While there are still many unknowns in FTX’s bankruptcy including what, exactly, happened to billions of dollars of customer deposits on the former crypto trading platform, one thing is almost certain: there will be an explosion of what the media has described as “clawback” lawsuits aimed at recovering as much of the missing customer funds as possible. And a 2021 ruling from the Second Circuit Court of Appeals in the long-running Bernie Madoff SIPC liquidation may dramatically expand the reach of those clawbacks.
Technically speaking, the “clawback” suits that FTX—or, quite possibly, someone with the title of “liquidating trustee”—will prosecute will come in the form of statutory fraudulent transfer actions. Bankruptcy Code sections 548(a) and 550(a) collectively give chapter 11 debtors in possession (and trustees appointed for bad-boy debtors and post-confirmation liquidating trusts) the power to sue and recover money and other forms of property the debtor sold, loaned, gifted, or otherwise transferred to third parties within two years of the bankruptcy filing if the transfers were (literally or constructively) designed to defraud other creditors.
As a baseline, section 550(a) doesn’t limit the trustee to recovery of fraudulently transferred property from the direct (initial) recipient of the transfer. Rather, 550(a) gives the trustee an expansive power to recover money and other property from not only initial transferees, but also secondary transferees-of-the-transferee and other “subsequent” transferees even further down the chain. Earlier this month, FTX literally warned potential transferee-defendants of plans to deploy this broad statutory power in a foreboding press release.
That doesn’t mean that every distant recipient three or four times removed from an FTX-Alameda fraudulent transfer will be exposed to a clawback. Bankruptcy Code section 550(b) contains a “good faith” defense that insulates subsequent transferees of assets that were otherwise fraudulently transferred to the initial transferee, but only if the subsequent transferee “takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer.”
Of course, questions as to what suffices as “good faith” and who bears the burden of pleading it and proving it have been extensively litigated and analyzed in myriad cases and scenarios over the years. That’s where the Second Circuit’s 2021 decision in In re Bernard L. Madoff Investment Securities LLC, 12 F.4th 171 (2d Cir. 2021), comes into play. In Madoff, the Second Circuit held that, in a fraudulent transfer complaint against a subsequent transferee, the trustee is not required to allege that the subsequent transferee lacked good faith or had any particular level of notice or knowledge of an underlying fraud. Instead, the Second Circuit determined that the good faith defense is an affirmative defense—i.e., the subsequent transferee-defendant, rather than the trustee-plaintiff, bears the burden of pleading (and ultimately proving) that it received the transfer in good faith.
Additionally, and significantly, the Second Circuit held that, to meet its burden of proving good faith, the subsequent transferee-defendant must prove that it lacked “inquiry notice” of possible fraud—a standard that raises a hybrid subjective-objective question of whether the subsequent transferee knew of any suspicious facts that would prompt a reasonable person to investigate whether there was actual or constructive fraud in the underlying transfer.
The Second Circuit’s decision reversed a 2014 district court ruling that placed a significantly higher burden on the SIPA liquidating trustee, who was pursuing (among other defendants) a lender to a Madoff “feeder fund” whose loan was indirectly repaid with alleged ponzi scheme proceeds. The district court held that the trustee bore the burden of pleading the lender’s lack of good faith and had to do so by alleging that lender was “willfully blind” to “red flags that suggest a high probability of fraud.”
When the case was remanded back to bankruptcy court following this ruling, the complaints were dismissed because the bankruptcy court concluded the trustee could not possibly meet the high burden of proving that the various subsequent transferees were “willfully blind” to the underlying indicia of fraud. The Second Circuit took a direct appeal of the bankruptcy court’s dismissal and flipped both the standard for proving the good faith defense (from willful blindness to inquiry notice) and the burden of asserting the defense in initial pleadings (from the trustee-plaintiff in the complaint to the subsequent transferee-defendant in its answer).
The Madoff “inquiry notice” ruling could have a dramatic impact on John Ray’s (or a future FTX liquidating trustee’s) ability to pursue remote subsequent transferees of FTX customer funds in fraudulent transfer actions. Simply put, the “inquiry notice” standard, if applicable in a Delaware chapter 11 case, will make it much easier for an FTX fraudulent transfer complaint against a remote transferee to survive a motion to dismiss (and therefore make defense of the litigation a much lengthier and more expensive proposition for the remote transferee).
Consider a hypothetical multi-step transfer scenario, variations of which may have occurred in substantial volume in FTX’s case:
- FTX fraudulently transfers 100 Ether (ETH) (100 ETH it was supposed to be holding as a deposit for an FTX customer) to Alameda (this is one way the initial FTX-Alameda fraudulent transfers likely occurred; according to the CFTC, initial fraudulent transfers of FTX customer funds also occurred when FTX customers unwittingly deposited their fiat currency directly into a disguised Alameda bank account);
- In an effort to earn a return on that ill-gotten ETH, Alameda then deposits 100 ETH with crypto lender Silvergate Capital;
- Silvergate converts the 100 ETH deposit to USD $110,000 (assuming 1 ETH = $1,100.00 on the trade date);
- Silvergate then then lends USD $110,000 to an end borrower, a fintech company (“Borrower Corp.”).
If the Second Circuit’s Madoff ruling is the controlling precedent (an open question given that FTX’s chapter 11 is pending in the Third Circuit), in order to prosecute a fraudulent transfer complaint against Borrower Corp. as a subsequent transferee, the FTX trustee will not be required to allege Borrower Corp.’s lack of good faith (i.e., the trustee will not have any obligation to spell out how Borrower Corp. was on “inquiry notice” of the underlying FTX-Alameda initial fraudulent transfer of customer funds). In answering the complaint, Borrower Corp. would bear the legal burden of pleading its good faith and lack of knowledge as an affirmative defense (or would risk waiving the right to assert it). If Borrower Corp. moves to dismiss the complaint at the pleading stage for the trustee’s failure to specifically state and describe why Borrower Corp. lacked good faith in accepting the Silvergate loan principal, it will not likely succeed. Instead, the case would likely survive dismissal and would proceed on the merits, with the parties litigating the inherently fact-intensive and subjective question of what “inquiry notice” Borrower Corp. had or didn’t have regarding the nefarious origins of the USD-denominated principal it borrowed from Silvergate.
With the risk of early-stage dismissal being confined under Madoff, it is plausible to assume that FTX or its liquidating trustee will be aggressive and expansive in its prosecution of subsequent transferees. And this likelihood is enhanced even further by the fact that a number of Alameda’s direct transferees (a group that could include both Alameda’s crypto lenders and borrowers) will prove uncollectable as they too have recently filed their own bankruptcies.
That does not mean that FTX subsequent-transferee defendants will be without any statutory defenses that could support cost-effective, pleading-stage dismissals. Given that many if not all of the FTX multi-tiered fraudulent transfer actions will involve conversions of crypto to fiat and ultimate subsequent transferees receiving some abstract form of “proceeds” of initial FTX-Alameda transfers, some defendants may raise a defense based on the theory that section 550(a) permits recovery of the initially-transferred crypto itself, but does not permit recovery of fiat “proceeds” of fraudulently transferred crypto.
This defense would derive from the Tenth Circuit Court of Appeals’ 2020 decision in In re Generation Res. Holding Co., LLC, 964 F.3d 958 (10th Cir. 2020). In Generation, the Tenth Circuit concluded that section 550(a) only permits recovery of the initially transferred “property”, not any cash or other “proceeds” exchanged for or derived from the initial “property” transfer. But later that year, the Bankruptcy Court in the Southern District of Texas (an increasingly popular venue for mega-bankruptcy filings), reached just the opposite conclusion: a trustee can recover “proceeds” of whatever property was initially fraudulently transferred. See Cage v. Davis (In re Giant Gray Inc.), 629 B.R. 814 (Bankr. S.D. Tex. 2020).
The Madoff decision may open the door a bit wider for FTX fraudulent transfer prosecutions. But that does not mean FTX will blindly sue every payee on Alameda’s books without regard to whether they were paid in good faith or otherwise. FTX or its liquidating trustee will want to have some evidence—even if circumstantial—that its subsequent-transferee defendants were aware (or could have been aware) that something wasn’t right at FTX/Alameda. Whether FTX will ever have that evidence in hand, and what sources it might come from, are wide open questions at this point.
Two of FTX and Alameda’s senior executives, recently charged with several felonies, are cooperating with the U.S. Attorney, and may end up sharing valuable knowledge as to who knew what about FTX’s internal dealings. And for some of Alameda’s last-minute payees (aka FTX subsequent transferees), the baseline evidence of bad faith might simply be Coindesk’s initial expose of Alameda’s questionable balance sheet, which was first published on November 2, 2022 (FTX filed its chapter 11 cases November 11th). As that story went viral, it’s not a stretch to theorize that anyone who took anything out of Alameda between November 2 and November 11 is at high risk of becoming an “inquiry notice” fraudulent transfer defendant. In any event, the development of fraudulent transfer cases and the identification of viable defendants will take time, and we should expect to see more illuminating revelations and headlines in the months (and years) to come.
