The Supreme Court recently denied certiorari in Picard v. Citibank, in which the petitioner sought review of a Second Circuit decision on a seemingly obscure point of law: the pleading burden for “good faith” under Section 550 of the Bankruptcy Code. The Second Circuit’s decision is part of, and highlights, a larger, systemic problem in the evolution of bankruptcy law over the last decade—the multiplication of trustee-friendly interpretations of the Bankruptcy Code that, when combined, leave innocent subsequent transferees unfairly vulnerable to meritless clawback suits. Many of these rulings have emerged in the Second Circuit in the context of Bernard Madoff’s collapsed $20 billion investment company, but the decisions may have broader ramifications for subsequent transferees in more modest bankruptcy proceedings.

Good Faith and the Madoff Litigations

The Bankruptcy Code provides a trustee with numerous tools to ensure that a debtor has not transferred its property to third parties in a way that unfairly favors certain creditors or fraudulently enriches others. Under Section 548 of the Bankruptcy Code, a trustee may “avoid,” or unwind, transfers from a debtor that were made with fraudulent intent or that were constructively fraudulent because the transfer was not made in exchange for fair consideration at a time when the debtor was insolvent or undercapitalized. Under Section 550 of the Bankruptcy Code, the trustee may recover property that is subject to avoidance from either the initial transferee or any third party that may have subsequently received the property (a “subsequent transferee”).

Because the subsequent transferee may be quite distant from the debtor, may have no knowledge that the funds they received originated from the debtor, or may have no way to know a debtor’s fraudulent intent, the Bankruptcy Code does not permit recovery by the trustee where the subsequent transferee took the challenged transfer “for value,” “in good faith,” and without knowledge of the fraudulent nature of the transfer. In this context, “good faith” turns on what the transferee knew when it took the transfer—that is, if the transferee did not know the initial transfer was fraudulent and paid a fair price for the transfer, it is allowed to keep the property it received.

In various litigations that have followed in the wake of Bernard Madoff’s Ponzi scheme in 2008, the trustee for Madoff’s investment company has sought to claw back billions of dollars of transfers from subsequent transferees. Many of these subsequent transferees are large and sophisticated financial institutions. They have raised a number of challenges to the trustee’s claims, almost all of which have been rebuffed by the courts. And the cumulative effect of these decisions has been to undermine the protections subsequent transferees are afforded by the Bankruptcy Code in the Second Circuit.

Take, for example, the following rulings:

  • In Picard v. Citibank, the Second Circuit held that a trustee who brings an action to claw back transfers against a subsequent transferee does not need to plead that transferee’s lack of good faith in its complaint. [1] The result is that a trustee need only assert two things to plead a claw back action: (i) that a particular initial transfer is avoidable, and (ii) that the defendant indirectly received those funds. Unlike a defendant in a non-bankruptcy fraud case, where the plaintiff must plead fraud with particularity, the subsequent transferee defendant here has few grounds to win a motion to dismiss, and instead will often be forced to litigate the case through discovery to summary judgment or trial.
  • Courts have held that trustees need not avoid an initial transfer before pursuing a recovery action against a subsequent transferee. [2] Those decisions remove another layer of protection for a subsequent transferee—the ostensible first step of bringing suit against the initial transferee. Further, they require the subsequent transferee to assume the burden of arguing the initial transfer should not be avoided—despite the subsequent transferee’s lack of involvement in (and so, lack of knowledge of) that transfer.

The effect of these rulings is that a trustee may bring a suit directly against a subsequent transferee without alleging the subsequent transferee’s bad faith. In such a suit, the subsequent transferee will paradoxically be forced to plead and prove its own good faith (i.e., that it was not on inquiry notice of any fraudulent nature of the initial transfer)—despite being far removed from the debtor and having little knowledge of the initial transfer to which it was not a party.

Not What Congress Intended

The cumulative effect of these decisions and others—which may be reasonable when viewed each in isolation—is to severely disadvantage innocent subsequent trustees. This burden runs counter to Congress’s intent when it drafted the Bankruptcy Code, which was to “avoid litigation and unfairness to innocent purchasers.” [3] As a matter of policy, too, it makes no sense to burden subsequent transferees in this way—as parties several steps removed from the debtor and any fraudulent transfer, they have few tools available to monitor whether the funds they accept in the normal course of business originated from a debtor, and so should instead benefit from a presumption of good faith. But as it stands, the law does not provide innocent subsequent transferees with the protections Congress intended.