Irving H. Picard v. Saul B. Katz et al

Filing 35

MEMORANDUM OF LAW in Opposition re: 20 MOTION to Dismiss THE AMENDED COMPLAINT OR, IN THE ALTERNATIVE, FOR SUMMARY JUDGMENT.. Document filed by Securities Investor Protection Corporation. (Attachments: # 1 Certificate of Service)(LaRosa, Christopher)

UNITED STATES DISTRICT COURT
SOUTHERN DISTRICT OF NEW YORK
-------------------------------------------------------------- :
SECURITIES INVESTOR PROTECTION
:
CORPORATION,
:
:
Plaintiff-Applicant,
:
:
v.
:
:
BERNARD L. MADOFF INVESTMENT
:
SECURITIES LLC,
:
:
Defendant.
:
-------------------------------------------------------------- :
In re:
:
BERNARD L. MADOFF,
:
:
Debtor.
:
-------------------------------------------------------------- :
IRVING H. PICARD, Trustee for the Liquidation :
of Bernard L. Madoff Investment Securities LLC, :
:
Plaintiff,
:
:
v.
:
:
SAUL B. KATZ, et al.,
:
:
Defendants.
:
-------------------------------------------------------------- :

Adv. Pro. No. 08-01789 (BRL)
SIPA LIQUIDATION
(Substantively Consolidated)

Adv. Pro. No. 10-05287 (BRL)

Case No. 1:11-cv-03605-JSR

SUPPLEMENTAL MEMORANDUM OF LAW OF THE
SECURITIES INVESTOR PROTECTION CORPORATION
IN OPPOSITION TO STERLING DEFENDANTS’ MOTION TO DISMISS OR,
IN THE ALTERNATIVE, FOR SUMMARY JUDGMENT
SECURITIES INVESTOR PROTECTION CORPORATION
805 Fifteenth Street, N.W., Suite 800
Washington, D.C. 20005
Telephone: [phone]
JOSEPHINE WANG
General Counsel
KEVIN H. BELL
Senior Associate General Counsel for Dispute Resolution
CHRISTOPHER H. LAROSA
Associate General Counsel
LAUREN T. ATTARD
Staff Attorney

TABLE OF CONTENTS
PAGE
TABLE OF AUTHORITIES .......................................................................................................... ii
STATEMENT OF THE ISSUE .......................................................................................................1
STATEMENT OF THE CASE ........................................................................................................2
A. Nature of the Case ................................................................................................................2
B. Statement of Facts ................................................................................................................4
1. The Nature of the Relationship ......................................................................................4
2. The Warning Signs ........................................................................................................6
SUMMARY OF THE ARGUMENT ..............................................................................................8
ARGUMENT .................................................................................................................................10
I. THE DEFENDANTS ARE LIABLE, INTER ALIA, UNDER
SECTION 548(a)(1)(A) OF THE BANKRUPTCY CODE AND
SECTION 276 OF THE NYDCL, UNLESS THEY CAN PROVE
“GOOD FAITH”................................................................................................................10
II. UNDER THE BANKRUPTCY CODE AND THE NYDCL, “GOOD
FAITH” IS PART OF AN AFFIRMATIVE DEFENSE AND THUS
SHOULD NOT BE DETERMINED ON A MOTION TO DISMISS ..............................12
A. The Standards Governing “Good Faith” Under the Bankruptcy
Code and the NYDCL Are Comparable ......................................................................13
III. SIPA DOES NOT ALTER SECTION 548(c)’s
“GOOD FAITH” STANDARD ........................................................................................15
IV. SECTION 548(c)’s “GOOD FAITH” STANDARD IS COMPARABLE TO
FEDERAL AND STATE LAW STANDARDS APPLICABLE TO THE
DEFENDANTS PRIOR TO THE BLMIS LIQUIDATION .............................................19
CONCLUSION ..............................................................................................................................25

TABLE OF AUTHORITIES
CASES:

PAGE

In re Adler, Coleman Clearing Corp., 198 B.R. 70 (Bankr. S.D.N.Y. 1996) ...................12, 15, 17
In re Adler, Coleman Clearing Corp., 218 B.R. 689 (Bankr. S.D.N.Y. 1998) .............................18
In re A.R. Baron Co., Inc., 226 B.R. 790 (Bankr. S.D.N.Y. 1998)................................................17
In re Bayou Group, LLC, 439 B.R. 284 (S.D.N.Y. 2010) ................................................. 10-14, 22
In re Bernard L. Madoff Investment Securities LLC, 424 B.R. 122
(Bankr. S.D.N.Y. 2010), appeal pending, No. 10-2378 (2d Cir.) . .............................................18
In re Best Products, Inc., 68 F.3d 26 (2d Cir. 1995) .....................................................................17
Brown v. E.F. Hutton Group, Inc., 991 F.2d 1020 (2d Cir. 1991).................................................22
City of Pontiac Gen. Emps. Ret. Sys. v. MBIA, Inc., 637 F.3d 169 (2d Cir. 2011) ........................21
Crigger v. Fahnestock & Co., 443 F.3d 230 (2d Cir. 2006) .................................................... 21-22
In re Dreier LLP, 2011 WL 2412581 (Bankr. S.D.N.Y. June 16, 2011) .......................... 10-14, 24
Drexel Burnham Lambert Group, Inc. v. Galdari, 1987 WL 6164
(S.D.N.Y. Jan. 29, 1987)..........................................................................................................18
Fezzani v. Bear, Stearns & Co., 592 F.Supp.2d 410 (S.D.N.Y. 2009) ..........................................23
First Capital Investment Holdings LLC v. Wilson Capital Group, Inc.,
2011 WL 2119737 (S.D.N.Y. May 23, 2011) .........................................................................23
First Lincoln Holdings, Inc. v. Equitable Life Assurance Society of U.S.,
43 Fed.Appx. 462 (2d Cir. 2002) .............................................................................................21
Gredd v. Bear Stearns Sec. Corp. (In re Manhattan Inv. Fund Ltd.),
359 B.R. 510 (Bankr. S.D.N.Y. 2007), aff=d., in part, and rev=d,
in part, 397 B. R. 1 (S.D.N.Y. 2007) .........................................................................................11
Grumman Allied Indus., Inc. v. Rohr Indus., Inc., 748 F.2d 729 (2d Cir. 1984) ...........................23
Harsco Corp. v. Segui, 91 F.3d 337 (2d Cir. 1997) .......................................................................21
HBE Leasing Corp. v. Frank, 61 F.3d 1054 (2d Cir. 1995) ....................................................12, 14

ii

TABLE OF AUTHORITIES
(cont.)
CASES:

PAGE

Hill v. Spencer Savings & Loan Assoc.
(In re Bevill, Bresler & Schulman), 83 B.R. 880 (D.N.J. 1988) ..............................................16
Hill v. Spencer Savings & Loan Assoc.
(In re Bevill, Bresler & Schulman, Inc.), 94 B.R. 817 (D.N.J. 1989) ......................................17
Jackson v. Mishkin (In re Adler, Coleman Clearing Corp.),
263 B.R. 406 (S.D.N.Y. 2001)...........................................................................................11, 15
Kosovich v. Metro Homes, LLC, 2009 WL 5171737
(S.D.N.Y. Dec. 30, 2009) ........................................................................................................23
In re Manhattan Inv. Fund Ltd., 397 B.R. 1 (S.D.N.Y. 2007).......................................................14
Merck & Co. v. Reynolds, __ U. S. __, 130 S.Ct. 1784 (2010) .....................................................21
Miller v. Harding, 2000 WL 1792990 (1st Cir. Dec. 5, 2000) ......................................................23
Picard v. Merkin (In re Bernard L. Madoff Investment Secs. LLC),
440 B.R. 243 (Bankr. S.D.N.Y. 2010) .....................................................................................13
Picard v. Taylor (In re Park South Securities, LLC), 326 B.R. 505 (Bankr. S.D.N.Y. 2005) ......17
In re PSINet, Inc., 271 B.R. 1 (Bankr. S.D.N.Y. 2001) .................................................................17
In re Refco Secs. Lit., 759 F.Supp.2d 301 (S.D.N.Y. 2010) ..........................................................14
SEC v. Albert & Maguire Sec. Co., 378 F.Supp. 906 (E. D. Pa. 1974) ...........................................9
SEC v. S.J. Salmon & Co., 375 F. Supp. 867 (S.D.N.Y. 1974) .........................................11, 15, 17
In re Sharp Int’l Corp., 403 F.3d 43 (2d Cir. 2005) ......................................................................11
SIPC v. Ambassador Church Finance/Development Group, Inc.,
788 F.2d 1208 (6th Cir.), cert. den. sub nom., Pine Street Baptist
Church v. SIPC, 479 U.S. 850 (1986) .........................................................................................15
Starr ex rel. Estate of Sampson v. Georgeson Shareholder, Inc.,
412 F.3d 103 (2d Cir. 2005).....................................................................................................22

iii

TABLE OF AUTHORITIES
(cont.)
CASES:

PAGE

In re Stratton Oakmont, Inc., 239 B.R. 698 (S.D.N.Y. 1999),
aff’d, 210 F.3d 420 (2d Cir. 2000) ...............................................................................12, 15, 17
Trefny v. Bear Stearns Secs. Corp., 243 B.R. 300 (S.D. Tex. 1999) .............................................16
U. S. v. DiPascali, Case No. 09 CR 764 (EJS) (S.D.N.Y.) .............................................................3

STATUTES AND RULES:
Securities Investor Protection Act, as amended, 15 U.S.C. '
78bbb..............................................................................................................................................19
78fff(b) .......................................................................................................................................2, 15
78fff-1(a) ..........................................................................................................................................2
78fff-2(c)(1) .............................................................................................................................17, 18
78fff-2(c)(3) ...............................................................................................................2, 9, 15, 16, 17
78lll(4)..............................................................................................................................................2

United States Bankruptcy Code, 11 U.S.C. §
544(b) ...............................................................................................................................................3
547....................................................................................................................................................2
548............................................................................................................................................1, 3, 9
548(a) ...............................................................................................................................................1
548(a)(1) ........................................................................................................................................10
548(a)(1)(A) ...................................................................................................................8, 11, 12, 13
548(c) ...................................................................................................1, 8-10, 12-14, 15, 19, 22-24
550(a)(2) ........................................................................................................................................14
550(b)(1) ........................................................................................................................................14

SIPC Rules, 17 C.F.R. §300.
100....................................................................................................................................................4
503(a) .......................................................................................................................................18, 19

iv

TABLE OF AUTHORITIES
(cont.)
STATUTES AND RULES:

PAGE

Rules of the Securities and Exchange Commission, 17 C.F.R. §240.
10b-5 ........................................................................................................................9, 10, 19, 20, 23
10b-10 ......................................................................................................................................19, 20
N.Y. Debtor and Creditor Law §
272............................................................................................................................................12, 13
273..............................................................................................................................................3, 13
274..............................................................................................................................................3, 13
275..............................................................................................................................................3, 13
276..................................................................................................................3, 8, 10, 11, 12, 23, 24
278..........................................................................................................................................3, 9, 10
278(1) .................................................................................................................................12, 23, 24
278(a) .............................................................................................................................................13
279..............................................................................................................................................3, 10
N.Y. Civil Procedure Law and Rules §
213(8) ...............................................................................................................................................3

TREATISE:
6 Collier on Bankruptcy ¶ 749.02 (16th ed. 2011) .........................................................................17
OTHER:
59 Fed. Reg. 59,612 (Nov. 17, 1994).............................................................................................20

v

Pursuant to this Court’s order of July 5, 2011, the Securities Investor Protection
Corporation (“SIPC”) submits this supplemental memorandum of law in opposition to
Defendants’ motion to dismiss the amended complaint (“Complaint”) or in the alternative, for
summary judgment (“Motion”).

This adversary proceeding arises in the context of the

liquidation of Bernard L. Madoff Investment Securities LLC (“BLMIS” or “Debtor”) under the
Securities Investor Protection Act, 15 U.S.C. §78aaa et seq. (‘SIPA”).1
STATEMENT OF THE ISSUE
SIPC addresses herein the following issue, raised by the Court at the July 1, 2011 hearing
held on the Defendants’ motion to withdraw the reference of this adversary proceeding:
Under section 548(c) of the Bankruptcy Code (11 U.S.C.), a
transferee may retain an interest in property that is the subject of an
avoidable transfer under section 548(a) if, among other things, the
transferee has taken in good faith. The issue at hand is whether
SIPA modifies the applicability, or the standard, of good faith
under section 548(c), notwithstanding that, to the extent consistent
with SIPA, the SIPA proceeding is to be “conducted in accordance
with, and as though it were being conducted” like an ordinary
bankruptcy liquidation, SIPA expressly confers upon the SIPA
trustee the power to avoid transfers, in particular, of customer
property, provisions of the Bankruptcy Code apply to a SIPA case
which include, among others, section 548, and in any event the
standard of good faith under section 548(c) is the same or
comparable to state and federal law standards to which some of the
Defendants were subject prior to the commencement of the
liquidation.
SIPC respectfully submits that SIPA does not modify the good faith standard under
section 548(c) and that the standard under section 548(c) applies in a SIPA case, but under the
facts alleged in this case, the Defendants did not take the transfers, which were of customer
property, in good faith.
1

For convenience, references to provisions of SIPA shall omit “15 U.S.C.”

STATEMENT OF THE CASE
A. Nature of the Case
Under SIPA section 78fff(b), unless inconsistent with SIPA, a SIPA proceeding is to be
conducted in accordance with the provisions of the Bankruptcy Code that apply to an ordinary
bankruptcy liquidation, and as though the proceeding were being conducted as an ordinary
bankruptcy liquidation. Thus, at a minimum, the SIPA trustee has all of the powers of a trustee
in a Title 11 case, including specifically the power to avoid transfers, and in particular, the power
to avoid transfers of “customer property.” See SIPA §§78fff-1(a) and 78fff-2(c)(3).

Under

SIPA section 78lll(4), customer property includes property that was received, acquired or held by
the broker-dealer for the accounts of customers and that has been unlawfully converted.

For

purposes of recovery in avoidance, such customer property is deemed to be property of the
debtor. See SIPA § 78fff-2(c)(3).
Substantial transfers were made by the broker-dealer in this case, BLMIS, to the
Defendants. Because the principal of the firm, Bernard Madoff (“Madoff”), ran a Ponzi Scheme,
monies transferred to the Defendants by BLMIS consisted of stolen customer funds and
therefore, “customer property.” In this proceeding, the Trustee for the liquidation of BLMIS
(“Trustee”) seeks to avoid only the transfers that he is empowered to under the Bankruptcy Code
(“Code”), made applicable by SIPA. These are garden variety avoidable bankruptcy transfers
consisting of $700 million of “principal,” but actually comprising stolen customer property, that
were made to the Defendants or their subsequent transferees during the avoidance periods
established under the Code. These transfers include: 1) preferential transfers under section 547
of the Code, 11 U.S.C. §547, that were made on or within 90 days of the filing of the application

2

for a SIPA customer protective decree (“SIPA Application”); 2) fraudulent conveyances under
section 548 of the Code, 11 U.S.C. §548, made within two years of the filing of the SIPA
Application; and/or 3) fraudulent transfers made within six years of the filing of the SIPA
application and avoidable under section 544(b) of the Code, 11 U. S. C. §544(b), and provisions
of New York State law. See §§ 273-279 of the N. Y. Debtor and Creditor Law (“NYDCL”), and
N. Y. Civil Procedure Law and Rules (“NYCPLR”) §213(8). Additionally, the Trustee seeks to
avoid another $300 million of transfers of stolen customer funds by the Debtor to the Defendants
or their subsequent transferees on some or all of the aforementioned grounds. These amounts
were the purely fictitious profits received by the Defendants on “trades” that were never placed
for them, the “trades” having been invented by Madoff to produce such fake profits as he wanted
the Defendants to receive.2 These transfers extend beyond the six-year look-back period as
permitted under section 544(b) of the Code and NYCPLR §213(8).
Although certain of the Defendants had a professional relationship with Madoff that
spanned nearly 25 years, the Trustee does not seek to recapture the transfers of principal that
were made to them beyond the statutory avoidance periods. Nevertheless, the length of the
relationship is relevant. The long-term nature of the relationship and its scope enabled the

2

As Frank DiPascali, Jr., a chief Madoff confederate, testified:
On a regular basis I used hindsight to file historical prices on
stocks then I used those prices to post purchase of [sic] sales to
customer accounts as if they had been executed in realtime. On a
regular basis I added fictitious trade data to account statements of
certain clients to reflect the specific rate of earn return that Bernie
Madoff had directed for that client.

Transcript of Aug. 11, 2009 Plea Proceeding at 47, filed in U. S. v. DiPascali, Case No. 09 CR
764 (EJS) (S.D.N.Y.).

3

Defendants to gain insight into Madoff and his operations. In the face of such knowledge, the
actions of the Defendants, as alleged in the Complaint, are proof of the Defendants’ lack of good
faith, and their inability, therefore, to establish good faith as a defense to the Trustee’s fraudulent
conveyance claims against them.
B. Statement of Facts
1. The Nature of the Relationship
The facts of this case are discussed in the main briefs opposing the Motion and are briefly
examined here as a predicate to analyzing the question at hand.
As alleged by the Trustee, investments or dealings with Madoff and BLMIS cut across
all lines of the real estate, sports, communications, private equity and hedge fund, empire of
Sterling Equities (“Sterling”), the partnership founded by Defendants Saul Katz and Fred
Wilpon. C-¶ 654.3 Over time, the Sterling partners established 483 accounts at BLMIS for
themselves and others, and from their accounts, they benefitted mightily.4 The fictitious BLMIS
“investments” generated consistent and above-market “profits” -- at least on paper -- that
provided a steady flow of cash for Sterling businesses, as 90% of Sterling’s investments were
kept at BLMIS during much of the association. C-¶¶ 662, 677, 742. The risk-free returns
created accounts for the Defendants at BLMIS that were nominally flush with cash which the
3

References herein to paragraphs of the Complaint are to “C-¶ ___.”

4

The establishment of multiple accounts allegedly was, in part, driven initially by a desire to
stay within the SIPA limit of $500,000 of protection per customer. See C-¶¶ 770, 771. Whether
the accounts in all instances genuinely belonged to the accountholders is unclear. For example,
the Trustee asserts that Saul Katz and Fred Wilpon had access to the accounts in the names of
their wives, yet withdrew funds from those accounts to satisfy their personal and business
obligations. See C-¶ 684. Multiple accounts that in fact belong to the same customer, albeit
established in someone else’s name for the sole purpose of increasing the protection, are
aggregated and eligible for only up to one $500,000 protection. See SIPC Series 100 Rules, 17
C.F.R. §300.100 et seq.
4

Sterling Defendants used in many ways: by withdrawing funds from the Defendants’ BLMIS
accounts and depositing them into a Sterling bank entity for use in the Sterling businesses (C-¶¶
701, 807–814); by touting the impressive gains in the BLMIS accounts as proof of Sterling’s
financial stability in order to induce refinancing of Sterling enterprises (C-¶¶ 699, 802); by using
the funds as collateral to negotiate loans for major business deals (C-¶¶ 815, 816, 847); or
simply by withdrawing the funds for direct use in the Sterling businesses (C-¶782). Through
these uses, the BLMIS accounts and thus, the money of other BLMIS customers, enabled the
Sterling businesses to develop, be sustained, and prosper.
The Defendants exploited the returns, unabashedly capitalizing on them to double their
“profits.”

Thus, for example, using the funds in their BLMIS accounts as collateral, the

Defendants obtained bank loans, deposited the loan proceeds into their BLMIS accounts, and
thereby doubled their BLMIS returns. Sterling created special entities for the limited purpose of
doubling returns. C-¶¶ 820-829. These “double-up” accounts almost consistently experienced
profitable returns even when the markets were not. C-¶ 837.
Madoff himself invested roughly $12 million in Sterling-related businesses, but always in
the name of his wife, Ruth, even though Ruth had no business dealings with Sterling. The
money for these investments allegedly came from BLMIS. C-¶¶ 780, 773.
The fact that Sterling was heavily vested in the success of Madoff and BLMIS provided a
powerful incentive to the Defendants to ignore signs of wrongdoing. Indeed, Sterling’s fate was
so completely intertwined with that of Madoff that when the BLMIS fraud was revealed, Sterling
immediately experienced a severe liquidity crisis, requiring it to restructure with bank lenders
over half a billion dollars in collective debt. C-¶¶ 790, 853. Yet, as described by the Trustee,

5

while BLMIS operated, the signals, which were unabating and persistent, incited the Sterling
Defendants to do nothing.
2. The Warning Signs
When Saul Katz’s son expressed concern over Sterling’s concentration of investment
through BLMIS, a hedge fund, Sterling Stamos, was created in 2002 as an alternative investment
vehicle to BLMIS designed to replicate the BLMIS profits. BLMIS customer funds provided
some of the start-up capital for the venture. C-¶¶ 706, 712, 713, 868. Once the hedge fund was
underway and having performed its due diligence, Sterling Stamos personnel assertedly
repeatedly warned Sterling partners about Madoff. Their concerns derived from the hedge
fund’s inability to generate Madoff’s consistent returns, the secrecy concerning his strategy, the
self-custodying and self-clearing of his operations, the persistent rumors of his front-running or
illegally placing trades based on advance information, and his use of a three-man audit firm. C-¶
869. Despite such repeated warnings, the Sterling partners ignored the advice, made no attempt
to confirm the information, and continued to invest through Madoff. C-¶¶ 706, 731, 873, 880896.
Sterling Stamos’s concerns about Madoff were reinforced to Sterling by Merrill Lynch
(“Merrill”) when Merrill acquired an interest in the Sterling Stamos hedge fund in 2007. As
early as 1998, Merrill had expressed reservations about Madoff and had flatly refused to invest
its own funds or to recommend to its clients that they invest through BLMIS. C-¶¶ 718, 898.
Although Merrill’s concerns were communicated to the Sterling partners, again, no due diligence
was performed and no attempt made to verify the allegations. C-¶¶ 904-912.
The warnings described above were not the first such warnings to the Sterling partners.
From 1996 onward, other financial institutions and industry professionals with whom Sterling

6

communicated, as well as trade publication articles read by Sterling partners, had sounded the
same alarm about Madoff, but all to no avail. See C-¶¶ 914-929, 932.
One option that the Sterling partners did consider in 2001 was the procurement of fraud
insurance which Arthur Friedman, the Sterling partner responsible for opening, closing and
monitoring the Defendants’ BLMIS accounts, advised would expressly protect against, among
other things, Ponzi scheme losses. Ultimately, the partners rejected the proposal because they
believed the vast sums invested by them through BLMIS would be uninsurable. C-¶¶ 946-948.
Perhaps not surprisingly, therefore, instead of heeding the warnings about Madoff and
investigating him, the Sterling partners took affirmative steps to protect him and to avoid
drawing unnecessary attention to him and his operation, by regulators, and to the fact that
BLMIS acted as an unregistered investment advisor. See C-¶¶ 949-973. The concealment went
even further, when Sterling partners and Madoff became complicit in Madoff using BLMIS
customer funds, to lend Sterling $54 million in order for it to finance the buy-out of the
television network SNY. Instead of a loan by Madoff, the advance of funds was memorialized in
a May 2004 letter as an “investment” by Ruth Madoff in SNY. C-¶¶ 990–1006. The letter was
signed by Fred Wilpon, Saul Katz and Ruth Madoff.

Wilpon and Katz clearly knew the

representations in the letter of an “investment” to be false, and the transaction to be, in fact, an
interest-free, no cost loan, from BLMIS to Sterling. C-¶ 1002.
The significance of the foregoing should have been all the compelling based on Sterling
Stamos’s experience with funds managed by the Bayou Superfund LLC, ultimately revealed to
be a sizeable Ponzi scheme. Having been sued by the bankruptcy trustee in Bayou in 2006 and
reached a multi-million settlement in 2009 for the partial return of principal and fictitious profit,
the Sterling partners, who were investors in Sterling Stamos and assertedly in the Sterling

7

Stamos funds that invested in Bayou, should have recognized the telltale signs of the Madoff
Ponzi scheme. C-¶¶ 1026 –1046. Instead, willingly seduced by the unrealistic returns generated
in the BLMIS accounts and the special privileges afforded them, the Sterling partners
affirmatively chose instead to exploit those advantages to the detriment of BLMIS customers.
Their actions benefitted themselves and their fellow Defendant BLMIS accountholders as well as
their subsequent transferees.
Having dramatically profited from the use of other investors’ money while BLMIS
operated, the Defendants would now benefit in its demise.

Thus, certain of the Sterling

Defendants and other Sterling-related entities filed 93 customer claims with the Trustee. See C¶1326. While disclaiming liability, they seek to share in the spoils of the liquidation – namely,
the SIPC advances and a share of customer property.
SUMMARY OF THE ARGUMENT
The issue raised by the Court concerns the content and scope, in an avoidance action
brought in connection with a SIPA liquidation, of the fraudulent transfer defense made available
through Section 548(c) of the Bankruptcy Code. That section exempts from the Bankruptcy
Code’s fraudulent transfer provision any transfer received by the transferee “for value and in
good faith.” See 11 U.S.C. § 548(c). For the reasons discussed below, unless Defendants can
avail themselves of that defense, they are liable for the receipt of fraudulent transfers under
Section 548(a)(1)(A) of the Bankruptcy Code (11 U.S.C.) and Section 276 of New York’s
Debtor and Creditor Law (“NYDCL”), inter alia, to the extent of roughly $1 billion.
Importantly, Section 548(c) creates an affirmative defense, facts relating to which need
not be pled by the plaintiff in order to state a claim. As a result, issues relating to the availability
of the defense cannot properly be resolved through a motion to dismiss.

8

In any event, application of the fraudulent transfer laws to creditors of a debtor in a SIPA
liquidation – like most of the Defendants here – merely effects the readjustment of rights and
obligations between and among estate creditors, an unequivocally Constitutional exercise and a
fundamental goal in all bankruptcy proceedings. See SEC v. Albert & Maguire Sec. Co., 378
F.Supp. 906, 911-912 (E. D. Pa. 1974). The fact that some creditors may enjoy fewer property
rights than they would have enjoyed outside of bankruptcy is neither exceptional nor unusual,
and instead is part of the ordinary re-ordering and adjustment of creditor rights characteristic of
bankruptcy.
Further, there is nothing in SIPA that modifies the “good faith” standard necessary to
sustain the defense available under Section 548(c). On the contrary, SIPA incorporates that
provision by reference, and includes a specific section (78fff-2(c)(3)) designed to ensure that
Section 548, along with the other avoidance provisions of the Bankruptcy Code, apply to the
fraudulent transfer of “customer property” to a customer of the liquidating broker-dealer.
Ultimately, the Defendants’ potential liability here is not meaningfully different from
what it was prior to the commencement of the BLMIS liquidation. At any time before that
liquidation commenced, for example, the Defendants could have been sued under the NYDCL
by other BLMIS investors, e.g., by investors who discovered the Ponzi scheme operated through
BLMIS and lost money, on a net basis, through investment in the scheme. As in this case, the
Defendants’ avoidance of liability in such a suit would have depended upon their ability to
sustain a defense under Section 278 of the NYDCL, which incorporates a “good faith” standard
not meaningfully different than the one provided under Bankruptcy Code Section 548(c).
If the Defendants had attempted to use Securities and Exchange Commission (“SEC”)
Rule 10b-5, 17 C.F.R. §240.10b-5, to enforce their purported entitlement to the assets reflected

9

on the fictitious account statements they received from BLMIS - as they suggest they could have
done – they would have faced essentially the same requirement. The statute of limitations on
their claims would have begun to run when a reasonably diligent investor would have discovered
the BLMIS fraud, and any claim brought after the expiration of the limitations period, as
measured from that date, would have been time barred. Further, in order to sustain a claim under
Rule 10b-5, the Defendants would have had to show that they reasonably relied upon the account
statements that they received from BLMIS. To make that showing, they would have had to
demonstrate that they did not ignore an obvious fraud without making a reasonable inquiry effectively the same showing they now must make to demonstrate “good faith” under Section
548(c). That section thus imposes upon the Defendants no different duty than the one they had
prior to the commencement of the BLMIS liquidation.
ARGUMENT
I.
THE DEFENDANTS ARE LIABLE, INTER ALIA, UNDER
SECTION 548(a)(1)(A) OF THE BANKRUPTCY CODE AND SECTION 276
OF THE NYDCL, UNLESS THEY CAN PROVE “GOOD FAITH”
Both Section 548(a)(1) of the Bankruptcy Code and Section 276 of the NYDCL provide
for the avoidance of any transfer made with the “actual intent to hinder, delay or defraud” a
creditor of the transferor. See 11 U.S.C. § 548(a)(1); NYDCL § 276. See also NYDCL §§ 278
and 279. Under both statutes, the intent of the transferor alone is relevant in determining the
voidability of the transfer in question. In this context, the intent of the transferee in receiving the
transfer does not matter. See, e.g., In re Bayou Group, LLC, 439 B.R. 284, 304 (S.D.N.Y. 2010)
(“Bayou Group”) (“Actual fraudulent conveyance claims under Section 548(a)(1)(A) turn on the
intent of the debtor in making the transfer; the state of mind of the transferee is irrelevant”); In re
Dreier LLP, 2011 WL 2412581, at ** 24, 28 (Bankr. S.D.N.Y. June 16, 2011) (“Dreier”) (“[T]o

10

state a claim under NYDCL § 276 the Complaint need only sufficiently allege fraudulent intent
by the transferor”). Further, in both cases, where actual intent to defraud on the part of the
transferor is proven, the transfer will be set aside regardless of the quantum or adequacy of any
consideration given by the transferee in exchange for the transfer. See, e.g., In re Sharp Int’l
Corp., 403 F.3d 43, 56 (2d Cir. 2005) (“Sharp”); Bayou Group, 439 B.R. at 301, 304. Finally, a
transfer that qualifies as an actual fraudulent conveyance under Section 548(a)(1)(A) and/or
Section 276 may be avoided in its entirety, as to both invested principal and “profits.” See, e.g.,
Sharp, 403 F.3d at 56; Bayou Group, 439 B.R. at 304.
To establish the intent required by Bankruptcy Code Section 548(a)(1)(A) and Section
276 of the NYDCL, it is not necessary to show that the transferor intended to target any
particular entity or individual, merely that the transferor’s intent was “directed toward present or
future creditors.” Bayou Group, 439 B.R. at 304. Moreover, in cases in which the debtor has
operated a Ponzi scheme, actual fraudulent intent may be established as a matter of law with
respect to transfers made in the course of the scheme, because such transfers “could have been
made for no purpose other than to hinder delay or defraud creditors.” Id. at 305 (quoting Gredd
v. Bear, Stearns Secs. Corp. (In re Manhattan Inv. Fund Ltd.), 359 B.R. 510, 517-18 (Bankr.
S.D.N.Y.), aff’d, in part, and rev’d, in part, 397 B. R. 1 (S.D.N.Y. 2007)).
For the reasons discussed below, nothing in SIPA or federal securities law changes the
application of these principles to a securities investor claiming the status of a “customer” in a
SIPA liquidation. On the contrary, the courts in this jurisdiction have repeatedly applied these
principles in that context to avoid fraudulent transfers made to investor/transferees. See, e.g.,
SEC v. S.J. Salmon & Co., 375 F. Supp. 867, 870-71 (S.D.N.Y. 1974) (“S.J. Salmon”); Jackson
v. Mishkin (In re Adler, Coleman Clearing Corp.), 263 B.R. 406, 435 (S.D.N.Y. 2001)

11

(“Mishkin”); In re Stratton Oakmont, Inc., 239 B.R. 698, 701 (S.D.N.Y. 1999), aff’d, 210 F.3d
420 (2d Cir. 2000) (“Stratton Oakmont”); In re Adler, Coleman Clearing Corp., 198 B.R. 70, 75
(Bankr. S.D.N.Y. 1996) (“Adler Coleman”). The Trustee has alleged – and it is not disputed that BLMIS operated a Ponzi scheme and that the Defendants received the transfers in issue as
part of the operation of that Ponzi scheme. The Defendants are liable under Section 548(a)(1)(A)
of the Bankruptcy Code and Section 276 of the NYDCL, inter alia, for the receipt of actual
fraudulent transfers unless they can sustain, among other elements, the good faith defense
available under each of those statutes.
II.
UNDER THE BANKRUPTCY CODE AND THE NYDCL,
“GOOD FAITH” IS PART OF AN AFFIRMATIVE DEFENSE
AND THUS SHOULD NOT BE DETERMINED ON A MOTION TO DISMISS
Once a plaintiff has made out a prima facie case for the avoidance of a transfer under the
Bankruptcy Code or the NYDCL, the transferee may avoid rescission of the transfer by
satisfying the terms of the defenses established through Bankruptcy Code Section 548(c) or
Section 278(1) of the NYDCL, respectively. See, e.g., Bayou Group, 439 B.R. at 308; Dreier,
2011 WL 2412581, at ** 26, 32. As noted, “good faith” on the part of the transferee is an
element of both defenses.5 See, e.g., Bayou Group, 439 B.R. at 308-09; Dreier, 2011 WL
2412581, at ** 26, 42. In fact, the transferee bears the burden to establish its good faith as an
affirmative defense that “may be raised and proved by the transferee at trial.” Dreier, 2011 WL

5

Section 278(1) of the NYDCL provides that a conveyance made to a transferee who gave “fair
consideration” in exchange therefor, and who lacked “actual knowledge” of the fraud, is not
avoidable under the statute. In order to show that it provided “fair consideration” for a
challenged conveyance, the transferee must prove, inter alia, that it acted in “good faith” in
exchanging the consideration provided for the property received. See NYDCL § 272. See also
Sharp, 403 F.3d at 53-54; HBE Leasing Corp. v. Frank, 61 F.3d 1054, 1058-59 (2d Cir. 1995)
(“HBE Leasing”); Dreier, 2011 WL 2412581, at *42.

12

2412581, at ** 26, 42 (quoting Picard v. Merkin (In re Bernard L. Madoff Investment Secs.
LLC), 440 B.R. 243, 256 (Bankr. S.D.N.Y. 2010)). As a result, a plaintiff need not plead facts
sufficient to demonstrate an absence of good faith in order to state a claim, and the question
whether the transferee received the transfer at issue in good faith, when it arises as part of the
affirmative defenses established through Bankruptcy Code Section 548(a)(1)(A) and NYDCL
Section 278(a), should not be resolved on a motion to dismiss.6 See, e.g., Dreier, 2011 WL
2412581 at 27 (“At the motion to dismiss stage, the Trustee need not plead lack of good faith as
an element of the claim itself”).
A.

The Standards Governing “Good Faith” Under the Bankruptcy Code and
the NYDCL Are Comparable

The “good faith” test applicable under Section 548(c) of the Bankruptcy Code consists of
two inquiries. “The first question typically posed is whether the transferee had information that
put it on inquiry notice that the transferor was insolvent or that the transfer might be made with a
fraudulent purpose.” Bayou Group, 439 B.R. at 310. Once it is clear that a transferee was on
“inquiry notice” of either the transferor’s possible insolvency or of the possibly fraudulent
purpose of the transfer, the next question is whether the transferee conducted a diligent
investigation of the facts that put it on inquiry notice. Id. at 312-13. As most commonly
phrased, the question is whether diligent inquiry of these facts by the transferee would have
revealed the fraudulent purpose of the transfer. Id.

6

The Trustee also brings claims for constructive fraudulent conveyance under the NYDCL,
however, which require proof that the transfer in question was made without “fair consideration”
by the transferee in exchange for the transfer. See NYDCL §§ 273-75. The transferee must
prove the consideration was given in “good faith” in order to meet the applicable standard for
“fair consideration,” and a plaintiff asserting claims for constructive fraudulent conveyance
therefore must allege facts sufficient to establish the absence of “good faith” as part of the
complaint. See NYDCL § 272; Dreier, 2011 WL 2412581, at *37-38.
13

An objective, “reasonable investor” standard applies to both components of Section
548(c)’s “good faith” test. Id. at 313. Under this standard, the focus is on what the transferee
“knew or should have known,” as an objective matter, rather than the transferee’s actual
knowledge and state of mind. Id. On several occasions, this Court has noted that, in applying
this standard, the Court should not consider the perspective of a generic “reasonable investor,”
but rather that of an investor of the same class or category of investor as the transferee. See id.;
In re Manhattan Inv. Fund Ltd., 397 B.R. 1, 23 (S.D.N.Y. 2007). Thus, for example, in one case,
the Court applied the “inquiry notice” test from the point of view of a “reasonably prudent
institutional hedge fund investor.”7 See Bayou Group, 439 B.R. at 313.
Under the NYDCL “good faith,” a transferee with actual or constructive knowledge of
the fraudulent scheme pursuant to which the challenged transfer was made is sufficient to vitiate
good faith. HBE Leasing, 48 F.3d at 636; Dreier, 2011 WL 2412581, at * 43. In this regard,
“constructive knowledge of fraudulent schemes will be attributed to transferees who were aware
of circumstances that should have led them to inquire further into the circumstances of the
transaction, but who failed to make such inquiry.” HBE Leasing, 48 F.3d at 636. Cf., In re
Refco Secs. Lit., 759 F.Supp.2d 301, 333 (S.D.N.Y. 2010) (Rakoff, J.). In practical application,
this test is indistinguishable from Bankruptcy Code Section 548(c)’s “good faith” standard.

7

Bankruptcy Code Section 550(a)(2) authorizes a bankruptcy trustee to recover property
transferred by the initial transferee to a subsequent transferee. See 11 U.S.C. § 550(a)(2).
Section 550(b)(1) provides an affirmative defense to such subsequent transferee comparable to
the defense available to initial transferees under Section 548(c). See 11 U.S.C. § 550(b)(1). As
in Section 548(c), the Section 550(b)(1) defense includes a “good faith” component, governed by
a “good faith” standard identical to the one applicable under Section 548(c). See Dreier, 2011
WL 2412581, at * 44.
14

III.

SIPA DOES NOT ALTER SECTION 548(c)’s “GOOD FAITH” STANDARD

Nothing in SIPA in any way alters the content or applicability of Section 548(c)’s “good
faith” standard in a SIPA liquidation.

On the contrary, as this Court and others in this

jurisdiction have consistently recognized, SIPA and the rules promulgated thereunder “manifest
a design to deny protection to transactions tainted by fraud.” Mishkin, 263 B.R. at 435. See also
Stratton Oakmont, 239 B.R. at 701; S.J. Salmon, 375 F. Supp. at 870-71; Adler Coleman, 198
B.R. at 75. Thus, for example, SIPA incorporates by reference the avoidance provisions of the
Bankruptcy Code, to the extent consistent with SIPA, and the courts have long recognized that a
SIPA liquidation is essentially a bankruptcy proceeding. See SIPA § 78fff(b). See also e.g.,
SIPC v. Ambassador Church Finance/Development Corp., 788 F.2d 1208, 1210 (6th Cir. 1986),
cert. den. sub nom., Pine Street Baptist Church v. SIPC, 479 U.S. 850 (1986).
Further, to ensure that the Bankruptcy Code’s avoidance provisions can be meaningfully
applied in the special circumstances often present in liquidations under SIPA, Congress included
a special provision in SIPA – Section 78fff-2(c)(3) - designed to ensure that the avoidance
provisions apply to fraudulent transfers made to brokerage customers, and also apply regardless
of the status of a customer as a “creditor” of the liquidating broker-dealer under state law.
Specifically, Section 78fff-2(c)(3) provides generally that, for purposes of applying the
avoidance powers under the Bankruptcy Code in a SIPA liquidation, customer property held by
the debtor “shall be deemed to have been property of the debtor,” and, if an avoidable transfer of
such property was made to a customer, the transferee customer “shall be deemed to have been a

15

creditor [of the debtor], the laws of any State to the contrary notwithstanding.”8 See SIPA §
78fff-2(c)(3). As has long been noted, the purpose of this provision is to ensure that a SIPA
trustee can use the avoidance powers conferred by the Bankruptcy Code to recover customer
property, even though, prior to the commencement of the liquidation, such property was not
“property of the debtor” and the debtor’s brokerage customers were not its “creditors” under
state fraudulent transfer law. See, e.g., Trefny v. Bear Stearns Secs. Corp., 243 B.R. 300, 321322 (S.D. Tex. 1999); Hill v. Spencer Savings & Loan Assoc. (In re Bevill, Bresler & Schulman,
Inc.), 83 B.R. 880, 894 (D.N.J. 1988). As one commentator has explained:
A customer receiving a voidable transfer is deemed to be a creditor
for purposes of avoidance, and the property so transferred is
deemed to have been property of the debtor. The customer is not
an actual creditor, and, under virtually all state and federal
securities laws, the property does not belong to the debtor prior to
transfer. The purpose of this legal fiction is to enable the trustee to
fit the transfer into the provisions of the avoidance sections of the
[Bankruptcy] Code. The legal fiction prevents a customer from
using a technical reading of the avoidance provisions of the
[Bankruptcy] Code to retain securities that would otherwise be
recoverable by the trustee. The overall purpose of…15 U.S.C. §
78fff-2(c)(3) is to prevent one or more customers from depriving
other customers of assets by keeping these assets out of the pool
available for distribution to customers on a ratable basis.

8

Section 78fff-2(c)(3) provides in full:
Whenever customer property is not sufficient to pay in full the
claims set forth in subparagraphs (A) through (D) of paragraph (1),
the trustee may recover any property transferred by the debtor
which, except for such transfer, would have been customer
property if and to the extent that such transfer is voidable or void
under the provisions of title 11. Such recovered property shall be
treated as customer property. For purposes of such recovery, the
property so transferred shall be deemed to have been the property
of the debtor and, if such transfer was made to a customer or for
his benefit, such customer shall be deemed to have been a creditor,
the laws of any State to the contrary notwithstanding.
16

6 Collier on Bankruptcy ¶ 749.02[1] at 749-4 (16th ed. 2011). See also Picard v. Taylor (In re
Park South Securities, LLC, 326 B.R. 505, 512-13 (Bankr. S.D.N.Y. 2005) (SIPA trustee had
standing to pursue avoidance actions against customers to whom debtor transferred funds from
other customers’ accounts); Hill v. Spencer Savings & Loan Assoc. (In re Bevill, Bresler &
Schulman, Inc.), 94 B.R. 817, 825-26 (D.N.J. 1989) (granting summary judgment to SIPA
trustee in action to avoid transfer of securities from debtor’s common safekeeping account to
customers’ individual accounts at other institutions).
Consistent with Section 78fff-2(c)(3), the fraudulent transfer provisions of the
Bankruptcy Code, and the companion provisions of applicable state law, have been repeatedly
endorsed by the courts as a mechanism for the recovery of fraudulent transfers effected by a
liquidating broker-dealer between customers of that broker-dealer. See, e.g., Mishkin, 263 B.R.
at 435. See also Stratton Oakmont, 239 B.R. at 701; S.J. Salmon, 375 F. Supp. at 870-71; Adler
Coleman, 198 B.R. at 75. Again, this application reflects an adaptation of one the fundamental
functions of bankruptcy law – reordering debtor-creditor relations through the adjustment of
priorities between and among creditors – to the unique circumstances that exist in liquidations
under SIPA. See, e.g., In re Best Products, Inc., 68 F.3d 26, 31-32 (2d Cir. 1995) (“Fixing the
order of priority of creditor claims against a debtor is an integral and historic bankruptcy
function, and without this power the bankruptcy court would be rendered powerless to
rehabilitate a debtor”); In re PSINet, Inc., 271 B.R. 1, 19 (Bankr. S.D.N.Y. 2001). In this regard,
SIPC liquidations include a class of creditors not found in garden variety liquidation
proceedings, namely, brokerage “customers” to whom the liquidating broker-dealer owes cash
and/or securities. See SIPA § 78fff-2(c)(1); In re A.R. Baron Co., Inc., 226 B.R. 790, 794
(Bankr. S.D.N.Y. 1998). Accordingly, where the transferee from whom a SIPA trustee seeks to
17

recover property claims to be a “customer” of the debtor broker-dealer, and where the property
that the trustee seeks to recover qualifies as “customer property” within the meaning of SIPA, the
trustee’s action merely helps ensure that “customer property” is distributed ratably, on the basis
of customers’ “net equities,” as SIPA requires. See SIPA § 78fff-2(c)(1); In re Bernard L.
Madoff Investment Secs. LLC, 424 B.R. 122, 132-34 (Bankr. S.D.N.Y. 2010), appeal pending,
No. 10-2378 (2d Cir.).
This re-adjustment of rights between and among customer-creditors is a fundamental part
of the bankruptcy process, and one entirely within the “bankruptcy power” conferred upon
Congress through the Constitution. As this Court has explained:
The United States Constitution confers broad powers upon
Congress to establish “uniform laws on the subject of
bankruptcies.” Art. I, § 8, cl. 4. Pursuant to this expansive
authority, Congress has consistently enacted bankruptcy statutes
that have altered vested creditors’ rights predating enactment.
It is the essential nature of any bankruptcy legislation to modify
and adjust debtor-creditor relationships, often affecting the vested
rights of certain creditors to assure the equitable treatment of all
creditors of the estate.
Drexel Burnham Lambert Group, Inc. v. Galdari, 1987 WL 6164 * 20 (S.D.N.Y. Jan. 29, 1987).
SIPC’s rules, which are promulgated under the auspices of the SEC and have the force
and effect of law, reinforce SIPA’s emphasis on the importance of the avoidance provisions in
the SIPA context. See, e.g., In re Adler, Coleman Clearing Corp., 218 B.R. 689, 699 (Bankr.
S.D.N.Y. 1998) (“The SEC promulgated the SIPC rules…and they have the force and effect of
law”). In this regard, SIPC Rule 503(a), 17 C.F.R. §300.503(a), precludes application of SIPC’s
Series 500 Rules, which, under some circumstances, determine the character of a customer’s
claim as one for cash or securities, if such application would interfere with a SIPA trustee’s

18

ability to “avoid any securities transaction as fraudulent, preferential, or otherwise voidable
under applicable law.” See 17 C.F.R. § 300.503(a); Mishkin, 263 B.R. at 435 and n. 19.
The fact that, for some purposes, SIPA is to be treated as part of the Securities Exchange
Act of 1934 (“1934 Act”) has no effect on the character or content of the “good faith” standard
applicable in avoidance actions brought in connection with liquidations under SIPA. While,
under Section 78bbb of SIPA, liquidations under SIPA are to be treated, under some
circumstances, as if SIPA “constituted an amendment to, and was included as a section of, such
[1934] Act,” this treatment is imposed only if SIPA does not provide otherwise. See SIPA §
78bbb (“Except as otherwise provided” in [SIPA,] the provisions of the [1934 Act] apply….”) .
As discussed, with regard to a SIPA trustee’s avoidance powers, SIPA specifically incorporates
by reference the Bankruptcy Code’s avoidance provisions, and then adapts those provisions to
the unique circumstances that obtain in liquidations under SIPA. See supra. In accordance with
limiting language in Section 78bbb, the specificity of these provisions precludes the application
of standards applicable under the 1934 Act, or any other provision of the federal securities laws,
to the exercise of a trustee’s avoidance powers.
IV.

SECTION 548(c)’s “GOOD FAITH” STANDARD IS COMPARABLE
TO FEDERAL AND STATE LAW STANDARDS APPLICABLE
TO THE DEFENDANTS PRIOR TO THE BLMIS LIQUIDATION
In any event, there is no meaningful difference between Section 548(c)’s “good faith”

standard and comparable standards under the federal securities laws. In fact, the Section 548(c)
standard is nearly identical to standards to which the Defendants were already subject under both
applicable state law, and the very federal securities law that the Defendants themselves invoke.
The Defendants point to SEC Rules 10b-10 and 10b-5 as the basis for their contention
that they lacked any duty to investigate the information they had indicating that the payments

19

they received from BLMIS were made as part of the operation of a Ponzi scheme. (See Dkt. No.
2 at 11-14.) Rule 10b-10 requires a securities broker-dealer to provide a brokerage customer
with a written confirmation of every transaction that occurs in the customer’s account. See 17
C.F.R. § 240.10b-10. Like many of the securities laws, the rule is grounded in the notion that the
securities markets function best through the disclosure of all material information. The rule is
therefore designed to provide customers with information sufficient to enable them to properly
exercise the substantive rights arising from their contractual relationships with their brokerdealers and to detect fraudulent activity in their accounts.

See, e.g., Confirmation of

Transactions, 59 Fed. Reg. 59,612, 59,613 (Nov. 17, 1994) (“For over 50 years, the customer
confirmation has served basic investor protection by conveying information allowing investors to
verify the terms of their transactions…[and] acting as a safeguard against fraud…” (emphasis
added)). A premise underlying Rule 10b-10 is thus that investors will use the information
contained on the confirmation statements provided to them pursuant to the rule to police activity
in their accounts; not, as the Defendants suggest, to excuse them from any further duty of
inquiry.
Rule 10b-5, upon which the Defendants also rely, makes the matter even clearer. The
Defendants suggest that, through Rule 10b-5, “the federal [securities] laws enforce the
customer’s rights whether or not a broker actually purchased securities…” because a broker who
accepts payment for securities that it never intends to deliver violates the rule.9 (Dkt. No. 2 at
13.) But Rule 10b-5 imposes a duty to investigate upon an investor in at least two ways.

9

The Defendants’ reliance on Rule 10b-5 in this context is rather curious given that they could
only have invoked the rule if they had discovered the BLMIS fraud. But the Defendants claim
that they did not discover that fraud, and had no duty to do so. If so, Rule 10b-5 would have
been of no use to them.
20

First, the statute of limitations governing actions brought under the Rule begins to run
when a reasonably diligent investor would have discovered the fraud for which the plaintiff sues.
See Merck & Co. v. Reynolds, __ U. S. __, 130 S.Ct. 1784, 1798 (2010); City of Pontiac Gen.
Emps. Ret. Sys. v. MBIA, Inc., 637 F.3d 169, 174-75 (2d Cir. 2011) (“City of Pontiac”). The
date a fact is deemed “discovered” is the date on which a reasonably diligent plaintiff could have
pled that fact with sufficient detail and particularity to survive a motion to dismiss. See City of
Pontiac, 637 F.3d at 175. An investor with information indicating that a securities transaction
may be fraudulent, who elects not to conduct a diligent inquiry – or, as here, any inquiry at all thus may be time-barred from bringing suit.
Second, an investor not time-barred from bringing suit must prove that he or she
reasonably relied upon the fraudulent representations forming the basis for the suit, here, the cash
and securities positions reflected in the fraudulent account statements supplied by BLMIS to the
Defendants. See, e.g., First Lincoln Holdings, Inc. v. Equitable Life Assurance Society of U.S.,
43 Fed.Appx. 462, 464 (2d Cir. 2002); Harsco Corp. v. Segui, 91 F.3d 337, 342 (2d Cir. 1997).
Although the standard governing justifiable reliance in this context is most recently described in
terms of “reasonably prudent investor,” and at other times as “recklessness,” the courts in this
jurisdiction uniformly examine objective facts and circumstances in evaluating the
reasonableness of an investor’s purported reliance.10 Compare, e.g., Crigger v. Fahnestock &

10

Although they have never developed a list of all relevant factors, courts frequently consider,
inter alia: (1) the sophistication and expertise of the plaintiff in financial and securities matters;
(2) the existence, or absence, or longstanding business or personal relationships between the
plaintiff and the broker-dealer; (3) the extent to which the plaintiff had access to relevant
information; (4) the existence, or absence, of a fiduciary relationship between the plaintiff and
the broker-dealer; (5) the extent to which the broker-dealer concealed, or attempted to conceal,
the fraud; (6) the extent to which the plaintiff had an opportunity to detect the fraud; (7) whether
21

Co., 443 F.3d 230, 234 (2d Cir. 2006), with Starr ex rel. Estate of Sampson v. Georgeson
Shareholder, Inc., 412 F.3d 103, 109 (2d Cir. 2005); Brown v. E.F. Hutton Group, Inc., 991 F.2d
1020, 1032 (2d Cir. 1991) (“Brown”). As a result, although articulated slightly differently, this
standard is functionally indistinguishable from the “reasonable investor” test applicable as part of
Bankruptcy Code Section 548(c)’s “good faith” standard. Cf., Bayou Group, 439 B.R. at 313
The Defendants would have been no better off had they elected to proceed under state,
rather than federal, law. Under New York law, a claim for common law fraud requires, inter
alia, proof of reasonable reliance by the plaintiff upon material misrepresentations or omissions
of fact by the defendant. See, e.g., Crigger, 443 F.3d at 234-35. In this context, the plaintiff has
a duty to investigate the legitimacy of an investment opportunity where the plaintiff “was placed
on guard or practically faced with the facts.” Id. at 234. As under Bankruptcy Code Section
548(c), a plaintiff “cannot close his eyes to an obvious fraud, and cannot demonstrate reasonable
reliance without making inquiry and investigation if he has the ability, through ordinary
intelligence, to ferret out the truth about the reliability of an investment.” Id. at 234-25. On this
basis, the Second Circuit recently upheld the propriety of jury instructions which advised the jury
that a plaintiff who invested in a Ponzi scheme had a duty to investigate the legitimacy of the
investment. The court explained, inter alia, that:
Where sophisticated businessmen engaged in major transactions enjoy
access to critical information but fail to take advantage of that access, New
York courts are particularly disinclined to entertain claims of justifiable
reliance.

______________________________
the plaintiff initiated or sought to expedite the transaction at issue; and (8) the generality or
specificity of the misrepresentations in question. See Brown, 991 F.2d at 1032.

22

Id. at 235 (quoting Grumman Allied Indus., Inc. v. Rohr Indus., Inc., 748 F.2d 729, 737 (2d Cir.
1984)). See also First Capital Investment Holdings LLC v. Wilson Capital Group, Inc., 2011
WL 2119737, at *5 (S.D.N.Y. May 23, 2011) (Rakoff, J.) (denying summary judgment to
plaintiffs based upon common law fraud claim brought under New York law because, inter alia,
“[w]hile, with hindsight, it seems clear that plaintiffs were swindled, there is evidence from
which a jury could conclude that their own alleged greed caused them to ignore what was plainly
to be seen – thus implicating the issue of justifiable reliance”); Kosovich v. Metro Homes, LLC,
2009 WL 5171737, at *6 (S.D.N.Y. Dec. 30, 2009) (Rakoff, J.), aff’d, 405 Fed. Appx. 540 (2d
Cir. 2010) (citing Fezzani v. Bear, Stearns & Co., 592 F.Supp.2d 410, 423 (S.D.N.Y. 2009) for
the proposition that “[c]ourts in the Second Circuit have found that the elements of common law
fraud are essentially the same as those which must be pleaded to establish a claim under § 10(b)
and Rule 10b-5”). With the substitution of “good faith” for “justifiable reliance,” the same
reasoning applies with equal force under Bankruptcy Code Section 548(c).
Apart from the duty to investigate based on the Sterling Defendants’ knowledge of the
Madoff operation and their experience with Madoff, the Defendants could have been sued at any
time under the actual fraud provision of Section 276 of the NYDCL by any other investor who
discovered the BLMIS Ponzi scheme and lost money in it. Cf., Miller v. Harding, 2000 WL
1792990, at **1-2 (1st Cir. Dec. 5, 2000) (upholding summary judgment entered in favor of
plaintiff in fraudulent conveyance suit brought by one Ponzi scheme investor against another
under state fraudulent conveyance law). If that had occurred, the Defendants would have been
liable under the NYDCL unless they could sustain a “good faith” defense under Section 278(1) –
precisely the same situation in which they find themselves here. As noted, the “good faith”
standard applicable under NYDCL Section 278(1) is no less rigorous than the one applicable

23

under Section 548(c), and the Defendants therefore are subject to no duty now that is different
from any duty that they had pre-liquidation.11 See supra.
Finally, it is worth noting that some of the Defendants were not BLMIS investors, at least
with respect to the transfers in issue, but rather the subsequent transferees of such investors.
These subsequent transferees therefore could have no claim to any special protection from the
securities laws regarding the subject transfers, even assuming, for the sake of argument, such
special protection were available to others.

11

The Defendants suggest the fraudulent conveyance laws do not apply to transfers made to
creditors of the transferor, and that they are immune from liability because the transfers to them
discharged an antecedent debt. (See Dkt. No. 2 at 8-9.) The Defendants are mistaken on both
points. Creditor status does not immunize the transferee of a fraudulent transfer from liability
under the fraudulent conveyance laws, and the courts in this jurisdiction have regularly allowed
fraudulent conveyance claims against creditors to go forward, particularly the recipients of Ponzi
scheme payments. See, e.g., Dreier, 2011 WL 2412581, at ** 2-3 (denying motion to dismiss
fraudulent conveyance claims brought under the NYDCL against “net winners” in Ponzi
scheme). Moreover, for the reasons discussed in detail above, under the NYDCL, the fact that a
payment discharges an antecedent debt is not relevant to the question whether the transferee has
received an actual fraudulent conveyance within the meaning of NYDCL Section 276. See
supra. It is relevant to the question whether the transferee gave “fair consideration” in exchange
for the transferee under NYDCL Section 278(1). Even then however, the transferee must
demonstrate that it received the transfer in question in “good faith” – the same obligation that the
Defendants have here. See supra.
24

CONCLUSION
For all of the reasons stated in SIPC’s main brief and in this supplemental brief, the
Defendants’ Motion should be denied.
Dated: July 22, 2011
Washington, D.C.
Respectfully submitted,
JOSEPHINE WANG
General Counsel
KEVIN H. BELL
Senior Associate General Counsel for Dispute
Resolution

/s/ Christopher H. LaRosa
CHRISTOPHER H. LAROSA
Associate General Counsel
LAUREN T. ATTARD
Staff Attorney
SECURITIES INVESTOR
PROTECTION CORPORATION
805 15th Street, N.W.
Suite 800
Washington, D.C. 20005
Telephone: [phone]
E-mail: [e-mail]
E-mail: [e-mail]
E-mail: [e-mail]
E-mail: [e-mail]

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