Offshore Harbor: Second Circuit Rules That Safe Harbor Blocks Clawback Actions Brought in Foreign Proceedings

The Second Circuit Court of Appeals has ordered the dismissal of all clawback actions brought by the liquidators of a Madoff feeder fund against foreign investors who made withdrawals before the Madoff fraud was revealed to the public. The decision, In re Fairfield Sentry Ltd., demonstrates that the Safe Harbor — which provides protections from clawback actions for investors in cases involving securities or certain other financial assets traded on public markets¹ — applies to actions brought in foreign insolvency proceedings when the plaintiffs bring clawback actions using US courts. Fairfield Sentry places a high bar of proof on plaintiffs who attempt to circumvent the Safe Harbor by alleging intentional fraud.

Background

Fairfield Sentry is part of the tsunami of litigation that stemmed from the Madoff scandal. The plaintiffs were liquidators for investment funds based in the British Virgin Islands that were feeder funds for Madoff. The defendants were fund investors who had redeemed some or all of their interests in the funds before Madoff’s arrest. After the funds were forced into BVI liquidation proceedings, the liquidators obtained recognition as foreign main proceedings under chapter 15 of the Bankruptcy Code, which governs cases commenced outside of the United States that are based on the law of the foreign main jurisdiction, rather than U.S. federal or state law. As discussed in our prior alert, the liquidators then filed approximately 300 clawback actions seeking to claw back over $6 billion in the chapter 15 case based on BVI statutory and common law theories. The defendants moved to dismiss based on the Safe Harbor.

The bankruptcy court dismissed most of the claims based on Bankruptcy Code section 561(d), which generally applies the Safe Harbor to chapter 15 cases. Because the Safe Harbor contains a carveout for fraudulent conveyance actions based on intentional fraud, it declined to dismiss claims based on allegations of intentional fraud. It further ruled that the Safe Harbor did not cover causes of action based on BVI common law, nor those against defendants who were alleged to have known of the Madoff fraud. The district court affirmed.

Second Circuit Decision

On appeal the Second Circuit affirmed the lower courts insofar as they had dismissed claims and ordered the dismissal of the remaining claims.

The court ruled that the allegations in the complaints based on alleged intentional fraud did not sufficiently allege fraudulent intent on the part of the transferors. The liquidators’ intentional fraud case relied upon their allegation that the funds’ administrator Citco Bank failed to follow up on suspicions regarding Madoff’s operations, and their argument that this allegation established both that Citco had actual fraudulent intent and that Citco’s actual fraudulent intent could be imputed to the funds. The decision rejected both parts of the liquidators’ argument.

First, the court reasoned that while Citco might have been negligent or reckless, there was no showing that it had intended or expected that investors would be defrauded — and that such a showing is necessary to prove intentional fraud. Second, it held that even assuming adequate allegation of Citco’s intentions, Citco’s alleged fraud could be imputed to the funds only if the funds were alleged to have been co-fraudsters, a conclusion doomed by the liquidators’ concession that the funds were victims of the Madoff fraud.

The decision also ordered the dismissal of claims based on BVI common law, ruling that the Safe Harbor precludes not only statutory avoidance actions but also common law actions that seek a similar remedy to what is applicable in statutory avoidance actions. Consequently, it determined that section 561(d), in applying the Safe Harbor to actions brought in chapter 15 foreign cases, bars actions based on the common law of the foreign tribunal’s jurisdiction.

Conclusions

The intentional fraud standard established in Fairfield Sentry is likely to be significant not only in chapter 15 foreign jurisdiction cases but also in domestic fraudulent conveyance litigation. Actual intent fraud is the principal exception to the scope of the Safe Harbor, and the ability of plaintiffs to impute fraudulent intent is often a critical issue in proving actual intent. The defendant-friendly standard in Fairfield Sentry will assist defendants in protecting themselves from clawback actions.

It is important for defendants that the decision was rendered on the pleadings. The defendants did not have to engage in discovery, which can be expensive and give leverage to plaintiffs in settlement negotiations.

One aspect of Fairfield Sentry that was not expressly analyzed in the decision is that among the defendants whose cases are to be dismissed are those whom the plaintiffs alleged had knowledge of the Madoff fraud. The Safe Harbor exception for cases involving intentional fraud refers to the knowledge of the transferor, not the transferee. This distinction has been the source of much consternation on the part of innocent recipients of fraudulent transfers; here the reverse may have been the case.

It is now nearly 20 years since the Madoff fraud was exposed. This litigation followed a winding path. Related actions brought by the liquidators regarding the same funds were dismissed by the Commercial Division of the Eastern Caribbean High Court of Justice of the BVI, which was affirmed by the Privy Council in London. While the result should be comforting to investors, the process illustrates how long it can take before insolvency-based litigation can be resolved.

The opinion contains an intriguing footnote regarding the so-called Ponzi scheme presumption, which provides for a relaxed standard of proof of intentional fraud in cases involving alleged Ponzi schemes, and which was often invoked by lower courts in Madoff-related litigation. Judge Menashi’s footnote cites to his concurring opinion in another Madoff decision and states that the Ponzi scheme presumption is an open question in the Second Circuit. It is likely that this issue will be explored in other litigation.

Kleinberg Kaplan represents a defendant in Fairfield Sentry.

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¹ For more information about the Safe Harbor see our Safe Harbor Resource Center here