If You Made Money Off Madoff, Good Luck Keeping It: Ann Woolner
If You Made Money Off Madoff, Good Luck Keeping It: Ann Woolner

Commentary by Ann Woolner

Jan. 2 (Bloomberg) -- Suspicious investors who removed their money from Bernard Madoff’s care before he pulled the bottom out from under his scheme have probably been congratulating themselves for their wisdom.

Even those who recouped their principal only to plunge it into the stock market and watch it sink now seem like winners. At least they’ve still got a remnant of the original sum.

That may not remain true for long. Now come court battles over who benefited from Madoff’s admitted fraud and who has dibs on whatever can be recovered.

In bankruptcy court and lawsuits, Madoff investors are about to be sorted out. The totally wiped-out loser is pitted against the pinched-but-not-punched victim, and they will both go after whoever escaped unscathed through those working to recover Madoff’s assets.

It’s going to get nasty, and not especially fair.

If it were fair, the wisest of investors, the ones who came to doubt the legitimacy of Madoff’s consistently good returns and got out, would be able to enjoy the fruits of their foresight.

Instead, depending on how suspicious they were, these are the investors most likely to be forced to cough up money to pay those less wary. At least, that’s the way the law has developed in bankruptcy court in Manhattan so far.

Investors who benefit from fraud, even if they knew nothing of any misdeeds, can be called on to return the fictitious earnings from their investments, even their principal if they redeemed it before the fraud was exposed.

Added to Assets

That money would be added to Madoff assets, to be divvied up among creditors, including the very same investors who had been forced to contribute to the pool.

“It’s the sharing-the-pain rule,” says Jay Westbrook, who teaches bankruptcy and commercial law at the University of Texas.

Those who withdrew from Madoff may have thought they got their own money back, but they were getting some other sucker’s money.

Assuming the receiver or trustee attempts to collect all he can, there is one way Madoff investors can avoid handing over that which they so wisely recouped.

They might be saved by proof of good faith.

That could be tricky, because in the federal district that covers Manhattan, good faith isn’t what you probably think.

Intent Doesn’t Count

It’s not enough that you committed no fraud and had no intention of profiting from anyone else’s fraud.

To lack good faith in this context, you don’t have to do anything “wrongful, improper or legally or ethically deplorable,” U.S. Bankruptcy Judge Adlai Hardin Jr. ruled in October in White Plains, New York.

Your spotless integrity is irrelevant if you withdrew from the fund because it smelled fishy to you. You read that right.

In Hardin’s Southern District of New York, if you pulled out because you began spotting red flags, that’s bad faith and you could be forced to bring that money back to the table.

Not fair? Hardin probably would agree.

“It would be quite reasonable for an investor to decide to redeem solely on the basis of the red flag,” Hardin wrote. Such investor “could not be criticized for doing so.”

Good-Faith Defense

“But if he does so, the courts have held that he cannot invoke the good-faith defense,” Hardin wrote. And without a good-faith defense, he has to fork over the money.

Good faith is you cashing out of the fund to buy a new yacht, to build a home in Palm Beach, because you have a new financial adviser with a different idea, or for any reason other than wariness over the honesty of the fund’s management.

Enjoy your yacht and pay those contractors.

But if you withdrew because of discomfort over, say, the fact that you never heard of the one-accountant firm in upstate New York that Madoff gave as its auditor, get a lawyer.

Hardin’s 95-page decision doesn’t specify exactly how suspicious the investor has to be or why to lose a good-faith defense. The Madoff case might decide that.

Hardin’s ruling stems from another fabled case, that of the Bayou Group of hedge funds. Bayou’s trustee is going after investors who had been snookered by the firm’s founder, Samuel Israel III, for about $400 million.

Suicide to Jump Bail

So far, the trustee has retrieved about $63.5 million from investors. (And Israel, sentenced to 20 years for the fraud, faked suicide to avoid prison and now is charged with jumping bail.)

Hardin’s ruling isn’t the final word. It’s likely to go up on appeal, although that will take a while.

“I don’t think the rules are at all settled,” says Westbrook.

Beyond measuring various investors’ good or bad faith, there is the question of what’s fair.

No one likes taking money from Ponzi victims, and some judges find ways around it. Westbrook says some use a “series of legal fictions” to say that whatever money you invested remained your money, so if you withdrew it, you can keep it.

“All of us can have nothing but profound sympathy for these folks,” he says. “It’s easy to say victims shouldn’t have to pay.”

It’s harder to say the pain should be shared evenly.

(Ann Woolner is a Bloomberg news columnist. The opinions expressed are her own.)

To contact the writer of this column: Ann Woolner in Atlanta at awoolner@bloomberg.net.

Last Updated: January 2, 2009 00:01 EST
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