Insolvency practitioners across the globe should be aware of a recent decision by the U.S. Court of Appeals for the Second Circuit, which reviews decisions rendered by US Bankruptcy Courts in the Southern District of New York (the “Bankruptcy Court”).  The Second Circuit’s decision in In re Picard, --- F.3d ----, 2019 WL 903978 (2d Cir. Feb. 25, 2019) vacated the Bankruptcy Court’s dismissal of an avoidance action commenced by Irving Picard, the trustee (the “Trustee”) overseeing bankruptcy litigation related to Bernard L. Madoff’s massive Ponzi scheme, concluding that the presumption against extraterritorial application of the U.S. Bankruptcy Code and principles of comity did not apply to the Trustee’s avoidance action.

The Ability of the United States Congress to Enact Legislation Having Extraterritorial Reach

“Extraterritoriality” has been defined as the application of one country’s laws to events or actions occurring outside its territorial boundaries. International law allows sovereigns to legislate extraterritorially in a number of circumstances,  including for example, policing the conduct of its own citizens.   In turn, the U.S. Constitution does not prohibit Congress from legislating extraterritorially, and in many instances, it expressly authorizes Congress to pass extraterritorial legislation.

The power to define and punish felonies on the high seas in conjunction with the grant of power under the necessary and proper clause have historically provided the basis of Congress’s authority to enact extraterritorial criminal legislation, particularly in the maritime context.  The powers have been read broadly to permit overseas application of federal criminal law, even extending to an American vessel at anchor within the territory of another nation.

Thus, whenever Congress enacts legislation that is intended to reach events or actions outside the territorial boundaries of the United States, it exercises its power to legislate extraterritorially. Although Congress’s constitutional authority to legislate extraterritorially is not without its limits, courts have consistently concluded that Congress has almost unfettered discretion to apply statutory provisions to govern events or actions outside the territorial boundaries of the United States. 

The Presumption Against Extraterritoriality

As noted, supra, Congress exercises almost unfettered discretion to legislate extraterritorially. If Congress, however, has not evinced the extraterritorial effect of a statutory provision, any disputed issue becomes a matter of statutory construction and interpretation. The presumption against extraterritoriality is a judge-made canon of statutory construction and interpretation regarding the territorial reach of federal statutes. 

In evaluating and interpreting these issues, commentators point to a synthesis of three rules of construction that form the presumption’s foundation. The first rule is that a federal statute that is silent on its extraterritorial applicability will be interpreted to have only domestic reach, absent a “clear indication of some broader intent.” The second provides that the “nature and purpose of a statute may provide an indication of whether Congress intended a statute to apply beyond the confines of the United States.” The third rule affords Congress the presumption that it enacted legislation that does not conflict with international law. 

In turn, four essential principles justify the presumption’s application, though “[the weight given to these [principles] by the [U.S Supreme] Court has varied over time.” In the first instance, the presumption is premised upon the “general observation that Congress ordinarily legislates with respect to domestic, not foreign matters [and] it knows how to give extraterritorial effect to its statutes when it wants to.”  The second principle is based upon safeguarding certainty  in the application of the relevant federal statute, thus minimizing “judicial-speculation-made-law”  and maximizing “a stable background against which Congress can legislate with predictable effects.” The third justification for the presumption is to “protect against unintended clashes between [U.S.] law and those of other nations which could result in international discord.”  The fourth and final principle supporting the presumption is the affirmance of “Congress’s role in the lawmaking process and limit[ing] activist judicial interpretation.” 

Avoidance Actions and the Presumption Against Extraterritoriality

As discussed, supra, in those instances where no legislative provision addresses the territorial boundaries of a federal statute, the presumption against extraterritoriality exists. At least one commentator has noted the difficulty in finding “any affirmative evidence of congressional intent to apply the avoidance mechanisms of the Code extraterritorially.”   The Bankruptcy Code, perhaps most notably in/via its avoidance provisions, lacks specific statutory provisions addressing its extraterritorial reach.   Nevertheless, the majority of courts that have addressed the issue have applied the Bankruptcy Code extraterritorially, or have labeled the event or conduct giving rise to the claim as arising domestically. 

Factual Background

As noted, in this case, the Trustee’s claims arose from Madoff’s Ponzi scheme, which folded in 2008 during the tumultuous financial crisis spawned from the collapse of the U.S. housing market. Although efforts to hide the fraud from investors and regulators were complex, Madoff’s was a classic Ponzi scheme.  Instead of investing money from his clients into financial instruments, as his investors (and regulators) believed, Madoff simply commingled funds into a checking account and then made distributions from the checking account. 

Many of the Madoff’s investors were non-domestic feeder funds.  A non-domestic feeder fund would obtain investments from foreign investors, pool the investments, and then feed the investments to Madoff’s New York entity.  When Madoff’s New York entity made disbursements, they would pass through the feeder fund and back to the original, foreign investors.  The Trustee sued the foreign investors, among others, under the Bankruptcy Code’s statutory avoidance powers and the Second Circuit’s decision encompasses certain of those foreign investors. 

The Bankruptcy Court Decision

The bankruptcy court presiding over the Madoff liquidation proceeding dismissed the avoidance actions against the foreign investors pursuant to the presumption against extraterritoriality and principles of international comity, concluding that  “the focus is the location of the transfer and not the location of the parties to the transfer; and a transfer from one foreign account to another foreign account is still a foreign transfer.”

Second Circuit Decision

The Second Circuit vacated the bankruptcy court’s decision, holding that the presumption against extraterritoriality and the principles of comity did not limit the Trustee’s statutory avoidance authority for transactions that occurred initially within the United States, notwithstanding that the transactions between the foreign feeder fund and foreign investors were extraterritorial.

The Second Circuit concluded that it must look to the specific statutory avoidance provision  advanced by the Trustee—Section 548(a)(1)(A) of the Bankruptcy Code—to determine the focus of Section 550 of the Bankruptcy Code, and the specific conduct that these statutory provisions were intended to regulate.  Interpreting these provisions together, the Second Circuit concluded that the avoidance and recovery of the foreign feeder fund from Madoff under these sections constituted the regulation of “domestic activity” involving (1) a U.S. debtor (the Madoff New York entity) and (2) the alleged fraudulent transfer of property from New York bank accounts.  It should be noted that the Second Circuit did not provide an opinion on whether either factor, standing alone, would permit a like conclusion.

The Second Circuit opined that if it did not vacate the bankruptcy court order, a gaping loophole would result, likely allowing the next Madoff to bypass the Bankruptcy Code’s avoidance reach by simply mimicking the foreign feeder fund to foreign investor model.  The presumption against extraterritoriality therefore did not prohibit the Trustee from seeking to recover transfers from the foreign feeder funds and the foreign investors.

The Second Circuit also determined that principles of international comity could not circumscribe the Trustee’s statutory authority to pursue his avoidance claims. The Court stated that U.S. law was not regulating the foreign investor’s relationship with the foreign feeder fund.  Instead, it was regulating Madoff’s transfer of funds to the foreign feeder fund.  

Practice Point

The Second Circuit decision likely closes a potential loophole, now preventing the Bankruptcy Code’s avoidance provisions from being bypassed, and further expands the trustee’s statutory avoidance powers beyond the United States, at least in New York and other jurisdictions bound by Second Circuit precedent.  Our clients who have both direct and indirect business connections to these jurisdictions should be cognizant of this enhanced risk.  

Patrick M. Birney

[1] The author originally published an article in the American Bankruptcy Institute Journal in September 2014 on the presumption against extraterritoriality in the context of the Trustee’s avoidance powers in the Madoff case.   Portions of this article, including content within quotations, were initially contained in the ABI Journal article.   See Patrick M. Birney, Revisiting Presumption Against Extraterritoriality in Avoidance Actions, XXXIII ABI Journal 9, 28-29, 70-71, September 2014 for original source citations.