Safe Harbor Bars Foreign Liquidators from Recovering Money Stolen in the U.S.
Originally posted on ABI.org
Another opinion shows that Congress wrote Section 546(e) in a manner that goes far beyond protecting the securities markets in the U.S.
Congress gave us a statute that allows fraudsters to launder stolen money in the U.S. through foreign banks, as revealed in an opinion by retiring Manhattan Bankruptcy Judge Stuart M. Bernstein.
Some of the money stolen by Ponzi-schemer Bernard Madoff went to so-called feeder funds in the British Virgin Islands. The feeder funds then distributed Madoff withdrawals through foreign banks. The feeder funds’ BVI liquidators obtained chapter 15 recognition and sued the foreign banks in the bankruptcy court.
Applying the safe harbor in Section 546(e), Judge Bernstein was required in his December 14 opinion to dismiss the liquidators’ claims for “unfair preference” and “undervalue transactions.” On a motion to dismiss, he allowed constructive trust claims to stand.
The Claims in More Detail
The offshore feeder funds made virtually all of their investments with Madoff. Naturally, they stopped allowing redemptions in 2008 after Madoff was arrested.
The feeder funds ended up in liquidation proceedings in the BVI, where liquidators were appointed. The liquidators obtained recognition of the BVI proceedings as the feeder funds’ foreign main proceedings under chapter 15.
The liquidators filed suit in the bankruptcy court against foreign banks that had received redemptions. The complaint alleged that the feeder funds hired a third-party administrator to calculate redemptions. Significantly, the complaint alleges that the administrator knew or was willfully blinded to the fact that the investments in Madoff were worthless.
The complaint also alleges that the defendant in the test case, a London bank, knew that Madoff was conducting a fraud.
In the bank’s motion to dismiss, the defendant bank did not challenge the assertions of bad faith and knowledge.
The liquidators sought some $54.5 million in redemptions paid to the London bank in the four years before the Madoff fraud was exposed. The complaint alleged that the redemptions were recoverable under BVI law as “unfair preferences” and “undervalue transactions” and under theories of constructive trust.
Following the Supreme Court’s Merit Management decision, the bank filed a motion to dismiss, raising issues common to 300 lawsuits filed by the liquidators to recover redemptions. The bank argued that the claims were barred by the so-called safe harbor in Section 546(e). To read ABI’s report on Merit Management Group LP v. FTI Consulting Inc., 138 S. Ct. 883 (Feb. 27, 2018), click here.
The Safe Harbor Applies to Some Claims
In brief, Section 546(e) bars avoidance claims that were made to or for the benefit of a “financial institution.” The redemptions were paid to a foreign bank.
Citing Sections 101(22)(A) and 741(2), Judge Bernstein said that “a customer of a financial institution such as a bank is also deemed to be a financial institution if the bank acts as the customer’s agent in connection with a securities contract.” Therefore, the funds themselves were “financial institutions” because they were customers of a bank.
Consequently, avoidance claims against the feeder funds were barred by Section 561(d), which makes the safe harbor applicable in chapter 15 cases.
The liquidators argued that the safe harbor did not apply because the claims were similar to intentional fraudulent transfer claims under Section 548(a)(1)(A). However, Judge Bernstein noted that the liquidators had not made claims based on intentional fraudulent transfers. Indeed, foreign representatives in chapter 15 are not allowed to mount claims under Section 548.
Judge Bernstein read the statute strictly. He said that the exception to the safe harbor for intentional fraudulent transfers “only applies to intentional fraudulent transfer claims under Bankruptcy Code § 548(a)(1)(A).” Furthermore, Judge Bernstein found no analogue in BVI law to claims for intentional fraudulent transfer.
In sum, Judge Bernstein dismissed the liquidators’ claims for “unfair preference” and “undervalue transactions” under BVI law as being barred by the safe harbor.
The Constructive Trust Claims
The bank contended that the liquidators’ constructive trust claims were preempted by federal law, namely, the safe harbor. Judge Bernstein said that “several courts” have held that state law claims to recover transfers are impliedly preempted by Section 546(e).
Judge Bernstein drew a line, observing that the Supremacy Clause is inapplicable to foreign law. “Courts do not assume that otherwise applicable foreign law is preempted absent express statutory language to that effect,” he said.
Finding no express preemption of foreign law, Judge Bernstein denied the motion to dismiss based on BVI constructive trust claims.
Service of Process
Judge Bernstein decided that service of process by mail on foreign defendants was sufficient even though mailed service is not permitted by the Hague Convention. In substance, he held that service by mail on the bank’s New York counsel was sufficient under Rule 4(f)(3) of the Federal Rules of Civil Procedure.
Caveat: Don’t try this at home. We recommend reading the opinion to identify a foolproof method for serving foreign defendants.
As interpreted by Judge Bernstein, Congress adopted a statute (the safe harbor) that renders foreign liquidators less able to set aside fraudulent transfers than domestic bankruptcy trustees.
Following the plain language of Section 546(e), Judge Bernstein decided that the exception to the automatic stay for fraudulent transfers with “actual intent” under Section 548(a)(1)(A) does not apply to a foreign law equivalent of Section 548(a)(1)(A).
Judge Bernstein’s reading of Section 546(e) means that foreign liquidators cannot avoid fraudulent transfers that could be avoided by domestic bankruptcy trustees.
We respectfully submit that Congress should revisit the issue as part of a thorough overhaul of the safe harbor, including the provisions that turn an ordinary party into a financial institution if a financial institution is the person’s agent or the person is a customer of a financial institution.