How Far Can the Trustee Reach?

How Far Can the Trustee Reach to Clawback Fraudulent Transfers?

Bernard Madoff’s infamous Ponzi scheme left victims in its wake worldwide and resulted in numerous bankruptcy and insolvency proceedings around the world. That included proceedings concerning Bernard L. Madoff Investment Securities LLC (BLMIS) and many of the investment funds, called feeder funds, that invested their clients’ money in BLMIS.

It is common practice under U.S. law that bankruptcy trustees¹ will seek to recover or “clawback” fraudulent transfers made prior to the commencement of a chapter 11 (or, indeed, chapter 7) bankruptcy case. The bankruptcy code also permits the representatives of foreign debtors to pursue litigation in U.S. courts to address those debtors’ U.S.-based assets and liabilities, including attempts under U.S. state or foreign law to recover improperly transferred funds.²

About Transfers

The cross-border aspects of large fraud cases like Madoff’s raise interesting issues for U.S. courts that have a real-world impact on creditors trying to recover assets and transferees trying to hold onto them. For example, the bankruptcy code authorizes a trustee to recover any avoided transfer from both initial and subsequent transferees,³ but what happens when the ultimate transferees are all outside of the United States? Does the bankruptcy code – a domestic law of the United States – apply to those transfers?

Similarly, while the bankruptcy code generally authorizes the clawback of fraudulent transfers, it contains exceptions that make certain transfers exempt from avoidance.⁴ Do those domestic law limitations apply to claims brought in US courts under purely foreign law?

The Impact of Two Decisions

These important issues and others were resolved by two decisions — In re: Irving H. Picard, Trustee for the Liquidation of Bernard L. Madoff Investment Securities LLC, 917 F.3d 85 (2d Cir 2019) and Fairfield Sentry Limited (in liquidation) v. Citibank N.A. London, United States District Court for the Southern District of New York, 19-CV-3911 (September 2002) — each arising out of litigation stemming from the unraveling of Madoff’s fraud.

Before its 2008 collapse, BLMIS solicited investment by promising returns “that seemed, and were, too good to be true.”⁵ Among BLMIS’ investors were the feeder funds, entities that pooled money from other investors, placing them in a ‘master fund’ at BLMIS for Madoff to invest on their behalf.⁶ Because BLMIS was part of a Ponzi scheme,⁷ withdrawals and other transfers to existing investors were often funded by deposits from new investors.

After Madoff’s fraud was discovered, and BLMIS was placed into liquidation under SIPA, many of the foreign feeder funds were themselves the subject of insolvency proceedings, including in BVI and the Cayman Islands. Under BVI and Cayman law, respectively, liquidators were appointed over the foreign funds and charged with, among other things making distributions of a fund’s assets, which included any recovery of monies that were improperly paid out.

Section 548 of the Bankruptcy Code allows a duly appointed bankruptcy trustee to avoid or set aside (commonly known as a clawback) transfers by a debtor that were made with “actual intent to hinder, delay or defraud” creditors.⁸ Pursuant to Section 550 of the Code, such transfers may be recovered from the debtor’s initial transferee or from subsequent transferees.⁹

Thus, the Code seeks to prevent fraudsters from attempting to wash their transfers by sending fraudulently transferred funds to another and then receiving a retransfer. It protects creditors by allowing for recovery, in appropriate circumstances, from transferees several steps removed from the original fraud.¹⁰

Fraudulent Transfers

Picard brought numerous fraudulent transfer actions seeking to recover funds transferred to investors by BLMIS. Among the many claims filed were avoidance and recovery actions against the feeder funds and their investors as subsequent transferees. In those cases, Picard sought to recover from the foreign transferees, who had no direct relationship with BLMIS and received the subject transfers from the feeder funds, not BLMIS.

The Bankruptcy Code is part of the domestic law of the United States, and therefore it is presumed to apply only domestically.¹¹ In other words, the fraudulent transfer provisions of the bankruptcy code will not allow a trustee to avoid and recover transfers that are purely international.

This is not to say that the bankruptcy code has nothing to say with respect to cross-border insolvency matters. On the contrary, Chapter 15 of the bankruptcy code specifically authorizes U.S. bankruptcy courts to recognize foreign insolvency proceedings and to permit the representatives of foreign debtors to use the U.S. courts to pursue claims, including avoidance and recovery actions under foreign law and in certain circumstances, U.S. state law. But foreign representatives are specifically prohibited from bringing claims under the bankruptcy code’s own avoidance and recovery provisions.¹²

So, while Picard’s claims sought to avoid and recover under the bankruptcy code’s fraudulent transfer provisions transfers received by foreign investors, the liquidators of the feeder funds sought to avoid and recover under foreign law transfers to some of those same investors.¹³

Despite the seeming similarities between these claims, the results were much different.

Conclusions of the Courts

As stated, Picard’s lawsuit seeks to avoid or set aside BLMIS’ transfers to the feeder funds and to recover the transferred amounts from the funds’ customers.¹⁴ These transfers – for example, from a BVI fund to its foreign investor – appear to be solely international and, therefore, beyond the scope of U.S. law to remedy. This was the conclusion of the district court. The district court dismissed Picard’s complaint holding that his claims solely relate to the transfer from an international fund to an international client and are, therefore, not subject to clawback. The Second Circuit reversed.

The Second Circuit ruled that these transfers are domestic activity and therefore involve domestic applications of the bankruptcy code.¹⁵ This is because the focus of the bankruptcy code’s avoidance provisions is on the debtor’s wrongful delivery of funds, not the transferee’s receipt of them. There is no question that the foreign investors received the subject funds in a purely international transaction from feeder funds located in BVI and the Cayman Islands, but the relevant transfer – and therefore the subject of the fraudulent conveyance claim – was made by BLMIS, a domestic firm, from its domestic bank account to a foreign recipient. Once that purely domestic transfer is avoided under section 548 of the bankruptcy code, section 550 of the code permits the trustee to recover that transfer from any initial or subsequent transferee, wherever they are located. That provision allows a trustee to trace transfers from a debtor to subsequent transferees and recover from those subsequent transferees, even those who may be several steps removed from the initial transfer. As the court noted, “if the directness of a transfer were relevant to a trustee’s ability to recover property under 550(a)(2), we cannot see how a trustee could ever recover property from any subsequent transferee, foreign or domestic.”¹⁶

In Contrast

Contrast this result with the feeder funds’ efforts to recover transfers made to their own investors. As stated, Chapter 15 generally precludes foreign representatives from using the bankruptcy code’s avoidance provisions, and it would be easy to imagine that for the same reasons, the statutory defenses to those claims would also not apply in Chapter 15 cases. One such defense is contained in bankruptcy code section 546(e),¹⁷ which exempts from avoidance of certain transactions by a debtor.

Among the transactions,¹⁸ that are exempted from avoidance, or ‘safe-harbored’¹⁹ are ‘settlement payments that were made by or to or for the benefit of a ‘financial institution’ in connection with a ‘securities contract.’²⁰ In Fairfield Sentry, the court was called to decide whether the bankruptcy code’s safe-harbor provisions barred the chapter 15 debtors’ foreign representatives from recovering under BVI law certain transfers made to the feeder funds’ investors.

The court held that they do and that sections 561 and 546(e) applied to extraterritorial (foreign) transfers. The district court first ruled that Section 561 expresses a clear congressional intent to apply to foreign transactions because that section limits a foreign representative’s avoidance powers “to the same extent” as a domestic bankruptcy trustee. See 11 U.S.C. 561(d) (“any provisions of this title relating to securities contracts . . .shall apply in a chapter 15 case . . .to limit avoidance powers to the same extent as in a proceeding under chapter 7 or 11 of this title”); Fairfield Sentry at *15. The district court also ruled that section 561 reflects a domestic application of US law because its focus is to limit the foreign representative’s avoidance power in the United States court. Fairfield Sentry at *16.

In these two cases, recoveries were sought from transferees who allegedly benefited from Madoff’s fraud at the expense of other creditors. Yet, the results were different – in one case, foreign transferees were required to return funds they received, and in the other, they were not. Whether these results were fair or not is beyond the scope of this article, but it suffices to say that when the next cross-border fraud unravels, the divide between winners and losers may come down to chance and which law applies.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can watch at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

• Anatomy of a Fraudulent Transfer
• Bankruptcy Claims Trading
• The Nuts & Bolts of a Chapter 11 Plan

This is an updated version of an article originally published on May 10, 2019.]

©2023. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.

1. Similar powers are given to a trustee appointed for a broker-dealer, like BLMIS, under the Securities Investment Protection Act (“SIPA”)
2. See, e.g., 11 U.S.C. 1509 (“If the court grants recognition under section 1517, and subject to any limitations that the court may impose consistent with the policy of this chapter (1) the foreign representative has the capacity to sue and be sued in a court in the United States; (2) the foreign representative may apply directly to a court in the United States for appropriate relief in that court; and (3) a court in the United States hall grant comity or cooperation to the foreign representative.” See, also, 11 U.S.C. 1511, 1512.
3.  See 11 U.S.C. 550
4. See, generally 11 U.S.C. 546.
5. 917 F.3d at 92.
6. Id.
7. In re: Irving H. Picard, Trustee for the Liquidation of Bernard L. Madoff Investment Securities LLC, United States Court of Appeals for the Second Circuit, Case No. 17-2292, February 25, 2019 at 5
8. See 11 U.S.C. § 548(a)(1)(A)(“The trustee may avoid any transfer … of an interest of the debtor in property … if the debtor voluntarily or involuntarily … made such transfer or incurred such obligation with actual intent to hinder, delay or defraud …”); In re Picard at 13.
9. See 11 U.S.C. § 550(a) (“Except as otherwise provided in this section, to the extent a transfer is avoided under section … 548 .. the trustee may recovery, for the benefit of the estate, the property transferred … from (1) the initial transferee of such transfer or the entity for whose benefit such transfer was made; or … (2) any immediate or mediate transferee of such initial transferee.”)
10. See 11 U.S.C. § 550(a)(2)
11.  See In re Picard at 14 (discussing the presumption against extraterritoriality)
12. See 11 USC 1521(a)(7).
13. Under Cayman and BVI law, the liquidators are appointed to replace the feeder fund’s directors and therefore only hold claims that the feeder fund could bring. The liquidators are not able to bring claims held by the feeder fund’s creditors or investors unless they receive an assignment of such claims. Because avoidance claims under US state law are creditor claims, the liquidators, absent such an assignment, do not have standing to bring such claims in a Chapter 15 case.
14.  See id at 10
15.  See id at 25
16.  Id at 39-40
17. Section 546(e) provides: “notwithstanding sections 544, 545, 547, 548 (a)(1)(B) and 548(b) of this title, the trustee may not avoid a transfer that is a margin payment, as defined in section 101, 741 or 761 of this title, or a settlement payment as defined in section 1010 or 741 of this title, made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, or that is a transfer made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, in connection with a securities contract, as defined in section 741(7), commodity contract, as defined in section 761(4), or forward contract, that is made before the commencement of the case, except under section 548(a)(1)(A) of this title.”
18. The foreign representatives did not dispute that the subject transfers were qualified transactions under section 546(e), rather the focus of the dispute was whether that section applied to purely foreign transfers sought to be recovered under foreign law.
19. In addition to being exempted from avoidance, these transactions are specifically exempted from the application of the automatic stay. See 11 U.S.C. 560. Thus, while the stay generally would prohibit a debtor’s contractual counterparty from a post-bankruptcy termination of a contract with the debtor, a counterparty to a safe-harbored contract retains that right. These provisions specifically apply in chapter 15 cases. See 11 U.S.C. 561.
20. This exemption itself contains an exception to its application – the exemption will not apply (that is, the transaction is subject to avoidance) if the transfer was made with the intent to defraud creditors.