AMERICAN BANKRUPTCY INSTITUTE Journal The Essential Resource for Today’s Busy Insolvency Professional Katz, Dreier Cut into Aggressive Trustees’ Positions Written by: profits or interest, Paul D. Sinclair About the Authors as well as the return Polsinelli Shughart PC; Kansas City, Mo. of principal. These Paul Sinclair is a shareholder in [email protected] claims are gener- Polsinelli Shughar PC in Kansas ally asserted under: Monika Machen City, Mo., and Monika Machen is a (1) a constructive Polsinelli Shughart PC; Chicago shareholder in the firm’s Chicago office. [email protected] fraudulent theory legal standard for the defendants’ objec- under § 548(a)(1)(B)‌ he collapse of the Bayou Group of tive good-faith defense, and moved the or state law, made hedge funds in August 2005 was cases toward trial on that defense. On Monika Machen applicable through Tthe precursor to a wave of Ponzi May 25, 2011, after trial to a jury, the § 544(a); and (2) an scheme litigation now reaching a spec- court entered judgments against seven actual fraud theory under § 548(a)(1)(A), trum of decision-making by bankruptcy defendants totaling some $13 million.3 or applicable state law. The advantage of and district courts. The objective of these While some defendants have paid their the state law fraudulent-transfer claims fraudulent-transfer suits is the return of individual judgment, others continue to is that § 548 only has a two-year reach- payments made to defendant investors challenge the objective standard and its back period, while state law may reach prior to the funds’ collapse, including duty of diligent inquiry. back four years, or, as in New York, six 6 not only profits or interest, but the return Since those judgments were entered, years. False profits are readily recover- of the defendant investors’ principal two other opinions from the Southern able, and often there are few defenses to redemptions as well. District of New York have differed their recovery except to the extent that In an adversary pro- defendants may be able to argue that sharply with Bayou IV’s determination ceeding out of there is a time value to money. As to In re of the meaning of “good faith”: Picard Bayou Group LLC interest paid in a redemption payment, (“Bayou III”),1 the U.S. Bankruptcy Court for the Southern District of Feature New York issued a wide-ranging deci- ,4 the Madoff trustee’s billion- courts reach differing conclusions based v. Katz 7 Paul D. Sinclair sion on many aspects dollar fraudulent-transfer suit against the upon the specific facts of each case. of fraudulent-transfer The primary focus of litigation in this Mets’ owners, and Gowan v. The Patriot law, and this decision represents, in the 5 area is whether investors must pay back Group LLC (In re Dreier LLP), involv- view of some, the high-water mark of ing the demise of New York’s Dreier their original principal received in the law favoring clawbacks by trustees. In law firm from a Ponzi scheme in which redemption payment. The constructive Bayou III, the court adopted the “objec- Marc Dreier sold $700 million of bogus fraudulent claims under § 548(a)(1)(B)‌ tive” standard for the determination of Solow Realty Development Corp. notes. require proof that the debtor received “good faith,” and after a detailed analy- As reported in the news, these decisions less than “reasonably equivalent value.” sis, granted summary judgment for some have caused a sharp decline in mar- A later subsection, § 548(d)(2), defines defendants, granted summary judgment ket trading in the purchase and sale of “value” as including the satisfaction of against others, and denied summary Madoff claims. “antecedent debt.” Courts have inter- judgment where it found that factual dis- preted the investors’ state law recission putes precluded such a ruling. Setting the Stage: The claim against the fraudulent scheme to This decision was followed by In Mechanics of Clawback Suits constitute “antecedent debt,” thus con- ,2 in 8 re Bayou Group LLC (“Bayou IV”) In a typical fraudulent-transfer suit stituting value, causing a constructive which the district court reversed summa- against investors who redeemed their fraudulent-transfer claim to fail. This ry judgments for the trustee, modified the Ponzi investments prior to a collapse, the brings squarely into play an actual fraud claim. The actual intent to defraud in 1 Bayou Accredited Fund LLC v. Redwood Growth Partners LP (In re Bayou trustee will assert claims to recover lost Group LLC), 396 B.R. 810 (Bankr. S.D.N.Y. 2008), rev’d in part, sub nom., 6 Uniform Fraudulent Transfer Act § 9(a); N.Y. McKinney’s CPLR § 213. Christian Bros. High School Endowment v. Bayou No Leverage Fund LLC 3 See, e.g., 09-cv-02313-PGG, Doc. 44. 7 See discussion of cases in In re Dreier LLP, 452 B.R. at 437-38. (In re Bayou Group LLC), 439 B.R. 284 (S.D.N.Y. 2010). 4 2011 WL 4448638 (S.D.N.Y. Sept. 27, 2011) (Rakoff, J.). 8 Jobin v. McKay (In re M&L Business Machine Co. Inc.), 84 F.3d 1330, 2 Christian Bros., 439 B.R. 284 (S.D.N.Y. 2010) (Gardephe, J.). 5 452 B.R. 391 (Bankr. S.D.N.Y. 2011) (Glenn, J.). 1341-42 (10th Cir. 1996).

44 Canal Center Plaza, Suite 400 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org Ponzi scheme cases is inferred from the Based on the jury instructions given fully blinded themselves to the fact that schemer’s intent to maintain its operation by the Bayou IV court, it is arguable Madoff Securities was involved in some by paying earlier investors.9 Thus, it is that the test for good faith is still illu- kind of fraud, that this might constitute presumed that each payment going out sory. As posed to the jury, the question a lack of good faith.18 Beyond “willful to the investor was made with the actual was “not whether a reasonable investor blindness,” the trustee alleged that defen- fraudulent intent to further the Ponzi would have in fact conducted a diligent dants were on “inquiry notice” of the scheme. Consequently, the investors’ investigation before closing its account. fraud but failed to diligently investigate only defense may be under § 548(c), by Instead…once a Defendant was on notice Madoff Securities, constituting a lack of proof of “good faith” and “value,” and of…possible fraud or insolvency, the good faith, citing to In re Manhattan Inv. with value shown by the recission claim, Defendant or their advisor was required Fund Ltd.19 The trustee further argued the remaining issue is the defendant’s to conduct a diligent investigation. The that a failure to further investigate consti- “good faith.” question then is whether that...diligent tutes a lack of good faith unless even dil- investigation could have uncovered the igent inquiry would not have unearthed Good Faith in Bayou III and IV fraud.”15 Because a reasonable, objective the fraud, citing to In re Agric. Research Bayou III noted that “good faith” is investor when confronted with warning & Tech. Group.20 not defined in § 548 of the Bankruptcy signs (or “red flags”) of problems with The court clearly distinguished Code, but must be determined using an investment will immediately with- between the objective-standard of inqui- an “objective” or “reasonable-person” draw its funds without further inquiry, ry approach and the subjective-standard standard. Courts look to what the trans- the jury was given a charge inconsistent of the inquiry (or willful blindness) feree knew or should have known. It is with expected behavior, thus setting up approach. It then, based on SIPA being a two-step test: (1) the transferee cannot another illusory test. “informed by federal securities law,” be found to have received the transfer in required more than “negligence nonfea- good faith if the circumstances would sance” to posit liability—squarely reject- place a reasonable person on inquiry of a Bayou III and IV’s insistence that, ing the Madoff trustee’s argument that debtor’s fraudulent purpose; and (2) once good faith is defined by the objective on notice, the investor must conduct a after perceiving a “red flag,” inves- duty of inquiry standard.21 “A securities diligent inquiry to discover the fraudu- investor has no inherent duty to inquire lent purpose. tors...must undertake a thorough about his stockbroker, and SIPA cre- The transferee is on inquiry notice ates no such duty.”22 The court equated if it knew or should have known of investigation of possible fraud by “conscious avoidance” with “willful information placing it objectively on their broker, is at odds with the blindness,” meaning that the defendant alert that there was a problem with the was aware to a high probability of the 10 fund. A failure to then investigate common-sense decision to bail out facts and consciously avoided confirm- will preclude assertion of a good-faith ing the facts. “But if, simply confronted 11 defense. Bayou III further found that of an investment once its soundness with suspicious circumstances, he fails the inquiry must lead to the conclu- to launch an investigation of his broker’s sion that the investors’ concerns were is challenged. internal practices—and how could he do allayed or set to rest. It acknowledged so anyway?—his lack of due diligence that this test will almost never be cannot be equated with a lack of good met if fraud is involved because the Picard v. Katz faith, at least so far as section 548(c) is In , the Madoff trustee, investor will first be confronted with Picard v. Katz concerned as applied in the context of a appointed under the Securities Investor stonewalling, and it will immediate- SIPA trusteeship.”23 ly redeem its investment before the Protection Act (SIPA), filed a 373-page inquiry can be completed.12 complaint against the Mets owners seek- In re Dreier Bayou IV concluded that the bank- ing recovery of more than a billion dol- Gowan v. The Patriot Group, LLC ruptcy court’s interpretation, with the lars. District Judge Jed Rakoff, in his 24 represents yet 16 (In re Dreier LLP) expanded inquiry-notice duty, renders Sept. 27, 2011, opinion, dismissed all another multi-million dollar bankruptcy the good-faith defense largely illusory claims except those alleging actual fraud case with its origins in a “brazen” Ponzi when a transferor is actually engaged and equitable subordination, reducing scheme.25 This decision is the bankruptcy in fraud.13 It takes the position that the the complaint to some $386 million. court’s ruling on a motion to dismiss a trigger for the inquiry is not merely that First, the court invoked the § 546(e) set- complaint against the Patriot Group “there is a problem with the fund,” but tlement-payment exclusion to dismiss LLC (the “defendant”) seeking under rather that red flags indicate either fraud the preference, constructive-fraud and both New York law and § 548 to recover or insolvency on the part of the fund. state law claims, leaving only claims for $16.5 million, which included $1.5 mil- As to due diligence, Bayou IV permits actual fraud under § 548(a)(1)(A), which lion in interest, based on an 11 percent factual development to support the is then limited to payments made to the per annum rate. Ultimately, the 17 Dreier argument that the investigation would investors in the two years prior to filing. court granted the motion to dismiss the Turning to the issue of good faith, be futile—or practically impossible—to 18 14 Id. at *4. discover the fraud. while defendants vehemently denied 19 397 B.R. 1, 22-23 (S.D.N.Y. 2007). that they ignored any red flags, both 20 916 F.2d 528, 536 (9th Cir. 1990). 21 9 In re Dreier, 452 B.R. at 424. 2011 WL 4448638; id. at *5. 22 10 Bayou III, 396 B.R. at 844-45. sides agreed that if the defendants will- Id. 23 11 Id. at 847. Id. 24 12 Id. at 852. 15 Case 09-cv-02313 (S.D.N.Y.), Doc. 41, page 16. 452 B.R. 391 (S.D.N.Y. 2011). 25 13 Bayou IV, 439 B.R. at 316. 16 2011 WL 4448638. Id. at 398 (“Among the most recent spate of frauds and Ponzi schemes, 14 Id. at 318. 17 Id. at *3. the crimes of Marc Dreier stand out as among the most brazen.”).

44 Canal Center Plaza, Suite 400 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org constructive-fraud claims as to recov- based on certain “red flags” suggesting all facets of the insolvency field. For more ery of principal, but permitted the actual the hedge fund was perpetrating a fraud. information, visit ABI World at www. fraud claims to remain under both New But as to the defendant, Patriot Group, abiworld.org. York law and § 548.26 the Dreier court found that, unlike Bear Addressing the recovery of prin- Stearns, Patriot Group did not appear to cipal, the court extensively surveyed have owed a duty to anyone (other than the affirmative defense of “good faith” its own investors) to investigate Dreier’s under both § 278(1) of the New York fraud, citing to Restatement (Second) Debtor and Creditor Law (NYDCL) of Torts, § 12(2) (1965). Even without and § 548(c) of the Bankruptcy Code.27 a duty, Patriot Group could not ignore Under the NYDCL, divergent tests had facts of which it was aware.33 developed in determining the “good In support of this alternative stan- faith” standard to be applied. Citing to dard that good faith precludes conscious the Second Circuit in HBE Leasing, it turning away or looks to whether the found that “‘good faith’ is satisfied if the defendant had a duty to inquire, the transferee acted without either actual or Dreier court refered to 3B Fed. Jury constructive knowledge of any fraudu- Prac. and Instr. 161.58 (5th Ed. 2011) lent scheme.”28 Some New York state (“To be held responsible for conscious court decisions “appear to have required avoidance or failure to investigate, a more active avoidance of the truth,” defendant ______must either be such as a “conscious turning away” from under a duty to investigate or have con- the subject.29 sciously avoided knowledge knowing Other New York opinions, however, the consequences of such avoidance.”), require an inquiry as to whether there and 1 Garrard Glenn, Fraudulent was a “failure to deal honestly, fairly Conveyances and Preferences § 304, at and openly.” The “earmarks” of the lat- 532 (1940) (“It comes always to a ques- ter version of the “good-faith” defense tion of the grantee’s good faith as dis- are “(1) an honest belief in the propriety tinguished from mere negligence. There of the activities in question; (2) no intent must, indeed, be more than negligence. to take unconscionable advantage of oth- There must be a conscious turning away ers; and (3) no intent to, or knowledge from the subject.”). of the fact that the activities in question will hinder, delay or defraud others.”30 Conclusion Ultimately, the Dreier opinion reached While Bayou III and IV, based on no conclusion on the New York standard 20 years of case law following Agric. for “good faith.” Research & Tech. Group, imposed on the As to “good faith” under § 548(c), definition of “good faith” a standard of the Dreier court noted that most courts “knew or should have known” with a rig- have applied an “objective” or “reason- orous duty of inquiry, that standard has able person” standard, citing to Bayou been decisively rejected by both judges Grp., Manhattan Inv. Fund and Agric. Rakoff and Martin Glenn in the Madoff Research & Tech. Group.31 In its view, and Dreier cases. The Dreier court has however, the Second Circuit has not distinguished Manhattan Inv. Fund on proclaimed its adherence to any spe- the basis that Bear Stearns, as a prime cific standard.32 broker, had a duty to investigate, which Analyzing Manhattan Inv. Fund, the was not present in either the SIPA or the district court noted that Judge Naomi Dreier investment context. Moreover, Buchwald, after considering whether Bayou III and IV’s insistence that, after what Bear Stearns knew or should have perceiving a “red flag,” investors— known triggered a duty to investigate regardless of their degree of sophistica- further, found that Bear Stearns as the tion—must undertake a thorough inves- fund’s prime broker had a duty to inquire tigation of possible fraud by their broker, is at odds with the common-sense deci- 26 As to the claims for recovery of the $1.5 million in interest, the defen- dant claimed that value had been provided because it was a contrac- sion to bail out of an investment once its tual interest payment for the time value of the use of money. The court soundness is challenged. n rejected this “value” argument because (1) Dreier LLP, the debtor, was not a signatory or obligor on the notes, and thus the payments did not extinguish a contractual obligation of the debtor; (2) the payment in Reprinted with permission from the ABI excess of principal did not reduce a valid contractual debt because Journal, Vol. XXXI, No. 1, February 2012. there was no valid contract; and (3) to the extent Patriot Group would assert a claim for an amount in excess of its principal, the court would The American Bankruptcy Institute is a subordinate such a claim, based upon Restatement (Third) of Restitution and Unjust Enrichment, § 61. Id. at 438-40. multi-disciplinary, nonpartisan organization 27 See id. at 445-451. 28 HBE Leasing Corp. v. Frank, 48 F.2d 623, 635-36 (2d Cir. 1995). devoted to bankruptcy issues. ABI has 29 Dreier, 452 B.R. at 446. more than 13,000 members, representing 30 Id. at 447. 31 Id. 33 32 Id. at 448. Id. at 449.

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