A recent decision by Judge Stuart Bernstein of the Bankruptcy Court for the Southern District of New York, Irving Picard, as trustee for Bernard L. Madoff Investment Securities LLC v. Citibank, N.A., clarifies the parameters of the “willful blindness” standard applicable in fraudulent conveyance actions, and illustrates practical applications of safe harbor defenses that may be asserted in such actions.
Willful Blindness Standard
The dispute arose in a suit brought by the Madoff trustee against Citibank and certain affiliates. The Citi defendants had provided financing to funds that had invested with Tremont, which operated as a feeder fund for Madoff Securities. The alleged transferee liability was based on the receipt by the Citi defendants of funds that had previously been paid by Madoff Securities to Tremont. Pursuant to Bankruptcy Code section 550(b)(2), which provides defenses for subsequent transferees, the Citi defendants had to establish that the transfers had been received “in good faith, and without knowledge of the voidability of the transfer avoided.”
The Citi defendants had conducted due diligence before extending the loans, including reviewing Tremont and Madoff Securities. The trustee’s position was that the Citi defendants could not meet the good faith standard because they had exhibited “willful blindness” in ignoring “red flags” that should have led them to conclude that Madoff Securities was a fraud. However, the court disagreed, determining that the trustee’s position rested on the implausible assumption that the Citi defendants knowingly loaned hundreds of millions of dollars to a borrower whose assets were based on a fraud.
While Judge Bernstein determined that the allegation that the Citi defendants made loans that they knew could not be repaid was implausible, he accepted as true (for the purposes of the motion to dismiss) the trustee’s allegation that Tremont knew that Madoff Securities was a Ponzi scheme. The decision, however, did not explain why the latter set of allegations was more plausible than the first.
Safe Harbor Issues
The decision also illustrates some critical practical difficulties in the application of safe harbor defenses in the context of a transaction with multiple transfers.
* A subsequent transferee may assert as a defense that the initial transfer is protected by the safe harbor defense, even if this defense was not raised by the initial transferee. The trustee had reached a settlement with Tremont pursuant to which Tremont did not raise safe harbor defenses. The Citi defendants were not precluded from themselves arguing that the safe harbor applied to the initial transfers.
* The relevant transaction for safe harbor purposes is the initial transfer. An initial transfer may be subject to a safe harbor defense, and that safe harbor defense may be asserted by either the initial transferee or the subsequent transferee. However, if the initial transfer is determined to be avoidable there is no separate safe harbor defense inapplicable to the subsequent transfer. This may be of critical importance because, as noted in our prior alert, under the Supreme Court’s Merit Management decision, the plaintiff in a fraudulent conveyance action has considerable discretion in structuring the allegations in a complaint with respect to who are the parties to the transfer to be avoided.
* Safe harbor defenses are not available to bad faith defendants. The trustee had alleged that Tremont knew that Madoff Securities was a sham, and such allegations were assumed to be true for the purposes of a motion to dismiss. Accordingly, the safe harbor defenses asserted by the Citi defendants were denied. As noted above, the Citi defendants were still able to ultimately prevail because they had valid subsequent transferee defenses.