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    Latest Madoff Ruling on Recovering Distributions: Trustee Need Not Show Recipient was Willfully Blind to Fraud to Overcome the Good Faith Transferee Defense

    S&K Analysis
    October 18, 2021

    In the long-running Madoff saga, the Second Circuit Court of Appeals recently ruled that the good faith defense to receiving a fraudulent transfer does not require a trustee to show that the recipient was “willfully blind” to the fraud to defeat the defense; rather, the trustee need only show that the recipient was on inquiry notice and did not take steps to reasonably investigate. The inquiry notice standard “requires knowledge of suspicious facts that need not suggest a ‘high probability’ of wrongdoing but nonetheless [are] sufficient to induce a reasonable person to investigate.”1 The willful blindness standard requires a recipient who “takes deliberate actions to avoid confirming a high probability of wrongdoing and who can almost be said to have actually known the critical facts.”2 The Second Circuit also made clear that it is the recipient who bears the initial burden of proof regarding the good faith defense. This is meaningful because it requires transferees to take further action when they become aware of red flags regarding potential fraud, and, even as to those who follow-up on such red flags in good faith, requires transferees to plead the defense in their initial response to a complaint or risk waiving it.


    Bernie Madoff ran his Ponzi scheme through his investment firm, Bernard L. Madoff Investment Securities LLC (“BLMIS”), a registered broker-dealer. When customers sought to withdraw returns on investments, BLMIS transferred funds directly to them. Some of those transferees subsequently transferred funds to their own investors. BLMIS, of course, was a sham—customer withdrawals were only supported by inflows from other investors as opposed to actual returns.

    After Madoff was arrested for securities fraud in 2008, BLMIS was placed into Securities Investor Protection Act (“SIPA”) liquidation before the U.S. District Court for the Southern District of New York (the “District Court”) and a SIPA trustee (the “Trustee”) was appointed. The proceedings were then referred to the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”). There, the Trustee undertook a number of actions to recover funds that had been transferred by BLMIS. Among those actions, the Trustee sought to avoid and recover a $213 million transfer from an initial transferee (“Initial Transferee”) and nearly $350 million in transfers from certain subsequent transferees (the “Subsequent Transferees,” and, collectively, the “Transferees”). The Trustee alleged that the Transferees had investigated BLMIS and had uncovered some suspicious information but failed to act further. In response to the Trustee’s complaint, the Transferees argued that the transfers should not be avoided based on the good faith transferee defenses provided under sections 548(c) and 550(b)(1) of the Bankruptcy Code. The Bankruptcy Court eventually dismissed the Trustee’s complaint, relying on a District Court ruling by Judge Jed S. Rakoff that “in a SIPA liquidation, a lack of good faith requires a showing of at least willful blindness to the fraud on the part of the transferee and the trustee bears the burden of pleading the transferee’s lack of good faith.”3

    Second Circuit’s Decision

    The Second Circuit disagreed with the lower courts’ legal analysis. Joining its sister circuits, it found “that a lack of good faith under Section 548 and 550 of the . . . Code encompasses an inquiry notice standard,” rather than a “willful blindness” standard. It pointed to the historical usage of the phrase “good faith” in the scope of fraudulent transfer law, existing precedent, and the legislative history of the Bankruptcy Code in reaching its conclusion.4 The Second Circuit expressly rejected the District Court’s finding that a different standard should apply in SIPA proceedings because SIPA is part of the securities laws and a lack of good faith under the securities laws requires fraudulent intent. It pointed to SIPA’s mandate that SIPA proceedings must be “conducted in accordance with, and as though it were being conducted under [the Bankruptcy Code],”5 and disagreed with the District Court’s policy consideration that the inquiry notice standard was unworkable and contrary to SIPA’s goals.6

    The Second Circuit’s decision lays out a three-step inquiry for courts considering a transferee’s alleged good-faith: (1) “a court must examine what facts the defendant knew; [which] is a subjective inquiry and not ‘a theory of constructive notice’”; (2) “a court determines whether these facts put the transferee on inquiry notice of the fraudulent purpose behind a transaction—that is, whether the facts the transferee knew would have led a reasonable person in the transferee’s position to conduct further inquiry into a debtor-transferor’s possible fraud”; and (3) “once the court has determined that a transferee had been put on inquiry notice, the court must inquire whether ‘diligent inquiry [by the transferee] would have discovered the fraudulent purpose’ of the transfer.”7

    The Second Circuit then considered the related question of which party bears the burden of pleading a transferee’s “good faith” (or the lack thereof). It rejected the District Court’s holding that SIPA “affects the burden of pleading good faith or its absence” and that “[i]t would totally undercut SIPA’s twin goals of maintaining marketplace stability and encouraging investor confidence if a trustee could seek to recover the investors’ investments while alleging no more than that they withdrew proceeds from their facially innocent securities accounts.”8 The Second Circuit found that such a policy-based justification was improper and, in any event, “placing the burden to plead good faith on the initial and subsequent transferees does not contradict the goals of SIPA.”9 Instead, again relying on Bankruptcy Code principles, the Second Circuit concluded that “good faith” was clearly an affirmative defense under sections 548(c) and 550(b)(1) of the Code that should apply in SIPA proceedings. This meant that the Trustee did not “bear the burden of pleading the transferee’s lack of good faith,” rather, the Transferees needed to plead the presence of “good faith” affirmatively in their response to the complaint—before ultimately proving the existence of “good faith” later in the action.10 Accordingly, the Second Circuit vacated the dismissal of the Trustee’s suit and remanded the litigation for trial.


    The Second Circuit’s ruling relaxes the pleading requirements for SIPA trustees seeking to avoid fraudulent transfers and stresses that traditional bankruptcy principles should generally apply to SIPA proceedings. Practically speaking, the Court’s holding will deprive only those defendants of the good faith defense who discover damaging facts about a debtor but make no further inquiries or take no further action. Such transferees may be liable to return all of the transfers they received from the debtor that occurred during the statutory reach back period. Transferees who believe they took in “good faith” should make sure to assert the defense in their initial response to an adversarial complaint so as not to waive it. If you have questions related to SIPA proceedings, please don’t hesitate to your primary contact at S&K.

    1 Picard v. CitiBank, N.A. (In re Bernard L. Madoff Inv. Secs. LLC), Case No. 20-1333, 20-1334, Slip Op. at 21 (2d. Cir. Aug. 30, 2021).

    2 Id.

    3 Picard at 4 (emphasis added).

    4Id. at 37-38.

    5 Id. at 39.

    6 Id. at 44. The District Court previously reasoned that “in the context of securities transactions such as those protected by SIPA, the inquiry notice standard . . . would be both unfair and unworkable” because it “would impose a burden of investigation on investors totally at odds with the investor confidence and securities market stability that SIPA is designed to enhance.” Id. at 22.

    7 Id. at 36-37.

    8 Id. at 55-56.

    9 Id. at 56.

    10 Id. at 53, 55.

    The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm or its clients, or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.


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