Picard v. Katz

Citations: 462 B.R. 447; 55 Bankr. Ct. Dec. (CRR) 133; 2011 U.S. Dist. LEXIS 109595; 2011 WL 4448638Docket: No. 11 Civ. 3605 (JSR); Adversary No. 10-05287

Court: District Court, S.D. New York; September 27, 2011; Federal District Court

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Defendants Saul B. Katz and others moved to dismiss the Amended Complaint filed by Trustee Irving H. Picard under the Securities Investor Protection Act (SIPA) to recover over a billion dollars from them. The complaint, spanning 373 pages, alleges claims of actual fraud, constructive fraud, and preferential transfer, among others, based on federal bankruptcy law and New York debtor and creditor law. The Court granted the motion to dismiss all claims except those alleging actual fraud and equitable subordination, while also tightening the recovery standards for these remaining claims. The ruling highlights essential bankruptcy concepts, including the definition of insolvency and the ability to avoid prior payments that deplete a bankrupt's assets in favor of specific creditors, known as "preferences." Preferences can be avoided if they occurred within 90 days prior to bankruptcy filing, as per 11 U.S.C. 547(b). Additionally, fraudulent transfers—either actual (intentional to defraud creditors) or constructive (inadequate consideration)—can be avoided if made within 2 years of bankruptcy under 11 U.S.C. 548(a)(1), although New York law allows avoidance for transfers made within 6 years. The decision outlines how these principles apply specifically to the Madoff Securities bankruptcy, noting unique aspects of the case.

Madoff Securities, a registered brokerage firm, is subject to the "safe harbor" provisions of the Bankruptcy Code, which allow for the appointment of a SIPA Trustee and relate to securities laws. Madoff and his firm perpetrated a Ponzi scheme, misleading customers into believing their investments were generating profits, which were actually paid from new customer funds without actual trades occurring. The safe harbor in section 546(e) shields customers from having to return payments made by Madoff Securities, limiting a bankruptcy trustee’s ability to recover such payments, unless actual fraud is proven. Section 546(e) restricts recovery actions related to "settlement payments" and "securities contracts," both of which apply to transactions between Madoff Securities and its customers. The definition of "settlement payment" is broad and includes all disbursements to customers. The Trustee contends that applying section 546(e) in this case contradicts its intended purpose of protecting the securities market from disruption during significant bankruptcies. However, this argument conflicts with the gravity of the alleged fraud, which involved approximately $68 billion and 4,900 customers, as noted in the Trustee's Amended Complaint.

The Court references the Enron case, highlighting concerns that reversing substantial transfers made to a large number of customers over a long period, such as those dating back to 2002, could negatively impact financial markets. It asserts that the clear language of the statute is paramount, and courts should not rely on legislative history when the statute's meaning is evident. Consequently, the Court grants the defendants' motion to dismiss all claims related to preference or constructive fraud under the Bankruptcy Code and New York law, specifically Counts 2 through 9 of the Amended Complaint. This action leaves the Trustee’s claim for actual fraud under section 548(a)(1)(A) of the Bankruptcy Code as the primary issue. This section allows the Trustee to void payments made by Madoff Securities to customers within two years of the bankruptcy filing if those payments were made with the intent to defraud creditors. The Court notes that Madoff's Ponzi scheme began well before the two-year window and continued until the bankruptcy, indicating that transfers during this period were made with fraudulent intent. However, under section 548(c), customers who provided value in good faith may retain their principal investments, while profits beyond the principal can be recovered by the Trustee if adequate proof of intent to defraud is established. The defendants argue that their good faith in receiving profits, based on Madoff's monthly statements, should protect them, citing a precedent that payments satisfying antecedent debts while the debtor is insolvent are not considered fraudulent.

Sharp's ruling did not extend to cases of actual fraudulent transfers due to inadequately alleged fraud. The Amended Complaint asserts that Madoff Securities intended to "hinder, delay, or defraud" customers in transfers made two years prior to the bankruptcy filing, thus establishing a prima facie case of actual fraud under section 548(a)(1)(A). The defendants' ability to claim the affirmative defense of taking for value and in good faith under section 548(c) is unaffected by Sharp, which only emphasizes the necessity for transfers to be linked to the Ponzi scheme. Defendants can defend against claims of actual fraud regarding principal payments by proving good faith; however, for payments exceeding principal, they must demonstrate both good faith and value received.

The definition of "lack of good faith" includes actual knowledge of Madoff's fraud, which the Trustee has not plausibly alleged. Conversely, willful blindness to Madoff's fraudulent activities could indicate a lack of good faith, a theory that the Amended Complaint supports. Allegations suggest the Sterling partners ignored clear signs of fraud due to the potential for short-term profits, despite the defendants' denials. The Amended Complaint provides enough detail regarding the defendants' consideration of fraud insurance and their creation of a hedge fund to survive a motion to dismiss related to willful blindness.

Additionally, the Trustee posits an alternative theory of "inquiry notice," which suggests the defendants were aware of potential fraud but did not investigate, also indicating a lack of good faith. The distinction between willful blindness (subjective) and inquiry notice (objective) is noted, with defendants contesting the relevance of the inquiry notice theory in this case.

A transferee has inquiry notice when the information acquired would prompt a reasonable person to investigate further. If the transferee fails to do so, this lack of investigation is considered a failure of good faith unless diligent inquiry would not have revealed the fraud. This principle has limited application in SIPA trusteeships due to the influence of federal securities law, which requires proof of fraudulent intent (scienter) to establish good faith. Investors are not inherently obligated to investigate their stockbroker, and SIPA does not impose such a duty. However, if an investor knowingly ignores red flags indicating potential fraud, this "willful blindness" reflects a lack of good faith. The court distinguishes between failing to investigate due to suspicious circumstances and willful blindness, noting that lack of due diligence does not equate to a lack of good faith under section 548(c) in SIPA cases. Regarding the Trustee's claims, for actual fraud, the Trustee can recover net profits from defendants simply by showing no value was received for transfers, while the return of principal requires proof of willful blindness. The Trustee also seeks to disallow or equitably subordinate the defendants’ claims against Madoff Securities’ estate. Although section 502(d) of the Bankruptcy Code supports disallowance of claims related to voidable transfers, SIPA’s section 78fff-2 allows customers who received such transfers to pursue their claims as creditors. Consequently, Count 10 must be dismissed, but the claims are not treated equally with other claims, as the court may subordinate claims under section 510(c) based on equitable principles.

Claims can be equitably subordinated when a claimant engages in inequitable conduct that harms creditors or provides the claimant with an unfair advantage. Inequitable conduct includes actions that, while lawful, contradict principles of equity and good conscience. The Amended Complaint sufficiently alleges that the defendants received fraudulent transfers without good faith, indicating inequitable conduct that likely harmed investors in Madoff Securities. Although the Trustee cannot disallow the defendants' claims outright, he can subordinate them by demonstrating that the defendants were aware of or recklessly disregarded Madoff's fraud. 

The Court dismisses all counts of the Amended Complaint except Counts 1 and 11. Under Count 1, the Trustee can recover the defendants' net profits by proving they did not provide value for the funds received, but must show willful blindness to recover the principal. The Trustee can also subordinate the defendants' claims against the estate by meeting the same burden of proof required under Count 1. 

Additionally, the original adversary proceeding, filed in Bankruptcy Court, has been transferred to this Court. The Trustee argues that section 546(e) should apply only to stockbrokers, but the statute's language does not support this limitation. Customers of Madoff Securities who received settlement payments are entitled to protection under section 546(e) as these payments were genuine transactions. The statute has been amended to broaden its applicability, indicating Congress's intent to maintain its current scope. The remaining claims in the Amended Complaint not barred by section 546(e) will also be addressed. No Ponzi scheme presumption is necessary for the claims in this case, as the alleged facts suffice to establish the fraudulent intent behind the transfers.

In re Agric. Research. Tech. Grp., 916 F.2d 528, 535 (9th Cir. 1990) establishes that a debtor's intent to hinder, delay, or defraud creditors may be inferred from the existence of a Ponzi scheme. The Trustee is likely to succeed in obtaining a summary judgment for the recovery of profits, but there is uncertainty about which profits can be recovered—whether only those received over the two-year look back period under section 548 or all excess profits received throughout the investment in Madoff. The Amended Complaint indicates that defendants gained $83,309,162 in the two years prior to bankruptcy and $295,465,565 over the entire investment period. The Court finds that the investment decisions of the defendants were sufficiently coordinated, allowing for the imputation of intent from their common entity, Sterling Equities, to all defendants. The Court also denies the defendants' request to convert their motion to dismiss into a motion for summary judgment, acknowledging that the Trustee has presented a reasonable case for additional discovery. While the initial burden to prove good faith rests with the defendants, the question of whether the burden shifts back to the Trustee after a prima facie showing of good faith is left undecided at this stage.