On September 6, 2013, the US Court of Appeals for the Seventh Circuit, in Peterson v. Somers Dublin Ltd., adopted the US Court of Appeals for the Second Circuit's broad interpretation of the safe harbor found in section 546(e) of the Bankruptcy Code, to protect transfers made in connection with a Ponzi scheme from avoidance.

Gregory Bell operated various mutual funds (Debtors) that invested in, among other things, notes issued by Thousand Lakes, LLC (Thousand Lakes). In 2007, Thousand Lakes stopped remitting money to the Debtors, which led Mr. Bell to discover that Thousand Lakes was being operated as a Ponzi scheme. Instead of notifying authorities, Mr. Bell operated the Debtors as a second-tier Ponzi scheme. By the end of 2008, both Mr. Bell and the manager of Thousand Lakes were indicted and ultimately sentenced to prison.

The bankruptcy trustee (Trustee) argued that investors who redeemed shares in the Debtors before the bankruptcy received preferences or fraudulent transfers under sections 547 and 548 of the Bankruptcy Code, respectively. However, section 546(e) of the Bankruptcy Code prohibits a trustee from avoiding "settlement payments" or other "transfers" made to a "financial participant" in connection with a securities contract, except in cases of actual fraud under section 548(a)(1)(A) of the Bankruptcy Code.

The US Bankruptcy Court for the Northern District of Illinois granted summary judgment in favor of the investors, holding that the transfers were protected under section 546(e) of the Bankruptcy Code. The parties appealed directly to the Seventh Circuit.

On appeal, the Trustee did not deny that the investors were "financial participants" or that each investor's redemption of shares was a "transfer" made to that investor, for purposes of the section 546(e) safe harbor. The Trustee also did not argue that the Debtors' payments to the investors were excluded from the scope of the safe harbor as actual fraudulent transfers under section 548(a)(1)(A) of the Bankruptcy Code. Instead, the Trustee argued that:

The Seventh Circuit affirmed the bankruptcy court's decision, holding that section 546(e) barred the avoidance action. It disagreed with the Trustee about the ambiguities of section 546(e), explaining that even if certain words were ambiguous, that only justifies examining legislative history to resolve that ambiguous language, not replacing it to implement legislative intent. Courts must apply the text of a statute as written, even if the result seems inequitable.

Therefore, the Seventh Circuit declined to replace the entire text of section 546(e) with the Trustee's interpretation of Congressional intent. Instead, the Court adopted the Second Circuit's broad interpretation of "settlement payment" to mean what it ordinarily does in the securities business: the financial settling-up after a trade (see Legal Update, Second Circuit Holds that "Settlement Payment" Safe Harbor Insulates Early Redemptions of Enron Commercial Paper from Fraudulent Transfer and Preference Attack). It also adopted the Second Circuit's more comprehensive definition of "transfer" to hold that a transfer from the Debtors to each redeeming investor had undoubtedly occurred, making it unnecessary to determine whether the transactions qualified as settlement payments (see Legal Update, In re Quebecor World (USA) Inc.: Second Circuit Broadly Applies Section 546(e) "Securities Contract" Safe Harbor). Finally, it adopted the US Supreme Court's interpretation of "in connection with" to conclude that it was more than comprehensive enough to cover the Debtors' redemption of the investors' shares.

Moreover, the Court noted that if the Trustee's interpretation was correct and transfers made by debtors that had any role in a fraud were excluded from the protections of section 546(e), then the actual fraud exception referring to section 548(a)(1)(A) would be rendered superfluous.

Dismissing the Trustee's textual argument, the Seventh Circuit held that the term "securities" includes securities issued by fraudulent actors for purposes of section 546(e) and the securities laws. The Court noted that one of the primary purposes of the Bankruptcy Code, and the securities laws generally, is to control fraud, and to exclude these instruments from their reach would drastically undermine the efficacy of those laws.

Peterson v. Somers Dublin Ltd. is the most recent decision addressing the scope of the section 546(e) safe harbor. In adopting the Second Circuit's reasoning, the Seventh Circuit has followed the trend of broadly interpreting the section 546(e) safe harbor to bar avoidance actions in a variety of cases involving securities and the securities markets. For example, see the following Legal Updates:

This case also confirms that there is no Ponzi scheme exception to the section 546(e) safe harbor, consistent with the US Court of Appeals for the Fourth Circuit's decision in In re Derivium Capital (see Legal Update, In re Derivium Capital: Fourth Circuit Rules Alleged Ponzi Scheme Transactions Not Avoidable as Fraudulent Transfers). At most, the existence of a Ponzi scheme can give rise to a presumption of actual fraud, which would trigger the section 548(a)(1)(A) exception to the section 546(e) safe harbor.