS’ enormous trading volume never impacted the market; that BLMIS’ rates of return were impossible; that BLMIS’ operations lacked transparency and controls; that BLMIS did not have a capable auditor; that BLMIS’ trade confirmations reported trades that reflected prices outside the range reported in the market; and that BLMIS’ account statements showed impossible dividends. In addition, the court found that as a result of all these facts, Legacy hired Khronos to review the entire history of BLMIS’ trades, past and future.

The court held that these facts, while compelling, did not rise to the level of actual knowledge. In other words, the allegations in Picard’s complaint did not “plead a plausible claim that [the defendants] actually knew that Madoff was not trading securities.” The existence of “red flags” such as the ones mentioned above was insufficient because

Alleging actual knowledge based on the existence of red flags amounts to pleading that the defendant, here Khronos and Legacy, knew or should have known that BLMIS was not engaged in the actual trading of securities. This is the objective standard of knowledge rejected by the District Court [in prior decisions].

Furthermore, the defendants’ behavior suggested that they did not know BLMIS was not trading securities. They did not pull their investments from BLMIS, even though “[i]t is common knowledge (undoubtedly more common among sophisticated financial professionals) that a Ponzi scheme will inevitably collapse.” And “retention of Khronos to conduct due diligence implies that Legacy did not know that Madoff was a fraud.”

On the willful blindness point, the court held that while the complaint properly alleged the first prong of willful blindness (that Legacy strongly suspected that, at a minimum, BLMIS’ option trades were not real), it did not allege the second prong (that Legacy turned a blind eye to its suspicions). Instead, in retaining Khronos, it was clear that “Legacy did not turn away or willfully blind itself to its suspicions,” and “like mostly everyone else, Khronos missed it.”

Conclusion

Judge Bernstein’s decision is a significant victory for similar investor defendants in the Madoff cases. Although their knowledge and intent may become a pivotal factor at the pleading stage, investors can take comfort that courts in New York will distinguish clearly between “knew” and “should have known,” and insist on the former before stripping them of their section 546(e) defense for constructive fraudulent transfer claims (and state law actual fraudulent transfer claims). Similarly, the relatively high bar for willful blindness may give them some comfort that the section 548(c) defense is available to protect their return of principal from attack as an actual fraudulent transfer even when the section 546(e) safe harbor is not.