April 30. 2012 9:00AM

Madoff case produces more legal fallout

By Bruce Arnold and Patrick M. Harvey


A new method of attempting to recover funds from failed investments has begun to creep into fund litigation. This is a troublesome development for innocent investors.

In cases where fraud has been proven — such as in the Bernie Madoff and In re Bayou litigation — receivers are adopting a particularly aggressive tact. Court-appointed receivers are now attempting to recoup payments that represent innocent investors’ principal — even if those payments were made months or years before the fund showed public signs of trouble.

The typical situation involves an investor redeeming his principal investment before the investment fund’s fraud was ever discovered or made public. Months or even years later, the fund’s fraud is discovered, made public and a receiver is appointed by a court to control the fund’s assets. The receiver then seeks to clawback that redeemed principal so as to distribute it among all remaining investors. Receivers argue that this pro-rata distribution is more equitable.

Traditional theory of recovery

Traditionally, receivers were able to clawback “profits” that had been paid to investors before the company’s fraud was discovered or disclosed. For example, an investor invests $1 million in an investment instrument. Over the course of the next year, the account gains $100,000 in profits on the initial $1 million investment. The investor then exercises his contractual right to redeem the full account value, $1.1 million, and ends his relationship with the fund. A year later, investigators learn that the fund was involved in fraudulent activity, and the fund’s gains were not actually gains. A court would then appoint a receiver, and under the traditional theory of recovery, the receiver might attempt to clawback the $100,000 in profits that the investor received.

As long as the receiver was only attempting to clawback the $100,000 in profits, the receiver did not need to prove that the investor had participated in the fraud. The theory was that this made sense on both backward- and forward-looking policy grounds. Looking back, clawing back profits enlarged the estate, which would eventually benefit investors who had lost their principal due to the investment fund’s fraudulent activity. Moreover, the theory went, clawing back only profits did not particularly injure the investor from whom it was taken, because that investor was arguably made whole when his principal was returned.

From a forward-looking standpoint, this standard encouraged openness and candor from investors who perceived potential fraud. If an investor became suspicious, the investor could simply withdraw his investment and report the possible fraud. At that point, the theory went, leaving aside the lost time value of money, the investor had not lost anything but possible “ill-gotten” gains, some of which might have been returned anyway through the receivership estate.

New cases

Three recent examples demonstrate a new, aggressive approach. In Madoff, Janvey (R. Allen Stanford), and In re Bayou, the receivers brought clawback claims for the investors’ principal, in addition to their net profits. While Madoff, Janvey, and In re Bayou are ongoing, they may signal a shift in courts’ willingness to allow receivers to pursue clawback claims for principal investments. This is a troubling development for investors who have withdrawn principal before the fraud was discovered or disclosed.

Importantly, In re Bayou suggested that even innocent investors may have a duty to investigate a possible — albeit undiscovered — fraud before withdrawing their principal.

For the innocent investor wanting to withdraw his investment in an underperforming fund, this raises questions about what the investor can do to keep the withdrawal safe from clawback actions. In In re Bayou, the district court questioned the wisdom of the bankruptcy court’s decision, and granted the investors a new trial regarding their principal. The district court reasoned that the bankruptcy court’s standard left investors who held suspicions as to the hedge fund’s possible fraud in a no-win situation. They could either: (a) invest personal resources in exposing fraud, thereby prohibiting their own recovery if fraud were found; or (b) try to redeem their investment as quickly as possible, thereby opening themselves up to a clawback action.

Neither option is particularly favorable for investors, nor does either serve the public policy interests that support investments. And yet, the district court still allowed the receiver to take the case to a jury trial, causing the investors to incur substantial legal fees that would never be recouped.

Given the recent recession, the number of failed investment instruments has exploded. Most of these failures are by funds that have engaged in no fraud, but simply failed for purely economic reasons. With the increase of these failures, however, it is likely that there will be an increase in fraud allegations.

As investors’ principals disappear in failing investments, “losing” investors might attempt to use fraud allegations as a pathway toward recovering a greater amount of principal than they could expect in a traditional distribution. Without a “loser pays” system of litigation, the mere threat of an expensive, unmeritorious lawsuit may be enough to force even innocent investors into settling. And if courts are increasingly open to allowing receivers to clawback withdrawn investors’ principal, that will only incentivize accusations of fraud from those who will not be made whole in a traditional proceeding.

Of course, there are legal strategies to defend against these new tactics, but with all of the uncertainty, early legal advice is crucial.

Bruce Arnold is managing director and Patrick M. Harvey is an attorney at Whyte Hirschboeck Dudek in Milwaukee.