Wednesday, January 10, 2018

Litigation "Good Faith" and Use of an Expert in Fraudulent Transfer Actions

By Bill Siegel

Picard v. Merkin (In re Bernard L. Madoff Investment Securities LLC), 09-1182 (Bankr. S.D.N.Y. Dec. 22, 2017) (the “Merkin Adversary”)

In the “clawback” lawsuits filed by the Trustee in the Madoff bankruptcy, the rule of law has been that investors can retain their principal investments, but must refund any fictitious profits.  However, even if investors were repaid their principal, they could face further scrutiny if the Trustee attempts to show that the investors lacked good faith under Section 546(c) of the Bankruptcy Code by ignoring the high probability of fraud.

In the Merkin Adversary, the Trustee argued that the even though the Defendant “feeder fund” had only been paid back a portion of its principal investment, the court inquired as to whether the Defendant’s fund managers lacked good faith, which the Judge termed “willful blindness,” as to whether they had reason to know that Madoff was operating a Ponzi scheme,  In determining whether “willful blindness existed, the Judge stated there were two prongs: “(1) the defendant must subjectively believe that there is a high probability that a fact exists, and (2) the defendant must take deliberate actions to avoid learning of that fact.” Picard v. Merkin (In re Bernard L. Madoff Investment Securities LLC), 09-1182 at 4 (Bankr. S.D.N.Y. Dec. 22, 2017).  

Here, the Judge noted that there were facts that gave rise to a question as to whether or not the Defendants lacked good faith due to their “willful blindness.”  This was especially true in light of the professional experience of Defendant’s fund managers.

Both sides retained experts to testify on the “good faith” defense.  Both sides moved to strike the other side’s expert opinions.  The Judge first examined Rule 702 of the Federal Rules of Evidence, regarding the admissibility of expert testimony:

A witness who is qualified as an expert by knowledge, skill, experience, training, or education may testify in the form of an opinion or otherwise if:

(a)     the expert’s scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue;

(b) the testimony is based on sufficient facts or data;

(c) the testimony is the product of reliable principles and methods; and

(d) the expert has reliably applied the principles and methods to the facts of the case.

FED. R. EVID. 702.

In summary, the Judge admitted the Trustee’s expert’s report and allowed the expert to testify as to the second prong in terms of what the fund manager should have done based on facts that it either knew or should have known.  In other words, the Trustee’s expert opined that the Defendant turned a “blind eye” to the returns it was receiving from Madoff and lacked good faith by failing to investigate the Madoff scheme. Id. at 15.

As for Defendant’s expert, the Judge struck the expert’s opinion, regarding what a fund manager would have discovered had there been appropriate due diligence, as being mere speculation and immaterial related to the first prong, i.e. whether there was sufficient subjective belief that Madoff was operating a Ponzi scheme. Id. at 18-19.  The Judge further struck the Defendant’s expert’s report  related to the second prong finding that it was a conclusory opinion on what constituted appropriate due diligence without any kind of analysis or discussion of methodology.  Id. at 19.

In conclusion, when faced with a good faith challenge in a fraudulent transfer matter, be it a Ponzi scheme or not, the focus will be on whether the transferee turned a “blind eye.”  In this regard,  if experts are retained, the experts may very well focus on the second prong in terms of what the transferee knew or should have known based on the facts and relative expertise of the transferee.  

So, what does a transferee do if there is reason to believe that a fraudulent transfer has been received: refuse to accept the transfer or give it back?  When faced with this situation, plan and document your due diligence in anticipation of potential litigation.

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