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Second Circuit Revives Clawback Efforts Aimed at Madoff Feeder Fund

Bernard Madoff escorted into federal court in Manhattan in 2009. Photo: Jin Lee/Bloomberg News

Efforts to recover funds transferred out of the country ahead of the collapse of Bernie Madoff's Ponzi scheme were revived Monday, after the U.S. Court of Appeals for the Second Circuit overturned decisions from the Manhattan district and bankruptcy courts.

The decision by the panel of Circuit Judges Dennis Jacobs, Rosemary Pooler and Richard Wesley will allow the trustee, Baker & Hostetler partner Irving Picard, to pursue claims against major investors that invested with Madoff through off-shore funds, including subsidiaries of HSBC, UBS and the billionaire Koch brothers to the tune of $4 billion, according to a spokeswoman for the trustee.

The appeal came after U.S. Bankruptcy Judge Stuart Bernstein of the Southern District of New York ruled that some 88 clawback cases were subject to extraterritoriality and international comity principles, and therefore blocked from pursuit by Picard.

Bernstein's rulings, involving so-called feeder funds that pulled money out of Madoff's fund inside a window ahead of the bankruptcy action, were buttressed by a 2014 decision by U.S. District Judge Jed Rakoff of the Southern District of New York, who laid out the reasons for blocking the clawback. Three feeder funds spread across the British Virgin Islands, Bermuda and the Cayman Islands pooled most of the investments, and are currently in the process of liquidating.

The issue, the appellate panel noted, was that both courts kept their focus on the wrong point in the transaction. Rakoff and subsequently Bernstein found that the trustee was barred from pursuing the investments sitting in funds in off-shore accounts. The panel found this was an error, as it was the withdrawing the funds from Madoff's accounts to begin with that dictated the right course of action.

"While the subsequent transfer may indirectly harm creditors by making property more difficult to recover, it is the initial transfer that fraudulently depletes the estate," the panel found. "Only the initial transfer involves fraudulent conduct, or any conduct, by the debtor."

The panel dug into the bankruptcy code to apply the proper test. Pointing to the recent U.S. Supreme Court decision in WesternGeco v. ION Geophysical, the panel looked to the statute's operable sections to look at them working in tandem. Since the transfers from Madoff are regulated by the avoidance clause in the bankruptcy code, the statute that authorizes the trustee to then pursue recovery is good to go.

"Recovery is the business end of avoidance," the panel noted.

The panel acknowledged that there existed a presumption against extraterritoriality by federal courts. But given the bankruptcy law itself, the trustee is free to pursue funds that were part of a domestic transfer, as monies departing the Madoff fund must have been, "regardless of where any initial or subsequent transferee is located" at the end of the day.

The panel also dealt with the question of comity, as the investment funds were themselves subject to foreign jurisdiction. Finding that prescriptive and adjudicative comity were in fact "distinct doctrines," the panel held that the situation required a prescriptive approach since the question was a matter of law, rather than of venue.

Again, while recognizing a deference to foreign bankruptcy proceedings often afforded by U.S. courts, the panel nonetheless found that it was proper for the trustee to pursue funds that were involved in the initial domestic transfer out of Madoff's accounts, regardless of who ultimately can claim the funds as their own.

"U.S. law is not regulating the investors’ relationships with the feeder funds," the panel stated. "It is regulating the debtor’s property transfers to the feeder funds."

In a statement, chief counsel to the trustee, Baker & Hostetler partner David Sheehan, applauded the panel's decision.

“In reversing the lower courts’ decisions to dismiss because of international comity, the court held that the United States has a compelling interest in applying U.S. law to recover property fraudulently transferred by a domestic debtor," Sheehan said. "This holding not only protects the victims of Madoff’s Ponzi scheme, it adds clarity to the current state of the law and provides a safeguard to protect creditors and investors of a domestic debtor in bankruptcy.”

Sullivan & Worcester partner Franklin Velie, Cleary Gottlieb Steen & Hamilton partner Thomas Moloney and Ballard Spahr of counsel Eugene Licker represented the various investors on appeal. None responded to requests for comment.

To date, the Madoff bankruptcy action has recovered more than $13 billion.

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