Ruling Limits Liability of Madoff 'Net Winners'; Interim Distribution to be Delayed?

Irving Picard, the trustee appointed to liquidate the now-defunct brokerage firm of convicted Ponzi schemer Bernard Madoff, was dealt yet another significant setback in his quest to collect funds for distribution to Madoff's defrauded investors.  On Tuesday, a federal judge rejected many of the claims in Picard's ongoing suit seeking $1 billion from owners of the New York Mets baseball team.  In addition to the dismissal of nearly all claims, United States District Judge Jed S. Rakoff narrowed the standard under which Picard could proceed in the case going forward.  Additionally, in the wake of the ruling, which many observers warned could severely limit Picard's potential recovery in the nearly 1,000 cases he has filed against those who withdrew more than they invested with Madoff, a lawyer for Picard stated that the first interim payment scheduled to be distributed to investors this month could likely be delayed.

In his suit, Picard had sought nearly $1 billion from various executives of the New York Mets baseball club, consisting of $300 million in principal investment and $700 million in so-called false profits. Consistent with the nearly 1,000 cases filed to date by Picard, the majority of which are the "clawback" actions, Picard has sought the return of funds withdrawn by the aptly-named net-winners within the six years prior to the filing date of the Madoff bankruptcy.  While federal bankruptcy laws only permit this lookback to seek funds withdrawn up to two years before the bankruptcy filing date, Picard has relied on the interplay between federal and state bankruptcy laws, which often permit a longer lookback period. Section  544(b) of the Bankruptcy Code defines this interplay, stating that the applicable state law can also be considered in expanding this lookback period.  Under section 213(8) of the New York Debtor and Creditor Law, fraudulent transfers can be avoided if they occurred within six years of the bankruptcy filing.

Under most bankruptcies and receiverships that parallel bankruptcy law, the use of state law to enlarge the applicable lookback period is routinely used and rarely challenged.  However, Judge Rakoff relies on the "safe harbor" provision codified in section 546(e) of the Bankruptcy Code that comes into play in the case of a registered securities brokerage firm and securities contracts.  This safe harbor restricts a bankruptcy trustee's power to recover payments that are otherwise avoidable under the Bankruptcy Code, and represents "the intersection of two important national legislative policies on a collision course - the policies of bankruptcy and securities law." In re Enron Creditors Recovery Corp., 2011 WL 2536101, *5 (2d Cir. June 28, 2011).  Section 546(e) covers an extremely broad definition of "settlement payments", which Judge Rakoff likens to a transfer made in connection with a securities contract, and "clearly includes all payments made by Madoff Securities to its customers."  Thus, by its "literal language," the Bankruptcy Code prohibits Picard from bringing any clawback action against Madoff customers except those paid in the case of actual fraud. 

Understandably, Picard argued that section 546(e) was inapplicable in the present situation, since its application would be inconsistent with the statute's purpose.  However, Judge Rakoff cites the purpose of section 546(e) in seeking to "minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries."  Here, Judge Rakoff relies on Picard's own characterization of the extent of Madoff's fraud in theorizing that the undoing of the transfers involving nearly 5,000 Madoff customers would have a substantial and similarly negative effect on the financial markets.  

However, it is the disparity between the current situation and the context in which that reasoning was previously invoked, the Enron fraud, that may serve as ammunition for the trustee's appeal.  Whereas Enron involved publicly traded shares of stock, which play a direct role in the interplay of the financial markets, Madoff customers invested in a private brokerage firm that was neither publicly traded nor a prominent market participant. The unwinding of transfers to potentially millions of Enron shareholders would have involved a complicated intertwining of numerous market participants.  Some will argue that the sheer volume of Madoff's purported trading qualifies it as a major participant in financial markets, but that purported trading, according to the trustee's extensive analysis of Madoff's business records, was as fictitious as the returns supposedly being generated.  But Judge Rakoff also bolsters his opinion using the constitutional principles of checks and balance by stating that, regardless of the legislative history, the judicial branch must only interpret what Congress has said, and may not deviate from what Congress clearly states.

The decision, arguably the most important legal decision in recent memory by Judge Rakoff, has immediate and severe ramifications for Picard.  Just as seen in the wake of Judge Rakoff's decision dismissing common law claims against HSBC, after which a plethora of 'piggback' motions were filed by similarly-situated financial institutions, one can expect the targets of Picard's current clawback suits to file motions on a much larger scale seeking the limiting of Picard's reach.  This limiting would be significant, in that it would effectively permit Picard to only seek funds withdrawn from Madoff in the two, rather than six, years prior to the unraveling of the scheme.  While many have struggled to estimate the true scope of these two scenarios, a lawyer for Picard estimated that up to $6 billion could be off the table if the ruling is upheld.  As noted by Allison Frankel in her excellent column, some high-profile beneficiaries of such a scenario would include Madoff's children, whose liability would decrease by $83.3 million, Bank Medici founder Sonja Kohn, whose clawback exposure would decrease by $27 million, and Frank Avellino and Michael Bienes, several principals behind a large feeder firm to Madoff, whose clawback liability would decrease by nearly $40 million.

Under an order issued the following day by Judge Rakoff, the decision cuts the possible liability of the Wilpons from nearly $1 billion to $386 million,  the total of all transfers made during the two-year period prior to the filing of the bankruptcy petition.

The ruling also affects the scheduled interim first distribution to victims scheduled to occur by the end of September.  According to Diana B. Henriques of the New York Times, who has authored a book on Madoff, an attorney for Picard stated that the initial distribution to victims would likely be delayed until the trustee has had an opportunity to determine the impact of the ruling on amounts owed to other victims of the fraud.  Victims were scheduled to share a pro rata portion of the first payment, which totaled $272 million.  

An attorney for Picard has already sought permission from Judge Rakoff to allow expedited review of the decision by the Second Circuit Court of Appeals. 

A copy of the Tuesday ruling is here.

A copy of the Wednesday order is here.