By Jonathan Stempel
NEW YORK (Reuters) - Victims of Bernard Madoff's epic fraud may be able to recoup only a small portion of the billions of dollars he allegedly funneled to selected customers in the last years of his Ponzi scheme.
At a hearing on Wednesday, a panel of the 2nd U.S. Circuit Court of Appeals in New York appeared inclined to limit the extent to which the trustee liquidating Madoff's firm may recoup "fictitious profits" and other transfers from customers.
The trustee, Irving Picard, has so far recouped $9.8 billion of the roughly $17.3 billion estimated to have been lost. He now wants the right to claw back money sent to various customers in the six years before Bernard L. Madoff Investment Securities LLC went bankrupt in December 2008.
Those customers say federal law lets Picard recoup money sent only in the two years prior to a bankruptcy, and only if payments were made with fraudulent intent. They claim not to have known Madoff was committing fraud.
The trustee "runs into the face of a statute that says, yes, you can recover, but only in connection with certain transactions," Richard Levy, a Pryor Cashman partner representing some customers, told the three-judge panel.
"Does it give (Picard) the right to expand the statute to the nth degree? No," he added. "Congress has drawn a line."
At issue was a "safe harbor" provision of the U.S. Bankruptcy Code that protects customers who receive transfers from a stockbroker that are made "in connection with a securities contract" or are "settlement payments."
While Madoff did not trade securities for many customers, U.S. District Judge Jed Rakoff ruled in a series of cases in 2011 and 2012 that transfers made more than two years before the bankruptcy were insulated from clawbacks.
That argument won some support from Wednesday's panel.
"The definition of securities contract has been expanded repeatedly," Circuit Judge Gerard Lynch told David Sheehan, a lawyer for the trustee. "I'm not sure why I shouldn't agree with Judge Rakoff that payments made to these investors were payments made pursuant to a securities contract. Help me out."
Sheehan countered that Madoff would merely move money from one customer to another, and thus did not affect the marketplace that Congress sought to regulate in adopting bankruptcy laws.
"People gave money to Madoff. He gave it back. That's all that happened here," Sheehan said. Letting Rakoff's rulings stand would "insulate Bernie Madoff's fraud," he added.
Greg Schwed, a partner at Loeb & Loeb representing other customers, disagreed. "That this is an outrageous windfall and a perversion of justice just isn't the case," he said.
Wednesday's hearing came as jurors in a nearby federal courthouse heard closing arguments in the criminal trial of five former employees of Madoff's firm accused by the government of aiding their former boss's fraud.
Madoff, 75, pleaded guilty in 2009 and is serving a 150-year prison term.
Among the cases that Rakoff had reviewed was Picard's $1 billion lawsuit against Fred Wilpon and Saul Katz, owners of the New York Mets baseball team.
One of his rulings reduced the size of that lawsuit to $386 million. That paved the way for a $162 million settlement, with a net payout that could ultimately be much less.
As part of his argument, Picard said Rakoff misinterpreted a 2nd Circuit decision in 2011 over payments linked to the former Enron Corp's bankruptcy.
But the 2nd Circuit panel had trouble drawing lines, including in cases where customers had contracted for Madoff to trade on their behalf and thought he was doing so.
Circuit Judge Christopher Droney asked if Picard could pursue customers if "the schemer is trying to make all kinds of securities trades to make profits in order to get back to some legitimacy," but didn't trade for those particular customers.
"The contract involving a purchase or sale of an actual security would be my definition," said Josephine Wang, a lawyer for the Securities Investor Protection Corp, which oversees broker liquidations and has worked with Picard on Madoff's.
Lynch later questioned that. "It says 'in connection with,' which is a pretty loose standard, I would think," he said, referring to the bankruptcy statute.
The 2nd Circuit typically takes from a few weeks to several months to rule.
Picard is not alone in seeking to repay Madoff victims. A $4.05 billion fund set up by the U.S. government and overseen by former U.S. Securities and Exchange Commission chairman Richard Breeden will pay customers and third parties who were harmed.
The cases are Picard v. Ida Fishman Revocable Trust et al, 2nd U.S. Circuit Court of Appeals, Nos. 12-2497, 12-2500, 12-2557, 12-2616, 12-3422, 12-3440, 12-3582 and 12-3585.
(Editing by Andrew Hay)