Two Recent Federal Court Decisions Clarify the Differing Treatment under SIPA of Returned Principal and Fictitious Profits

Two recent federal court decisions – one at the circuit level and the other at the district court level, and both arising out of the Madoff Ponzi scheme – offer further clarification on the differing legal status of returns to investors in a fraud of invested principal versus returns of fictitious profits.  In turn, the differing legal status of these two categories of returns impacts the extent to which the trustee can claw back money from investors and the extent to which investors can make valid claims on the estate.  See “Two Key Levels of Risk Facing Hedge Funds That Buy or Sell Bankruptcy Claims,” Hedge Fund Law Report, Vol. 4, No. 27 (Aug. 12, 2011).  For hedge fund managers that trade Madoff claims or other bankruptcy claims, these legal decisions will impact the investment calculus.  The circuit court decision also offers important insight on the complex process of calculating “net equity” under SIPA – an issue that many hedge fund managers first encountered when trying (often with limited success) to get money out of Lehman’s failed U.S. prime brokerage business, and an issue that continues to impact the value of Madoff claims.  See generally “Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices,” Hedge Fund Law Report, Vol. 4, No. 25 (Jul. 27, 2011).

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