Judge Jed S. Rakoff of the Southern District of New York last week ruled that the U.S. Bankruptcy Code does not permit a bankruptcy trustee to recover foreign transfers. Specifically, Judge Rakoff refused to allow Irving Picard, the trustee of Bernard L. Madoff Investment Securities LLC (“BLMIS”), to recoup monies initially transferred from BLMIS to non-U.S. investment firms that were direct investors in BLMIS, and then subsequently transferred to such firms’ non-U.S. customers. Picard argued that Section 550(a)(2) of the Bankruptcy Code empowers a bankruptcy trustee to recover fraudulently transferred funds from subsequent transferees of the initial recipient. Judge Rakoff declined, however, to give that provision extraterritorial application, and denied recovery against the non-U.S. indirect BLMIS investors. (Kelley Drye & Warren LLP represents certain alleged subsequent transferees.)
To date, Picard has recovered over $9.8 billion through litigation and settlements and distributed over $5.3 billion to former Madoff customers. Among other things, for over five years Picard has been diligently pursuing claims against so-called “net winners,” i.e., BLMIS investors who withdrew from BLMIS amounts in excess of their invested capital. These investors include investment firms located outside of the United States that acted as “feeder funds” for BLMIS; they solicited capital from non-U.S. customers and invested it with BLMIS. Nearly all of the withdrawals made by these firms from BLMIS prior to its downfall were in turn transferred back to their customers. Picard obtained judgments avoiding the initial transfers from BLMIS to the investment firms as fraudulent transfers, and then sought under Section 550(a)(2) to recover the subsequent transfers from the non-U.S. defendants.
A recent Supreme Court decision, Morrison v. National Australia Bank Ltd., held that U.S. statutes are presumed “to apply only within the territorial jurisdiction of the United States,” unless Congress clearly intended otherwise. Judge Rakoff broke the Morrison ruling into two parts. He first considered whether the utilization of Section 550(a)(2) to recover the transferred BLMIS funds would in fact constitute an “extraterritorial” application of that section. Picard argued that because the intent of the fraudulent conveyance provisions of the Bankruptcy Code and Section 550 is to allow bankruptcy trustees to recover the property of debtors that are situated within the United States, the application of Section 550(a)(2) is inherently within U.S. territorial jurisdiction. Judge Rakoff disagreed, stating that Section 550(a)(2) focuses on the actual transfer of property from the entity that initially received an improper transfer from the debtor to an alleged subsequent transferee, and not on “the relationship of that property to [the] debtor.” He determined that because the actual transfers from the investment firms to their customers took place outside of the U.S., Picard required Section 550(a)(2) to apply extraterritorially in order to prevail.
Judge Rakoff then examined whether Congress had intended for Section 550(a)(2) to apply outside of U.S. territory. Section 541(a) of the Bankruptcy Code, for example, contains clear evidence of such intent. It expressly states that the “bankruptcy estate” created upon the commencement of a case consists of property interests of the debtor “wherever located and by whomever held.” In contrast, Section 550 contains no such language of congressional intent. Picard argued that express language in Section 550 was not necessary. He contended that the reference in Section 550 to “property” transferred sufficed to apply the extraterritorial intent expressly stated in Section 541 to Section 550(a)(2) as well.
Judge Rakoff rejected that argument. He held that under the precise language of Section 541, “fraudulently transferred property becomes property of [the bankruptcy] estate only after it has been recovered by the Trustee.” Picard could not rely on Section 541 with respect to property not yet recovered for evidence of congressional intent to apply Section 550(a)(2) beyond the ambit of U.S. territory.
Judge Rakoff held that, because section 550(a) does not apply extraterritorially and Picard’s use of that section to recover foreign transfers “would be precluded by concerns of international comity,” Picard has the burden to allege specific facts showing domestic transfers. He ruled that because both the transferors and the transferees reside outside of the United States, Picard could not plausibly do so.
In essence, the decision means that Picard has to wait alongside other creditors in the foreign liquidation proceedings of the “feeder fund” firms; he cannot use the U.S. Bankruptcy Code to bypass those proceedings. Judge Rakoff observed that permitting Picard to go against non-U.S. customers of the feeder funds would improperly interfere with those liquidation proceedings. He stated that even if Section 550(a)(2) were to apply extraterritorially, such application should be precluded under principles of international comity.
Judge Rakoff further noted that Picard had argued strenuously in previous actions that the non-U.S. customers, having had no direct relationship with BLMIS, could not assert claims against BLMIS and share in recoveries with direct BLMIS customers. He therefore rejected Picard’s argument that the non-U.S. customers would be receiving improper preferential treatment by virtue of being shielded from his efforts to recover fraudulent transfers.
Judge Rakoff also turned aside Picard’s concerns that a failure to apply Section 550(a)(2) extraterritorially would create a loophole that will enable fraudulent U.S. debtors to hide their assets offshore through a series of multiple transfers. The presumption against extraterritorial application of U.S. statutes, Judge Rakoff stated, needs to take precedence in order “to protect against unintended clashes between our law and those of other nations.” Judge Rakoff noted that if any such intentional fraud were to occur, it could properly be addressed through the utilization of applicable foreign laws.
This decision puts substantial limitations of the extraterritorial reach of the Bankruptcy Code. In particular, it will limit the effect of the clear congressional intent to apply Section 541 to property “wherever located and by whomever held.” But if the ruling stands on appeal, it should provide substantial comfort to investors outside of the United States that invest indirectly with U.S. firms or companies. If those investments ultimately fail, non-U.S. indirect investors will not find themselves subject to the threat of recovery actions in U.S. bankruptcy cases.