Of the hundreds, if not thousands, of investors caught in Bernard Madoff’s web, a select few may be breathing easy because they redeemed their holdings before the collapse of Bernard L. Madoff Investment Securities. But the relief may be short-lived. Case law stemming from the 2004 blowup of $450 million hedge fund firm Bayou Group may force those who profited with Madoff to give the money back.
The U.S. Bankruptcy Court for the Southern District of New York found in October that some Bayou investors were paid “fictitious profits” when Bayou was insolvent. Madoff has been charged with running a $50 billion Ponzi scheme; Bayou was much smaller, but in essence it too was a Ponzi operation. No one in the Bayou case has been forced yet to return any profits, but there has been a partial settlement. The case is still in the courts, but so-called clawback laws may require investors who came out ahead to return their winnings.
“Actual intent to hinder, delay or defraud creditors is a fraudulent transfer that can be rescinded,” explains Michael Missal, a partner at Washington law firm K&L Gates and a former lawyer for the enforcement division at the Securities and Exchange Commission. At issue is the concept of fraudulent conveyance. Missal says it means investors can keep the money they have withdrawn only if it was taken out in good faith — without any idea, for instance, that there were problems.
Lawyers for investors who lost money in Bayou argue that some of those who got out were tipped off to the imminent collapse. One way for Bayou investors to defeat a fraudulent-transfer claim would be by “affirmatively showing that it was redeemed in good faith and for value,” Missal says, “a tough thing to do in some circumstances.”
In 2006, Bayou’s court-appointed receiver brought more than 130 fraudulent-transfer proceedings against investors who had redeemed profit and principal. The move was aimed at recovering some $122 million, and the court subsequently ruled that “fictitious profits” had to be returned and that investors who made money could even be required to pay interest. Appeals have been filed, and to date about 90 investors who cashed out of Bayou have settled, agreeing to return profits as well as a portion of their principal. Several dozen have also been ordered to return all of their principal. The court did side with a small group of investors who got out before the blowup, ruling that they had done so in good faith. A number of cases have been ordered to trial.
If the Bayou fight seems complicated, imagine what may ensue over Madoff, who had far more investors and much greater losses.
David Herzog, a partner at Indianapolis-based law firm Baker & Daniels, which is representing DePauw University’s endowment in its efforts to recoup its investment with Bayou, says there are strong parallels with the Madoff case. But the complexity of the alleged Madoff fraud and its huge cast of characters — investors, advisers, subadvisers, brokerage and clearing operations — as well as its international scope, may keep it from ever being untangled.
Another case that may prove pertinent is that of Tom Petters, whose Minnetonka, Minnesota–based Petters Group Worldwide allegedly perpetrated a $2 billion fraud, says Christopher Addy, a principal at Montreal-based due diligence firm Castle Hall Alternatives. Prosecutors allege that Petters used the firm to defraud hedge funds and other investors from 1995 to 2008.
“Petters is a very good example for two reasons: One, a lot of people accessed him through Palm Beach [Florida] circles, similar to Madoff, and through an intermediary that they thought was doing appropriate due diligence,” Addy notes. “And two, Petters’s strategy was similar to Madoff’s in the sense that you couldn’t prove any assets were there.”
Madoff has probably taken note of what happened to Samuel Israel III, the founder and manager of Bayou. Israel was sentenced last April to 20 years in prison for defrauding investors. He faked his suicide and went on the lam but turned himself in less than a month later and is now serving his time.
