Kathy Bazoian Phelps
Senior Counsel in Ponzi Scheme Litigation
and Bankruptcy Matters

Kathy is a senior business trial attorney with more than 30 years experience prosecuting and defending claims for high net worth clients involved in Ponzi scheme matters and in bankruptcy proceedings. Kathy’s practice includes recovering assets for clients in complex fraud cases under standard fee and alternative fee arrangements. She also handles SEC and CFTC whistleblower claims. Kathy also serves as a mediator in bankruptcy matters, in complex business disputes, and in matters requiring detailed knowledge about fraud or Ponzi schemes.

Kathy’s Clients in Ponzi Scheme Cases and Bankruptcy Matters
Equity Receivers
Bankruptcy Trustees
High Net Worth Investors
Debtors in Bankruptcy
Secured and Unsecured Creditors

Wednesday, April 4, 2012

Ponzi Victims Pitted Against Each Other: Madoff Trustee v. California Attorney General

Posted by Kathy Bazoian Phelps

“An under-appreciated evil of substantial frauds . . . is how they pit their victims against one another.”  United States v. Dreier, 682 F. Supp. 2d 417, 418 (S.D.N.Y. 2010).

In the typical Ponzi case, some victims may employ strategies to seek advantage over other victims. These may include asserting: (1) equitable claims such as constructive trust to take the entirety of an asset rather than a pro rata share; (2) restitution claims in forfeiture proceedings; (3) a variety of legal claims to recover damages on theories such as breach of fiduciary duty or aiding and abetting against insiders and professionals; (4) the good faith defense to clawback suits in an effort to hold on to money already paid; and (5) in equity receivership actions, a more advantageous distribution scheme to one category of creditors over another.

Now, however, the Attorney General of California, Kamala D. Harris, has found a new and creative way to seek an advantage for some of Madoff’s victims. Not surprisingly, the victims for whom she seeks an advantage are her constituents in California. She filed a civil enforcement action against Stanley Chais and his probate estate in the California Superior Court in Los Angeles, seeking restitution and damages of $270 million. Chais ran a major feeder fund for Madoff which she contends violated state securities laws. Her amended complaint is available here.

At the same time, for the benefit of Madoff’s customers, Irving Picard, the trustee of Bernard L. Madoff Investment Securities, LLC, has a clawback suit against the estate of Chais pending in the bankruptcy court in New York. Picard contends that Chais acquired all of his assets through fraudulent transfers from Madoff. Picard’s complaint against the Chais defendants is here.

And so Harris and Picard are competing for the same assets – Chais’s assets – and it’s hundreds of millions of dollars. Who will win?

This high-stakes issue is squarely presented to the bankruptcy court in New York in a suit that Picard recently filed against Harris. Picard contends that Harris’s suit in Los Angeles violates the automatic stay of bankruptcy, and he has requested a preliminary injunction to enforce the stay. Harris has filed a forceful opposition. As of this writing, the motion has not yet been set for hearing. Picard’s complaint against Harris is here and his motion for a preliminary injunction is here. Harris’s opposition is here.

Picard’s brief in support of his motion for a preliminary injunction argues:

· The bankruptcy court in New York has subject matter jurisdiction over Harris’s claim.
· Because of the nature of Picard’s requested relief to preserve and protect property of the Madoff estate, Harris cannot raise a sovereign immunity defense and the court can enter an injunction against her action.
· Her action violates the stay of 11 U.S.C. § 362(a).
· Her action is a disguised fraudulent transfer action that violates § 362(a)(1).
· Her action seeks to obtain customer property in violation of § 362(a)(3).
· Her action is not excepted from the automatic stay by the police and regulatory power exception in § 362(b)(4).
· Her action seeks to recover on the trustee’s claim in violation of § 362(a)(6).
· The court should stay the Harris’s action under § 105 to allow for the fair and equitable administration of the bankruptcy estate.
· The injunction would avoid unnecessary proceedings because if Harris were to prevail in her action, the trustee will in any event pursue any transfers of customer property from the Chais defendants to the subsequent transferees.

In her brief in opposition, Harris argues:

· The automatic stay does not apply to an enforcement action against a non-debtor like Chais.
· Her enforcement action does not seek to recover a claim against the debtor and thus is not barred by § 362(a)(1) or (6).
· Her action does not seek or seek to control property of the estate or customer property and thus is not barred by § 362(a)(3).
· There is no justification to extend the stay under § 105.
· Her action is excepted from the stay by § 362(b)(4), the police and regulatory power exception.
· Because of that exception, the trustee is not entitled to a stay under § 105.

The tough question that Picard will have to answer is why he should be permitted to block the victims of Chais’s fraud from collecting against his probate estate while at the same time refusing under SIPA to recognize the claims of those very victims who invested, not directly with Madoff, but instead in feeder funds like that of Chais. Picard previously argued, and the bankruptcy and district courts held, that investors in Madoff’s feeder funds do not qualify as “customers” under SIPA. SIPC v. Bernard L. Madoff Investment Securities, LLC, 454 B.R. 285 (Bankr. S.D.N.Y. 2011), aff’d sub nom. Aozora Bank Ltd. v. SIPC, 2011 U.S. Dist. LEXIS 150753 (S.D.N.Y. Jan. 4, 2012).

The tough questions that Harris will have to answer are the slippery slope questions: If a state enacts a law making failure to pay a debt illegal, with enforcement by the state’s attorney general, would § 362(b)(4) except such an “enforcement” action from the automatic stay? And if that action is not excepted from the stay because it is only an attempt to collect a debt, how is her present enforcement action any different?  Also, what if every state attorney general filed a similar action against Chais’s probate estate?

This litigation is immensely important to Madoff’s victims because of its potential impact on how Chais’s assets will be distributed. We will watch it closely and continue to report on it for you. In The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes, automatic stay issues are addressed in §§13.02[2][f] and 20.06[5] and issues of competing victims’ claims are addressed in § 16.07.

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