Bernie Madoff's Frauds Continue To Reverberate Years Later

Seven years after Bernie Madoff was sentenced to 150 years in prison for frauds worth an estimated US$65 billion, the legal shockwaves from his disgraced empire continues to reverberate.  In a case that was recently decided by the Grand Court of the Cayman Islands, the court determined how the remaining value of a Cayman “feeder fund”, once part of the Madoff empire and now in official liquidation, should be distributed among its investors.

 

In this case, Herald and Primeo were open-ended investment funds.  They both placed funds for investment with a Madoff-related entity called BLMIS. 

 

In 2007, Primeo assigned the credit of its account with BLMIS to Herald in return for subscribing for shares in Herald.  The number of Herald shares provided to Primeo was based on the perceived value of Primeo’s account with BLMIS, which at that time was valued at US$466 million. 

 

In 2008, it was discovered that BLMIS was a Madoff run Ponzi scheme, with the consequence that every reported Net Asset Value (“NAV”) had been misstated, including the NAV used to calculate the value of Primeo’s consideration under its subscription with Herald. 

 

Herald was subsequently put into liquidation and its liquidator sought to determine how the remaining value in the fund should be distributed among its shareholders, including Primeo.  In particular, the liquidator was tasked with determining whether Primeo’s shareholding in Herald should be adjusted to reflect the fact that it had received a greater number of shares in Herald than it would have otherwise received if the actual value of its account with BLMIS had been known at the time of the subscription.  

The issues before the Cayman Court were:  (a) whether Herald’s share register should be rectified; and, (b) if so, on what basis should any rectification be performed.  

Under the applicable Cayman Islands Companies Law, the concept of rectification implied restoring the shareholder’s register to a position that accurately reflected the relative position of all shareholders as it would be if all subscriptions and redemptions had been transferred at a “true” NAV per share.  The court found that since every subscription and redemption of shares in Herald after the initial offering had occurred on the basis of a fraudulently misstated NAV, there could be no clearer case in which the power of the liquidator to rectify should be exercised.  The court held that any rectification needed to apply equally to all remaining shareholders.

 

There were several methods as to what basis rectification should be performed.  The liquidator submitted that the register should be rectified so that the net loss of subscription monies in Herald was borne rateably and that the remaining shareholders shared equitably in the pool of funds available for distribution. 

Two methods were proposed to achieve this:  (a) the net investment method – this method calculates each shareholder's economic interest on the basis of the amount of their total subscriptions, less any redemptions, as a percentage of the total surplus fund available for distribution; and  (b) the rising tide method – this method directly takes account of redemptions that have already been paid to investors in addition to the remaining value in the company.  It works by distributing remaining funds to shareholders according to the value each shareholder has already realized.

 

The Cayman Court found that both methods would create a result whereby Herald's shareholders would "share in the common misfortune of Madoff's fraud".  However, he concluded that the Companies Law prevented either method from being available.

Instead, the court held that the proper approach was to assign a constant “true” NAV for each and every subscription and redemption throughout Herald’s active life.  Since Herald’s NAV had been fraudulently misstated since its inception, the true NAV was held to be the initial offering price of the shares.  All NAVs after this date needed to be disregarded despite the value that may have actually been assigned (and paid) for shares at the time. 

 

The court directed the liquidator to recalculate each subscription and redemption of shares in Herald  at this constant “true” NAV and rectify the share register accordingly. 

Regards,

Blair

Court Appointed Receiver Liable to pay Substantial Indemnity Costs

Earlier this year ( June 9th ), I wrote about a case in which the Court of Appeal for Ontario set aside "breathtakingly broad" receivership orders that put in place an "investigative receivership".  This month, the court released its ruling on costs arising from its decision. See Akagi v. Synergy Group (2000) Inc. 2015 ONCA 771. 

 

On the appeal, the court  had set aside ex parte orders issued by Justice Colin Campbell of the Superior Court of Justice (Commercial List).  The court concluded that the orders appointing the receiver stood “on a fundamentally flawed premise” and were “unjustifiably overreaching in the powers they granted”. 

 

In the court’s view, both the judgment creditor, Mr. Akagi - who commenced the receivership proceedings without taking any initial steps to recover on his judgment - and the receiver, J.P. Graci and Associates Ltd., who took the investigative receivership too far, should bear the cost consequences of the orders having been set aside.

 

Mr. Akagi applied for the initial ex parte order appointing the receiver after obtaining a default judgment in the amount of approximately $147,000 based on allegations of fraud arising out of the loss of funds he had contributed to a tax program marketed and sold by the Synergy Group.  The program was supposed to generate tax loss allocations for him, but did not.  His judgment was against the Synergy Group and certain individuals associated with it.  The initial order made by Justice Campbell granted a receivership over all the assets and undertakings of the Synergy Group and an additional company, Integrated Business Concepts Inc. (“IBC”).   

 

It soon became clear however that the principal purpose of the receivership order was not to recover on Mr. Akagi’s judgment debt but to institute a broad ranging inquiry – a roving “investigative receivership” – into what was alleged to be a much larger tax fraud scheme, and to do so, purportedly on behalf of approximately 3,800 other investors who may have been caught in the tax scheme as well.  None of these investors were a party to the Akagi action or the receivership application, none purported to seek to have their interests protected, and Mr. Akagi and the receiver maintained throughout that they did not purport to represent the interests of those investors. 

 

Subsequently, through a series of further ex parte applications, the receivership order morphed into a wide ranging investigative receivership, freezing and otherwise reaching the assets of 43 additional individuals and entities including authorizing the registration of certificates of pending litigation against their properties.  Only three of these entities and individuals had any connection to the underlying Akagi action and only two were actually judgment debtors.

 

The Court of Appeal set aside the receivership orders on the basis that the receivership had proceeded on an entirely misguided course, the orders were impermissibly over-reaching, and the ex parte proceedings themselves had been tainted by certain procedural errors including the receiver's failure to disclose to Justice Campbell that the Canada Revenue Agency had discontinued its investigation into the tax allocation scheme several months before the receivership was sought when evidence of that inquiry had formed the basis for obtaining the orders.

 

All of the appellants, including IBC and Student Housing Canada Inc., sought their costs on a full or substantial indemnity basis against both Mr. Akagi and the receiver, jointly and severally. 

 

The receiver argued that no costs should be awarded against it because it was proceeding in good faith and simply carrying out what it understood to be its court-ordered mandate.  It’s conduct and activities pursuant to the receivership orders were approved by the court in two orders and the general rule is that a receiver is not exposed to costs against it personally in receivership proceedings.

 

Mr. Akagi argued that his involvement with the receivership had been limited solely to obtaining the initial receivership order and to defend that order throughout the receivership.  He argued against responsibility for costs incurred by the appellants subsequent to the initial order. 

 

The Court of Appeal did not accept that Mr. Akagi’s involvement in the receivership proceedings was minimal or limited to obtaining the initial order.  Mr. Akagi had tenaciously defended the subsequent ex parte orders.  Mr. Akagi’s counsel had attended and participated in various motions, scheduling appointments and examinations.  Mr. Akagi was a central participant on the appeal itself.  He instituted and supported the proceedings throughout.

 

As a result, the Court of Appeal found him responsible for costs. 

 

As for the receiver, the court held that it was also liable to pay costs.   The principle that costs are rarely awarded against the receiver applies only when the receiver is acting in his capacity as receiver in the course of the receivership.  It does not apply where the receiver turns itself into a real litigant, drawing others into the fray and forcing them to defend themselves in what amounted to a process that was extraneous to the creditor-driven receivership.

 

The court did not make a finding that the receiver acted in bad faith.  In its view however, the receiver had misconceived its role, and in the process had lost its objectivity in the notion that it was an investigative receiver.  Mr. Akagi’s claim was a relatively small one that did not justify or require the intrusive and far-reaching mareva like orders that were obtained.  In taking these steps, the receiver undermined its neutral position as an officer of the court and turned itself into a litigant for the cause.  As a litigant, it was subject to the loser pays costs regime that applies. 

 

The court awarded costs against the receiver on a substantial indemnity scale as a measure of its disapproval of its conduct. 

 

It awarded costs against Mr. Akagi on a partial indemnity basis.  It appeared to the court that the receiver was the more active litigant pushing for potential action on behalf of all 3,800 alleged victims and calling the shots on the over-reaching orders that were obtained.  In addition, the court reasoned that Mr. Akagi, as an unpaid creditor at least had some interest in pursuing the receivership.

Regards,

Blair

Insolvency and Underfunded Defined Benefit Pension Plans

The Supreme Court of Canada recently released a decision that many see as a victory for creditors of companies with underfunded defined benefit pension plans.  Indalex Limited ("Indalex") was the sponsor and administrator of two employee pension plans, one for salaried employees and the other for executive employees. It then became insolvent. Indalex sought protection from its creditors under the Companies' Creditors Arrangement Act ("CCAA") . Both plans had "wind-up deficiencies".

In a series of court-sanctioned steps, the company was authorized to enter into debtor in possession ("DIP") financing in order to allow it to continue to operate. The CCAA court granted the DIP lenders priority over the claims of all other creditors.

Ultimately, with the approval of the CCAA court, Indalex sold its business but the purchaser did not assume its pension liabilities. The proceeds of sale were not sufficient to pay back the DIP lenders so Indalex's parent company, the guarantor of the debt, paid the shortfall and stepped into the shoes of the DIP lenders in terms of priority. The CCAA court authorized payment in accordance with the priority but ordered that an amount be held in reserve so that the members of the pension plans could argue their rights to share in the proceeds of sale.

The plan members challenged the priority granted to the parent company and claimed that the pension plans had priority in the amount of the wind up deficiency by virtue of a statutory deemed trust under section 57(4) of the Pension Benefits Act (PBA), Ontario and also by reason of a constructive trust arising from Indalex's alleged breaches of fiduciary duty as an administrator of pension funds.

The motions judge dismissed the motions and held that the plan members were unsecured creditors. The Ontario Court of Appeal reversed the ruling and held that the wind up deficiencies were subject to deemed and constructive trusts which had priority over the DIP financing and other secured creditors.

The Supreme Court of Canada allowed the parent's appeals. A narrow 4 - 3 majority of the seven member court upheld the Court of Appeal's finding that the statutory deemed trust in section 57(4) of the PBA applies to the entire unfunded deficiency on the wind up a pension plan. However, all the judges agreed that under the doctrine of federal paramountcy, the CCAA court ordered priority had the same effect as a legislative provision and superseded the statutory deemed trust.

All member of the seven judge panel also agreed that where an employer is also the plan administrator, there is a conflict between the roles of the employer as an employer and its role as plan administrator in insolvency proceedings. The fiduciary duty of the administrator to the plan members requires at the very least notice of the insolvency proceedings so that the plan members can take steps to protect their interests.

Justice Deschamps wrote - In an insolvency, often large claims of ordinary creditors are left unpaid and the promise of defined benefits made to employees during their employment is put at risk. Although the employer in this case breached a fiduciary duty, the harm suffered by the members of the pension plan resulted from the employer's insolvency and not from the breach of the fiduciary duty.

To improve the prospect of pensioners receiving their full benefits after a pension plan is wound up, the Ontario Legislature has protected contributions to the pension fund that have accrued but are not yet due at the time of the wind up while providing for a deemed trust that supersedes all other provincial priorities over certain assets of the plan sponsor. The court held that the deemed trust extends to contributions the employer must make to ensure that the pension fund is sufficient to cover liabilities upon wind up. In this case however, the deemed trust was superseded by the security granted to the DIP creditors.

There are good reasons for giving special protection to members of a pension plan in insolvency proceedings. Parliament considered doing so before enacting the most recent amendments to the CCAA but chose not to. In an insolvency process a CCAA court must consider the employer's fiduciary obligations to plan members as their plan administrator. It must grant a remedy where appropriate. However, courts should not use equity to do what they wish parliament had done through legislation.

Justice Cromwell wrote - In an insolvency, pension plans and creditors may find themselves in a zero-sum game with not enough money to go around. Although all current contributions are up-to-date, the company's pension plan did not have sufficient assets to fulfill the pension promises made to its members. In this case, the deemed trust provisions of the Pension Benefits Act did not apply and even if it did, the superpriority would override it.  Justice Cromwell concluded that Indalex had failed in its duty to the plan beneficiaries as their administrator and that the beneficiaries ought to have been afforded more procedural protections in the CCAA proceedings. However, the Court of Appeal erred in using the equitable jurisdiction of a constructive trust to defeat the super-priority ordered by the CCAA judge.

Regards,

Blair