A U.S. appeals court said that Citigroup Inc. must face a lawsuit over Bernie Madoff’s Ponzi scheme that seeks to recover $343 million the bank allegedly received after it became aware the funds might have suspicious origins.

The appellate ruling resurrected a lawsuit by Irving Picard, the trustee tasked with recovering money for Ponzi scheme victims, alleging that Citi accepted money from Mr. Madoff’s phantom investment firm despite knowing facts suggesting it was engaged in fraudulent activity.

Mr. Picard’s case against Citi was dismissed by the bankruptcy court overseeing his liquidation of Bernard L. Madoff Investment Securities LLC and by the federal district court in New York, which found the trustee was required to prove that Citi lacked good faith by being “willfully blind” to “red flags” of fraudulent activity.

The Second Circuit Court of Appeals ruled Monday that wasn’t the correct…

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