June 10, 2014

Ruling Explains and Extends Application of Good Faith Defense to Fraudulent Transfer Actions in SIPA Context

In an April 27, 2014 decision in the Madoff cases, Judge Jed S. Rakoff ruled that the standard of good faith should be considered differently in a Securities Investor Protection Act (SIPA) liquidation. To defeat a good faith defense in a SIPA case, the trustee must prove that the defendant either had actual knowledge of the fraud or that it was “willfully blind” to it; unlike in an ordinary bankruptcy case, knowledge of facts that should have caused further investigation was not sufficient to defeat a good faith defense. Judge Rakoff’s decision extends the application of the good faith defense to subsequent transferees and makes clear that the Trustee must plead particularized allegations that the transferee knew of or was willfully blind to the fraud as part of his claim.

Judge Jed S. Rakoff’s April 27, 2014 decision in the Madoff cases reassures investors who were not complicit in a fraud or willfully blind to it that they can invest with a broker dealer and withdraw their principal investment without having to worry that they will be required to return those funds. Specifically, Judge Rakoff ruled that the issue of good faith should be considered differently in a Securities Investor Protection Act (SIPA) liquidation than in an ordinary bankruptcy case.1

To defeat a good faith defense in a SIPA case, the trustee must prove that the defendant either had actual knowledge of the fraud or that it was “willfully blind” to it; knowledge of facts that should have caused further investigation was not sufficient to defeat a good faith defense.2 In an ordinary bankruptcy case, if circumstances indicated that the debtor’s intent may have been fraudulent, a defendant is on “inquiry notice” and must conduct a diligent inquiry to preserve a good faith defense.

A bankruptcy trustee has the power to reverse fraudulent transfers made by a debtor prior to bankruptcy and to recover the property transferred if the transfer was made (i) with actual intent to hinder, delay or defraud the debtor’s creditors, or (ii) in exchange for less than reasonably equivalent value while the debtor was insolvent or in similar financial distress.3 However, a transfer recipient that has taken a transfer “for value and in good faith . . . may retain any interest transferred . . . to the extent that such transferee . . . gave value to the debtor in exchange for such transfer . . .”4 This defense would protect most returns of principal to investors (who clearly gave value to the extent they lost principal) unless the transfers were not received in “good faith.” The standard for establishing good faith is a critical issue in such cases.


Madoff’s multi-billion dollar Ponzi scheme is well-known. BLMIS collected funds directly from investors and through domestic and international feeder funds; it ostensibly exercised complete discretion over the invested funds but, in reality, never invested them at all. Instead, it created fictitious paper customer account statements and trading records and used funds received from customers to satisfy withdrawals by other customers.

The balance under management based on customer account statements as of the end of November 2008 was $64.8 billion. However, the principal amount actually invested in BLMIS was only $19.5 billion. Because funds were withdrawn by investors on the basis of their account statements, some investors, referred to as “net winners”, were able to withdraw more than they invested while others, referred to as “net losers”, lost some or all of the principal that they put into BLMIS.

In an attempt to obtain funds to make the net losers whole, Irving Picard, the Trustee for the BLMIS liquidation, sued hundreds of investors that had directly or indirectly received funds from BLMIS in the years prior to its exposure as a Ponzi scheme. The Trustee sued under the U.S. Bankruptcy Code fraudulent transfer provision, which encompasses transfers made with either actual intent to defraud or for less than reasonably equivalent value.

The Bankruptcy Code provision reaches transfers made within two years prior to the bankruptcy but a separate provision of the Bankruptcy Code permits use of the New York fraudulent transfer law, which allows challenges to transfers within six years prior to bankruptcy.5 Judge Rakoff previously ruled, in separate decisions, that a “safe harbor” provision of the Bankruptcy Code limited the Trustee’s claims to those made with actual intent to defraud under the Bankruptcy Code’s two year reach-back, eliminating challenges to transfers made for less than equivalent value or outside of two years pre-bankruptcy.6

While most of the fraudulent transfer suits were brought to recover amounts received by net winners in excess of their principal, where Picard believed that a net loser received transfers in bad faith, he sought the return of all funds including withdrawals of principal.

When defendants invoked the defense that they received the transfers “for value” and “in good faith,” the standard for determining good faith became a primary issue. In fraudulent transfer cases in the non-securities context, courts have found that a transfer recipient who was on inquiry notice of a potential fraud, but failed to investigate, did not receive the transfer in good faith.

In those cases, where a transferee was aware of suspicious circumstances – so-called red flags – that should have caused a reasonable person in the transferee’s position to investigate the matter further but the transferee did not do so, the transferee was deemed to lack good faith.7 However, because BLMIS was a broker-dealer of securities, and its liquidation is governed by SIPA, the defendants argued that they should be held to the standard of good faith that would apply to cases under the federal securities law.

The Decision

Judge Rakoff held that a lack of good faith “requires a showing that a given defendant acted with willful blindness to the truth, that is, he intentionally chose to blind himself to the red flags that suggest a high probability of fraud."8 In doing so, Judge Rakoff rejected the Trustee’s contention that transferees should be held to an objective standard of “inquiry notice.”9 He noted that under federal securities laws, which inform interpretation of the Bankruptcy Code’s avoidance provisions when applied in a SIPA liquidation like the BLMIS case, a securities investor has no inherent duty to inquire about his stockbroker.10

Accordingly, a customer’s failure to investigate “does not equate with a lack of good faith.”11 In the court’s words:

In sum, the Court finds that, in the context of this litigation and with respect to both section 548(c) and section 550(b)(1), “good faith” means that the transferee neither had actual knowledge of the Madoff Securities fraud nor willfully blinded himself to circumstances indicating a high probability of such fraud.12

Judge Rakoff extended the application of this rationale in two important ways. First, he held that this standard of good faith applies to parties who did not receive transfers directly from BLMIS; so-called subsequent transferees.13 The Bankruptcy Code section dealing with the recovery of transfers that have been avoided provides a similar but distinct defense for a subsequent “transferee that takes for value . . . in good faith, and without knowledge of the voidability of the transfer avoided.”14

To the extent that a subsequent transferee defendant did not have actual knowledge of the BLMIS fraud and did not willfully blind itself to circumstances indicating a high probability of such fraud, it would have a good faith defense.15 This would be so even if the Trustee could allege and prove that the initial transferee had knowledge of the fraudulent nature of BLMIS’s activities.

Second, again relying on securities law, Judge Rakoff held that the Trustee cannot make a plausible claim that he is entitled to recover money from a transferee (or subsequent transferee) unless he pleads particularized allegations that the transferee knew of or was willfully blind to the fraud.16

The burden is on the Trustee to plead with specificity a lack of good faith as part of a fraudulent conveyance cause of action. Judge Rakoff specifically stated that “a defendant may succeed on a motion to dismiss by showing that the complaint does not plausibly allege that that defendant did not act in good faith.”17

Judge Rakoff returned the good faith-defense cases to the Bankruptcy Court which will hear motions to dismiss that test whether, consistent with Judge Rakoff’s opinion, the Trustee’s complaints contain sufficiently specific allegations of a lack of good faith.18 In the meantime, the Trustee is seeking to appeal the decision.19


1 Securities Investor Protection Corporation (“SIPC”) v. Bernard L. Madoff Investment Securities LLC (“BLMIS”), No. 12 Misc. 115, 2014 WL 1651952 (S.D.N.Y. Apr. 27, 2014) (the “Decision”).

2 Picard v. Katz, 462 B.R. 447, 455 (S.D.N.Y. 2011); Picard v. Avellino, 469 B.R. 408, 412. Judge Rakoff’s recent decision implements his rulings in these prior cases and sets forth a clear avenue for innocent investors to seek dismissal of the suits against them.

3 11 U.S.C. § 548(a). Section 548 deals with the “avoidance” of transfers, a judicial determination that the transfers are void. A separate section, § 550, deals with the recovery of the transfers that were avoided, or declared void.

4 11 U.S.C. § 548(c). 11 U.S.C. § 550(b) contains a parallel defense to recovery of a transfer declared void under § 548.

5 11 U.S.C. § 544.

6 Picard v. Katz, 462 B.R. 447; Picard v. Greiff, 476 B.R. 715 (S.D.N.Y. 2012); SIPC v. BLMIS, No. 12 Misc. 115, 2013 WL 1609154 (S.D.N.Y. Apr. 15, 2013). The Trustee has appealed the Greiff and SIPC decisions to the Second Circuit Court of Appeals and those appeals remain pending (case no. 12-2557).

7 See, e.g., In re Manhattan Inv. Fund, 397 B.R. 1, 23 (Bankr. S.D.N.Y. 2007); In re Bayou Grp., LLC, 439 B.R. 284, 310 (S.D.N.Y.2010).

8 Decision at *2 (emphasis added).

9 Even in a non-SIPA, inquiry notice case, a defendant can succeed with a good faith defense if it can establish that an investigation would have been futile. Bayou Grp., supra, 439 B.R. at 317. In the Madoff case, where the SEC failed to discover the long-running fraud after being put on notice, ordinary customers should be able to demonstrate that an inquiry would have been futile.

10 Decision at *3.

11 Decision at *3.

12 Decision at *4.

13 Decision at *4.

14 11 U.S.C. § 550(b)(1)

15 Decision at *4.

16 Decision at *5.

17 Decision at *5.

18 Decision at *5.

19 The Trustee filed pleadings on June 5, 2014 asking Judge Rakoff to amend the decision to certify it for immediate appeal.