Second Circuit Applies Federal Bankruptcy Law, Not Securities Law, In Madoff SIPA Liquidation

The Madoff decision makes the following essential points:

• A SIPA liquidation is to be conducted like a Chapter 7 bankruptcy liquidation;
• The federal securities laws do not apply in a SIPA liquidation;
• Federal bankruptcy law, not securities law, governs fraudulent transfer litigation in a SIPA liquidation ("… no reason to depart from the meaning of the good faith defense under [Code] Section 548 and 550 as it is applied in an ordinary bankruptcy [case]."). 2021 WL 3854761 at 15.
• "… SIPA does not compel departing from the well-established burden-of-pleading rules … [meaning that] the initial or subsequent transferee bears the burden of pleading good faith."
• "[P]lacing the burden to plead good faith on the initial and subsequent transferees does not contradict the goals of SIPA." , at 18.

Relevance

The appellate courts have been wrestling with the good faith issue in fraudulent transfer litigation over the past 20 years. See, Janvey v. GMAG, LLC, 977 F.2d 422, 428 (5th Cir., 2020) (reversed district court's judgment in favor of defendants who received fraudulent transfer "while on inquiry notice of a Ponzi scheme."; "good faith defense must fail" because defendants never "diligently investigated their initial suspicions of [debtor's] fraud while on inquiry notice."; receiver's suit brought under Texas Uniform Fraudulent Transfer Act (TUFTA), not under Bankruptcy Code §548, which "is not necessarily substantively congruent with state law counterparts, despite a common ancestry."; Texas Supreme Court had answered certified question from Fifth Circuit that "transferee on inquiry notice [had] to conduct an investigation into the fraud, … irrespective of whether a hypothetical investigation would reveal fraudulent conduct."; but Fifth Circuit left 'for another day … what actions a party must take to show that [it] diligently investigated fraud for the purposes of a TUFTA good faith defense."); Templeton v. O'Cheskey, 785 F.3d 143,164(5th Cir. 2015) (in Code §548 suit, transferee may "rebut" proof of inquiry notice by showing that it "conducted a 'diligent investigation' into [its] suspicions."), citing In re Bayou Group, LLC, 439 B.R. 284, 314-15 (S.D.N.Y. 2010) (reversing bankruptcy court, held that information suggesting mere "infirmity in [debtor) or in integrity of its management" is insufficient to trigger inquiry notice; "the great weight of authority holds that it is information suggesting insolvency or a fraudulent purpose in making a transfer that triggers inquiry notice," but an investigation may not be required if the transferee can establish that a diligent investigation would not have uncovered debtor's insolvency or a fraudulent purpose; "a transferee is entitled to offer evidence and to argue to the finder of fact that no diligent investigation would have disclosed the transferor's insolvency or fraudulent purpose. If the transferee can meet its burden of demonstrating that a diligent investigation would not have led to the discovery of the fraud, it may prevail on this prong of the good faith affirmative defense."); Gold v. First Tenn. Bank Nat'l Ass'n (In re Taneja), 743 F.3d 423 (4th Cir. 2014) (applying good faith test under section 548(c); bank officers had expert knowledge of industry and investigated collateral for debtor's mortgages; market-wide economic conditions hindered officers' ability to detect underlying fraudulent conduct by debtor; lender established good faith under both (a) subjective and (b) objective standard by having neither: 1) actual knowledge of fraud; nor 2) " information that would [reasonably] have led it to investigate further"; its actions "were in accord with [its] and the industry's usual practices."); In re Hannover Corp., 310 F.3d 796, 800 (5th Cir. 2002) (independent third party unaffiliated with debtors acted in good faith when it accepted payments from debtors on contract that had been negotiated at arms-length; transferee's "state of mind" important; no way of learning of debtor's insolvency; knew of SEC suit from newspapers, but "undertook its own investigation, contacting the SEC and the … court … receiving assurances … from the … court ….").

Facts

The trustee sued the initial transferee (A) who received $212 million from Madoff and three subsequent transferees (collectively, B) for roughly $350 million. The initial transferee, A, was a so-called "feeder fund," a firm that "pooled money from investors and invested directly (or indirectly) with [Madoff]." 2021 WL 3854761, at 1. The subsequent transferees here were investors with the feeder fund who withdrew money from the fund, after the fund "received" it from Madoff. Id.