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

Filing 36

SUPPLEMENTAL MEMORANDUM OF LAW in Opposition re: 20 MOTION to Dismiss THE AMENDED COMPLAINT OR, IN THE ALTERNATIVE, FOR SUMMARY JUDGMENT.. Document filed by Irving H. Picard. (Bohorquez, Fernando)

UNITED STATES DISTRICT COURT
SOUTHERN DISTRICT OF NEW YORK
In re:

Adv. Pro. No. 08-01789 (BRL)

BERNARD L. MADOFF INVESTMENT
SECURITIES LLC,
Debtor,

SIPA LIQUIDATION
(Substantively Consolidated)

IRVING H. PICARD, Trustee for the Liquidation of Adv. Pro. No. 10-5287 (BRL)
Bernard L. Madoff Investment Securities LLC,
Plaintiff,
v.

11-CV-03605 (JSR) (HBP)

SAUL B. KATZ, et al.,
Defendants.

TRUSTEE’S SUPPLEMENTAL MEMORANDUM OF LAW IN FURTHER OPPOSITION
TO THE STERLING DEFENDANTS’ MOTION TO DISMISS THE AMENDED
COMPLAINT OR, IN THE ALTERNATIVE, FOR SUMMARY JUDGMENT
BAKER & HOSTETLER LLP
45 Rockefeller Plaza
New York, New York 10111
Telephone: [phone]
Facsimile: [phone]
Attorneys for Irving H. Picard, Trustee for the
Substantively Consolidated SIPA Liquidation of
Bernard L. Madoff Investment Securities LLC
and Bernard L. Madoff

TABLE OF CONTENTS
Page
PRELIMINARY STATEMENT .....................................................................................................1 
I. 

THE CODE AND THE NYDCL GOVERN THE QUESTION OF THE
DEFENDANTS’ GOOD FAITH AND DUTY OF INQUIRY ...........................................3 
A. 
B. 

Good Faith Under The NYDCL Also Involves An Objective Duty Of
Inquiry ......................................................................................................................6 

C. 

The Defendants Were Willfully Blind To Facts That Would Have Caused
A Reasonably Prudent Person To Investigate Possible Fraud .................................7 

D. 
II. 

Good Faith Under The Code Requires A Reasonable Inquiry In The Face
Of Possible Fraud.....................................................................................................4 

The Defendants’ Good Faith Is An Affirmative Defense And Issue Of Fact ........10 

THE FEDERAL SECURITIES LAWS AND NEW YORK COMMON LAW
RECOGNIZE THAT INVESTORS HAVE A DUTY OF INQUIRY IN
CONNECTION WITH THEIR INVESTMENTS.............................................................10 
A. 

The Federal Securities Laws And New York Common Law Impose A
Duty Upon Investors To Inquire When On Notice of Possible Fraud ...................11 
1. 
2. 

B. 

An Investor’s Duty of Inquiry Is Evaluated Under An Objective
Standard .....................................................................................................13 
Sophisticated Investors Have A Heightened Degree Of Diligence ...........13 

Because Of Their Willful Blindness To Facts That Should Have Prompted
An Investigation, The Defendants Are Deemed To Be On Notice Of The
Fraud Under The Securities Laws And New York Common Law ........................14 

III. 

THE COMPLAINT PROPERLY STATES FRAUDULENT CONVEYANCE
CLAIMS AGAINST THE DEFENDANTS ......................................................................18 

IV. 

SECTION 546(e) DOES NOT APPLY HERE .................................................................20 
A. 

Section 546(e) Does Not Apply To A Fiction .......................................................21 

B. 

The Transfers At Issue Were Not Made In Connection with a Securities
Transaction .............................................................................................................23 

C. 

Section 546(e) Is An Affirmative Defense ............................................................24 

CONCLUSION ..............................................................................................................................25 

-i-

TABLE OF AUTHORITIES
Page(s)
CASES
Alfa v. Enron Creditors Recovery Corp. (In re Enron Creditors Recovery Corp.),
422 B.R. 423 (S.D.N.Y. 2009).................................................................................................22
Armstrong v. Collins,
2010 U.S. Dist. LEXIS 28075 (S.D.N.Y. Mar. 24, 2010) .....................................................5, 6
Armstrong v. McAlpin,
699 F.2d 79 (2d Cir. 1983).......................................................................................................13
AXA Vericherung AG. v. N.H. Ins. Co.,
391 Fed. App’x 25 (2d Cir. 2010)............................................................................................17
Barron Partners LP v. Lab123, Inc.,
No. 07 Civ. 11135 (JSR), 2008 WL 2902187 (S.D.N.Y. July 25, 2008) ................................11
Bear, Stearns Secs. Corp. v. Gredd (In re Manhattan Inv. Fund Ltd.),
397 B.R. 1 (S.D.N.Y. 2007), aff’d, 2009 U.S. App. LEXIS 11806
(2d Cir. June 2, 2009) ..................................................................................................4, 5, 6, 10
Brown v. Third Nat’l Bank (In re Sherman),
67 F.3d 1348 (8th Cir. 1995) .....................................................................................................6
Christian Bros. High Sch. Endowment v. Bayou No Leverage Fund, LLC (In re Bayou
Group, LLC),
439 B.R. 284 (S.D.N.Y. 2010).........................................................................................4, 6, 10
Cohen v. Cohen,
No. 09 Civ. 10230 (RJH), 2010 WL 1157283 (S.D.N.Y. March 29, 2011) ............................13
Crigger v. Fahnestock & Co.,
443 F.3d 230 (2d Cir. 2006)............................................................................................. passim
Cuthill v. Greenmark, LLC (In re World Vision Entm’t, Inc.),
275 B.R. 641 (Bankr. M.D. Fl. 2002) ........................................................................................5
Degirolomo v. Track World, Inc. (In re Laurel Valley Oil Co.),
No. 07-6109, 2009 WL 1758741 (Bankr. N.D. Ohio June 16, 2009)......................................24
Dodds v. Cigna Secs., Inc.,
12 F.3d 346 (2d Cir. 1993).......................................................................................................13
Domenikos v. Roth,
288 Fed. App’x 718 (2d Cir. 2008)..........................................................................................11

-ii-

TABLE OF AUTHORITIES
(continued)
Page(s)
Eclaire Advisor Ltd. v. Daewoo Eng.,
375 F. Supp. 2d 257 (S.D.N.Y. 2005) (Rakoff, J.) ..................................................................10
First Capital Inv. Holdings LLC v. Wilson Capital Group, Inc.,
No. 10 Civ. 2948 (JSR), 2011 U.S. Dist. LEXIS 57638 (S.D.N.Y. May 23, 2011) ....12, 16, 17
First Capital Inv. Holdings LLC v. Wilson Capital Grp., Inc.,
2011 U.S. Dist. LEXIS 57368 (S.D.N.Y. May 23, 2011) .......................................................14
Fisher v. Sellis (In re Lake States Commodities, Inc.),
253 B.R. 866 (Bankr. N.D. Ill. 2000) ........................................................................................6
Fraternity Fund Ltd. v. Beacon Hill Asset Mgmt., LLC,
479 F. Supp. 2d 349 (S.D.N.Y. 2009)........................................................................................5
Geltzer v. Mooney (In re MacMenamin’s Grill Ltd.),
No. 09–8266 (RDD), 2011 WL 1549056 (Bankr. S.D.N.Y. Apr. 21, 2011) ...........................22
Gowan v. The Patriot Grp. (In re Dreier),
2011 WL 2412581 (Bankr. S.D.N.Y. June 16, 2011)...................................................... passim
Gredd v. Bear, Stearns Secs. Corp. (In re Manhattan Inv. Fund Ltd.),
359 B.R. 510 (Bankr. S.D.N.Y. 2007) .......................................................................................4
Grumman Allied Indus. v. Rohr Indus., Inc.,
748 F.2d 729 (2d Cir. 1984).....................................................................................................14
Hall v. Frith,
51 Misc. 600, 101 N.Y.S. 31 (Sup. Ct. N.Y. Co. 1906) ..........................................................18
Hayes v. Palm Seedlings Partners-A (In re Agric. Research & Tech. Grp.),
916 F.2d 528 (9th Cir. 1990) .....................................................................................................6
HBE Leasing Corp. v. Frank,
48 F.3d 623 (2d Cir. 1995).........................................................................................................6
Higgins v. Crouse,
147 N.Y. 411, 42 N.E. 6 (1895) ...............................................................................................12
Hill v. Spencer Savings & Loan Association (In the Matter of Bevill),
83 B.R. 880 (D.N.J. 1988) .................................................................................................18, 19
In re Adomo,
619 F.2d 216 (2d Cir. 1980).....................................................................................................21
In re Bernard L. Madoff Inv. Secs., LLC,
424 B.R. 122 (Bankr. S.D.N.Y. 2010) .....................................................................................23
-iii-

TABLE OF AUTHORITIES
(continued)
Page(s)
In re Enron Creditors Recovery Corp. v. Alfa,
No. 09-5122-bk(L), 2011 U.S. App. LEXIS 13177 (2d Cir. June 28, 2011) ..........................21
In re Eugenia VI Venture Holdings, Ltd. Litig.,
649 F.Supp.2d 105 (S.D.N.Y. 2008)........................................................................................12
In re Global Crossing Ltd. Secs. Litig.,
313 F.Supp.2d 189 (2d Cir. 2003) ...........................................................................................12
In re Gosman,
2005 Bankr. LEXIS 3183 (Bankr. S.D. Fla. Mar. 1, 2005) .......................................................5
In re IndyMac Mortg.-Backed Secs. Litig.,
No. 09 Civ. 4583 (LAK), 2011 U.S. Dist. LEXIS 67781 (S.D.N.Y. June 21, 2011) ..............13
In re J.P. Jeanneret Assocs., Inc.,
769 F. Supp. 2d 340 (S.D.N.Y. 2011)......................................................................................23
In re Polaroid Corp. Secs. Litig.,
465 F. Supp. 2d 232 (S.D.N.Y. 2006)......................................................................................11
In re Taubman,
160 B.R. 964 (Bankr. S.D. Ohio 1993)....................................................................................19
In re Western World Funding, Inc.,
54 B.R. 470 (Bankr. D. Nev. 1985) .........................................................................................22
Interpool Ltd. v. Patterson,
890 F. Supp. 259 (S.D.N.Y. 1995).............................................................................................7
Jobin v. McKay (In re M & L Bus. Mach. Co.),
84 F.3d 1330 (10th Cir. 1996) ...................................................................................................6
Johnson v. Neilson (In re Slatkin),
525 F.3d 805 (9th Cir. 2008) ...................................................................................................21
Kipperman v. Circle Trust F.B.O. (In re Grafton Partners),
321 B.R. 527 (9th Cir. BAP 2005)...............................................................................21, 22, 24
Kirschner v. Bennett (In re Refco Secs. Litig.),
759 F. Supp. 2d 301 (S.D.N.Y. 2010)........................................................................................5
Kosovich v. Metro Holmes LLC,
No. 09 Civ. 6992 (JSR), 2009 U.S. Dist. LEXIS 121390 (S.D.N.Y. Dec 30, 2009)...............14
Liss v. Smith,
991 F. Supp. 278 (S.D.N.Y. 1998)...........................................................................................15
-iv-

TABLE OF AUTHORITIES
(continued)
Page(s)
Mallis v. Bankers Trust Co.,
615 F.2d 68 (2d Cir. 1980) ......................................................................................................14
Merck & Co. v. Reynolds,
130 S. Ct. 1784 (2010) .............................................................................................................13
Mishkin v. Ensminger (In re Coleman Clearing Corp.),
247 B.R. 51 (Bankr. S.D.N.Y. 1999) ...................................................................................6, 21
Picard v. Chais (In re Bernard L. Madoff Inv. Secs. LLC),
445 B.R. 206 (Bankr. S.D.N.Y. 2011) .....................................................................................19
Picard v. Merkin (In re Bernard L. Madoff Inv. Secs. LLC),
440 B.R. 243 (Bankr. S.D.N.Y. 2011) .........................................................................21, 22, 24
Pub. Emps. Ret. Sys. of Miss. v. Merrill Lynch,
714 F.Supp.2d 475 (S.D.N.Y. 2010)........................................................................................17
Roeder v. Lockwood and First Nat. Bank (In re Lockwood Auto Grp., Inc.),
428 B.R. 629 (Bankr. W.D. Pa. 2010) .......................................................................................5
Schauer v. Alterton,
151 U.S. 607 (1894) ...................................................................................................................6
Schlaifer Nance & Co. v. Estate of Warhol,
119 F.3d 91 (2d Cir. 1997).......................................................................................................14
SEC v. Forte,
2009 WL 4809804 (E.D. Pa. Dec. 15, 2009) .............................................................................6
Secs. & Exch. Comm’n v. Milan Capital Grp., Inc.,
No. 00 CIV. 108 (DLC), 2000 WL 1682761 (S.D.N.Y. 2000) ...............................................15
Secs. & Exch. Comm’n v. Zandford,
535 U.S. 813 (2002) .................................................................................................................24
Sharp Int’l Corp. v. State Street Bank & Trust Co. (In re Sharp Int’l Corp.),
403 F.3d 43 (2d Cir. 2005).......................................................................................................20
SIPC v. Rossi (In re Cambridge Capital, LLC),
331 B.R. 47 (Bankr. E.D.N.Y. 2005).......................................................................................10
SIPC v. Stratton Oakmont, Inc.,
234 B.R. 293 (Bankr. S.D.N.Y. 1999) .....................................................................................10
Staehr v. Hartford Fin. Servs. Grp., Inc.,
547 F.3d 406 (2d Cir. 2008).....................................................................................................11
-v-

TABLE OF AUTHORITIES
(continued)
Page(s)
Steed Finance LDC v. Nomura Secs. Int’l, Inc.,
No. 00 Civ. 8058, 2004 U.S. Dist. LEXIS 18580 (S.D.N.Y. Sept. 14, 2004), aff’d,
148 Fed. App’x 66 (2d Cir. 2005)......................................................................................11, 13
Terry v. June,
432 F. Supp. 2d 635 (W.D. Va. 2006) .......................................................................................6
Thomas H. Lee Equity Fund V, LP v. Grant Thornton LLP (In re Refco Secs. Litig.),
No. 07 MDL 1092 (JSR), 07 Civ. 8663 (JSR), 2011 U.S. Dist. LEXIS 33554
(S.D.N.Y. Mar. 28, 2011) ..................................................................................................11, 14
U.S. v. McCombs,
30 F.3d 310 (2d Cir. 1994).......................................................................................................20
United States v. Orozco-Prada,
636 F. Supp. 1537 (S.D.N.Y. 1986), aff’d, 847 F.2d 836 (2d Cir. 1988) ..................................7
Wider v. Wootton,
907 F.2d 570 (5th Cir. 1990) ...................................................................................................22
Williamson v. Brown,
15 N.Y. 354 (1857) ..................................................................................................................17
Wood v. Carpenter,
101 U.S. 135 (1879) .................................................................................................................13
STATUTES
11 U.S.C. §§ 101 et. seq......................................................................................................... passim
11 U.S.C. § 544 ..............................................................................................................................19
11 U.S.C. § 544(b) ..........................................................................................................................3
11 U.S.C. § 546 ................................................................................................................................4
11 U.S.C. § 546(e) ................................................................................................................. passim
11 U.S.C. § 548(a)(1)(A) .........................................................................................................19, 21
11 U.S.C. § 548(c) ............................................................................................................4, 6, 7, 10
15 U.S.C. §§ 78aa et seq. .................................................................................................................1
15 U.S.C. § 78fff-2(c)(3) ...........................................................................................................3, 18
15 U.S.C. § 78fff(b) .......................................................................................................................24

-vi-

TABLE OF AUTHORITIES
(continued)
Page(s)
N.Y. Debt. & Cred. Law §§ 270 et seq. (McKinney’s 2011) ................................................ passim
Securities Exchange Act of 1934 § 10(b) ................................................................................13, 23
RULES
17 C.F.R. § 240.10b-5 (2010) ........................................................................................................23
Fed. R. Civ. P. 8 .............................................................................................................................10
Fed. R. Civ. P. 9(b) ........................................................................................................................10
OTHER AUTHORITIES
H.R. 12889, 74th Cong., 2d Sess. 193 (1936) (statement of Harry Zalkin) ..................................18
Pomeroy & Symons, A Treatise on Equity Jurisprudence as Administered in the United
States of America § 606 (5th Ed. 1941) .....................................................................................5
REPORT OF SPECIAL STUDY OF SECURITIES MARKETS OF THE SECS. AND EXCH. COMM’N,
H.R. DOC. NO. 95 .....................................................................................................................18
DEFINITIONS
Amended Complaint (the “Complaint” or “Compl.”)
Trustee’s Memorandum in Opposition to the Sterling Defendants’ Motion to Dismiss the
Amended Complaint or, in the Alternative, for Summary Judgment (the “Trustee’s
Opposition” or “Tr.’s Br.”)
Memorandum of Law in Support of the Sterling Defendants’ Motion to Dismiss the
Amended Complaint or, in the Alternative, for Summary Judgment (the “Motion to
Dismiss” or “Defs.’ Br.”)
Memorandum of Law in Support of the Sterling Defendants’ Motion to Withdraw the
Reference (the “Motion to Withdraw” or “Defs.’ Withdrawal Br.”)
Additional Reforms to the Securities Investor Protection Act: Hearing Before The Subcomm. on
Capital Markets, Insurance, and Government Sponsored Enterprises of the H. Comm. on
Financial Services, 111 Cong. 22 (Dec. 2009) (the “Cong. Subcomm. Hr’gs Dec. 2009”)

-vii-

By Order dated July 1, 2011, this Court withdrew the reference to the United States
Bankruptcy Court in the above-captioned adversary proceeding to decide three threshold issues
raised by the Sterling Defendants (the “Defendants”) in their Motion to Dismiss the Amended
Complaint or, in the Alternative, for Summary Judgment (the “Motion to Dismiss”) previously
filed before Bankruptcy Judge Lifland. Per this Court’s July 1 Order, Irving H. Picard (the
“Trustee”), as trustee for the substantively consolidated liquidation of the business of Bernard L.
Madoff Investment Securities LLC (“BLMIS”) and the estate of the Bernard L. Madoff
(“Madoff”) under the Securities Investor Protection Act (“SIPA”), 15 U.S.C. §§ 78aa et seq., by
and through his undersigned counsel, respectfully submits the following Supplemental
Memorandum in Further Opposition to the Motion to Dismiss.
PRELIMINARY STATEMENT
The Trustee’s Complaint asserts fraudulent conveyance claims against the Defendants
under the Bankruptcy Code (the “Code”), 11 U.S.C. §§ 101 et. seq., and analogous provisions of
McKinney’s New York Debtor and Creditor Law (“NYDCL”), §§ 270 et seq., and seeks to avoid
and recover approximately $300 million in fictitious profits that the Defendants received over the
course of the Ponzi scheme. The Trustee also seeks approximately $700 million in transfers
representing the return of principal investment that the Defendants received within the six-year
period prior to December 11, 2008, a time when they were on inquiry notice of the fraud. Under
well-established principles of fraudulent conveyance laws, the Defendants cannot retain these
fraudulent transfers because at the time they received them, the Defendants lacked “good faith.”
On July 1, 2011, this Court withdrew the reference “to make a determination of the
threshold issues that were raised by the movants,” which “include[d] all three issues raised by
movants” in their Motion to Withdraw: (i) whether, in connection with the Defendants’
affirmative defense of good faith to the Trustee’s fraudulent conveyance claims, SIPA (which

incorporates the Code) and the NYDCL improperly impose a retroactive duty of inquiry on the
Defendants that they did not previously have under federal securities laws; (ii) whether the
Defendants were owed an antecedent debt by BLMIS as set forth on their customer statements
that would preclude the Trustee’s fraudulent conveyance claims; and (iii) whether § 546(e) of the
Code provides a “safe harbor” for the fraudulent transfers made by BLMIS to the Defendants.
(Dkt. No. 33, Tr. 32-34.)
The standard applicable to the Defendants’ affirmative defense of good faith to the
Trustee’s fraudulent conveyance claims is the objective “reasonably prudent” transferee test set
forth in the jurisprudence under the Code and the NYDCL. Attempting to exempt themselves
from the fraudulent conveyance laws and their obligation to demonstrate good faith to retain the
fraudulent transfers they received from Madoff, the Defendants argue that the Code and the
NYDCL impermissibly impose upon them a retroactive duty of due diligence that they did not
otherwise have under the securities laws. (Defs.’ Withdrawal Br. 23.) To the contrary, the
fraudulent conveyance laws impose no duty of inquiry the Defendants did not already have under
the federal securities laws or the New York common law. Where investors, like the Defendants
here, admittedly failed to conduct an inquiry and were “willfully blind”1 to facts that call for
investigation, notice of the fraud is imputed to them—under the fraudulent conveyance laws, the
federal securities laws, and the New York common law.
The other arguments advanced by the Defendants in their pursuit to immunize themselves

1

As used in the Complaint and herein, the terms “willful blindness,” “closed eyes,” “conscious
disregard” or “conscious avoidance” refer to the Defendants’ conduct, not the legal standard
governing their good faith. As discussed below, whether or not the Defendants can establish
their affirmative defense of good faith under the Code or the NYDCL turns on whether they were
on notice of facts that would have caused a reasonable person to inquire into the legitimacy of
their investments with Madoff. Defendants’ willful blindness to Madoff’s fraud is evidence that
they cannot meet that burden.

2

from the Trustee’s avoidance claims are similarly without merit. The Defendants were not owed
an antecedent debt on account of their last fictitious BLMIS statements, and § 546(e) of the Code
does not provide a “safe harbor” to transfers Madoff made to the Defendants in furtherance of
the Ponzi scheme.
I.

THE CODE AND THE NYDCL GOVERN THE QUESTION OF THE
DEFENDANTS’ GOOD FAITH AND DUTY OF INQUIRY
The current action is part of a SIPA proceeding that is conducted in accordance with

chapters 1, 3, 5, 7 and Parts I and II of title 11 of the United States Code. SIPA § 78fff-2(c)(3)
explicitly authorizes the Trustee to avoid and recover transfers that are void or voidable under
the Code, including transfers “to or on behalf of” customers, such as the Defendants. Notably,
this provision of SIPA refers only to the Code in connection with the avoidance and recovery of
fraudulent and preferential transfers, and makes no reference to any other federal regulatory
schemes, including the federal securities laws.
Thus, the issue of good faith, which is an affirmative defense to the Trustee’s fraudulent
conveyance claims, is governed by the Code, the NYDCL,2 and the applicable case law
thereunder, which establishes the parameters of the “duty of inquiry” in connection with the
transfers Defendants received from BLMIS.3 While the Code contains some express “safe

2

Pursuant to § 544(b) of the Code, the Trustee may also avoid any transfer that is avoidable
under relevant state law—in this case, NYDCL §§ 273-76.
3

Neither the Code nor the NYDCL requires the Trustee to plead transferee intent to defraud in
order to avoid fraudulent transfers. See Gowan v. The Patriot Grp. (In re Dreier), 2011 WL
2412581, at *24, *28-33 (Bankr. S.D.N.Y. June 16, 2011). Without any basis in law, the
Defendants seek to transform their own burden of proving a good faith defense, which implicates
their duty of inquiry once on notice, into an additional element that the Trustee must
prove. They argue that the Trustee must prove the element of actual knowledge often seen in
aiding or abetting fraud cases under the securities laws, because they were customers of a SIPA
registered entity and had no duty “to question their broker’s statements.” (Defs.’ Br. at 68-69.)
The Defendants’ arguments would necessitate rewriting SIPA to incorporate the securities laws
instead of the Code, or rewriting the Code and the NYDCL to impose both a heightened pleading
3

harbors” that exempt particular categories of transfer recipients and/or particular types of
transfers from the avoidance provisions, transfers to broker-dealer “customers” in furtherance of
a Ponzi scheme are not among them. See 11 U.S.C. § 546.
A.

Good Faith Under The Code Requires A Reasonable Inquiry In The Face Of
Possible Fraud

The good faith defense under § 548(c) involves a two-step inquiry: “(1) whether [the
transferee] was on inquiry notice of the [debtor’s] fraud and (2) whether the [transferee] was
diligent in its investigation of the [debtor].”

Bear, Stearns Secs. Corp. v. Gredd (In re

Manhattan Inv. Fund Ltd.) (“Manhattan II”), 397 B.R. 1, 23 (S.D.N.Y. 2007), aff’d, 2009 U.S.
App. LEXIS 11806 (2d Cir. June 2, 2009); Christian Bros. High Sch. Endowment v. Bayou No
Leverage Fund, LLC (In re Bayou Group, LLC) (“Bayou”), 439 B.R. 284, 310-12 (S.D.N.Y.
2010); (Tr.’s Br. 80-81.) “An objective, reasonable investor standard applies to both the inquiry
notice and the diligent investigation components of the good faith test.” Bayou, 439 B.R. at 313
(collecting cases). This analysis focuses on whether the Defendants had information that would
have suggested to a reasonably prudent investor that he should have investigated further, and
then determines whether the investigation was reasonable under the circumstances. Manhattan
II, 397 B.R. at 23; Bayou, 439 B.R. at 310-13.
“Inquiry notice is informed by the standards, norms, practices, sophistication and
experience generally possessed by” investors similar to the Defendants. Bayou, 439 B.R. at 313.
Once on inquiry notice, unless a defendant conducts a diligent investigation, it cannot carry its
burden of establishing good faith. Manhattan II, 397 B.R. at 22-23; see also Gredd v. Bear,

standard and an additional element of intent that is not found in either statutory scheme. That
said, to the extent it were required, the Complaint meets even a knowledge-based standard
because it alleges with specificity that the Defendants ignored all reasonably diligent inquiries
into any of the indicia of fraud known to them. (See generally Compl. Sects. IX-X.)

4

Stearns Secs. Corp. (In re Manhattan Inv. Fund Ltd.) (“Manhattan I”), 359 B.R. 510, 526
(Bankr. S.D.N.Y. 2007) (diligent investigation requires “more than simply ask[ing] the
wrongdoer if he was doing wrong”); Roeder v. Lockwood and First Nat. Bank (In re Lockwood
Auto Grp., Inc.), 428 B.R. 629, 636 (Bankr. W.D. Pa. 2010). A transferee on inquiry notice
cannot turn a blind eye to mounting evidence of fraud, and if he chooses not to inquire, he will
be found to lack good faith. Manhattan II, 397 B.R. at 25 n.39 (“[g]iven what [Defendants]
learned, taking no steps at all. . . amounted to willful ignorance, which . . . defeat[s] the good
faith defense.”); Armstrong v. Collins, 2010 U.S. Dist. LEXIS 28075, at *82-83 (S.D.N.Y. Mar.
24, 2010); In re Gosman, 2005 Bankr. LEXIS 3183, at *52 (Bankr. S.D. Fla. Mar. 1, 2005);
Cuthill v. Greenmark, LLC (In re World Vision Entm’t, Inc.), 275 B.R. 641, 599 (Bankr. M.D. Fl.
2002); (Tr.’s Br. 82.).4
This district,5 and all of the circuits that have addressed this issue have applied an

4

Congress has considered and rejected proposals that would have amended SIPA to elevate the
objective “reasonably prudent” standard to a heightened standard when examining a transferee’s
good faith defense. In December 2009, Professor John C. Coffee, Jr., Professor of Law at
Columbia University Law School, testified before a House of Representatives subcommittee
regarding that proposed amendment:
Today, anyone who is sued in a fraudulent conveyance has a good faith defense
under the Bankruptcy Code. The case law has construed that to mean that you
have to show not just subjective good faith, but that you have the good faith of an
objective reasonable person. It’s a negligence test.
Cong. Subcomm. Hr’gs Dec. 2009, at 22. This bill has not been enacted.
5

This Court recently recognized that “[c]onstructive knowledge is ‘[k]nowledge that one using
reasonable care or diligence should have, and therefore that is attributed by law to a given
person.’” Kirschner v. Bennett (In re Refco Secs. Litig.), 759 F. Supp. 2d 301, 334 (S.D.N.Y.
2010) (quoting Fraternity Fund Ltd. v. Beacon Hill Asset Mgmt., LLC, 479 F. Supp. 2d 349, 368
(S.D.N.Y. 2009)). Constructive knowledge is consistent with long-standing hornbook principles
of equity. Pomeroy & Symons, A Treatise on Equity Jurisprudence as Administered in the
United States of America § 606 (5th Ed. 1941) (“Constructive knowledge as generally applied by
the American courts has been to inquire whether the facts are sufficient to put a prudent man
upon an inquiry, and whether an inquiry has been prosecuted with reasonable care and
diligence.”); see also In re Dreier, 2011 WL 2412581, at *42-47 (Bankr. S.D.N.Y. 2011)
5

objective standard in determining a transferee’s good faith under the Code.6 This standard is
consistently applied in actions seeking the return of principal from Ponzi scheme investors.7 The
objective, “reasonably prudent” standard for inquiry notice and diligent investigation is not of
recent vintage in the fraudulent conveyance laws. For example, in Schauer v. Alterton, 151 U.S.
607, 621 (1894), Justice Harlan wrote for the Supreme Court:
[I]f [the transferee] had knowledge or actual notice of circumstances sufficient to
put him, as a prudent man, upon inquiry as to whether his brother intended to
delay or defraud his creditors, and he omitted to make such inquiry with
reasonable diligence, he should have been deemed to have notice of such fact, and
therefore such notice as would invalidate the sale to him, if such sale was in fact
made with the intent upon the part of the vendor to delay or defraud other
creditors.
B.

Good Faith Under The NYDCL Also Involves An Objective Duty Of Inquiry

Because the fraudulent conveyance provisions of the NYDCL and the Code are applied
in parallel,8 the test for good faith under the NYDCL is equivalent to that under § 548(c) of the
Code.

Pursuant to the NYDCL, “[c]onstructive 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
(observing without deciding proper legal standard for good faith affirmative defense that “most
courts have applied an ‘objective’ or ‘reasonable person’ standard to a transferee’s ‘good faith’
defense under § 548(c)”) (citations omitted).
6

Bayou, 439 B.R. at 310 n.23 (collecting cases applying objective good faith under § 548(c));
Manhattan II, 397 B.R. at 22-23; Brown v. Third Nat’l Bank (In re Sherman), 67 F.3d 1348,
1355 (8th Cir. 1995); Hayes v. Palm Seedlings Partners-A (In re Agric. Research & Tech. Grp.),
916 F.2d 528, 535-36 (9th Cir. 1990); Jobin v. McKay (In re M & L Bus. Mach. Co.), 84 F.3d
1330, 1334-38 (10th Cir. 1996).

7

See Bayou, 439 B.R. at 313-14; Armstrong, 2010 U.S. Dist. LEXIS 28075, at *59-60; SEC v.
Forte, 2009 WL 4809804, at *6 (E.D. Pa. Dec. 15, 2009); Terry v. June, 432 F. Supp. 2d 635,
641 (W.D. Va. 2006); Fisher v. Sellis (In re Lake States Commodities, Inc.), 253 B.R. 866, 878
(Bankr. N.D. Ill. 2000).
8

Mishkin v. Ensminger (In re Adler, Coleman Clearing Corp.), 247 B.R. 51, 116 (Bankr.
S.D.N.Y. 1999) (“The two statutes devolve from the same source, are founded on the same
principles and are designed to effectuate the same purposes.”).

6

Leasing Corp. v. Frank, 48 F.3d 623, 636 (2d Cir. 1995) (emphasis added). Good faith under the
NYDCL also involves an objective, “reasonable” inquiry and a transferee’s failure to reasonably
inquire into suspicious circumstances defeats a defendant’s good faith defense.9
C.

The Defendants Were Willfully Blind To Facts That Would Have Caused A
Reasonably Prudent Person To Investigate Possible Fraud

The Trustee alleges that the Defendants knew of facts that would have placed a
reasonably prudent person in their position on inquiry notice concerning the legitimacy of their
BLMIS investments. Their deliberate and admitted failure to investigate, and their continued
willful blindness to suspicious facts that demanded investigation, defeat any notion that the
Defendants received transfers from BLMIS in good faith.10
The Sterling Partners (as defined in the Complaint) were long-time close friends and
business partners of Madoff, who substantially benefitted from the Ponzi scheme. (Compl. ¶¶
732-41.) In addition to the hundreds of millions in fictitious profits they received, Madoff
allowed Defendants to use their accounts as collateral to borrow funds that were reinvested with
BLMIS (enabling them to double their returns) and as leverage to obtain significant sources of
financing for their multitude of businesses. (Id. ¶¶ 782-90.) The Defendants’ collective finances
and financing ability for every aspect of their business became so dependent upon their BLMIS
accounts that they could not extract their investments from Madoff without near financial
collapse, as demonstrated by events post-revelation of the fraud. (Id. ¶¶ 853-64.)
9

See United States v. Orozco-Prada, 636 F. Supp. 1537, 1543 (S.D.N.Y. 1986), aff’d, 847 F.2d
836 (2d Cir. 1988); Interpool Ltd. v. Patterson, 890 F. Supp. 259, 268 (S.D.N.Y. 1995); (Tr.’s
Br. 87-88.).

10

See In re Dreier, 2011 WL 24122581, at *46 (in discussing generally the principles of
“conscious turning away,” “conscious avoidance,” “conscious ignorance” and an “ostrich
defense” “most often applied in criminal cases,” the court noted that “if it is proved that the
[d]efendants consciously avoided facts that would suggest that the transfers were made with a
lack of good faith, the [d]efendants may not retain the otherwise avoidable transfers based on the
§ 548(c) defense”) (citations omitted).

7

The Sterling Partners are sophisticated investors collectively worth several hundreds of
millions of dollars, if not more, who own a business enterprise that includes, among other things,
a real estate empire and a baseball franchise. (Id. ¶¶ 656-72.) They partnered with investment
professionals to form their own hedge fund, Sterling Stamos, of which they currently remain
general partners.

(Id. ¶¶ 702-10, 879-80, 1067-71.)

And unlike any other retail BLMIS

customer, the Sterling Partners opened and administered 483 BLMIS accounts: approximately
300 for themselves, their families, trusts and entities; the rest for friends, employees, and
business associates they brought to BLMIS. (Id. ¶¶ 678-79.)
During the six years prior to Madoff’s confession, the Defendants continued to invest
hundreds of millions with Madoff despite mounting evidence strongly suggesting the potentially
fraudulent nature of their BLMIS investments, including:


The Sterling Partners knew of industry articles published in early 2001 in which many
hedge fund industry professionals questioned Madoff’s legitimacy and reported returns
(Compl. ¶¶ 925-32; Tr.’s Br. Sect. I.A.);



The Sterling Partners investigated obtaining a “one-of-a-kind” insurance policy to protect
their Madoff investments against fraud, including coverage expressly for a Ponzi scheme
(Compl. ¶¶ 938-48; Tr.’s Br. Sect. I.A.);



The Sterling Partners were repeatedly told by their hedge fund partners at Sterling
Stamos that BLMIS would fail its due diligence protocols and that as fiduciaries, Sterling
Stamos could not invest any of its own investors’ funds with BLMIS (Compl. ¶¶ 867937; Tr.’s Br. Sects. I.E, 1.F.);



The Sterling Partners formed Sterling Stamos for the express purpose of recreating
Madoff-like returns, but it could not duplicate Madoff’s returns (Compl. ¶¶ 1067-71), and
Defendant Saul Katz admitted that “nobody knows how Madoff does it” (Compl. ¶
1050.);



The Sterling Partners discussed with Sterling Stamos the potential that Madoff might be
engaging in illegal front-running at BLMIS, including that their hundreds of millions of
dollars invested with Madoff could be frozen if BLMIS were even investigated (Compl.
¶¶ 881, 886-90, 902; Tr.’s Br. Sects. I.E.2, I.F.1.);



The Sterling Partners were warned on repeated occasions by their Sterling Stamos hedge
fund partners—who openly questioned Madoff’s legitimacy for years—that they should
redeem their investments from BLMIS (Compl. ¶¶ 868-74.);

8



A Merrill Lynch executive expressly warned the Sterling Partners of his serious concerns
about Madoff’s legitimacy. The Merrill executive rejected Defendant Saul Katz’
suggestion that Sterling Stamos invest with BLMIS, advising him that Madoff would not
pass Merrill’s due diligence requirements (id. ¶¶ 897-912.);



Other industry professionals warned the Sterling Partners of their concerns regarding
Madoff’s legitimacy (id. ¶¶ 913-19.);



The Sterling Partners appeased Madoff’s demands for secrecy and avoidance of
regulatory scrutiny by restructuring Sterling Stamos at great expense and effort in order
to avoid having to make any disclosures (id. ¶¶ 949-67; Tr.’s Br. Sect. I.D.);



The Sterling Partners were familiar with the SEC’s registration and disclosure rules for
investment advisers and should have known that Madoff was evading his obligation to
register (Compl. ¶¶ 968-73.);



From the Sterling Partners’ experience in another Ponzi scheme, Bayou Superfund LLC
(“Bayou”), they knew that many of the same “red flags” that led to their redemption out
of Bayou were also present with regard to their BLMIS investments (id. ¶¶ 891-94; 102546; Tr.’s Br. Sect. I.G.);



The Sterling Partners failed to conduct any diligence into a “special” investment
opportunity Madoff offered them, which involved a different strategy, i.e., “style drift,”
he promised would generate returns of up to 50% more than usual, but for which
required new capital. Without conducting any due diligence in connection with this new
“strategy,” indeed without even an understanding as to what the new strategy entailed,
the Sterling Partners blindly invested another $22 million with Madoff (Compl. ¶¶ 104145; Tr.’s Br. 34-35.); and



Certain Sterling Partners knew that Madoff was willing to falsify significant business
transactions because Defendants Fred Wilpon, Saul Katz and Marvin Tepper worked
together with Madoff to falsely document a $54 million transaction (Compl. ¶¶ 990-1006;
Tr.’s Br. Sect. I.J.).
When faced with a mountain of red flags, express warnings from trusted, professional

financial advisors, and their own suspicions that their investment returns might be the product of
fraudulent and even criminal activity (including, in particular, a Ponzi scheme), rather than doing
what reasonably prudent and notably sophisticated investors with hundreds of millions of dollars
at stake would do—redeem, as they were urged to do by their trusted advisors, or conduct some
modicum of diligence to protect their investments—the Sterling Defendants did neither. Instead,
the Partner Defendants continued to invest hundreds of millions of dollars with Madoff, choosing
instead to avoid confirming the obvious, and admittedly conducted no diligence or investigation

9

into any of the indicia of fraud surrounding their BLMIS investments. (See Compl. ¶¶ 12, 890,
895, 905, 912, 914, 932, 1024, 1045-46, 1057, 1061, 1064, 1074-75; Tr.’s Br. 33-35.)
The Sterling Defendants’ willful blindness to the mounting facts which suggested that
their BLMIS investment returns might be the product of illegal or fraudulent activity fails as a
matter of law to satisfy the “good faith” defense.
D.

The Defendants’ Good Faith Is An Affirmative Defense And Issue Of Fact

Under both the Code and NYDCL § 276,11 proving good faith is the Defendants’ burden
as an affirmative defense that need not be pled in the Complaint12 and is a question of fact.
Courts routinely deny motions to dismiss fraudulent conveyance claims on the ground that a
defendant’s good faith cannot be resolved until full discovery of the evidentiary record.13
II.

THE FEDERAL SECURITIES LAWS AND NEW YORK COMMON LAW
RECOGNIZE THAT INVESTORS HAVE A DUTY OF INQUIRY IN
CONNECTION WITH THEIR INVESTMENTS
Contrary to the Defendants’ argument, the fraudulent conveyance laws did not impose

11

Although good faith is an element of the Trustee’s prima facie constructive fraud claims under
§§ 273-75 (Tr.’s Br. 78-79), these claims are not subject to the heightened pleading standard of
Fed. R. Civ. P. 9(b) as “[t]his is not the kind of fraud to which Rule 9(b) applies.” Eclaire
Advisor Ltd. v. Daewoo Eng., 375 F. Supp. 2d 257, 268 (S.D.N.Y. 2005) (Rakoff, J.). Rather, all
that is required is that the Trustee’s claims meet the “bare-bones pleading requirements of Rule
8, Fed. R. Civ. P.,” id., which the Trustee has undoubtedly gone beyond.
12

In re Dreier, 2011 WL 2412581, at *26 (good faith under Code § 548(c) is not an element of
trustee’s prima facie case, and that transferees bear the burden of establishing good faith as to
both actual and constructive fraud claims; further holding same as to intentional fraud under
NYDCL § 276); SIPC v. Stratton Oakmont, Inc., 234 B.R. 293, 318 (Bankr. S.D.N.Y. 1999);
Bayou, 439 B.R. at 303-308; Manhattan II, 397 B.R. at 22; (Tr.’s Br. 72-74.).

13

In re Dreier, 2011 WL 2412581, at *26-*29, *33 (declining to consider Code § 548(c) defense
on a motion to dismiss, noting that “good faith” under § 548(c) is appropriately addressed at
summary judgment after discovery or trial); Manhattan II, 397 B.R. at 23 (denying motion for
summary judgment on good faith); Eclaire Advisor Ltd., 375 F. Supp. 2d at 269 n.5 (“[T]he
question of whether a transfer is made for fair consideration is a question of fact most suitably
resolved at the summary judgment stage.”); SIPC v. Rossi (In re Cambridge Capital, LLC), 331
B.R. 47, 63-64 (Bankr. E.D.N.Y. 2005) (same); (Tr.’s Br. 70-71.).

10

upon the Defendants a duty of inquiry they did not already have under the federal securities laws
or the New York common law, both of which impose upon investors a duty to inquire when
alerted to suspicious circumstances indicating potential fraud in connection with their
investments. Because the Defendants deliberately failed to make a reasonable inquiry and chose
to close their eyes to the circumstances that called for investigation, the securities laws and the
common law impute knowledge of Madoff’s fraud to them.
A.

The Federal Securities Laws And New York Common Law Impose A Duty
Upon Investors To Inquire When On Notice of Possible Fraud

It is well-settled under the securities laws and New York common law that “[w]here the
circumstances would suggest to an investor of ordinary intelligence the probability that it has
been defrauded, a duty of inquiry arises, and knowledge will be imputed to the investor who does
not make such an inquiry.” 14 Steed Finance LDC v. Nomura Secs. Int’l, Inc., No. 00 Civ. 8058,
2004 U.S. Dist. LEXIS 18580, *23-24 (S.D.N.Y. Sept. 14, 2004), aff’d, 148 Fed. App’x 66 (2d
Cir. 2005); accord Thomas H. Lee Equity Fund V, LP v. Grant Thornton LLP (In re Refco Secs.
Litig.), No. 07 MDL 1092 (JSR), 07 Civ. 8663 (JSR), 2011 U.S. Dist. LEXIS 33554, at *45
(S.D.N.Y. Mar. 28, 2011) (“When a party is aware of circumstances that indicate certain
representations may be false, that party cannot reasonably rely on those representations, but must
make additional inquiry to determine their accuracy.”); Barron Partners LP v. Lab123, Inc., No.
07 Civ. 11135 (JSR), 2008 WL 2902187, at *5 n.3 (S.D.N.Y. July 25, 2008) (in context of
securities fraud claims, this Court noting that “[r]easonable reliance entails a duty to investigate
14

See Domenikos v. Roth, 288 Fed. App’x 718, 719-720 (2d Cir. 2008) (knowledge of fraud
imputed to plaintiff who, like the Defendants here, performed no inquiry whatsoever) (citations
omitted); Staehr v. Hartford Fin. Servs. Grp., Inc., 547 F.3d 406, 427 (2d Cir. 2008) (“Storm
warnings need not detail every aspect of the alleged fraudulent scheme.”) (citation and marks
omitted)); In re Polaroid Corp. Secs. Litig., 465 F. Supp. 2d 232, 243 n.2 (S.D.N.Y. 2006)
(“[C]oncept of inquiry notice is hostile to the notion [of] ‘leisurely discovery’” of the scheme)
(citations omitted).

11

the legitimacy of an investment opportunity where plaintiff was placed on guard or practically
faced with the facts” (citation omitted)); In re Eugenia VI Venture Holdings, Ltd. Litig., 649
F.Supp.2d 105, 118 (S.D.N.Y. 2008) (a heightened degree of diligence is required of an investor
where circumstances were such that the investor “had hints of falsity”) (citation omitted)).
In the common law fraud context, the Second Circuit in Crigger v. Fahnestock & Co.,
443 F.3d 230 (2d Cir. 2006), articulated the reasonably prudent investor duty of inquiry as
follows:
Circumstances may be so suspicious as to suggest to a reasonably prudent
plaintiff that the defendants’ representations may be false, and that the plaintiff
cannot reasonably rely on those representations, but rather must make additional
inquiry to determine their accuracy. Put another way, if the plaintiff has the means
of knowing, by the exercise of ordinary intelligence, the truth, or the real quality
of the subject of the representation, he must make use of those means, or he will
not be heard to complain that he was induced to enter into the transaction by
misrepresentations.
Id. at 234-35 (citations and marks omitted).
Likewise, the New York Court of Appeals has long recognized the duty of inquiry under
New York common law for claims sounding in fraud:
[W]here the circumstances are such as to suggest to a person of ordinary
intelligence the probability that he has been defrauded, a duty of inquiry arises,
and if he omits that inquiry when it would have developed the truth, and shuts his
eyes to the facts which call for investigation, knowledge of the fraud will be
imputed to him.
Higgins v. Crouse, 147 N.Y. 411, 416, 42 N.E. 6, 11-12 (1895) (emphasis added).15 “While the
law does not require that a defrauded party go to the ends of the earth to discover the falsity of a
statement, patent foolishness is not excused.” First Capital Inv. Holdings LLC v. Wilson Capital
Group, Inc., No. 10 Civ. 2948 (JSR), 2011 U.S. Dist. LEXIS 57638, at *15-16 (S.D.N.Y. May
15

Accord In re Global Crossing Ltd. Secs. Litig., 313 F.Supp.2d 189, 202 (2d Cir. 2003)
(“Inquiry notice is tantamount to actual discovery of a fraud when a plaintiff, having received
knowledge sufficient to trigger a diligent investigation, fails to inquire into the facts.”).

12

23, 2011) (emphasizing how investors “appear not to have conducted the slightest due diligence,
for example, they made no effort” to verify information material and relevant to their investment
(citations omitted) (emphasis added)).16
1.

An Investor’s Duty of Inquiry Is Evaluated Under An
Objective Standard

The securities laws and common law analyze an investor’s duty of inquiry applying an
objective test. See Armstrong v. McAlpin, 699 F.2d 79, 86-88 (2d Cir. 1983); see also Wood v.
Carpenter, 101 U.S. 135, 141 (1879) (“The presumption is that if the party affected by any
fraudulent transaction or management might, with ordinary care and attention, have reasonably
detected it, he reasonably had actual knowledge of it.”); Dodds v. Cigna Secs., Inc., 12 F.3d 346,
350 (2d Cir. 1993) (in securities fraud context, inquiry notice standard is objective); Crigger, 443
F.3d at 236 (“[T]here was ample evidence that the . . . investment opportunity was a Ponzi
scheme and that investors of reasonable means and prudence . . . bore a legal duty at least to
inquire further . . . .” (emphasis added)). Defendants here fail that test.
2.

Sophisticated Investors Have A Heightened Degree Of Diligence

“[T]he more sophisticated the investor and the more resources available to the investor,
the greater the burden on the investor to act to protect itself.” Steed Finance LDC, 2004 U.S.
16

The Defendants claim that as a result of Merck & Co. v. Reynolds, 130 S. Ct. 1784, 1797
(2010), inquiry notice is “plainly not the applicable standard” for the Trustee’s claims. (Defs.’
Br. 69 n.30.) Merck stands for no such thing. Merck arises in the context of when the statute of
limitations has run for claims under the Securities Exchange Act of 1934 § 10(b), “based on the
precise language of that statute.” In re IndyMac Mortg.-Backed Secs. Litig., No. 09 Civ. 4583
(LAK), 2011 U.S. Dist. LEXIS 67781, at *26 (S.D.N.Y. June 21, 2011). Far from “reject[ing]
inquiry notice . . . the Supreme Court explicitly reaffirmed the doctrine,” noting its application to
“not only those facts that plaintiff actually knew” but that a hypothetical, reasonably diligent
plaintiff could have known. Cohen v. Cohen, No. 09 Civ. 10230 (RJH), 2010 WL 1157283, at
*18 (S.D.N.Y. March 29, 2011). Here, the Trustee’s fraudulent conveyance claims brought
under the Code and NYDCL implicate neither the heightened pleading standards of scienter for a
plaintiff suing for fraud under the Securities Exchange Act nor the statute of limitations for any
claim.

13

Dist. LEXIS 18580, at *23 (citation omitted). While the “law is indulgent of the simple or
untutored; . . . the greater the sophistication of the investor, the more inquiry that is required.”
Crigger, 443 F.3d at 235.
The Defendants here are not “widows or orphans,” Schlaifer Nance & Co. v. Estate of
Warhol, 119 F.3d 91, 98 (2d Cir. 1997), but rather, are extremely sophisticated businessmen and
investors. “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.” Id. (quoting Grumman Allied Indus. v.
Rohr Indus., Inc., 748 F.2d 729, 737 (2d Cir. 1984)); see also In re Refco Secs. Litig., 2011 U.S.
Dist. LEXIS 33554, at *44-45 (this Court noted that the standards for an investor’s duty to
inquire are “understandably more exacting” when the investor is a “sophisticated business
entity”).17
B.

Because Of Their Willful Blindness To Facts That Should Have Prompted
An Investigation, The Defendants Are Deemed To Be On Notice Of The
Fraud Under The Securities Laws And New York Common Law

The application of analogous federal securities and common law principles to the

17

The Second Circuit has articulated “reasonable reliance” so as to meet the elements of a fraud
claim in terms of a “reasonably prudent” investor. See Crigger v. Fahnestock and Co., Inc., 443
F.3d 230, 234 (2d Cir. 2006) (concluding that reasonable and prudent investors had a duty to
investigate the legitimacy of their investment opportunity in the face of suspicious
circumstances); see First Capital Inv. Holdings LLC v. Wilson Capital Grp., Inc., 2011 U.S.
Dist. LEXIS 57368, at *15-16 (S.D.N.Y. May 23, 2011) (noting that financially sophisticated
investors had a “duty to exercise ordinary diligence and conduct an independent appraisal of the
risk they were assuming”); Kosovich v. Metro Holmes LLC, No. 09 Civ. 6992 (JSR), 2009 U.S.
Dist. LEXIS 121390, at *10-11 (S.D.N.Y. Dec 30, 2009) (“An absence of justifiable reliance
defeats a securities fraud claim, and because this element involves inquiry into what a
reasonable investor should have done, [an investor’s] professed financial cluelessness is beside
the point if he acted unreasonably.” (emphasis added)). Other courts have analyzed the issue of
a plaintiff’s reliance from the perspective of a plaintiff’s recklessness. See, e.g., Mallis v.
Bankers Trust Co., 615 F.2d 68, 79 (2d Cir. 1980) (Friendly, J.). Courts uniformly examine the
objective facts and circumstances when determining the reasonableness of an investor’s reliance.

14

Defendants’ conduct here yields the same effect as under the fraudulent conveyance laws: the
Defendants are, as alleged, deemed on notice of the fraud. In the face of the circumstances set
forth in the Complaint that would suggest to reasonable investors that their BLMIS investments
might be the product of fraudulent activity, the Defendants had a duty to inquire. That duty to
inquire was heightened as a result of the hints of falsity surrounding the Defendants’ investments
and by virtue of their sophistication.
Moreover, the Sterling Partners’ duty to investigate the legitimacy of their BLMIS
investments was elevated further by virtue of their role as a fiduciary. Beginning in 1996, they
coordinated with Madoff in the formation and administration of a BLMIS investment option for
their employees’ 401(k) plan for which two of the Sterling Partners served as plan trustees.
(Compl. ¶¶ 974-982.)18 By December 2008, approximately 90% of the 401(k) plan was invested
with BLMIS. (Id. ¶ 752.) Yet, the Defendants concede that they conducted little diligence into
BLMIS during the 1980s and admit that they conducted no due diligence into BLMIS at any time
in response to any of the facts of which they became aware beginning in or about 2000 that
called for investigation. (Compl. ¶¶ 752-53, 914; Tr.’s Br. 33-35.)
The Second Circuit’s decision in Crigger v. Fahnestock is informative here. In Crigger,
the jury returned a verdict dismissing the fraud claims against the defendants. The plaintiffinvestors appealed, asserting that the district court had: (i) improperly instructed the jury that the
investors were under a duty to investigate their investments commensurate with their
18

Liss v. Smith, 991 F. Supp. 278, 297 (S.D.N.Y. 1998) (“It is … black-letter ERISA law that
‘the most basic of ERISA’s investment fiduciary duties [is] the duty to conduct an independent
investigation into the merits of a particular investment.’ . . . ‘The failure to make any
independent investigation … of a potential plan investment has repeatedly been held to constitute
a breach of fiduciary obligations.”); Secs. & Exch. Comm’n v. Milan Capital Grp., Inc., No. 00
CIV. 108 (DLC), 2000 WL 1682761, at *5 (S.D.N.Y. 2000) (“A variety of circumstances may
raise enough questions about the legitimacy of an investment to make a person’s failure to
investigate before recommending that investment reckless.”).

15

sophistication; and (ii) improperly declined to charge the jury that the investors’ negligence was
not a bar to their fraud claim. Crigger, 443 F.3d at 235-36.
The Second Circuit upheld the district court’s jury instructions, finding they “accurately
and clearly set out the plaintiffs’ duty of investigation, given the suspicious circumstances and
plaintiffs’ savvy.” Id. at 236. The Second Circuit also reasoned that the plaintiff-investors’
proposed jury instruction that their own negligence was not a bar to a fraud claim, “would run
counter to the principle . . . that New York law generally requires a plaintiff to employ such wit
and experience as he has to look into an investment when the circumstances would alert such an
investor to pause and inquire.” Id. at 236.
Notably, the evidence adduced at trial in Crigger described facts remarkably similar to
many of the allegations in the Complaint. In Crigger, the plaintiff-investors had substantial
experience with millions of dollars in investments; worked with financial advisors and
accountants prior to investing in the Ponzi scheme; failed to heed their accountants’ warnings
about the investment; were told to make no unauthorized direct contact with the company in
which they were investing “on pain of being ‘automatically disqualified’ from participation;” and
each of the plaintiff-investors testified at trial that the investment was “something along the lines
of ‘too good to be true.’” Id. at 236.19
So too here. (Compl. Sect. VI, VIII-X.) As this Court noted in First Capital:
Also, while, 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. Since the plaintiffs and their principals are financially
19

The Second Circuit held that “these circumstances created a fact question as to whether these
sophisticated investors, exercising reasonable prudence, should have been sufficiently alerted to
look into the legitimacy of the proposed transactions, and avoid the loss,” and that the jury
evidently decided that plaintiffs failed to investigate the investment in a manner commensurate
with their level of sophistication. Crigger, 443 F.3d at 236.

16

sophisticated, they “had a duty to exercise ordinary diligence and conduct an
independent appraisal of the risk they were assuming.”
****

All the while, plaintiffs appear not to have conducted the slightest due diligence;
for example, they made no effort to find out whether Wilson Capital even had a
“trade program.” Whether such blindness was a product of gullibility or greed, it
at least creates a triable issue of whether plaintiffs’ reliance on defendants’
representations was reasonable and justifiable. 20
Id at *15-16 (citation omitted); see also Pub. Emps. Ret. Sys. of Miss. v. Merrill Lynch, 714
F.Supp.2d 475, 480 (S.D.N.Y. 2010) (“[W]hether a plaintiff had sufficient facts to place it on
inquiry notice is often inappropriate for resolution on a motion to dismiss . . . .” (citation and
marks omitted)).
In sum, the Trustee has alleged detailed facts showing that the Defendants had repeated
warnings regarding Madoff’s fraud, but closed their eyes to the facts which called for
investigation, instead choosing for business and financial reasons not to inquire.

Because

analogous securities laws and common law would impose the same duty to inquire upon
Defendants under the foregoing circumstances, BLMIS’s insolvency and the fraudulent
conveyance laws which govern their good faith defense do not operate to retroactively alter the
Defendants’ diligence obligations.21 The Defendants have not and simply cannot meet their

20

See AXA Vericherung AG. v. N.H. Ins. Co., 391 Fed. App’x 25, 35 (2d Cir. 2010) (vacating
jury’s approximately $35 million award to plaintiffs for fraudulent inducement, barring claims
on limitations grounds, reasoning that a reasonable reinsurer like plaintiff could not “continue to
turn a blind eye to repeated circumstances indicating that it may be a victim of a fraud”).

21

The Defendants also remain subject to the long-established law that they cannot keep other
customers’ stolen money unless they are bona fide purchasers for value. The same fundamental
principles underlying the securities laws, common law and fraudulent conveyance law that
operate to impute notice of the fraud to the Defendants for failing to inquire would also preclude
their assertion of a bona fide purchaser defense. “[W]here a purchaser has knowledge of any
fact, sufficient to put him on inquiry as to the existence of some right or title in conflict with that
he is to purchase, he is presumed either to have made the inquiry and ascertained the extent of
such prior right, or to have been guilty of a degree of negligence equally fatal to his claim, to be
considered as a bona fide purchaser.” Williamson v. Brown, 15 N.Y. 354, 362 (1857). Thus,
17

burden on this motion of proving their good faith in connection with the Trustee’s fraudulent
conveyance causes of action. At a minimum, questions of material fact are in dispute and require
discovery to proceed.
III.

THE COMPLAINT PROPERLY STATES FRAUDULENT CONVEYANCE
CLAIMS AGAINST THE DEFENDANTS
The Defendants’ claim that SIPA creates an exception for “customers” from the

avoidance of fraudulent transfers is wrong. (Tr.’s Br. 68-69.) The plain language of SIPA
§ 78fff-2(c)(3) explicitly authorizes and empowers the Trustee to avoid transfers to the full
extent of the Code, expressly including transfers to or on behalf of customers:
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.
15 U.S.C. § 78fff-2(c)(3) (emphasis added).
This authority is not merely consistent with, but necessary to, Congress’ goal of equitable
treatment among customers, as demonstrated by both the plain language and legislative purpose
of SIPA and its predecessor.22

even though a party has paid valuable consideration for property transferred to him, and there is
an absence of proof that the party was a participant in the vendor’s fraud upon his creditors,
courts nevertheless have rejected the bona fide purchaser defense where that party “had
knowledge sufficient to put him on inquiry, if not actual notice, of the vendor’s fraud.” Hall v.
Frith, 51 Misc. 600, 101 N.Y.S. 31, 34 (Sup. Ct. N.Y. Co. 1906).
22

See REPORT OF SPECIAL STUDY OF SECURITIES MARKETS OF THE SECS. AND EXCH. COMM’N,
H.R. DOC. NO. 95, at 411-12; Analysis of H.R. 12889, 74th Cong., 2d Sess. 193 (1936)
(statement of Harry Zalkin) (purpose of authorizing trustee to avoid preferential and fraudulent
transfers made to certain customers at expense of others was to effectuate provision calling for
ratable participation in single and separate fund); Hill v. Spencer Savings & Loan Association (In
18

In addition, the Defendants’ contention that the fabricated BLMIS customer statements
created a valid obligation, rendering the transfers from BLMIS immune to the fraudulent
conveyance laws, is based on the same faulty premise that Judge Lifland expressly and
unequivocally rejected in the Bankruptcy Court’s interpretation of “net equity” within the
meaning of SIPA, now on appeal before the Second Circuit. (Tr.’s Br. 61-62.) And even if the
BLMIS customer statements created obligations, as the Defendants claim, any such “obligations”
and/or transfers to the Defendants would still be avoidable as actual and constructive fraudulent
conveyances. The transfers from BLMIS to the Defendants are presumed, as a matter of law, to
be actual fraudulent conveyances under Code § 548(a)(1)(A) and NYDCL § 276 because they
were made during the course of a Ponzi scheme. (Tr.’s Br. 59-60, 71-76.)23 The Bankruptcy

the Matter of Bevill), 83 B.R. 880, 898 (D.N.J. 1988) (explaining SIPA’s “purpose” “to restore
and maintain the confidence of investors in the capital markets. . . is advanced by the equitable
distribution of property. . . [a]doption of the new categories of customer property. . . in the 1978
amendments to SIPA were intended to cure certain inequities under the 1970 Act in the treatment
of customers of the bankrupt broker.”). Hill also rejected the defendant’s claim that avoidance of
a transfer by the debtor brokerage to customer’s account amounted to a taking of defendant’s
property in violation of the Fifth Amendment because, among other things, the “case involve[d]
only the prospective application of a bankruptcy law.” Id. at 897. To the extent Defendants
claim any unlawful retroactive taking in violation of the Fifth Amendment, their claim must fail
as they have been on notice of SIPA and the Code’s avoidance provisions since their enactment
years before they opened their first BLMIS account. See id.
23

Of the approximately $300 million in fictitious profits that this action seeks to recover, $140
million was withdrawn beyond six years of the Filing Date. The Trustee may properly pursue
recovery of amounts transferred beyond the six years under New York’s discovery rule—made
applicable by § 544 of the Code—which sets the limitations period for a fraudulent conveyance
action “commenced within six years after the commission of the fraud or within two years of the
date the fraud was or should have been discovered [with reasonable diligence], [w]hichever is
longer.” Picard v. Chais (In re Bernard L. Madoff Inv. Secs. LLC), 445 B.R. 206, 232 (Bankr.
S.D.N.Y. 2011). Standing in the shoes of an unsecured creditor (who need not be identified until
trial), the Trustee has adequately pled that during the relevant period, “Madoff’s fraud was either
(1) not discovered and could not have been discovered with reasonable diligence by at least one
unsecured creditor; or (2) was only discovered, and could only have been discovered with
reasonable diligence, by at least one unsecured creditor within two years of the filing date.” Id.;
Compl. ¶¶ 1370-71; see also In re Taubman, 160 B.R. 964, 989-90 (Bankr. S.D. Ohio 1993)
(holding under UFCA trustee in a Ponzi scheme not limited in the number of years he could
19

Court in the Dreier bankruptcy confirmed that fraudulent intent of the transferor is all that is
required by the NYDCL. See In re Dreier LLP, 2011 WL 2412581, at *28-33 (review and
rejection of caselaw holding that transferee intent is required under § 276).
Moreover, Madoff’s transfers to the Defendants are constructively fraudulent under the
Code and NYDCL because they were neither for “value” nor received in good faith. (Tr.’s Br.
58-60, 77-89.) When investors invest in a Ponzi scheme, payments by the debtor that exceed
their investments are not made for reasonably equivalent value. (Id. at 77-80.) Even as to the
principal invested, an investor in a Ponzi scheme does not, strictly speaking, provide “value” by
the mere fact of its investment. A good faith investor generally would be entitled to a claim of
rescission to recover the full amount of his investment due to the fraud perpetrated by the debtor.
Here, however, these Defendants are not entitled to a claim for the equivalent of their principal
investment since December 2002, because they lacked good faith at the time of the transfers, and
for the same reasons set forth in Section II above, cannot state a fraud claim against the estate.
(See generally Compl. Sects. IX and X.)
Finally, contrary to the Defendants’ assertions, the Second Circuit’s decision in Sharp
Int’l Corp. v. State Street Bank & Trust Co. (In re Sharp Int’l Corp.), 403 F.3d 43 (2d Cir. 2005),
does not preclude the avoidability of the transfers here. (Tr.’s Br. 66-68.) Sharp reiterates that
where, as here, “actual intent to defraud creditors is proven, the conveyance will be set aside
regardless of the adequacy of consideration given.” Sharp, 403 F.3d at 56 (citing U.S. v.
McCombs, 30 F.3d 310, 328 (2d Cir. 1994)) (emphasis added).
IV.

SECTION 546(e) DOES NOT APPLY HERE
Defendants argue that other than intentional fraudulent transfers made within two years

reach back to recover transfers where fraud was not discovered other than by debtor and coconspirators).

20

of the commencement date, transfers made to them are not avoidable because they constitute
transfers made by a “stockbroker” and “in connection with a securities contract.”

(Defs.’

Withdrawal Br. 18-19.)24 Defendants are incorrect.
A.

Section 546(e) Does Not Apply To A Fiction

No court to consider the issue has extended the “safe harbor” provision of § 546(e)25 to a
Ponzi scheme that engaged in no relevant securities activity. As Judge Lifland stated, “[c]ourts
have held that to extend safe harbor protection in the context of a fraudulent securities scheme
would be to ‘undermine, not protect or promote investor confidence . . . [by] endorsing a scheme
to defraud SIPC,’ and therefore contradict the goals” of § 546(e). Picard v. Merkin (In re
Bernard L. Madoff Inv. Secs., LLC), 440 B.R. 243, 267 (Bankr. S.D.N.Y. 2011) (quoting In re
Adler, Coleman Clearing, 247 B.R. at 105 (declining to grant safe harbor protection in fraudulent
Ponzi scheme); Kipperman v. Circle Trust F.B.O. (In re Grafton Partners), 321 B.R. 527, 539
(9th Cir. BAP 2005) (“The few decisions that involve outright illegality or transparent
manipulation reject § 546(e) protection.”)); see also Johnson v. Neilson (In re Slatkin), 525 F.3d
805, 809, 816-19 (9th Cir. 2008) (holding that § 546(e) safe-harbor defense does not apply where
debtor operated a Ponzi scheme because he was not “engaged in the business of effecting
transactions in securities”).
The purpose of § 546(e) is to protect securities transactions without destabilizing the
24

Defendants do not argue that the transfers constitute “settlement payments” for purposes of §
546(e). To the extent their submission of supplemental authority constitutes an attempt to invoke
this language, it is inapplicable because no securities transaction relating to any alleged
“settlement payment” was ever “completed.” In re Adomo, 619 F.2d 216, 222 (2d Cir. 1980).
Moreover, the Defendants’ reliance on In re Enron Creditors Recovery Corp. v. Alfa, No. 095122-bk(L), 2011 U.S. App. LEXIS 13177 (2d Cir. June 28, 2011), is unfounded because that
case merely interpreted the definition of “settlement payment” in connection with a preference,
and there were, in fact, actual transactions that occurred in that case.
25

Defendants concede that § 546(e) does not operate to preclude avoidance of intentional
fraudulent transfers under § 548(a)(1)(A) of the Code. (Defs.’ Withdrawal Br. 19.)

21

public or private markets involving actual transactions that do or could impact the markets
generally. In re Grafton Partners, 321 B.R. at 532-33; see also Merkin, 440 B.R. at 267-68.
However, here, no relevant securities transactions took place. Therefore, no statutory purpose
would be served here where there are no transactions and some customers would be harmed at
the expense of others. Merkin, 440 B.R. at 267-68. To the contrary, this result would authorize a
fraud and contravene the statute. Id.; Wider v. Wootton, 907 F.2d 570, 573 (5th Cir. 1990)
(refusing to apply § 546(e) where doing so “would lend judicial support to ‘Ponzi’ schemes by
rewarding early investors at the expense of later victims”) (quoting In re Western World
Funding, Inc., 54 B.R. 470, 481 (Bankr. D. Nev. 1985)).
Courts in this District have identified five factors relevant to a consideration of whether
the safe harbor applies to a particular transaction.26 The most cursory review of these factors
shows the utter irrelevance of § 546(e) to the transfers here: each of them presupposes an actual
transaction. In short, “[i]t is relatively easy to conclude that Congress never could have meant to
permit § 546(e) to protect transactions that themselves were assaults on the securities markets, as
that would be a perversion of the statute’s purpose.” Geltzer v. Mooney (In re MacMenamin’s
26

These include whether:
(1) the transactions have long settled by means of actual transfers of consideration, so that
subsequent reversal of the trade may result in disruption of the securities industry, creating a
potential chain reaction that could threaten collapse of the affected market;
(2) consideration was paid out in exchange for the securities or property interest as part of
settlement of the transaction;
(3) the transfer of cash or securities effected contemplates consummation of a securities
transaction;
(4) the transfers were made to financial intermediaries involved in the national clearance and
settlement system;
(5) the transaction implicated participants in the system of intermediaries and guarantees which
characterize the clearing and settlement process of public markets and therefore would create the
potential for adverse impacts on the functioning of the securities market if any of those
guarantees in the chain invoked.
Alfa v. Enron Creditors Recovery Corp. (In re Enron Creditors Recovery Corp.), 422 B.R. 423,
439 (S.D.N.Y. 2009) (citations omitted).

22

Grill Ltd.), No. 09–8266 (RDD), 2011 WL 1549056, at *9 (Bankr. S.D.N.Y. Apr. 21, 2011)
(Drain, J.).
B.

The Transfers At Issue Were Not Made In Connection with a Securities
Transaction

Defendants rely on the language in § 546(e) that the Trustee may not avoid “a transfer
made by or to…[a] stockbroker…in connection with a securities contract.” But the transfers
here were not made in connection with a securities contract. BLMIS did not purchase, loan or
sell any relevant securities.

(Compl. ¶¶31-35.) The computer system upon which BLMIS

purportedly conducted trades was not connected to any outside system; customer statements
were entirely fabricated; and the only funds transferred to customers like the Defendants
consisted of other people’s money. (Id.); In re Bernard L. Madoff Inv. Secs., LLC, 424 B.R. 122,
127-28 (Bankr. S.D.N.Y. 2010).
Defendants rely on cases holding that Madoff’s Ponzi scheme was a fraud “in connection
with the purchase and sale of any security” for purposes of Rule 10b-5. (Defs.’ Br. 83-84.) But
Rule 10b-5 addresses the commission of fraud and making of false statements. Section 546(e),
by contrast, regulates transfers. While Madoff made misrepresentations in connection with
securities, this has nothing to do with the transfers he made to customers, which were made in
connection with furthering his Ponzi scheme, not in connection with a securities contract. Rule
10b-5 is not relevant to this inquiry.27
27

Rule 10b-5 arises in the context of the very different remedial scheme of securities laws
designed to prevent fraudulent misrepresentations or omissions in connection with securities
purchases or sales under the Securities Exchange Act of 1934. Because broad interpretation of
remedial legislation like Rule 10b-5 is appropriate to effectuate its remedial intent, fraud in
connection with inducing the payment of money to purchase securities has been held by various
courts to be within the scope of the Securities Exchange Act even in circumstances in which no
purchases occurred. In re J.P. Jeanneret Assocs., Inc., 769 F. Supp. 2d 340, 361 (S.D.N.Y.
2011) (“[t]he ‘in connection with the purchase or sale’ requirement [under Rule 10b-5 must be
construed ‘not technically and restrictively, but flexibly to effectuate its remedial purpose.’”)
23

Finally, SIPA incorporates the provisions of the Code, but only to the extent that the
Code is consistent with SIPA. See SIPA § 78fff(b). SIPA would not permit an interpretation of
§546(e) that would apply to phantom securities transactions, where this would result not only in
shielding the fraudulent transfers made by Madoff, but also preferring net winner customers to
the exclusion and prejudice of the net loser customers—both of which would be flatly contrary to
SIPA’s policy of equitable treatment among customers.
C.

Section 546(e) Is An Affirmative Defense

Section 546(e) applies, if at all, as an affirmative defense to claims brought by a trustee,
and the burden of proof rests on the defendant. Merkin, 440 B.R. at 267; see also Degirolomo v.
Track World, Inc. (In re Laurel Valley Oil Co.), No. 07-6109, 2009 WL 1758741, at *2-3
(Bankr. N.D. Ohio June 16, 2009). Unless its application is clearly established on the face of the
Complaint, it “does not tend to controvert [the trustee’s] prima facie case.” Merkin, 440 B.R. at
267. Even assuming the statute had any relevance, here, where there was only the illusion of
securities activity, Defendants cannot establish its application as a matter of law.

(quoting Secs. & Exch. Comm’n v. Zandford, 535 U.S. 813, 820–21 (2002)). The purpose of §
546(e), however, is to prevent the snowballing effect on the markets of unraveling securities
transactions implicating the system of guarantees implicit in the clearance system for public
securities. In re Grafton Partners, 321 B.R. at 532-33. As discussed above, endorsing the Ponzi
scheme would undermine instead of promote investor confidence.

24

CONCLUSION
For the reasons discussed above and in the Trustee’s Opposition, the Trustee respectfully
requests that the Defendants’ Motion to Dismiss be denied.
Date: July 22, 2011
New York, New York

By: /s/ David J. Sheehan
BAKER & HOSTETLER LLP
45 Rockefeller Plaza
New York, New York 10111
Telephone: [phone]
Facsimile: [phone]
David J. Sheehan
Email: [e-mail]
Fernando A. Bohorquez, Jr.
Email: [e-mail]
Regina L. Griffin
Email: [e-mail]
Attorneys for Irving H. Picard, Trustee for the
Substantively Consolidated SIPA Liquidation
of Bernard L. Madoff Investment Securities
LLC and Bernard L. Madoff

25