Bienenstock and Bentley Team Up on Questions Around Which Investors Will Be Pursued, What Might Happen and Whether Investors Will Have to Return Principal as Well as Profit.

By Teresa Zink

Investors who withdrew some or all of their money from Bernard L. Madoff Investment Securities before the discovery of the massive alleged fraud may still find themselves on the hook as the bankruptcy trustee pursues claims for the return of profits, and in some cases even principal, according to legal experts.

Which investors may be targeted? What are the likely outcomes? Will investors be required to return principal as well as profits? Seasoned New York bankruptcy litigators Martin Bienenstock of Dewey & LeBoeuf and Philip Bentley of Kramer Levin Naftalis & Frankel provided some answers to these and other questions during a frank discussion on clawback litigation at HB Litigation Conferences’ “Madoff & Ponzi Scheme Litigation Conference held June 3 in New York City.

The recording of the program is available. Click HERE for more information.

With Bienenstock taking the role of the plaintiff and Bentley speaking for defendants (roles they admitted are more often reversed in their law practices) the pair delved into the lengths and limits of the bankruptcy law and what claims the bankruptcy trustee can bring, including preference claims, certain avoidance claims and some fraudulent transfer claims.

Preference Claims

Preference claims are generally claims of the trustee in which, within 90 days of the bankruptcy filing, Madoff made a payment to a creditor that enabled the creditor to receive more than the creditor would have received if the bankruptcy had been administered under Chapter 7 of the Bankruptcy code, according to Bienenstock. He noted that if the trustee wants to go after an “insider creditor,” the reach back is 180 days if he can show Madoff was insolvent at the time the payment was made.

Were investors creditors? Precedent says the answer is “yes,” according to Bienenstock, based on rulings in the bankruptcy involving the Bayou group of hedge funds, which was at the time considered the largest Ponzi scheme on record. In Bayou, U.S. Bankruptcy Judge Adlai S. Hardin held that investors are creditors because they have tort claims to recover money obtained by trick, misrepresentation, rescission or similar actions, said Bienenstock. So investors are owed at least the amount of their debt; any payment by Madoff to an investor would be a payment to a creditor on behalf of antecedent debt. According to Bienenstock, it is not difficult to make a prima facie case of preference to any investor who received money from Madoff in the 90 days before the bankruptcy and who had not already received the total amount of their investment.

What are the defenses?

The next question, therefore, is what defenses might be brought allowing the recipient to keep the payment? According to Bienenstock, if the recipient gave new value, for example if he or she was investing into the fund at the time the payment was received, the amount of the new investment would offset the preference claim.

Another defense available under bankruptcy law is the “ordinary course defense.” If the payments were made in the ordinary course of business, there would not be a preference. But is there such a thing as the “ordinary course of business” of a fraud scheme? Bienenstock asked.

Bentley, who was heavily involved in litigating the Bayou case, interjected that a big problem in defending these claims is that a number of courts have clearly said, “when you are running a Ponzi scheme, there is no such thing as the ‘ordinary course of business.’” However, he said, there are arguments that can be made. According to Bentley, the purpose of the ordinary course of business exception is to prevent the debtor from preferring some creditors over others. Looking at the redemptions made in the last 90 days before Madoff’s insolvency, he said it is clear that the redemptions weren’t being accelerated. “They did not have suspicions about Madoff’s collapse, and Madoff wasn’t doing them a favor by honoring the redemptions. He was honoring them as requested. So if you are looking at the patterns that the ordinary course of business exception is designed to protect, that is the pattern that is shown here,” said Bentley.

Fraudulent Transfer Claims

Another way the bankruptcy trustee can recover property is through fraudulent transfer claims either brought by the trustee under the Bankruptcy Code or, by taking over avoidance actions brought by creditors. Bienenstock cautioned that to the extent creditors want to pursue their own remedies, they need to be sure it is a remedy that is not transferred to the bankruptcy estate or trustee to control.

According to Bienenstock, fraudulent transfer claims can involve allegations of actual intent or what is known as “constructive intent.” The trustee’s first choice is to sue on the ground that transfers were made with actual intent to hinder, delay or defraud creditors. If so it is recoverable. Under judge Hardin’s reasoning, ordinary payments made by Madoff would have an “actual intent” element because they were all made with the intent to fool other creditors and make it appear the scheme was legitimate, Bienenstock said. According to Bentley, “I think the general expectation is that it is going to be very hard to defeat the showing that all payments to investors were made with actual fraudulent intent.”

The recording of the program is available. Click HERE for more information.

Constructively fraudulent transfers, according to Bienenstock, focus on the concept that: “When you don’t have enough assets to repay all your debts, you shouldn’t make gifts.” In other words, there must be a transfer for which the debtor does not receive an exchange of reasonably equivalent value. How does this play in Madoff? If the trustee can show there was no exchange of reasonably equivalent value, he only needs to show one of three other elements in order to show a constructively fraudulent transfer; that the company making the transfer was insolvent, that there was insufficient working capital to continue the business, or that there was knowledge and belief that the company would incur debts beyond its ability to pay them. In Madoff , according to Bienenstock, for most all of the transfers there was no reasonably equivalent value “and I doubt that solvency is even going to be challenged, so the prima facie case for constructively fraudulent transfers ought to be pretty easy for the trustee to make. Is that game over?”

Value and Good Faith

No, according to Bentley, there are defenses. First, that the transferee gave value and second that he or she acted in good faith. He said the fight over value will hinge on a legal issue and several factual issues. The legal issue was litigated in Bayou, according to Bentley, “I and colleagues advanced an argument to Judge Hardin, that he rejected and is now up on appeal.” In the Madoff case that argument would be that an investor who redeemed his or her money in Madoff had a legal right to get back not only their principal, but also pre-judgment interest that would have been available if they brought a fraud claim in the New York courts.

What about the element of good faith? This issue was litigated quite a bit in Bayou, according to Bentley and in the Madoff case it will come up not in cases where investors are sued for profits, “because with profits all he has to show is less than fair value and he will win.” This element will arise in suits where the trustee is seeking return of principal as well as profits.

Who Will Be Sued For Principal?

Which investors are likely to be sued for principal? To date the trustee has primarily sued insiders, people who had a special relationship with Madoff, and some feeder funds who are alleged to have had a heightened duty to investigate, according to Bentley. Who will be next in line? Possibly the investors who redeemed the full amount of their Madoff accounts.

A possible defense to a suit to recover principal would be if the investor did not pull all of his or her money out of Madoff, “that would give you strong grounds to argue that you had no suspicions of fraud,” according to Bentley.

Teresa ZinkTeresa Zink is a freelancer writer and former editor of litigation news reports living near Philadelphia. She wrote this article based on recordings from HB Litigation Conferences’ Madoff & Ponzi Scheme Litigation Conference held June 3, 2009.

The recording of the fully-accredited program is available. It’s great for sharing with colleagues and, depending on your state rules, getting additional CLE. Check the rules first. Click HERE for more information about the audio package.