Restructuring

Contributed by Ijeoma Anusionwu
The Madoff investment scandal was arguably the most widespread and financially devastating Ponzi scheme on record, with a fraud on customers estimated at $64 billion.  Shortly after the scheme’s discovery in 2008, the Securities Investor Protection Corporation (“SIPC”) commenced a liquidation pursuant to the Securities Investor Protection Act (“SIPA”) and appointed Irving H. Picard as SIPA trustee.
On behalf of Madoff’s defrauded customers, Picard has brought actions against a variety of defendants, including international banks that allegedly failed to detect Madoff’s fraud and allegedly facilitated the creation of feeder funds that enabled the Ponzi scheme to thrive for many years.  Recently, in one of these lawsuits, Picard v. HSBC, Nos. 11 Civ. 763 & 11 Civ. 836 (JSR) (S.D.N.Y. July 28, 2011), Picard sought to recover approximately $8.6 billion against HSBC, UniCredit and other financial institutions.  He asserted not only the “typical” statutory causes of action, such as equitable subordination and avoidance based upon preferential and fraudulent transfers, but also various common law theories of recovery, such as unjust enrichment, aiding and abetting fraud, and aiding and abetting breach of fiduciary duty.  Picard premised these common law claims on the financial institutions’ alleged failure to investigate Madoff Securities properly despite red flags suggesting fraud.  The HSBC court, however, dismissed these common law claims on the ground that, as a SIPA trustee standing only in the shoes of the debtor, Picard lacked derivative standing to bring claims that belonged to Madoff’s customers.
Picard relied on several theories to assert trustee standing to bring customers’ claims against third party banks.  First, he argued that, although nothing in the Bankruptcy Code, SIPA, or Rule 15c3-3 of the Securities Exchange Act of 1934 explicitly granted him standing, these statutes implicitly did so by respectively (i) allowing a bankruptcy trustee to recover monies on behalf of a debtor’s estate, in satisfaction of creditors’ claims; (ii) requiring a SIPA trustee to investigate and report facts regarding fraud, misconduct, mismanagement, irregularities, and any other causes of action available to the estate; and (iii) requiring the separation of customers’ property from the general pool of the estate’s assets.  The District Court judge, Judge Rakoff, rejected all three arguments, holding that it was settled law that the Bankruptcy Code does not confer standing on a trustee to assert claims in creditors’ stead.  Moreover, because SIPA only vests a SIPA trustee with the same powers as a bankruptcy trustee, the Court concluded that nothing in SIPA granted standing to Picard.  Finally, because Rule 15c3-3 is not a part of SIPA and does not address the rights Picard sought to pursue, the Court found it inapplicable.
Second, Picard argued that he had standing to bring customers’ claims based on the common law theory of bailment.  Under this theory, a bailee would have the right to bring claims on behalf of bailors for the recovery of bailed property.  Picard characterized Madoff’s customers as the bailors, Picard as the bailee, and funds the customers entrusted to Madoff as the bailments or bailed property.  The Court found that, because Picard was not seeking to return recovered bailments, as a common law bailee would, but was instead seeking to recover monies that he would distribute pro rata pursuant to SIPA, Picard’s claim as bailee of customer property was unsupportable.  In addition, Judge Rakoff noted that a bailee brings claims for the loss or destruction of bailed property; Picard’s claim, on the other hand, was for conduct that occurred prior to the alleged bailment, i.e., the customers’ investments in Madoff’s Ponzi scheme, because the defendant banks’ actions, Picard alleged, made the Madoff investments appear profitable and thereby induced customers to invest and entrust Madoff Securities with their funds.  Finally, under New York law, a bailment cannot exist where the would-be bailee is a thief, such as Madoff.
Third, Picard unsuccessfully argued that, as the enforcer of SIPC’s subrogation rights, he should have standing under SIPA to recover funds already advanced by SIPC to satisfy customers’ claims.  On this point, the Court concluded that, also pursuant to SIPA, SIPC’s subrogation rights could only kick in after customers’ claims had been satisfied.  Thus, granting Picard standing based on SIPC’s rights would directly violate SIPA’s priority scheme by allowing SIPC to assert its recovery rights before customers were made whole.  Also, pursuant to SIPA, the Court found that SIPC’s subrogation rights are only allowed against the debtor’s estate, not third parties such as the banks.  Consequently, the Court held that Picard’s subrogation enforcer theory also failed to support a finding of standing.
Fourth, Picard argued that the Second Circuit’s holding in Redington granted SIPA trustees standing to sue third parties on behalf of the customers of failed broker-dealerships.  Following remand from the U.S. Supreme Court, however, the Second Circuit in Redington affirmed the dismissal of the action on jurisdictional grounds and did not have to address the standing issue.  As a result, Judge Rakoff concluded that Redington lacked any precedential value.  Therefore, Redington could not be construed as conferring standing on a SIPA trustee.
Finally, the Court added that not only could Picard not bring his common law claims on behalf of the customers, but also the doctrine of in pari delicto (the Unclean Hands doctrine) barred him from bringing such claims on behalf of the estate.  Accordingly, under the law as stated in the HSBC decision, the only recovery actions available to a SIPA trustee are the typical bankruptcy-type claims available to a debtor, not common law claims that belong to customers and creditors.  Any recoveries for common law claims in the Madoff liquidation will now have to be pursued by the customers themselves.