In a 2021 ruling, the U.S. Court of Appeals for the Second Circuit revived nearly 100 lawsuits seeking to recover fraudulent transfers made as part of the Madoff Ponzi scheme. In one of the latest chapters in that resurrected litigation, the U.S. Bankruptcy Court for the Southern District of New York held in Picard v. ABN AMRO Bank NV (In re Bernard L. Madoff Investment Securities LLC), 654 B.R. 224 (Bankr. S.D.N.Y. 2023), that a defendant in fraudulent transfer litigation cannot offset its fraudulent transfer liability against a claim the creditor asserts against the debtor because there is no mutuality between the two claims. The court also ruled that, depending on the specific facts and equities of the case, recoupment might be asserted as an affirmative defense in avoidance litigation. Finally, it held that unjust enrichment cannot ordinarily be raised as an affirmative defense and is particularly disfavored in bankruptcy because it undermines the Bankruptcy Code's priority scheme.
Setoff in Bankruptcy
Section 553 of the Bankruptcy Code provides that, with certain exceptions, the Bankruptcy Code "does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case." Section 553 does not create setoff rights—it merely preserves certain setoff rights that otherwise would exist under contract or applicable non-bankruptcy law. See Collier on Bankruptcy ("Collier") ¶ 553.04 (16th ed. 2023) (citing Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995)); Feltman v. Noor Staffing Grp., LLC (In re Corp. Res. Servs. Inc.), 564 B.R. 196 (Bankr. S.D.N.Y. 2017) (section 553 does not create an independent federal right of setoff, but merely preserves any such right that exists under applicable non-bankruptcy law). As noted by the U.S. Supreme Court in Studley v. Boylston Nat. Bank, 229 U.S. 523 (1913), setoff avoids the "absurdity of making A pay B when B owes A." Id. at 528; see also In re Lehman Brothers Holdings Inc., 404 B.R. 752, 756 (Bankr. S.D.N.Y. 2009) (discussing the historical underpinnings of the setoff doctrine).
The Bankruptcy Code defines a "claim," in relevant part, as a "right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured," and it defines a "debt" as a "liability on a claim." 11 U.S.C. §§ 101 (5)(A), (12).
With certain exceptions for setoffs under "safe-harbored" financial contracts, a creditor is precluded by the automatic stay from exercising setoff rights against a debtor in bankruptcy without court approval. See 11 U.S.C. §§ 362(a)(7), (b)(6), (b)(7), (b)(17), (b)(27), and (o). Stayed setoff rights are merely suspended, however, pending an orderly examination of the parties' obligations by the court, which will generally permit a valid setoff unless it would be inequitable to do so. See In re Ealy, 392 B.R. 408 (Bankr. E.D. Ark. 2008).
A creditor stayed from exercising a valid setoff right must be granted "adequate protection" (see 11 U.S.C. § 361) against any diminution in the value of its interest caused by the debtor's use of the creditor's property. Ealy, 392 B.R. at 414.
Setoff is expressly prohibited by section 553 if: (i) the creditor's claim against the debtor is disallowed; (ii) the creditor acquires its claim from an entity other than the debtor either (a) after the bankruptcy filing date or (b) after 90 days before the petition date while the debtor was insolvent (with certain exceptions); or (iii) the debt owed to the debtor was incurred by the creditor (a) after 90 days before the petition date, (b) while the debtor was insolvent, and (c) for the purpose of asserting a right of setoff, except for setoff under "safe-harbored" financial contracts. See 11 U.S.C. § 553(a)(1)–(3).
Section 553(b) provides that, except for setoffs under safe-harbored financial contracts, the trustee or a chapter 11 debtor-in-possession may recover any amount offset by a non-debtor on or within 90 days before the bankruptcy petition date to the extent the non-debtor improved its position by reducing any "insufficiency."
Thus, for a creditor to be able to exercise a setoff right in bankruptcy, section 553 requires on its face that: (i) the creditor have a right of setoff under applicable non-bankruptcy law; (ii) the debt and the claim are "mutual"; (iii) both the debt and the claim arose prepetition; and (iv) the setoff does not fall within one of the three prohibited categories specified in the provision.
The Bankruptcy Code does not define the term "mutual debt." Debts are generally considered mutual when they are due to and from the same persons or entities in the same capacity, but there is some confusion among the courts on this point. See In re Am. Home Mortg. Holdings, Inc., 501 B.R. 44, 56 (Bankr. D. Del. 2013); see generally Collier at ¶ 553.03[3][a] (citing cases).
Creditors typically rely on the remedy of setoff if the mutual debts arise from separate transactions, although the issue is murky. See Collier at ¶ 553.10. By contrast, if mutual debts arise from the same transaction, the creditor may have a right of "recoupment," which has been defined as "a deduction from a money claim through a process whereby cross demands arising out of the same transaction are allowed to compensate one another and the balance only to be recovered." Westinghouse Credit Corp. v. D'Urso, 278 F.3d 138, 146 (2d Cir. 2002); accord Newbery Corp. v. Fireman's Fund Ins. Co., 95 F.3d 1392, 1399 (9th Cir. 1996); In re Matamoros, 605 B.R. 600, 610 (Bankr. S.D.N.Y. 2019) ("recoupment is in the nature of a defense and arises only out of cross demands that stem from the same transaction").
Unlike setoff, recoupment is not subject to the automatic stay (see In re Ditech Holding Corp., 606 B.R. 544, 600 (Bankr. S.D.N.Y. 2019)), and may involve both pre- and postpetition obligations. See Sims v. U.S. Dep't of Health and Human Services (In re TLC Hosps., Inc.), 224 F.3d 1008, 1011 (9th Cir. 2000) (citing Collier at ¶ 553.10).
Even though section 553 expressly refers to prepetition mutual debts and claims, many courts have held that mutual postpetition obligations may also be offset. See Zions First Nat'l Bank, N.A. v. Christiansen Bros., Inc. (In re Davidson Lumber Sales, Inc.), 66 F.3d 1560 (10th Cir. 1995); Official Comm. of Unsecured Creditors of Quantum Foods, LLC v. Tyson Foods, Inc. (In re Quantum Foods, LLC), 554 B.R. 729 (Bankr. D. Del. 2016).
However, setoff is available in bankruptcy only "when the opposing obligations arise on the same side of the … bankruptcy petition date." Pa. State Employees' Ret. Sys. v. Thomas (In re Thomas), 529 B.R. 628, 637 n.2 (Bankr. W.D. Pa. 2015); accord Pereira v. Urthbox Inc. (In re Try the World, Inc.), 2023 WL 5537564, at *13 (Bankr. S.D.N.Y. Aug. 28, 2023) (noting that "claims are not in the same right and between the same parties, standing in the same capacity" where the claims underlying an alleged setoff right accrued prepetition and the "liability for the fraudulent-transfer claim is held by the Trustee as a postpetition obligation") (internal quotation marks and citations omitted); In re Williams, 2018 WL 3559098, at *3 (Bankr. D.N.M. July 23, 2018) (section 553 does not permit a creditor to collect a prepetition debt by withholding payment of a postpetition debt owed to the debtor); In re Enright, 2015 WL 4875483, at *3 (Bankr. D.N.J. Aug. 13, 2015) (same); Kramer v. Sooklall (In re Singh), 434 B.R. 298, 308 (Bankr. E.D.N.Y. 2010) ("It is well established that a party will be unable to assert a setoff where the party is being sued for fraudulent transfers … because … there is no mutuality of obligations … "); In re Passafiume, 242 B.R. 630, 633 (Bankr. W.D. Ky. 1999) ("Claims which arise post-petition lack the requisite mutuality, even if they arise with regard to work performed pre-petition.").
Stockbroker Liquidations Under SIPA
Congress enacted the Securities Investor Protection Act, 15 U.S.C. §§ 78aaa et seq. ("SIPA"), in 1970 to deal with a crisis in customer and investor confidence and the prospect that capital markets might fail altogether after overexpansion in the securities brokerage industry led to a wave of failed brokers. The law was substantially revamped in 1978 in conjunction with the enactment of the Bankruptcy Code.
A SIPA proceeding is commenced when the Securities Investor Protection Corporation ("SIPC") files an application for a protective decree regarding one of its member broker-dealers in a federal district court. If the district court issues the decree, it appoints a trustee to oversee the broker-dealer's liquidation and refers the case to the bankruptcy court.
Thereafter, the bankruptcy court presides over the SIPA case, and the case proceeds very much like a chapter 7 liquidation, with certain exceptions. SIPA expressly provides that "[t]o the extent consistent with the provisions of this chapter, a liquidation proceeding shall be conducted in accordance with, and as though it were being conducted under chapters 1, 3, and 5 and subchapters I and II of chapter 7 of [the Bankruptcy Code]." SIPA § 78fff(b).
SIPA affords limited financial protection to the customers of registered broker-dealers. SIPC advances funds to the SIPA trustee as necessary to satisfy customer claims but limits them to $500,000 per customer, of which no more than $250,000 may be based on a customer claim for cash. SIPC is subrogated to customer claims paid to the extent of such advances. Those advances are repaid from funds in the general estate prior to payments on account of general unsecured claims.
The SIPA trustee has substantially all of a bankruptcy trustee's powers, including the avoidance powers. Thus, if property in the customer estate is not sufficient to pay customer net equity claims in full, "the [SIPA] trustee may recover any property transferred by the debtor which, except for such transfer, would have been customer property if and to the extent that such transfer is voidable or void under the provisions of [the Bankruptcy Code]." SIPA § 78fff-2(c)(3). However, neither a SIPA trustee nor a bankruptcy trustee may avoid certain transfers made by, to, or for the benefit of stockbrokers, repurchase agreement participants, swap agreement participants, and certain other entities, unless the transfer was made with actual intent to hinder, delay, or defraud creditors in accordance with section 548(a)(1)(A). See 11 U.S.C. §§ 546(e), (f), and (g).
Madoff
Bernard L. Madoff Investment Securities LLC ("MIS") was the brokerage firm that carried out Bernard Madoff's infamous Ponzi scheme by collecting customer funds that it never invested and making distributions of principal and fictitious "profits" to old customers with funds it received from new customers. After the scheme collapsed in December 2008, the U.S. District Court for the Southern District of New York issued a protective decree for MIS under SIPA.
Because the customer property held by MIS was inadequate to pay customer net equity claims, the SIPA trustee sought to recover funds that would have been customer property had MIS not transferred them to others. Certain customers had "net equity" claims, because they had withdrawn less than the full amount of their investments from their MIS accounts before entry of the protective decree. Other customers had no net equity claims, because they withdrew more money from their accounts than they had deposited. These customers received not only a return of their principal investment but also fictitious "profits" that were actually other customers' money.
In 2010, the SIPA trustee commenced hundreds of adversary proceedings in the bankruptcy court against former MIS customers and third parties seeking, among other things, to avoid and recover many payments as actual and constructive fraudulent transfers under federal law (see SIPA § 78fff-2(c)(3); 11 U.S.C. §§ 548(a)(1)(A) and 548(a)(1)(B)) as well as state fraudulent transfer laws (as made applicable in a SIPA proceeding under SIPA § 78fff-2(c)(3) and section 544 of the Bankruptcy Code).
That litigation included an adversary proceeding against ABN AMRO Bank N.V. (presently known as Royal Bank of Scotland, N.V.) ("AMRO"), a Dutch financial institution that maintained offices in the United States. The proceeding sought to recover pursuant to sections 105(a) and 550(a) of the Bankruptcy Code approximately $308 million that AMRO received as a "subsequent transferee" from two "feeder funds" that invested with MIS in accordance with 2006 and 2008 swap agreements between AMRO and the feeder funds as well as related transactions. The SIPA trustee alleged that the payments were made with the actual intent to defraud MIS's customers and creditors and could therefore be recovered from AMRO as a subsequent transferee.
The AMRO adversary proceeding was dismissed, together with avoidance litigation involving hundreds of other defendants, after the U.S. District Court for the Southern District of New York held on April 28, 2014, that: (i) contrary to normal practice, a SIPA trustee bears the burden of pleading the affirmative defense of lack of good faith in connection with litigation seeking to recover a fraudulent transfer from a subsequent transferee under section 550(a)(2); and (ii) because SIPA is part of federal securities law, the trustee must plead the "willful blindness" standard applied to some securities law claims. That standard requires "a showing that the defendant acted with willful blindness to the truth, that is, he intentionally chose to blind himself to the red flags that suggest a high probability of fraud," rather than the "inquiry notice" standard, "under which a transferee may be found to lack good faith when the information the transferee learned would have caused a reasonable person in the transferee's position to investigate the matter further." Sec. Inv. Prot. Corp. v. Bernard L. Madoff Inv. Sec. LLC, 516 B.R. 18, 21 (S.D.N.Y. 2014) (citations and internal quotation marks omitted), vacated and remanded sub nom. In re Bernard L. Madoff Investment Securities LLC, 12 F.4th 171 (2d Cir. 2021), cert. denied, No. 21-1059 (U.S. Feb. 28, 2022).
On August 31, 2021, however, the U.S. Court of Appeals for the Second Circuit reversed the 2014 district court decision, ruling that: (i) "inquiry notice," rather than "willful blindness," is the proper standard for pleading a lack of good faith in fraudulent transfer actions commenced as part of a SIPA stockbroker liquidation case; and (ii) the defendants, rather than the SIPA trustee, bear the burden of pleading on the issue of good faith under section 550 of the Bankruptcy Code. See In re Bernard L. Madoff Investment Securities LLC, 12 F.4th 171 (2d Cir. 2021), cert. denied, No. 21-1059 (U.S. Feb. 28, 2022). The decision, which involved test cases for approximately 90 dismissed actions, breathed new life into avoidance litigation seeking recovery of $3.75 billion from global financial institutions, hedge funds, and other participants in the global financial markets.
Pursuant to a stipulated order dated November 12, 2021, the bankruptcy court, in accordance with the Second Circuit's August 2021 decision, reopened the AMRO adversary proceeding and vacated its order dismissing the proceeding.
On March 22, 2022, the SIPA trustee filed a motion for leave to amend his complaint against AMRO, which opposed the motion on the grounds of futility and moved to dismiss.
The bankruptcy court denied AMRO's motion to dismiss on March 3, 2023. Among other things, the bankruptcy court concluded that the trustee's amended complaint adequately pleaded a cause of action for recovery of a fraudulent transfer under section 550.
AMRO filed an answer to the trustee's complaint in which it denied most of the substantive allegations and asserted 34 affirmative defenses and two counterclaims against the SIPA trustee for unjust enrichment. The trustee moved to dismiss the counterclaims on July 17, 2023.
On August 24, 2023, AMRO moved to amend its answer to assert eight additional affirmative defenses and supplement its counterclaims, arguing that the trustee would not be prejudiced by the proposed amendments. The SIPA trustee opposed the motion insofar as it sought leave to amend two affirmative defenses (numbers 31 and 42) alleging that AMRO was entitled to the affirmative defenses of setoff, recoupment, and unjust enrichment. In the alternative, the trustee asked the court to hold the proposed amendments in abeyance until the court resolved the trustee's motion to dismiss the amended counterclaims.
The Bankruptcy Court's Ruling
The bankruptcy court denied AMRO's motion to amend its answer in part and granted it in part.
U.S. Bankruptcy Judge Cecilia G. Morris explained that a court will deny a motion to amend a pleading if the proposed amendment is futile because "the proposed amendments would fail to cure prior deficiencies or to state a claim under Rule 12(b)(6) of the Federal Rules of Civil Procedure." Madoff, 654 B.R. at 233 (quoting Panther Partners Inc. v. Ikanos Commc'ns, Inc., 681 F.3d 114, 119 (2d Cir. 2012)). According to Judge Morris, AMRO's motion to amend its affirmative defenses to assert claims of setoff and unjust enrichment must be denied on the basis of futility, but it was premature to deny AMRO's request to amend its recoupment affirmative defense.
First, Judge Morris noted that a defendant in fraudulent transfer litigation in bankruptcy cannot assert a right of setoff because the required mutuality between the potential avoidance liability and the defendant's prepetition claim against the debtor is absent. Id. at 234 (citing Try the World, 2023 WL 5537564, at *13; Singh, 434 B.R. at 308). In this case, she explained, AMRO did not dispute that the claim upon which its alleged setoff right was based arose prepetition in connection with its investments in the Madoff feeder funds. Having concluded that there was no mutuality, the bankruptcy court accordingly denied AMRO's motion to amend its affirmative setoff defense.
Next, the bankruptcy court concluded that allowing AMRO to amend its recoupment affirmative defense might similarly be futile because AMRO did not allege that there was a "single unified transaction" involved in the 2006 and 2008 swap agreements between AMRO and the Madoff feeder funds. According to Judge Morris, for there to be a single unified transaction—and therefore a recoupment right under non-bankruptcy law—the opposing claims must "result from a set of reciprocal contractual obligations from the same set of facts." Id. at 235 (quoting Pereira v. Equitable Life Ins. Soc'y of the U.S. (In re Trace Int'l Holdings, Inc.), 289 B.R. 548, 562 (Bankr. S.D.N.Y. 2003)). However, because the availability of a recoupment defense depends in part on the equities of the case, which had not been adequately developed at this stage of the litigation, the bankruptcy court allowed AMRO to amend its recoupment affirmative defense.
Finally, the bankruptcy court denied AMRO's motion to amend its unjust enrichment affirmative defense. Judge Morris explained that, to state a claim for unjust enrichment under New York law, a plaintiff must plead that the defendant was enriched at the plaintiff's expense and that "equity and good conscience require the plaintiff to recover the enrichment from the defendant." Id. at 236 (quoting Moshik Nadav Typography LLC v. Banana Republic, LLC, 2021 WL 2403724, at *2 (S.D.N.Y. June 10, 2021)). However, she noted, unjust enrichment is typically asserted as a claim, rather than a defense. Moreover, Judge Morris emphasized, the enforcement of an unjust enrichment claim in bankruptcy could "wreak … havoc" on the Bankruptcy Code's priority scheme by allowing "a separate allocation mechanism" favoring a single creditor in the form of a constructive trust as a remedy for unjust enrichment. Id. at 237 (quoting In re Commodore Bus. Machs., Inc., 180 B.R. 72, 83 (Bankr. S.D.N.Y. 1995)).
According to the bankruptcy court:
There is nothing inequitable, in bad conscience, or unjust in allowing the Trustee to proceed in marshalling and preserving the assets of the estate. [AMRO] has not presented a substantial reason to do so and risk[s] disrupting the priority system ordained by the Bankruptcy Code. The Court will not allow [AMRO] to amend the affirmative defenses in so far as [it] seek[s] to add a defense of unjust enrichment.
Id. at 238.
Outlook
Madoff represents one of the latest chapters in the protracted saga regarding the Madoff Ponzi scheme and the SIPA trustee's more than decade-long efforts to recover customer funds transferred to various parties as part of the fraudulent enterprise. Key takeaways from the ruling include: (i) a trustee's claim arising from a prepetition fraudulent transfer involving the debtor is considered a postpetition claim of an entity other than the debtor such that a defendant cannot offset that liability against a prepetition claim the creditor asserts against the debtor because the claims lack the required mutuality; (ii) depending on the specific facts and equities of the case, recoupment may be asserted as an affirmative defense in avoidance litigation; and (iii) unjust enrichment cannot ordinarily be raised as an affirmative defense and is particularly disfavored in bankruptcy because it undermines the Bankruptcy Code's priority scheme.
As a postscript, shortly after the bankruptcy court handed down its decision in Madoff, AMRO voluntarily dismissed its counterclaims—thereby resolving the trustee's pending motion to dismiss—noting that, in light of the court's decision, the counterclaims, which mirror AMRO's affirmative defenses, are no longer necessary. Even so, with the bankruptcy court's permission to amend AMRO's affirmative defenses other than setoff and unjust enrichment, the litigation would appear far from over.
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