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Jeff Baskies & Justin Savioli: Madoff Trustee Cannot Sue Banks & Argue Their Failure to Perform Due Diligence Contributed to the Harm of the Alleged Ponzi Scheme


"Over many years, a number of very substantial financial institutions (JP Morgan, UBS and HSBC included) apparently profited to the tune of more than $600 million in fees from Bernard L. Madoff, through his brokerage firm, Bernard L. Madoff Investment Securities LLC ("BLMIS").


After the demise of the Madoff Ponzi scheme, the court appointed trustee, Irving Picard, sued the financial institutions seeking in excess of $8 billion in damages, alleging, among other things, that had their greed for the lucrative fees not blinded them, the financial institutions would have performed due diligence on BLMIS that would have led to revealing Madoff’s alleged Ponzi scheme 10 or more years earlier.


Picard’s claims were dismissed by the trial court and such dismissal was recently upheld on appeal to the US 2nd Circuit Court of Appeals.


Obviously, the Madoff decision was a huge blow to the trustee’s attempts to regain sufficient funds to fully satisfy all the Madoff investors, and the decision was obviously hugely important to several large financial institutions whose actions (or inactions) were ultimately sheltered by legal arguments.


However, it will be interesting to see if the Madoff case will have any ramifications for other present or future Ponzi scheme cases/trustees. The litigants and the trustees in the Rothstein Case and the Sanford Securities Case will need to closely examine this holding and perhaps adjust their tactics in light of the decision. The true reach of the case and the impact of its holding will be written in the years to come."


In Estate Planning Newsletter # 1384, Jeff Baskies discussed many of the issues raised by the alleged fraud perpetrated by Bernard Madoff. Jeff's commentary touched on the impact to individual investors, hedge funds and charities, and briefly addressed a few of the tax issues. In Estate Planning Newsletter #1411, Jeff provided members with commentary on the various income tax issues that Madoff investors and their advisors had to wrestle with during the tax filing season.


Now, Justin Savioli joins Jeff and together they provide members with their analysis of the Second Circuit’s recent decision affirming the district court’s dismissal of the trustee’s claims against a number of prominent financial institutions.


Jeffrey A. Baskies is a Florida Bar certified expert in Wills, Trusts, and Estates law. He practices at Katz Baskies LLC, a Boca Raton, FL, boutique trusts & estates, tax & business law firm. In addition to over ten dozen published articles, he is the author of ESTATE, GIFT, TRUST, AND FIDUCIARY TAX RETURNS: PLANNING AND PREPARATION (West 2013). He can be reached at www.katzbaskies.com..


Justin M. Savioli is a graduate of the University of Miami (B.A.) and University of Miami School of Law (J.D., cum laude). He served as an Articles and Comments Editor on the University of Miami Inter-American Law Review and was a member of Phi Alpha Delta, a professional law fraternity. He received his Masters of Laws in Taxation (LL.M.) from the University of Florida. Mr. Savioli is a member of the Florida Bar, the South Palm Beach County Bar Association, the Greater Boca Raton Estate Planning Council, and is an active member of the Council's Speakers Bureau. He participates in the Estate Planning Committee of the Real Property Probate and Trust Law Section of the Florida Bar. Mr. Savioli has served as an adjunct faculty member at Florida Atlantic University, teaching both estate planning and probate administration.


Before we get to their commentary, Ken Crotty asked us to bring the following to the attention of members regarding his Business Entities Newsletter #138. Ken has prepared three sample documents that can be used to inform the IRS that a trust is disregarded for income tax purposes. Ken created a sample Default Form 1041 which can be filed for a Grantor Trust. Ken has also created samples showing the reporting necessary under Option 1 and Option 2 that he discussed in his Business Entities Newsletter #138. Simply click on the hyperlinks to view Ken’s sample documents.


Now, here is Jeff and Justin’s commentary:


EXECUTIVE SUMMARY:


Over many years, a number of very substantial financial institutions (JP Morgan, UBS and HSBC included) apparently profited to the tune of more than $600 million in fees from Bernard L. Madoff, through his brokerage firm, Bernard L. Madoff Investment Securities LLC ("BLMIS").


After the demise of the Madoff Ponzi scheme, the court appointed trustee, Irving Picard, sued the financial institutions seeking in excess of $8 billion in damages, alleging, among other things, that had their greed for the lucrative fees not blinded them, the financial institutions would have performed due diligence on BLMIS that would have led to revealing Madoff’s alleged Ponzi scheme 10 or more years earlier.


Picard’s claims were dismissed by the trial court and such dismissal was recently upheld on appeal to the US 2nd Circuit Court of Appeals.


FACTS:


In 1986, long before his arrest in December 2008, Bernard L. Madoff, through his brokerage firm, BLMIS, established an account at Chemical Bank. Chase Manhattan acquired Chemical Bank in 1996 and in 2000 Chase merged with JPMorgan to become JPMorgan Chase & Co ("JPMorgan"). It appears that JPMorgan may have become aware of Madoff's fraudulent activities and began withdrawing its own money from Madoff's funds. However, JPMorgan took no action to close Madoff's accounts. Instead, JPMorgan collected approximately $500 million in fees, interest payments and revenue from BLMIS.


UBS AG acted as sponsor, manager, administrator, custodian and primary banker of the funds, facilitating customer investment in BLMIS. It is alleged, again, that UBS was either aware of the fraud or purposely turned its head to obvious signs, and took no action to stop it. Instead, UBS earned itself approximately $80 million in fees through these investments.


Access International Advisors LLC ("Access") became concerned about Madoff's activities as early as 2006. However, allegedly Access took steps to actively conceal any evidence of their knowledge and concerns, opting instead to actively recruit investors for Madoff's feeder funds, earning themselves additional fees.


Unaccredited S.p.A. and two of its subsidiaries ("Unicredit") purportedly promoted feeder funds while aware of the concerns surrounding those funds. Again, the banks earned tens of millions of dollars in fees while ignoring any risk to their customers.


HSBC Bank plc ("HSBC") also apparently ignored all indications of Madoff's wrongdoing and instead pursued earning fees through the establishment of at least eighteen feeder funds in seven different countries. These funds represented almost 40% of all the funds held by BLMIS.


In 2008, after Madoff's arrest, the Securities Investor Protection Corporation ("SIPC") filed an application under the Securities Investor Protection Act ("SIPA"), asserting that Madoff's brokerage firm (BLMIS) required protection. Judge Lawrence McKenna appointed Irving Picard, a partner at the law firm Baker Hostetler, as SIPA trustee and referred the case to the bankruptcy court.


Between 2009 and 2010, Picard, acting as Trustee under SIPA, filed suit against all of the foregoing institutions (as well as some others), seeking damages in excess of $8 billion. The suit alleged that a number of banks knew or should have known of Madoff's fraud and that each financial institution turned a blind eye to Madoff's misdeeds in favor of engaging in transactions that produced significant fees for each institution. Picard was attempting to pursue the action as Trustee of Madoff's estate or, in the alternative, recover under a theory of contribution or, as a last resort, pursue the claims on behalf of the customers of the various financial institutions.


The United States District Court for the Southern District of New York dismissed Picard's suit. Picard appealed to the 2nd U.S. Circuit Court of Appeals, which affirmed the lower court's ruling, holding that the claims were barred by the doctrine of in pari delicto, contribution does not apply under SIPA and that the equities did not allow Picard to pursue an action on behalf of the wronged customers.


COMMENT:


In Pari Delicto


The appeals court first analyzed the application of in pari delicto. "Under New York law, one wrongdoer may not recover against another." In re Madoff, citing Kirschner v. KPMG LLP, 938 N.E.2d 941, 950 (N.Y. 2010). The court noted that this principle was used to bar a claim filed by a defrauded corporation where the corporation’s management was complicit in the fraudulent acts. See In re Madoff citing Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114, 120 (2d Cir. 1991). (This is sometimes referred to as the "Wagoner rule".)


The 2nd Circuit read the SIPA legislation closely and noted that "a SIPA trustee is vested with the 'same powers and title with respect to the debtor and the property of the debtor ... as a trustee in a case under Title 11." In re Madoff, quoting 15 U.S.C. s. 78fff-1(a). Typically, a bankruptcy trustee is deemed to "step into the shoes of the debtor", which would also impute the debtor's misconduct to the trustee. "The debtor's misconduct is imputed to the trustee because, innocent as he may be, he acts as the debtor's representative." In re Madoff, citing Wight v. BankAmerica Corp., 219 F.3d 79, 87 (2d Cir. 2000). BLMIS would not be allowed to pursue a claim against the third parties that helped facilitate BLMIS's fraud and because Picard stepped into the shoes of BLMIS, he also may not pursue a claim against the co-conspirators.


Contribution


The court next looked at the contribution claim. Under New York law, "two or more persons who are subject to liability for damages for the same personal injury, injury to property or wrongful death, may claim contribution among them whether or not an action has been brought or a judgment has been rendered against the person from whom contribution is sought.” N.Y. C.P.L.R. section 1401.


The court argued that Section 1401 requires that the person seeking contribution bust have been compelled to make the payment against which contribution is sought. See In re Madoff, quoting N.Y. State Elec. & Gas Corp. v. FirstEnergy Corp., No. 3:03-CV-0438 (DEP), 2007 WL 1434901, at *7 (N.D.N.Y. May 11, 2007) (emphasis omitted). Because the SIPA payments were not compelled under state law, however, and were instead required under federal law, contribution was not permitted. "[I]t is settled in this Circuit that there is no claim for contribution unless the operative federal statute provides one." In re Madoff (citations omitted). Because SIPA does not provide for a right of contribution, this recovery right is not available under New York law.


Bailee


Finally, the court considered one of the more interesting arguments advanced by Picard. Picard argued that as the SIPA trustee he was acting as a bailee of the customers' property, allowing him to pursue actions on their behalf to recover that property.


The general rule is that for a person to have standing that person must "assert [that person's] own legal rights and interests, and cannot rest [such person's] claim to relief on the legal rights or interests of third parties." Warth v. Seldin, 422 U.S. 490, 299 (1975). It is with this fundamental rule that the 2nd Circuit unwinds this portion of Picard's cause of action. "[T]he Supreme Court ruled that federal bankruptcy law does not empower a trustee to collect money owed to creditors." In re Madoff.


Picard appeared to base his position on an older 2nd Circuit case - Redington v. Touche Ross & Co., 592 F.2d 617 (2d Cir. 1978), rev’d, 442 U.S. 560 (1979). Redington involved a SIPA trustee who sued the accountant of an insolvent brokerage firm for violating the Securities Exchange Act and common law. The U.S. Supreme Court in its review of Redington held that no private right of action existed under the Securities Exchange Act and so never reached the question of whether the SIPA trustee had standing to sue in the first place - because there was no federal issue, standing never needed to be addressed. After Redington, the 2nd Circuit began rejecting third-party claims filed by SIPA trustees but there remained a lingering question of whether any portion of Redington remained good law - i.e., whether a SIPA trustee has standing to pursue a cause of action on behalf of third parties where there is an implied right of action.


In the Madoff decision, the 2nd Circuit ruled that Redington has no precedential effect.


The court also analyzed SIPA and noted that a SIPA liquidation is not designed to function as a bailment. Instead, it is meant to act as a liquidation under the Bankruptcy Code. "[SIPA] does not confer upon SIPA trustees a power, denied all other bankruptcy trustees, to sue third parties on claims that belong to persons other than the estate. Nowhere does the statute reference bailment, or characterize customers as 'bailors' or trustees as 'bailees,' or in any way indicate that the trustee is acting as bailee of customer property." Again, because SIPA does not specifically authorize a SIPA trustee to act as a bailee and because a trustee under the Bankruptcy Code cannot act as a bailee for the customers, neither can a SIPA trustee.


Moreover, the court argued, even if Picard could be viewed as a bailee, it would not apply to the funds at issue here. "A bailment is 'a delivery of personalty for some particular purpose, or on mere deposit, upon a contract express or implied, that after the purpose has been fulfilled it will be redelivered to the purpose has been fulfilled it will be redelivered to that person’s directions, or kept until it is reclaimed.'” In re Madoff, quoting 9 N.Y. Jur. 2d Bailments and Chattel Leases § 1 (West 2013). The property delivered here was for investment in BLMIS or the feeder funds, which pre-dated Picard's appointment as SIPA trustee. Picard was entrusted with the funds after they had been impaired and he never had control over them. (Although, assuming that a SIPA trustee steps into the shoes of the debtor, it is difficult to see why the timing matters here.)


Perhaps more importantly, Picard was not seeking to recover specific assets for individual customers. Instead, he was seeking to recover monetary amounts that had belonged to various customers and then distribute all of the amounts recovered ratably pursuant to SIPA (i.e., the money recovered on behalf of one customer under a bailment theory may be paid to another customer), which is not in keeping with traditional notions of bailment.


Equitable Subrogation


Picard also attempted to assert an implied right of equitable subrogation under SIPA. "As a final resort, the Trustee relies on a catch-all provision included in the 1978 amendments to SIPA, which states that the subrogation rights afforded by § 78fff-3(a) should not be read to diminish 'all other rights [SIPC] may have at law or in equity.'" In re Madoff, quoting 15 U.S.C. section 78fff-3(a). Picard reasoned that this language granted him an implied right of equitable subrogation.


The court found this reasoning to be unpersuasive when it looked at the legislative history for when this language was added. "The wording cited by Picard was proposed by SIPC itself as a 'Minor Substantive or Technical Amendment[]' in order to 'make clear that SIPC's subrogation rights under the 1970 Act are cumulative with whatever rights it may have under other State or Federal laws.'" In re Madoff, quoting Hearings on H.R. 8064, 94th Cong. 197, 199 (1976) (Memorandum of the Securities Investor Protection Corporation in Regard to Certain Comments Concerning H.R. 8064).


Immunity Argument


Picard also advanced the notion that if he and SIPC were not entitled to bring a cause of action against the banks on behalf of the customers, then the customers would not bring their own suits and the banks would effectively be immunized from liability. The court seemed confused by this argument and gave some rather unclear reasoning in footnote 29, where the court holds that not only can customers pursue their own causes of action against the banks, customers already have begun pursuing these actions.


However, it should be noted that one of the cases cited in the footnote as an example of a customer pursuing a cause of action against the banks was the action filed by MLSMK Investment Company, a Palm Beach, Florida partnership that directly deposited $12.8 million into Madoff's Chase account between October and December 2008. This case was also dismissed by the 2nd Circuit in 2011. It is unclear how many of the potential litigants who have a cause of action to pursue against the various financial institutions have the financial wherewithal to pursue such an action.


Conclusion


Obviously, the Madoff decision was a huge blow to the trustee’s attempts to regain sufficient funds to fully satisfy all the Madoff investors, and the decision was obviously hugely important to several large financial institutions whose actions (or inactions) were ultimately sheltered by legal arguments.


However, it will be interesting to see if the Madoff case will have any ramifications for other present or future Ponzi scheme cases/trustees. The litigants and the trustees in the Rothstein Case and the Sanford Securities Case will need to closely examine this holding and perhaps adjust their tactics in light of the decision. The true reach of the case and the impact of its holding will be written in the years to come.


HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!


Jeffrey A. Baskies
Justin M. Savioli


CITE AS:


LISI Estate Planning Newsletter #2120 (July 25, 2013) at http://www.LeimbergServices.com Copyright 2013 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.


CITE:


In Re: Bernard L. Madoff Investment Securities LLC, Nos. 11-5044, 11-5051, 11-5175, 11-5207, 2nd Cir.; 2013 U.S. App. LEXIS 12551