Bloomberg News

Madoff Trustee Wins Once, Loses Twice with Rakoff: Bankruptcy

December 10, 2013

The trustee liquidating Bernard L. Madoff Investment Securities Inc. scored one victory and incurred two losses late last week at the pen of U.S. District Judge Jed Rakoff.

On a fourth issue, Rakoff left the door open a crack for Madoff trustee Irving Picard to sue executives of so-called feeder funds who collected money from their own customers which they in turn invested in the Madoff Ponzi scheme.

Picard might end up victorious on that issue depending on how the U.S. Supreme Court rules in a case argued before the high court in early October.

Rakoff’s ruling on Dec. 6 regarding feeder funds was in large part pre-ordained by a decision he wrote in September when sitting by designation as one of three judges in the U.S. Court of Appeals reviewing another district judge’s dismissal of a lawsuit against JPMorgan Chase & Co. (JPM:US) and Bank of New York Mellon Corp. (BK:US)

The September decision was in a suit filed by investors who contended the banks were aware of Madoff’s fraud and should be liable because they continued providing banking services. The district court dismissed the suits, citing the 1998 federal Securities Litigation Uniform Standards Act, or SLUSA.

Rakoff wrote the decision in September finding that SLUSA applied and upheld dismissal. For a discussion of the opinion, click here for the Sept. 19 Bloomberg bankruptcy report.

Rakoff’s decision Dec. 6 resulted from several lawsuits he took out of bankruptcy court where Picard is suing feeder fund managers. In district court, Rakoff heard argument in October 2012 and issued his opinion last week.

Following the September ruling involving JPMorgan, Rakoff said that Picard doesn’t have the right to file suit based on claims belonging to individual customers. It didn’t matter, Rakoff said, that Picard is a different brand of trustee appointed under the Securities Investor Protection Act.

As with JPMorgan, Rakoff said Picard is barred from suing under what’s known as the in pari delicto rule. That rule prevents one perpetrator of a fraud from suing another. Picard is barred from suing because the law views the trustee as infected with Madoff’s fraud since the trustee steps into the bankrupt’s shoes.

This time, Picard advanced a somewhat different argument. As trustee, Picard said, he received assignments of claims that otherwise could have been brought by individual defrauded customers.

In a fleeting victory, Rakoff said the in pari delicto rule only barred Picard from bringing suits that belonged to the fraud-riddled firm. It doesn’t bar Picard from suing based on claims belonging to customers, Rakoff said in his opinion.

Even so, the feeder fund managers argued that the suits are nonetheless barred by SLUSA.

In accord with the September decision, Rakoff said that SLUSA does apply. However, Rakoff couldn’t dismiss the suits because there are issues peculiar to each suit that weren’t before him.

Specifically, Rakoff sent the feeder fund suits back to bankruptcy court for decisions on other SLUSA issues.

U.S. Bankruptcy Judge Burton Lifland was assigned to decide whether the suits are based on a misrepresentation in connection with the sale of a “covered security.” If a covered security was involved, the suits would be dismissed under SLUSA.

Back in bankruptcy court, Picard can argue there were no purchases of covered securities because customers’ money was used entirely to pay other customers.

In addition, the U.S. Supreme Court will soon decide whether covered securities are involved simply because customers thought there were securities when in fact none were ever purchased.

In October, the Supreme Court heard argument in an appeal involving the R. Allen Stanford Ponzi scheme. The court will decide if SLUSA applies to bar a suit even if no securities were purchased. For details on the Supreme Court case, click here for the Nov. 13 Bloomberg bankruptcy report.

Picard is currently asking the Supreme Court to hear an appeal from a ruling in June from the U.S. Court of Appeals in Manhattan. The appeals court upheld a ruling originally made by Rakoff, like the one last week, that the law views the bankruptcy trustee as tainted by the fraud Madoff committed.

Picard’s second loss involved his suit against Stephanie Mack, widow of Bernard Madoff’s son Mark, and Deborah Madoff, wife of Madoff’s son Andrew.

Picard argued that the in pari delicto defense shouldn’t preclude him from suing Madoff family members. Rakoff disagreed and dismissed the suit as to the two women. The judge said that an exception to in pari delicto allowing suit against family is a “novel proposition unsupported by any legal authority.”

Picard wanted to sue the two women for recovery of money given them by their husbands that was originally stolen from customers.

The one clear-cut victory for Picard involved Credit Suisse AG (CS:US), Barclays Plc (BARC) and 17 other foreign banks. They wanted an immediate appeal from Rakoff’s Oct. 29 opinion giving Picard the right to sue them as feeder-fund customers.

In the October ruling, Rakoff said Picard isn’t required to obtain a judgment first against the feeder funds before he can sue the banks. Rakoff interpreted bankruptcy law to mean that Picard can sue feeder-fund customers even if the time limit has lapsed for suing the funds themselves.

After ruling in October, Rakoff sent the cases back to Lifland for further processing. Last week, Rakoff refused to allow an appeal before the suits are finished entirely because there is no “substantial ground” for believing his October ruling was in error.

Picard and his lawyers are reviewing Rakoff’s rulings and have no comment at this time, according to an e-mail from Amanda Remus, the trustee’s spokeswoman.

The Madoff firm began liquidating in December 2008 with the appointment of Picard as trustee under the Securities Investor Protection Act. Madoff individually went into an involuntary Chapter 7 liquidation in April 2009, and his case was later consolidated with the investment firm’s liquidation. He’s serving a 150-year prison sentence following a guilty plea.

So far, Picard has recovered about $9.5 billion, or about 54 percent of customers’ investments.

The decisions last week by Rakoff are part of In re Bernard L. Madoff Investment Securities LLC, 12-mc-00115, U.S. District Court, Southern District New York (Manhattan). The Madoff liquidation in bankruptcy court is Securities Investor Protection Corp. v. Bernard L. Madoff Investment Securities LLC, 08-01789, U.S. Bankruptcy Court, Southern District of New York (Manhattan). The criminal case is U.S. v. Madoff, 09-cr-00213, U.S. District Court, Southern District of New York (Manhattan).

Updates

Nortel Assets to Be Allocated by Courts, Not in Arbitration

Although Nortel Networks Inc. generated $7.5 billion from liquidation of its assets and those of subsidiaries around the world, a dispute over allocation is preventing distributions to creditors.

How the assets will be allocated among the various Nortel companies and their creditors will be decided by courts, not in arbitration, according to a Dec. 6 ruling from the U.S. Court of Appeals in Philadelphia.

The Nortel companies filed for bankruptcy reorganization in January 2009 in the U.S., Canada and London. They reported $11.6 billion in consolidated assets against debt totaling $11.8 billion as of Sept. 30, 2008.

Mediation failed to resolve disputes about how sale proceeds should be distributed among Nortel companies around the world.

Liquidators in the U.K. contended that an agreement to allow sales of assets also included a commitment to arbitrate how proceeds should be distributed. The bankruptcy court in Delaware and the court in Canada both concluded there was no commitment to arbitrate.

In the Dec. 6 opinion, the Philadelphia appeals court looked at the agreement and it too found no commitment to arbitrate. Dividing the assets is therefore up the courts.

U.S. Bankruptcy Judge Kevin Gross previously said the allocation dispute is keeping the case “tied up in knots seemingly forever.”

Originally, the judges in the U.S. and Canada scheduled an allocation trial to begin Jan. 6. The date was pushed back several times, and is now set to begin on May 12 and continue for 19 trial days.

Reports from experts, previously due this month, were pushed back to Jan 24. Examinations of experts, once scheduled for Feb. 28, will now take place from March 17 to April 4.

The appeal is In re Nortel Networks Inc., 13-2739, U.S. Third Circuit Court of Appeals (Philadelphia).

The bankruptcy case is In re Nortel Networks Inc., 09-10138, and the parent’s Chapter 15 case is In re Nortel Networks Corp. (NRTLQ:US), 09-10164, both in U.S. Bankruptcy Court, District of Delaware (Wilmington).

Bankruptcy Reform News

ABI Commission to Propose Bankruptcy Reform in 2014

Today’s bankruptcy law, adopted by Congress 35 years ago, is “antiquated,” according to Al Togut, co-chairman of the commission established by the American Bankruptcy Institute to study reform of the U.S. Bankruptcy Code.

One year from now, the ABI commission will issue its report offering “specific reform in the Bankruptcy Code” with respect to individuals, small business, and large companies, Togut said in a press conference yesterday. The ABI is a non-for-profit organization with 13,000 members.

Robert J. Keach, co-chairman, said that testimony taken by the commission suggests that Chapter 11 is working less well for middle-market companies than it is for large enterprises attempting to reorganize. He said the commission is “thinking seriously” that the “one size fits all” concept in the 1978 bankruptcy law isn’t working now.

Togut, a bankruptcy lawyer in New York, said he too has a “very definite understanding” that the law is “not working right” for smaller companies. Togut cautioned that neither he nor the commission has drawn any hard conclusions as yet.

Keach said the rights of secured creditors “need to be looked at very carefully and calibrated very carefully,” given the perception in some quarters that it’s now the secured lender who’s in possession, not the bankrupt company, known as debtor in possession.

There will be an analysis, Keach said, about whether some provisions currently contained in loan agreements for bankrupt companies should be barred or limited.

Times have changed, Togut explained, because 35 years ago the entire creditor body remained in place through a Chapter 11 reorganization. Now, ownership of debt can turn over, sometimes more than once.

Likewise, there was little secured debt 35 years ago, almost always leaving unsecured creditors with some equity in the company above what was then one layer of secured debt.

Now, it’s not unusual for there to be three layers of secured debt, with nothing left for unsecured creditors.

Keach said the commission is also studying the so-called safe harbor and other exceptions to the automatic stay where creditor actions are halted with the filing of bankruptcy. Keach also said he was given an “earful” about preference reform.

Previously, Keach said, preference suits were filed to even out recoveries by unsecured creditors. Now, he said, preference suits are brought to pay costs of running the Chapter 11 case or to increase recoveries for secured creditors.

The ABI does not lobby Congress, and it won’t propose a bill, Keach and Togut said. Other organizations, they said, may take the commission’s proposals to Congress.

Advance Sheets

Unconfirmed Arbitration Has No Preclusive Effect

Courts are split on the question of whether an arbitration award, not yet confirmed in federal court, can be given preclusive effect in bankruptcy or other federal actions.

U.S. District Judge Margaret M. Morrow in Los Angeles parted company with several lower courts, including a bankruptcy court in New York in the 1998 bankruptcy of Texaco Inc. She ruled in her Sept. 11 opinion that an unconfirmed award isn’t entitled to preclusive effect in a later bankruptcy.

She relied in large part on a 1984 U.S. Supreme Court case called McDonald which held that arbitration is not a judicial proceeding.

In the case before her, the arbitration award was confirmed later in state court after the bankruptcy court had ruled, incorrectly in her view, that the arbitration had preclusive effect.

Even though confirmation of the award came after the judgment in bankruptcy court, that was sufficient to give the award preclusive effect.

The case is Houng v. Tatung Co. (In re Houng), 12-01341, U.S. Bankruptcy Court, Central District California (Los Angeles).

To contact the reporter on this story: Bill Rochelle in New York at wrochelle@bloomberg.net

To contact the editor responsible for this story: Andrew Dunn at adunn8@bloomberg.net


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