We've been pretty quiet about Madoff on this blog, so I think it's time for a few words on the matter. I want to quickly recap two critical decisions in the case and then raise the issue of the alignment of incentives between the trustee and the Madoff victims.

The big issue in the Madoff bankruptcy is how much money the trustee, Irving Picard, will be able to claw back in to the estate under fraudulent transfer actions from net winners in the Ponzi scheme (and various aiders and abetters).  

Last September, Judge Rakoff made a major ruling in the Madoff case (Picard v. Katz, 462 B.R. 447 (SDNY 2011)). He ruled that the 546(e) settlement payment defense bars most actions by the Madoff estate's trustee, Irving Picard, unless actual fraud is alleged under 548(a)(1). If that ruling stands, then the trustee cannot pursue clawback actions using section 544 of the Code, which allows the trustee to use state frauduluent conveyance law.  The result is to deprive the trustee of the very favorable 6-year statute of limitations under the New York version of the Uniform Fraudulent Conveyance Act. Instead, the trustee is limited to pursuing "actual intent to hinder, delay, or defraud" actions under 548(a)(1), which have a 2-year statute of limitations. In other words, the ruling chops off 2/3s of the clawback period. The ruling is thus extremely favorable to net winners to the extent that their winnings were in three to six years before the bankruptcy.   

Judge Rakoff expanded that ruling last month in another important opinion that explains that the clawback can only be applied to net winners (on an all-in/all-out basis irrespective of time) and then only to the extent of their withdrawals in the two years pre-filing.  Rakoff, however, also held that the trustee had stated a sufficient case to survive a 12(b)(6) motion to dismiss on his 548(a)(1) claim. because the defendants' 548(c) good faith taker for value argument--namely that the payments were made to them in satisfaction of the debt Madoff, as a stockbroker, owed them based on holding their accounts--doesn't fly.  

While I have normative issues with the settlement payment defense being WAY too broad, it's pretty clear that Rakoff applied it correctly. The best argument for the trustee was that there were no settlement payments because there were no securities--everything was bogus--but as Rakoff rightly observed, there is a fraud exception built in to 546(e), and that's and only that is what the trustee can argue. Yet, it is kind of hard to square Judge Rakoff's rejection of the trustee's argument about 546(e) with his acceptance of the trustee's argument about 548(c). Yes, Judge Rakoff's ruling on 548(c) is consistent with general Ponzi scheme jurisprudence, but the inconsistency in the opinions about whether the formalities of the transactions will be respected (for 546(e) purposes) or disregarded (for 548(c) purposes) is noticeable. The result, though, is to split the baby and let the trustee pursue clawbacks, but only for a limited period and against a limited number of investors for a limited amount. Lots more that could be said about all of this, but I assume it is all going up to the 2d Circuit, which I would expect to confirm both rulings. 

(2) Trustees and Settlement.

The dynamics of the Madoff case raise some questions about the incentives of bankruptcy trustees. Before I proceed, I want to emphasize that I have no reason to think that the trustee in this case is acting in anything but good faith. Instead, I am making a more general point about the structure of trustee arrangements.

The trustee is ultimately operating the estate for the benefit of the claimants. Many of the Madoff claimants were counting on their investments for own retirements or for their business's pension plans. These tend to be claimants who need money now, rather than in five or ten years. They have immediate liquidity needs, so they are likely claimants who would settle for a smaller recovery sooner. This goes for net winners (who still come away with much less than they thought they had) and net losers. And net winners have the uncertainty of the clawbacks hanging over their heads making financial planning difficult. They don't know if they are looking at 2 or 6 years or if they are looking at clawbacks at all.

All of this suggests that many of the defendants (net winners) and economic plaintiffs (net losers) in the clawback litigations have real incentives to settle--or sell their claims (I'm not sure what the Madoff claim market looks like). The real plaintiffs in interest--the net losers--are not at the table, however. Instead, they have the trustee litigating and negotiating for them. 

This structure makes sense given the collective action problems involved, but only so long as the trustee's incentives align with the net loser's. They don't. The trustee does not have the liquidity pressures of Madoff net losers, which makes him less likely to cut deals and settle with the net winners, even if the net winners are willing to settle at a price that the net losers would take because of their liquidity discount.

There is some sort of personal reputational gain possible for the trustee that probably correlates roughly with the total dollar figure for recovery, but I don't think that's likely to be affecting things. More importantly, the trustee's law firm gets compensated before the victims as an administrative expense of the estate. I've got no quarrel with administrative expense priority--you gotta pay the grave digger--but the trustee's firm's compensation is not based on the recovery, but on hourly billing, which would seem to create a disincentive to reach quick settlement.

Two factors might mitigate against this. First, there is supposedly a 10% discount from the trustee. As far as I can tell that's a discount from an arbitrary price that is designed to make the trustee appear to be operating in the spirit of economy; I don't think of this as a pro bono case. Second, and more important, there is a further 20% holdback on fee payments (after the 10% discount) until the conclusion of the case. That means there is a time value discount on the heldback fees, which is tantamount to a further discount from face (but probably not a 20% discount from face).

All else equal, the holdback would seem to help align the trustee's interests with those of the victims. But a few factors might reduce the effectiveness of the holdback. First, I imagine that the trustee's law firm is charging more than would be charged if the services were put out for auction, so that premium might offset the 10% discount and the timevalue discount on the holdback. (And given that other legal services are auctioned, why not do this in bankruptcy for trustee's counsel...)  

Second, the holdback might be too large or too small to properly align incentives, although it might help optimize them, even if they remain suboptimal. And third, the trustee (or really his law firm) might be able to monetize the holdback now, say by borrowing against in on a non-recourse basis. While there would be a time value cost, that would easy any liquidity pressures created by the holdback. Borrowing against the holdback would raise some eyebrows (and I  have no reason to think it is occuring), but law firm finances (and litigation finance in particular) is really a black box.

In the end, we have a situation in which both the victims and the trustee are at least nominally time sensitive, but in which they also both have theoretical possibilities of monetizing delayed cashflows. As far as I can tell, however, there haven't been a lot of settlements in the case other than a few splashy big dollar ones like with the Wilpons. That makes me wonder if the trustee-victim incentives are properly aligned. There's no way to really test things, but I think the Madoff case provides a nice illustration of the role that liquidity demands can play in shaping bankruptcy cases.