As the Madoff Securities and Stanford Financial schemes have unraveled in recent months, financial industry participants have had to scrutinize closely their involvement with these entities. A key issue in each of these cases will be the extent to which the trustee (or similar representative) can “claw back” payments made as part of the Ponzi and related fraudulent schemes. The U.S. Bankruptcy Court for the Southern District of New York recently considered similar facts in Bayou Accredited Fund, LLC v. Redwood Growth Partners, L.P. (In re Bayou Group, LLC).1 In that case, the Court analyzed redemptions from the Bayou Group funds that had been run as a Ponzi scheme. The Court allowed the trustee to avoid all transfers that took place within the statutory time period on account of fictitious profits, requiring recipients to repay all such amounts to the trustee. With respect to payments of principal, though, the Court held that such payments also constituted fraudulent transfers, but were subject to a “good faith” defense. To the extent the recipient could demonstrate that it objectively should not have been aware of the Ponzi scheme at the time of redemption, the recipient would not have to pay principal amounts back to the trustee. Recipients of funds from Madoff Securities (and likely Stanford Financial) should consider the applicability of the Bayou standard to their redemptions.

Background

Beginning within months of its creation, Bayou Fund, LLC (“Bayou Fund”) falsified its performance reports and financial statements, concealing trading losses and transfers to principals of the fund. In 2003 the Bayou Fund was dissolved and four new hedge funds (the “Bayou Hedge Funds,” and, together with the Bayou Fund and affiliated entities, “Bayou”) were created. The fraudulent scheme continued. Bayou paid redemptions from the Bayou Fund, and later from the Bayou Hedge Funds, inflated by the fabricated performance reports, in part with money from new investors. In 2005 Bayou collapsed, the scheme came to light, and the principals pled guilty to various forms of fraud. In 2006, the United States District Court for the Southern District of New York appointed Jeff Marwil as receiver (the “Receiver”) for Bayou, and on May 30, 2006 the Bayou entities filed their chapter 11 cases.

Certain debtors in Bayou’s chapter 11 cases then sought to avoid as fraudulent transfers certain redemptions paid within the statutory time limitation. The Court considered motions for summary judgment in 33 adversary proceedings brought by the debtors. In considering the summary judgment requests, the Court considered the standards governing when redemption payments from Ponzi schemes may be clawed back by a trustee.

Applicable Statutory Provisions

Section 548 of the Bankruptcy Code allows the trustee or debtor-in-possession in a bankruptcy case to avoid certain transfers made in the two years prior to the commencement of the bankruptcy case. These fraudulent transfers can be recovered and brought into the estate for the benefit of its legitimate creditors.

Section 548(a)(1)(A) of the Bankruptcy Code permits the trustee to avoid any transfer made within the two years prior to its bankruptcy case if the debtor “made such transfer . . . with actual intent to hinder, delay, or defraud” any present or future creditor. The Bankruptcy Code also creates a “good faith” exception to the “actual fraud” standard. Section 548(c) creates a “good faith” defense for transferees, stating that “a transferee . . . that takes for value and in good faith has a lien on or may retain any interest transferred . . . to the extent that such transferee . . . gave value to the debtor in exchange for such transfer.”

Fraudulent transfers need not be actually fraudulent to be avoided. A transfer that is made for less than equivalent value while the debtor is insolvent is constructively fraudulent and can also be avoided under section 548. Section 548(a)(1)(B) of the Bankruptcy Code states that the trustee may avoid any payment for which the debtor “received less than a reasonably equivalent value in exchange for such transfer . . . and was insolvent on the date that such transfer was made . . . or became insolvent as a result of such transfer.”

Section 544 of the Bankruptcy Code allows the trustee to avoid any transfer avoidable under applicable law by an unsecured creditor of the debtor. As a result, section 544 incorporates state fraudulent transfer law, which is generally analogous to section 548. Among other things, this can greatly expand the look-back period for avoidance of fraudulent transfers, because many state statutes of limitations are longer than the two years provided by section 548.

The Profit Portion of Each Redemption is Avoidable

In the Bayou case, the Court held that any payment of fraudulent “profits” was a constructive fraudulent transfer as defined under section 548(a)(1)(B) of the Bankruptcy Code (and analogous state law).2 With respect to payments of fictitious profits from Ponzi schemes, the Court held that “the Bayou hedge funds were insolvent during the relevant period,”3 and, because the recipient provided no reasonably equivalent value in consideration for the false profits, the recipient could not establish a good faith defense.4 With respect to the transferees, the Court specifically found that “Plaintiffs have . . . established all the statutory elements entitling them to judgment against all defendants under Section 548(a)(1)(B) in respect of those portions of redemption payments limited to fictitious profits” and permitted the avoidance of all payments of profits.5

Payment of Principal May Be Subject To Good Faith Defense

Next the Bayou Court examined whether the Receiver could avoid payments of principal made as part of a Ponzi scheme. The Bayou Court held that because Ponzi scheme payments were by definition made “with actual intent to hinder, delay, or defraud,” the transfer of this portion of the investment would still be avoidable unless the investor took in “good faith.”6 The Court therefore determined what constitutes good faith for the purposes of section 548(c):

The test is whether the defendant requested redemption after learning of a “red flag” which, under an “objective” standard, should have put the defendant on “inquiry notice” of some infirmity in Bayou or the integrity of its management. The rule does not require that the “red flag” be of such specificity as to put the recipient on “inquiry notice” of the actual fraud, or embezzlement, or looting, or whatever ultimately proves to be the cause of loss. It is sufficient if the red flag puts the investor on notice of some potential infirmity in the investment such that a reasonable investor would recognize the need to conduct some investigation.7

The Court noted that a transferee’s lack of “good faith” under 548(c):

does not necessarily entail a finding or carry an imputation that he was guilty of any sort of mala fides or otherwise deserving of opprobrium. To the contrary, any rational investor or financial advisor, on inquiry notice of a warning signal respecting an investment, would be entirely justified in requesting or recommending redemption and could not be criticized for doing so . . . . But if he does so, the courts have held that he cannot invoke the good faith defense under Section 548(c).8

The Court clarified that good faith is to be determined at the time the transferee makes its decision to redeem the investment. “If a defendant can prove that his request for redemption was not motivated by knowledge of a red flag portending infirmity within Bayou, that defense is not undermined by delays in payment or other post-request red flags.”9

The good faith standard is an objective one – courts will focus on what the transferee should have known rather than the transferee’s actual knowledge or motivation.10 However, the Court recognized an exception in cases in which the transferee can demonstrate its actual subjective good faith (with reference to objective evidence, not mere assertions).11

The good faith defense is best demonstrated by the facts related to the adversary proceeding with respect to the transfer made to DB Structured Products, Inc. (“DBSP”). DBSP invested in a Bayou hedge fund to hedge its own risk resulting from two separate swap transactions.12 In each swap transaction, DBSP agreed to pay the counterparty the amount that a hypothetical investor in the Bayou fund would receive. Though not required to do so by contract, DBSP hedged each of the swap transactions by actually making investments equivalent to the hypothetical investments contemplated by the swap transactions.13

When one of the swap counterparties terminated its swap agreement, DBSP redeemed the corresponding investment in Bayou. DBSP did not redeem the investment corresponding to the other swap transaction, which was still active.14

The Trustee sought to avoid the payment to DBSP on account of redemption. The Court ruled that “[t]hese facts would establish DBSP’s good faith defense even if Deutsche Bank or DBSP had received knowledge of ‘red flags’ putting them on inquiry notice with respect to the Bayou hedge funds.”15

For this reason, the Court held that DBSP redeemed its investment in good faith, and the principal amount of its investment could not be avoided by the trustee.16

By contrast, certain transferees argued that they took in good faith because “inquiry after notice of a red flag would have been futile because no amount of diligent investigation would have uncovered the Bayou fraud.”17 The Court rejected this argument as a factual matter, noting that “readily ascertainable facts . . . made quite apparent that there was misrepresentation in the published financials and some serious defect in the financial affairs of the Bayou hedge funds that could not withstand scrutiny.”18 The Court also rejected the argument as a matter of law, holding that section 548 “does not turn upon whether the investordefendant could or should . . . actually discover the fraud.”19

The Court similarly rejected the “inconclusive diligent investigation” argument advanced by certain transferees, who argued that they took in good faith because they undertook diligent investigations but discovered no fraud.20 The Court held:

What the cases do not hold is that the defendant’s good faith defense is established if the investigation is not carried on to the point that it proves that there was a fraud . . . . The “inconclusive diligent investigation” argument must be rejected because it is precisely the purpose and the effect of the objective approach adopted by all the courts in interpreting 548(c) to virtually rescind the availability of the ‘good faith’ defense where the transferee or its surrogate conducts an investigation that is diligent but that at the same time leaves the transferee with concerns or suspicions.21

For this approach to work, the Court noted, the transferee’s concerns must be “allayed or set to rest,”and the transferee must then redeem its investment for an independent good-faith reason.22

Conclusion

Because of its fact pattern and its thorough analysis, Bayou is likely to be invoked in any case in which a trustee seeks under section 548 of the Bankruptcy Code to avoid prior redemptions from a Ponzi scheme. It is critical that investors fully analyze any potential “good faith” defenses they might have to determine if they may be able to preserve any payments of principal received from Madoff Securities or Stanford Financial.