On June 29, 2015, the US Court of Appeals for the Second Circuit, in In re Lehman Brothers, Inc., held that a bank that enters repurchase agreements (commonly known as "repos") with a broker-dealer does not qualify as a "customer" under the Securities Investor Protection Act (SIPA) and is therefore not entitled to special legal protections when that broker-dealer fails (No. 14-890, (2d Cir. June 29, 2015)).

Doral Bank and Doral Financial Corporation (collectively, Doral or the bank) entered into a series of six repos with Lehman Brothers Inc. (Lehman), which involved the sale of securities to Lehman coupled with an agreement to repurchase the securities back from Lehman at a future date. These transactions were governed by industry-standard Master Repurchase Agreements (MRAs). Notably, the MRAs described the relationship between Doral and Lehman as "contractual" and did not mention a fiduciary relationship between the parties. The MRAs gave Lehman full legal title over the underlying securities, and Lehman was free — subject to its obligation to resell the securities on the repurchase date — to sell, transfer, pledge or hypothecate the securities as it desired.

Before the securities could be repurchased, Lehman filed for bankruptcy and entered into liquidation under SIPA. The SIPA trustee then sought protection under SIPA, arguing that the repos did not entitle Doral to recover as a "customer" of Lehman. If Doral was found to be a customer of Lehman, then under SIPA, Doral would be entitled to the prompt return of any property that Lehman was holding on Doral's behalf (the securities that Lehman never re-sold to Doral as required under the MRAs, less the contractual repurchase price for the securities). Conversely, if Doral was not a customer of Lehman, then Doral would be relegated to pursuing a claim for those unreturned securities in the ordinary course of Lehman's bankruptcy proceedings.

In June 2013, the bankruptcy court affirmed the SIPA trustee's determination that the repos did not make Doral a "customer" under SIPA. In February 2014, the district court affirmed the bankruptcy court's decision. Doral appealed to the US Court of Appeals for the Second Circuit.

The Court noted that a claimant only receives special protections under SIPA if it is a "customer" of the broker-dealer. SIPA defines customer as "any person . . . who has a claim on account of securities received, acquired, or held by the debtor in the ordinary course of business as a broker or dealer from or for the securities accounts of such person for safekeeping, with a view to sale, to cover consummated sales, pursuant to purchases, as collateral, security, or for purposes of effecting transfer." Whether a claimant qualifies as a customer is determined on a transaction-by-transaction basis.

The Court held that the bank was not a "customer" for purposes of SIPA because Lehman's unrestricted ownership of the securities defeated any suggestion that the bank entrusted the securities to Lehman when it entered into the repos.

The Court noted that, since SEC v. F.O. Baroff Co., the Second Circuit has held that to be a customer under this definition, an investor must have "entrusted" property to the broker-dealer (497 F.2d 280, 283 (2d Cir. 1974)). Most recently, in In re Bernard L. Madoff Investment Securities LLC, the Second Circuit reaffirmed that the "critical aspect of the 'customer' definition is the entrustment of cash or securities to the broker-dealer for the purposes of trading securities" (654 F.3d 229, 236 (2d Cir. 2011)).

First, the Court rejected the SIPA trustee's argument that repos necessarily involve entrustment. Rather, the Court held that entrustment must bear "the indicia of the fiduciary relationship between a broker and his public customer." This "fiduciary relationship," in turn, arises out of the broker-dealer's obligation to handle the customer's assets for the customer's benefit. (Mere delivery is not entrustment for the purpose of this definition.)

Second, the Court held that the bank did not entrust anything to Lehman. Rather, it sold the securities to Lehman, which acquired full legal title. In other words, Lehman and the bank were arms-length contractual counterparties, and each entered the repos for its own benefit. Lehman owned the securities, and could do what it wanted with them. In particular, Lehman:

The Court's conclusion aligns the Second Circuit with the Eleventh Circuit, the only other circuit to expressly consider whether repos involve entrustment.

This case highlights one of the risks of entering into a repo with a broker-dealer counterparty. It demonstrates that, where a broker-dealer counterparty fails before the repurchase leg of a repo transaction, a bank that entered into the repo will not be granted favored "customer" status in a SIPA proceeding and will not be able to cut in line in front of other creditors of the broker-dealer for return of its securities under the transaction.

For more information on repos and the MRA, see Practice Note, Repos: Overview (US).