Legal battle looms for Madoff early exiters

Investors who withdrew their money from Bernard L. Madoff Investment Securities LLC or other Madoff vehicles prior to the recent discovery of Madoff's alleged massive fraud are undoubtedly counting their blessings. Many of these investors, however, may soon receive an unpleasant New Year's surprise. Many are likely to be sued by the trustee of Madoff Investment Securities, who is expected to use his extensive powers under the Bankruptcy Code to seek to claw back not only the profits received by redeeming investors but also, in many instances, their investment principal as well.

Madoff's trustee, appointed last month under the Securities Investor Protection Act of 1970, is vested with the powers of a bankruptcy trustee to recover assets transferred before the Dec. 15 bankruptcy filing. This includes the power to recover preferential transfers, or payments made within 90 days before the bankruptcy that benefited some creditors at the expense of others. The trustee will also have the power to recover fraudulent transfers -- that is, payments made for the purpose of cheating creditors (intentional fraudulent transfers), as well as payments made for less than fair value while insolvent (constructive fraudulent transfers).

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Which investors are at greatest legal risk? One group of investors that Madoff's trustee is likely to sue consists of those who received distributions after Sept. 12. The trustee is likely to seek to recover these payments on preferential transfer grounds.

The basis for the trustee's claims in these suits will be relatively simple: the payments were made within 90 days before the bankruptcy and had the effect of "preferring" these investors over those who did not redeem. Investors will assert a variety of defenses, and some will fare better than others. Defendants who invested in Madoff through a feeder fund or other intermediary may be in a particularly strong position. These investors may be entitled to "holder in due course"-type protections by virtue of the fact that they were the subsequent, not the initial, recipient of redemption payments.

What may surprise redeemers and other observers most is that those who withdrew their money from Madoff during the 90-day preference period are not the only likely litigation targets. Many investors who redeemed as many as six years before the Madoff bankruptcy will probably also be sued by the trustee. Specifically, the trustee is likely to assert fraudulent transfer claims against at least two groups of investors.

First, those who profited from their Madoff investments will be asked to return their profits. (Intense debate over how "profits" are calculated will be a central feature of these suits.)

Second, and most controversially, investors who redeemed as long ago as December 2002 may be asked to return their principal, as well as their profits.

The latter category of suits is sure to strike many as surprising and unfair. But suits of this sort were recently upheld by a bankruptcy court in New York, the same court (though not the same judge) that is overseeing the Madoff bankruptcy. In a series of decisions arising from of the collapse of the Bayou group of hedge funds, the court required investors who redeemed years before Bayou's collapse to return their principal, as well as their profits, if at the time they redeemed they "should have known" of the fraud at Bayou.

Bayou's bankruptcy arose out of a massive Ponzi scheme -- believed at the time to be the largest ever, though now dwarfed by Madoff's far larger alleged fraud. For almost 10 years, Bayou's principals concealed their trading losses by falsifying their financial records and by using monies raised from new investors to pay out purported profits and to honor redemption requests. By the time the fraud was discovered in 2005, Bayou had virtually no remaining assets, and it owed hundreds of millions of dollars to defrauded investors.

Bayou's receiver filed for bankruptcy and, within a few months, commenced more than 100 fraudulent transfer lawsuits against investors who had redeemed prior to the funds' collapse. (No preference claims were brought, since Bayou's collapse, and consequently all redemptions, preceded its bankruptcy filing by more than 90 days.) The receiver contended that all of the redemptions were intentional fraudulent transfers, since Bayou's principals -- in classic Ponzi scheme fashion -- had made these payments for the purpose of sustaining their fraudulent scheme by fostering the illusion that the funds were profitable.

The bankruptcy court agreed. The court ruled that all redemption payments were intentional fraudulent transfers, and that investors who, through luck or diligence, came across "red flags" indicating the possibility of fraud were required to return their principal, as well as their profits. Notably, none of these investors were insiders, and none had actual knowledge of the Bayou fraud. The court nevertheless found that these investors "should have known" of the fraud, that upon seeing the red flags, they should have investigated further, and that further inquiry would have led them to discover the fraud. On this basis, the court held that these redeemers did not redeem in "good faith" and, consequently, were not entitled to the protections that shield recipients of fraudulent transfers from liability to the extent they gave value in good faith.

Will Madoff redeemers be required to return their principal, as well as their profits, based on the Bayou rulings? That remains to be seen. In the first place, it is unclear whether Madoff's receiver will argue that red flags were visible to all investors -- that this was, as some have argued, a fraud in plain view -- and that, as a result, all redeemers should be required to return their principal. The receiver may opt instead for a more modest approach, seeking to apply the Bayou rulings only to those redeemers who actually suspected fraud or who came across particular red flags not visible to all.

In either event, the receiver's attempt to apply the Bayou rulings to Madoff redeemers will be hotly contested, on both factual and legal grounds. As a factual matter, defendants will be able to point to Madoff's extraordinary success in perpetuating his alleged Ponzi scheme over a span of decades. If no fraud was found by the Securities and Exchange Commission despite its several investigations, nor by the various sophisticated institutional investors that conducted due diligence of their own, how can it be said that anyone "should have known" what was occurring?

As a legal matter, defendants will contend that the Bayou court's rulings were wrong and should not be followed here. Madoff's investors, like Bayou's, had the legal right to demand the return of their principal, that is, to rescind their investments on fraud grounds. Consequently, the return of their principal did not diminish the net worth of the Madoff funds, and a strong argument can be made that these payments did not violate the fraudulent transfer laws. Moreover, defendants will be able to raise serious questions about the wisdom of a rule that penalizes those investors who, through diligence, savvy or luck, noticed red flags that others overlooked or ignored, and took action to protect their investments. Penalizing such behavior by requiring these investors to return their principal is hardly conducive to the sort of attentiveness to risk that the courts should seek to foster.

Philip Bentley is a partner in the bankruptcy and creditors' rights department of Kramer Levin Naftalis & Frankel LLP. In addition to now representing a number of Madoff redeeming investors, he previously represented 70 Bayou redeemers in litigation brought by Bayou's receiver.

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