The fallout from the collapse of Bernie Madoff’s Ponzi scheme has generated both headlines and interesting legal issues. InMadoff Securities International Ltd v Raven & ors , Flaux J considered a number of points of general interest. In particular, he provided important guidance on the extent to which claimants can use ‘anchor defendants’ to give the English court jurisdiction over other defendants domiciled elsewhere in the EU. The judgment contains an interesting discussion on the question of whether directors can be sued for breach of their fiduciary duties for acts that have been authorised or ratified by shareholders. The case also provides a useful illustration of the difference between proprietary injunctions and freezing orders. Finally, Flaux J explained the extent to which the court will, when considering whether to grant a freezing order, infer a risk of dissipation of assets from allegations of dishonesty against a defendant.
Through his New York-based company, Bernard L Madoff Investment Securities LLC (BLMIS), Bernard Madoff perpetrated a massive multibillion-dollar fraud on investors by way of a Ponzi scheme. In 1983 he established Madoff Securities International Limited (MSIL), a UK-incorporated entity. MSIL was 99% owned by Bernard Madoff (his brother, Peter, held the remaining 1%). The ostensible purpose of MSIL was to hold a seat on the London International Financial Futures Exchange. However, its primary function was to facilitate the concealment of Mr Madoff’s fraud and the distribution of its proceeds. In particular, Mr Madoff used MSIL to launder stolen money and as a vehicle for making payments of stolen money.
In the 1980s Mr Madoff met Mrs Kohn, an Austrian national who lived and conducted her affairs internationally through a series of corporate vehicles. Mrs Kohn subsequently began to introduce investors to Mr Madoff; the money they invested with him amounted to billions of dollars. Over the years, Mrs Kohn and her corporate vehicles received tens of millions of dollars directly from BLMIS and indirectly via MSIL. Mrs Kohn said that the payments were primarily by way of legitimate commission for the introduction of customers but they were not described as such in the invoices submitted by her companies, which instead referred to ‘services’ such as ‘research, analysis and consulting’.
MSIL (by its liquidators) issued proceedings against (i) the directors of MSIL (including Peter Madoff and his two sons); and (ii) Mrs Kohn and her corporate vehicles (together, the ‘Kohn defendants’). The majority of the MSIL directors were domiciled in the UK; however, Peter and his two sons were not. MSIL claimed that:
- in making the payments to the Kohn defendants, the directors of MSIL breached their respective contractual and fiduciary duties owed to MSIL because each knew the payments were inappropriate and suspicious and/or had knowledge of numerous indicia that they were illegitimate payments; and
- Mrs Kohn knew the payments were really secret payments or ‘kickbacks’ for introducing money into Madoff’s scheme and that the various invoices were, in fact, sham documents intended to hide the true nature of payments made to the Kohn defendants. MSIL claimed that the Kohn defendants, therefore, held the payments (and their traceable proceeds) on constructive trust for MSIL.
BLMIS issued a separate claim against the Kohn defendants, in which it pleaded that as a matter of New York law, the Kohn defendants received and held the BLMIS payments as constructive trustees and/or were liable to make restitution, on the basis that it would be inequitable for them to retain the monies.
Article 6.1 of EC Regulation 44/2001 on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters (the ‘judgments regulation’) provides that a person i) domiciled in a member state; and ii) sued as one of a number of defendants may be sued in the courts of the place where any one of the other defendants is domiciled – provided that the claims are ‘so closely connected that it is expedient to hear and determine them together to avoid the risk of irreconcilable judgments resulting from separate proceedings’.
This means that, under Article 6.1, if a claimant sues a defendant who is domiciled in England (often known as an ‘anchor defendant’) then that claimant may be able to join other relevant defendants (who are domiciled in other EU member states) to the claim.
Both MSIL and BLMIS sought to rely on Article 6.1 to give the English court jurisdiction over their claims against the Kohn defendants. In the case of MSIL, this was not disputed. As MSIL had issued proceedings against both the directors of MSIL and the Kohn defendants, the Kohn defendants accepted that the English-domiciled directors acted as anchor defendants and that the English court had jurisdiction over MSIL’s claim against them.
By contrast, BLMIS was only suing the Kohn defendants, and not the directors of MSIL. The Kohn defendants argued that Article 6.1 only applies where the claimant seeking to rely on it has a claim against the anchor defendant, and so the Kohn defendants applied to set aside the proceedings against them. In other words, BLMIS could not ‘piggy-back’ onto MSIL’s claim against the directors of MSIL. The issue, therefore, (on which there was no prior European or English case law) was whether the same ‘anchoring’ applies where the claimant seeking to invoke Article 6.1 (BLMIS) does not, in fact, have a claim against the English-domiciled defendants, but where another claimant with a similar claim (ie MSIL) is suing all the relevant defendants.
Flaux J found in favour of the Kohn defendants and held that Article 6.1 only applies where the same claimant is suing both the English-domiciled anchor defendant and the defendants domiciled elsewhere. He rejected BLMIS’ submissions that a broad ‘assessment-based’ approach should be taken to Article 6.1 to give effect to its underlying purpose of preventing irreconcilable judgments. The judge said that this would ‘drive a coach and horses’ through the well-established principle that any derogation from the general rule – that defendants should be sued in the courts of the state in which they are domiciled (Article 2 of the Regulation) – should be interpreted restrictively.
RATIFICATION OF DIRECTORS’ ACTS BY SHAREHOLDERS
For reasons that are beyond the scope of this article, one issue that was relevant to all the applications before the Court was whether MSIL could demonstrate a serious issue to be tried against the directors of MSIL.
The directors of MSIL relied on the fact that the payments to the Kohn defendants had been made on the instructions of Mr Madoff, who was the 99% shareholder of MSIL (and with whom his brother, the other 1% shareholder, always agreed). They argued that the making of the payments had been authorised by the shareholders and was not a breach of their fiduciary duties at all or, if it was a breach of fiduciary duty, it had subsequently been ratified by the consent of all the shareholders of the company.
It is well-established that, where the conduct of the directors of a company has been approved or authorised by the shareholders of that company, the company cannot bring a claim for breach of duty against the directors. In effect, the company is bound by the consent of its shareholders and adopts the directors’ actions as its own.
An exception to this general rule, which was not in dispute in this case, applies where the transaction authorised by the shareholders is one that jeopardises the company’s solvency or causes loss to its creditors. However, this narrow exception did not assist MSIL because, at the time the payments were made to the Kohn defendants, MSIL was solvent. MSIL, therefore, argued that there was a wider exception and that the general rule would not apply where the shareholders, in ratifying the directors’ acts, were acting dishonestly or using the company as a vehicle for fraud or wrongdoing.
Flaux J found support for the existence of this wider exception in the comments of Sir Andrew Morritt V-C in Bowthorpe Holdings Lts & anor v Hills & ors . In that case, the vice-chancellor said that the general rule will not apply if the relevant transaction is not ‘bona fide or honest’. He then went on to refer to a ‘second exception, which may merely be an exemplification of the first, [which] is that the transaction must not be likely to jeopardise the company’s solvency or cause loss to its creditors’. Flaux J took this to mean either that there were two exceptions to the general rule (including the wider one put forward by MSIL) or that there was one broad exception, of which a case where there is prejudice to creditors is just one subset.
Flaux J went on to review a number of other cases where the judges appeared at least to have recognised the existence of a wider exception to the general rule ‘to the effect that a transaction can be impugned by the company if it is not honest, bona fide and in the best interests of the company’. Against that background, and on the facts, Flaux J held that the claimants could show ‘at least a serious issue to be tried, that the fact that the payments were all approved and indeed required by Mr Madoff does not excuse the directors of MSIL from breach of fiduciary duty in permitting and making the payments’.
PROPRIETARY INJUNCTIONS AND FREEZING ORDERS
The effect of a freezing order is to restrain a defendant from dealing with or disposing of its assets, with a view to ensuring that there are funds available to satisfy any judgment eventually given in a claimant’s favour. A proprietary injunction, on the other hand, is made against specific assets in the defendant’s hands, which are alleged to belong to the claimant.
MSIL applied for, and obtained, both a proprietary injunction and a freezing order against the Kohn defendants. In giving his reasons for granting the proprietary injunction sought by MSIL, Flaux J made a number of comments that show that a claimant may be able to obtain a proprietary injunction in circumstances where a freezing order would not be available. He noted that the test for obtaining a proprietary injunction was the one set out in American Cyanamid v Ethicon  and that, in contrast to an application for a freezing order, there was no requirement for the applicant to show that there is a real risk of the defendant dissipating or disposing of its assets1. Furthermore, even if there has been a delay in making an application, which might lead to the refusal of a freezing order, a proprietary injunction may nonetheless be granted. Finally he quoted the statement of Staughton LJ in Republic of Haiti v Duvalier  that a claimant:
‘… who seeks to enforce a [proprietary] claim… will more readily be afforded interim remedies, in order to preserve the asset which he is seeking to recover, than one who merely seeks a judgment for debt or damages.’
In this case, these factors meant that, as MSIL had established a sufficiently arguable case that they were entitled to a proprietary remedy, ‘arguments by Mrs Kohn along the lines of: “it would be frightfully inconvenient to tell you what I’ve done with your money or to be prevented from continuing to use it” when, on this hypothesis she should not have had the money in the first place, do not cut much ice’.
APPLICATION FOR A FREEZING ORDER
As explained above, an applicant for a freezing order must show that there is a real risk that, unless restrained by an injunction, the defendant will dissipate or dispose of its assets other than in the course of business. MSIL’s primary submission on this point was that the very nature of the case of dishonesty against the Kohn defendants was sufficient to demonstrate a risk of dissipation.
The difficulty for MSIL was that in Thane Investments Ltd & ors v Tomlinson & ors , Gibson LJ said that allegations of dishonesty were not, by themselves, sufficient to enable a court to grant a freezing order. If strictly applied, this analysis would restrict the ability of claimants to obtain freezing orders because it is likely to be much harder to adduce evidence that specifically demonstrates a risk of dissipation than it will be to make more general allegations of dishonesty.
Following the decision of Patten J in Jarvis Field Press Ltd v Chelton & ors , Flaux J accepted Thane Investments as authority for the proposition that an ‘unfocused’ finding of dishonesty is not, in itself, enough to ground an application for a freezing order. However he also held, like Patten J, that the court could infer a risk of dissipation from the specific allegations of dishonesty made against the particular respondents to the application.
In this case, the Kohn defendants had submitted invoices to MSIL that falsely described the services provided. Flaux J commented that this ‘cries out for a proper explanation from Mrs Kohn which, bluntly, has not, in my judgement, been provided by the evidence she has put before the court’. The particular allegations made by MSIL, that the Kohn defendants had submitted sham invoices to disguise the true nature of payments of millions of dollars made over many years, were sufficient to demonstrate a serious risk of dissipation.
Finally, it is worth noting that the Kohn defendants also sought to resist MSIL’s application for a freezing order on the basis of delay. They pointed out that MSIL had put them on notice of the fact that they intended to obtain a freezing order more than two months before the application was made and eight months before it was heard. The Kohn defendants argued that this ‘leisurely approach’ indicated i) that MSIL did not really consider that there was a genuine risk that they would dissipate their assets and ii) that there was no such risk.
Flaux J accepted that there had been some delay in this case. However, he took the view that this was only one of several considerations to be taken into account. Another consideration was that, as an adjunct to the freezing order, a defendant would normally be ordered to provide disclosure of its assets. This was an important element of the relief sought by MSIL and could aid the subsequent enforcement of any order obtained at trial – particularly as Mrs Kohn had not provided voluntary disclosure of her assets. Indeed this failure to disclose her assets clearly influenced the judge’s thinking, as is reflected by his comment that ‘if Mrs Kohn were not going to dissipate her assets, why has she not given disclosure of them’?
By Barry Donnelly, partner, and Jonathan Pratt, professional support lawyer, litigation and dispute resolution department, Macfarlanes LLP.