At this year’s Heckerling conference in Florida one of the speakers asked a conference room of (I’d guess) over a thousand trusts-and-estates attorneys/CPAs from across the country how many of them had clients affected by the Madoff scandal: easily 9 out of 10 raised their hands. The breadth and scope of this scandal is truly amazing.
As you might expect there was a good deal of discussion regarding what trustees and other fiduciaries (our clients) need to be thinking about if they’re unlucky enough to be administering trusts or estates that invested with Madoff. Here are a few of the highlights:
[1.] For those trustees and other fiduciary investors who cashed out before the fraud was detected . . . you’re not out of the woods yet. Think "claw back".
As reported in an excellent on-line piece by the law firm K&L Gates entitled The Madoff Dissolution: A Consideration of the Bayou Precedent and Possible Next Steps, in Ponzi-scheme cases such as Madoff’s courts have regularly held that each individual redemption payment made to an investor who cashed out before the scheme is discovered is presumptively a fraudulent transfer. Based on this fraudulent-transfer theory courts can compel investors to pay back funds received from the Ponzi scheme unless they can affirmatively show that they received the funds in good faith and for value.
Citing to a similar case, the Bayou matter, presided over by the very same NY judge presiding over the Madoff case, the linked-to K&L Gate piece gave us a glimpse of what Madoff investors can look forward to:
In 2006, Bayou’s court-appointed receiver brought over 130 fraudulent transfer adversary proceedings against Bayou investors that had redeemed fictitious profit and principal within two years of Bayou’s bankruptcy filing. Later in 2008, the Bayou receiver brought New York state law claims against persons redeeming up to six years before the bankruptcy filing. In a series of rulings, the court held that redemption payments from a Ponzi scheme presumptively satisfied the “actual fraud” prong of the fraudulent transfer standard and that the “good faith” affirmative defense requires an objective test of whether a reasonable and prudent investor should have been on inquiry notice of the fraud, and, if on inquiry notice, the redeemer was diligent in its investigation.[11] In addition, the court ruled as a matter of law that redemption payments received by investors in excess of their original principal based on artificially inflated results, or so-called “fictitious profits,” were required to be refunded to the estate, regardless of the redeemer’s good faith.[12] Moreover, the court held that a redeeming investor cannot utilize the good faith affirmative defense unless it can show it conducted a diligent investigation of each potential problem or red flag.[13]
As a result of these rulings, all of the investors in the Bayou matter who redeemed their investments within the six-year clawback period were ordered to return fictitious profits and may be required to pay pre-judgment interest on those profits. Over 90 redeemers have settled with the estate for the return of false profits and a portion of their principal. In addition, the court has ordered several dozen investors to refund all of their principal. The court upheld the good faith defenses of a small number of redeemers, and ordered trial of a handful more cases. To date, the Bayou receiver has recovered through settlement and legal rulings approximately $68 million, with an anticipated litigation recovery for creditors of the Bayou estate, net of expenses, of between 15 and 20 cents per dollar.
For those of you looking to drill down into this issue a good starting place would be the two Bayou opinions cited in the K&L Gates piece: In re Bayou Group, LLC, 362 B.R. 624 (Bankr. S.D.N.Y. 2007) and In re Bayou Group, LLC, 396 B.R. 810, *__ (Bankr. S.D.N.Y. 2008).
[2.] What tax issues should you be thinking about?
From an income-tax perspective, the consensus seems to be that Madoff investors need to focus on (1) entitlement to a theft loss deduction under IRC § 165 and (2) the ability to file amended returns seeking refunds for taxes paid on phantom income reported from the Madoff firm. These issues are summarized nicely in an on-line piece published by the Gibbons law firm entitled Federal Income Tax Treatment of Investment Losses From L’Affaire Madoff.
Warning: make sure your clients don’t forfeit claiming a refund for taxes paid on 2005 phantom income. Here’s how this point was summarized in an on-line piece published by the Gibbons law firm:
For most taxpayers, the current open years are 2005, 2006, and 2007. A taxpayer will need to file an amended return for 2005 by April 15, 2009 if the taxpayer filed the 2005 return on or before April 15, 2006. If a taxpayer obtained an extension for filing until October 15, 2006, the taxpayer will have three years from the date of filing in 2006 to file the amended return.
By filing an amended return, the taxpayer implicitly reduces its adjusted basis by the amount of the reduction in reported income. This reduction will also reduce the overall amount of the theft loss deduction.
For a comprehensive list of on-line sources addressing the tax fallout from the Madoff case go to More Tax Planning for Madoff Victims on the Tax Prof Blog.