Restructuring

Contributed by Alexander Woolverton
Bernard Madoff’s historic Ponzi scheme has spawned court opinions of an ever increasing number of fascinating precedent, from subjects such as the doctrines of comity and in pari delicto.  In January, in Marshall v. Picard (In re Bernard L. Madoff Investment Securities LLC), the United States Court of Appeals for the Second Circuit handed down a decision validating the Madoff trustee’s release of claims against alleged Madoff co-conspirators that Madoff customers were trying to enforce.
Background
After his notorious Ponzi scheme was revealed, and Bernard Madoff was arrested, the Securities Investor Protection Corporation placed Bernard Madoff’s broker-dealer, Bernard L. Madoff Investment Securities LLC (BLMIS), into a liquidation proceeding and appointed a trustee to oversee its liquidation.  In connection with the liquidation, the trustee was responsible for liquidating BLMIS so that the claims of its customers could be satisfied.  For the trustee, however, this was no easy task.  Because BLMIS customer account statements were fictitious and did not reflect actual securities positions that could be liquidated, there did not appear to be a definitive way to determine how much customers were owed.  The trustee’s solution was to use the “net investment method;” that is, if a customer withdrew more than they invested, they were considered a “net winner” and their claims against BLMIS would be denied; customers that invested more than they withdrew would have their claims allowed.
In order to recover money from one of BLMIS’s largest “net winners,” the trustee commenced an adversary proceeding in May 2009 against the estate of Jeffry M. Picower, one of Madoff’s alleged co-conspirators, and related defendants.  The trustee alleged that the Picower defendants had made improper withdrawals from BLMIS totaling approximately $7.2 billion and sought to recover those amounts.  In December 2010, the trustee and the Picower defendants settled the adversary proceeding, and the Picower defendants agreed to return $5 billion to the BLMIS estate.  In exchange, the trustee agreed to seek court approval of a release of claims he might have had against the Picower defendants and to seek an injunction from the Bankruptcy Court preventing third parties from suing the Picower defendants on account of claims that are “duplicative or derivative of the claims brought by the Trustee.”
While settlement negotiations between the trustee and the Picower defendants were ongoing, former BLMIS customers filed complaints in the United States District Court for the Southern District of Florida “on behalf of putative classes allegedly adversely affected by the Trustee’s method for calculating net equity.” The Florida actions were enjoined by the bankruptcy court on the basis that they violated a prior protective order, “usurped causes of action belonging to the estate in violation of the . . . automatic stay . . . and undermined the Bankruptcy Court’s jurisdiction over the administration of the BLMIS estate.”  The Trustee sought to enjoin these actions as being within the scope of the release he sought to obtain in connection with his settlement with the Picower defendants.
In January 2011, the bankruptcy court approved the release and enjoined the Florida Actions.  The bankruptcy court further stated that the claims of the former BLMIS customers were “subsumed” in the release language.  On appeal by the customers, the District Court for the Southern District of New York affirmed the release and injunction.  The customers appealed the district court’s decision to the United States Court of Appeals for the Second Circuit.
Discussion
The Second Circuit’s analysis began with its clarification that the BLMIS estate includes causes of action possessed by the trustee, as well as claims based on rights derivative of, or derived from, the trustee’s.  In light of the fact that derivative claims are property of trustee’s estate, the court observed that “the parties have not objected, nor could they have objected, to the plain text of the injunction” because “by its own terms, [it] is limited to third party claims based on derivative or duplicative liability or claims that could have been brought by the Trustee against the Picower releasees.”
While the release given by the trustee was limited by its own terms to claims that were estate property, the appellants contended their claims were individual claims rather than derivative.  The court, however, disagreed.  Derivative claims, the court wrote, are those that “‘arise[] from harm done to the estate’ and that ‘seek[] relief against third parties that pushed the debtor into bankruptcy.’”  More specifically, derivative injuries are “based upon ‘a secondary effect from harm done to [the debtor],’” while particularized injuries (that do not constitute estate property) are those that “can be ‘directly traced to [the third party’s] conduct.’”
The appellants argued that their complaints “assert[ed] non-derivative conspiracy-based claims predicated upon the Picower defendants’ direct participation in the theft of BLMIS customers’ funds.” The court disagreed.  The court stated that the appellants’ complaints alleged nothing more than steps necessary to effect the Picower defendants’ fraudulent withdrawals of money from BLMIS and that their complaints in the Florida Action even cited “the factual allegations contained in the Trustee’s complaint in New York’s bankruptcy court multiple times in support of their claims.”  Indeed, the court wrote that the “appellants’ alleged injuries are inseparable from, and predicated upon, a legal injury to the estate—namely, the Picower defendants’ fraudulent withdrawals from their BLMIS accounts of what turned out be other BLMIS customers’ funds.”  As such, the court did not agree that the appellants alleged any particularized harm, such as misrepresentations made by the Picower defendants to the appellants directly.  The court concluded that the claims the appellants sought to pursue in the Florida action were within the scope of the release approved by the bankruptcy court and were properly enjoined.  The court did, however, state that the appellants could “conceivably” allege a sufficiently particularized claim to bring their claims outside the realm of the injunction.
Conclusion
While the court took care to clarify that releases of the independent claims of third party non-debtors are still subject to higher scrutiny, the court’s ruling serves as a reminder that releases of derivative claims by a debtor or trustee may be upheld as valid.