On the day that Bernard Madoff pleaded guilty and went right to jail, I was interviewed by CNBC Europe on what to expect next. I’ve expanded my comments into the following analysis.

Madoff Jailed, What’s Next?

Following Madoff’s guilty plea and subsequent incarceration, the focus now shifts away from liability, which he’s admitted. Now, the emphasis will be toward three areas: recovering funds in order to compensate Madoff fraud victims, civil lawsuits by the victims against Madoff and third parties, and criminal investigations into who may have aided and abetted Madoff’s fraud. This article explores the many legal issues to be faced in these pursuits.

Recovery of Assets for Madoff Victims

Irving Picard has been appointed trustee. The purpose of the trustee is to marshal all Madoff assets that can be found, into one large pool for distribution to fraud victims who file claims. The law allows the trustee, in his pursuit of maximizing assets for the claimants, to “claw back” any payments that Madoff may have made. Because this was a Ponzi scheme, we know that the money of new investors was used to pay off prior investors. Prior investors may have received two types of payments: first, re-payment of their principal; second, payment of supposed profits or investment gains, which we now know were completely fabricated. The law allows the trustee to “claw back” both types of payments.

Investors who may have received some money back from Madoff are therefore vulnerable to having it taken back by the trustee. Even if an investor received some Madoff distributions but still lost money overall, that investor is still at risk of the trustee clawing back what little the investor received. There is precedent for such clawback. After the 2005 collapse of hedge fund Bayou Group, the trustee appointed in that case clawed back returns of principal and interest that investors received before the collapse, and re distributed those assets to fund claimants.

Strategies Against Clawback

Investors who received funds from Madoff, whether bogus profits or returns of principal, are wise to proceed cautiously. In fact, they are caught in a precarious Catch 22: Do they file claims as Madoff victims, when those claims could alert the trustee that the claimants also received funds from Madoff?

For those people who received distributions from Madoff, the key approach is to convert any funds received into exempt assets, i.e., exempt from the “clawback” reach of the trustee. A 401(k) is one exempt asset, and I’ve recently read one asset protection attorney counsel that Madoff distributions be placed in a 401(k) to avoid the clawback reach of the trustee. The problem with that strategy is that extraordinary contributions to a qualified plan can be clawed back as fraudulent conveyances. To illustrate, if a person has been making annual $10,000 contributions to her 401(k), and suddenly now deposits $100,000, the new large deposit might be challenged by the trustee as made with specific intent to hinder the trustee from reaching those assets. Unless the investor could show some supervening legitimate purpose for the extraordinary deposit, the trustee would likely be successful in clawing it back. Additionally, contributions to 401(k)s and other qualified plans usually have annual limits that are too small to offer any significant protection to a Madoff investor.

Alternatively, funds received from Madoff might be used to purchase annuity policies or life insurance policies, which are exempt assets in many states. Although this strategy is still vulnerable to a fraudulent conveyance claim by the trustee, the investor may defend his action as legitimate financial or estate planning, thus presenting a possible supervening legitimate purpose. The question becomes: who the judge believes. Thus, even this strategy offers no guaranty that the funds in the policy would be exempt from clawback by the trustee.

One extreme strategy would be to take the funds, buy a house in Florida and use it as a primary residence. Florida law allows an unlimited “homestead” exemption, whereby one’s primary residence is immune from the reach of a creditor. OJ Simpson availed himself of this exemption after losing the civil lawsuit brought by his victim’s family. He moved to Florida and bought a mansion, which was exempt from attachment by his civil creditors. In comparison, New York’s homestead law only exempts an owner’s first $50,000 of equity in a primary residence. (NY CPLR §5206(a)).

A more reasonable and equally effective strategy would be to purchase a foreign annuity or life insurance policy. As noted above, such policies are normally exempt, but are vulnerable to a fraudulent conveyance claim. However, if the policy is issued by a foreign company, and assets are wired offshore to that company, those assets would be outside the jurisdiction of the U.S. court system, and beyond the reach of the trustee. If the assets are held in a secure foreign jurisdiction, one with strong local asset protection laws, the clawback will be thwarted. Favorable laws in such a jurisdiction would include non recognition of foreign (i.e., U.S.) court judgments and orders, anti duress provisions and a short statute of limitations period in which to bring a challenge. Of course, this strategy should only be employed with the assistance of a qualified attorney, one with proper experience with the foreign jurisdiction. Irrespective of the asset protection benefits of such an offshore strategy, compliance with U.S. tax laws, i.e., proper disclosure to the IRS and payment of taxes due on foreign income, must always be followed.

Tax Issues

The Internal Revenue Code (IRC) may provide some small measure of relief for Madoff victims. The relief is based upon the following premise: Madoff victims, who were under the illusion that they were making money and paid taxes on the money they thought they were making, have now discovered that not only did they make no money, but they suffered financial loss. They should therefore not have to pay tax on that phantom profit and should receive some relief for theft loss. Relief for theft loss in indeed available under IRC§165(e). Per case law, for an allowable theft loss deduction, there must be a showing of criminal intent. Because Madoff pled guilty to crimes, that requirement is satisfied. Theft losses are deductible in the year of discovery and not in the year sustained. (IRC§165(e)).

In addition, Madoff victims are also allowed to amend past years’ tax returns and seek a refund from the IRS for taxes paid on the phantom income. Currently, the IRC provides a three year window to amend past returns (I.R.S. Publication 17; Form 1040X). This, however is of limited comfort to Madoff victims who paid tax on phantom profits for many years. There are currently two proposals in Congress that, if adopted, would allow a greater window to amend past tax returns. The Fraudulent Tax Relief Act, proposed by Representative Ackerman (D NY), is currently before the House Ways and Means Committee and would extend the amendment window back to 1995 (which was allegedly the last year in which Madoff made real trades). A second bill, proposed by Representative Meeks (D FL), is also pending, and would extend the tax loss carry back from three years to ten. In addition to legislation by Congress, the IRS could itself draft regulations that would extend the lookback. Consultation with qualified tax counsel is recommended.

Will Victims Get Any Money Back?

This is a great uncertainty. What appears to be certain, however, is that whatever funds the trustee does succeed in marshalling, whether by clawback or location of Madoff’s assets or restitution from Madoff himself, there will not be nearly enough money to make victims whole again. The trustee has reportedly located less than $1 billion to date; but defrauded investors allegedly lost some $65 billion.

Distribution of money from the trustee’s fund to the fraud victims will be full of thorny legal issues. One certain issue pertains to the status, or more properly, the priority, of the various types of victim claimants. For example, will a wealthy hedge fund investor be treated the same way as an elderly middle class couple’s retirement fund? What about pension funds? Does each fund have one claim, or does each pensioner have an individual claim? These questions and others will keep lawyers busy for many years to come.

Besides distributions from the trustee, Madoff victims may be able to look to the SIPC (Securities Investor Protection Corporation). Similar to FDIC insurance on individual bank accounts, SIPC insures securities accounts, but only to a maximum of $500,000 (a trifling number for some who invested many millions with Madoff), and only for securities bought in the last twelve months (some victims had been Madoff clients for years).

It is also almost certain that victims will be filing thousands of civil legal actions, and it’s quite possible that there will be a class action certification for many of the suits. Defendants in the civil actions would include Madoff himself, of course, along with the officers and directors of the Madoff institutions, all the various Madoff corporate entities, members of the Madoff family, institutions which acted as funnels or feeder funds for Madoff investments (primarily hedge funds), the accountants and auditors who audited the Madoff institutions, the financial advisors who recommended Madoff investments, and the custodians of Madoff investments (banks, trust companies, etc.).

How Will the Trustee Get Assets to Pay Back the Victims?

One way is via the trustee’s clawback, discussed above. However, the extent of the trustee’s clawback powers is not clear. One issue: how far back can the trustee claw? Under federal bankruptcy law, any payments made within ninety days of a bankruptcy filing (in this case, December 11, 2008) may be reached by the trustee. (11 USC § 547(b)). Under New York State law, actions to recover fraudulently transferred funds have a six year statute of limitations. (NY CPLR § 213). Other laws possibly at play: SIPC regulations, and federal/state civil and criminal forfeiture statutes, which may also be a basis for compelling the return of distributions from Madoff investors.

Another way that the trustee will gather funds is to investigate and uncover where Madoff may have hidden assets. The trustee will certainly have to deal with issues related to the location of “secret” offshore accounts, most likely held in the names of obscure foreign corporations, trusts, foundations and other entities.

Recent offshore events will make the trustee’s investigation easier. Formerly “secret” offshore jurisdictions are no longer so. For instance, in December, 2008 Liechtenstein signed an exchange of information agreement (EIA) with the U.S. Treasury Department. More recently, the Liechtenstein government indicated its willingness to become even more transparent, in an effort to be removed from a “blacklist” of “non cooperative tax haven” jurisdictions compiled by the OECD (Organization for Economic Cooperation and Development). That blacklist includes only three jurisdictions: Liechtenstein, Monaco and Andorra. Andorra also recently made overtures toward opening up and sharing information with other governments. In addition, Swiss banking secrecy has been significantly eroded by UBS’s admission that it conspired with, and assisted, U.S. citizens in committing tax fraud, and by UBS’s consequent disclosure of the names of Americans with fraudulent Swiss bank accounts. Litigation between the U.S. and UBS is pending in a federal court in Miami. The common belief among asset protection and offshore practitioners is that ultimately, UBS will hand over the identities of some 52,000 Americans with non compliant foreign accounts. UBS will be forced to capitulate it has too many assets located within the United States that would be seized, which would almost certainly kill the bank that is already so crippled in the current financial market. If there are Madoff assets in Switzerland, they will likely be uncovered.

Where else offshore might those funds be? We’ve written about this before, and concluded that it is likely that a great portion of Madoff’s money is held in Monaco. One of three blacklisted jurisdictions (see above), Monaco has not signed a Mutual Legal Assistance Treaty (MLAT, which Switzerland, the Cayman Island and most other jurisdictions have signed), nor an exchange of information agreement. Moreover, Monaco is a rich and stable European jurisdiction (unlike many South Pacific or Caribbean jurisdictions), with considerable funds on deposit (reputedly $120 to $140 billion). Its banking and financial sectors are first class, and a deposit of hundreds of millions of dollars (or even a billion or two) would not cause a ripple within such a large banking system. We believe that the trustee should be looking for Madoff money in Monaco, or perhaps real estate in France and elsewhere purchased through Madoff-funded Monaco corporations.

Finally, there is no doubt that Madoff will be ordered by the court to make restitution, which is routine in Ponzi schemes. The question is whether Madoff will cooperate and disclose where his assets may be found. He knows that he will die in jail no matter what he does; what incentive is there for him to cooperate? On the other hand, with the erosion of offshore secrecy, as discussed above, Madoff’s hidden assets may very well be uncovered without his cooperation.

In any event, it is certain the reverberations from the Madoff affair will keep lawyers and judges busy for many years to come, both within the U.S. and offshore. It is also certain that Madoff’s investors will never be made whole. Madoff investors should therefore seek to minimize their losses and protect what little they have received.

Asher Rubinstein is a partner at Rubinstein & Rubinstein, LLP. His practice concentration is domestic and offshore asset protection, wealth preservation and tax planning. He may be reached at (212) 888 6600 and via www.assetlawyer.com.