In re Bernard L. Madoff Investment Securities LLC: Second Circuit Applies Section 546(e) Safe Harbor to Protect Madoff Ponzi Scheme Payments

Practical Law Legal Update 9-595-7247 (Approx. 6 pages)

In re Bernard L. Madoff Investment Securities LLC: Second Circuit Applies Section 546(e) Safe Harbor to Protect Madoff Ponzi Scheme Payments

by Practical Law Finance

Background

Bernard L. Madoff Investment Securities LLC (BLMIS) purported to execute a "split stroke conversion strategy" for customers of its investment advisory unit. This strategy would have consisted of timing the market to purchase a basket of stocks on the S&P 100 Index, and then hedging those purchases with related options contracts. In practice, however, BLMIS's investment advisory business conducted no actual securities or options trading on behalf of its customers. Rather, BLMIS deposited customer investments into a single commingled checking account and fabricated customer statements to show fictitious securities trading activity and returns ranging from between 10 and 17 percent annually. When customers sought to withdraw money from their accounts, BLMIS sent them cash from the commingled checking account.

Following the collapse of Madoff's Ponzi scheme in 2008, BLMIS was placed in liquidation under the Securities Investor Protection Act (SIPA) and Irving H. Picard (Trustee) was appointed as the SIPA trustee. The Trustee was required under the SIPA to collect and set aside a fund of "customer property" to repay BLMIS customers ratably in proportion to each customer's "net equity."

The Trustee sought to avoid, as fraudulent transfers under section 548(a) of the Bankruptcy Code, the transfers to hundreds of BLMIS customers who had profited (whether knowingly or not) from the Ponzi scheme by withdrawing more from their accounts than they had invested. Certain BLMIS customers (Defendants) moved to dismiss these avoidance actions, on the grounds that these transfers were protected by the section 546(e) safe harbor, and therefore could not be clawed back by the Trustee.

Section 546(e) states, in relevant part, that a trustee may not avoid a transfer, by certain protected parties, that is:

A "settlement payment."
A transfer made "in connection with a securities contract."

The US District Court for the Southern District of New York agreed with the Defendants that the payments were shielded by section 546(e) and dismissed the Trustee's clawback claims, with the exception of actual-fraud claims.

The Trustee appealed to the Second Circuit, arguing that section 546(e) should not apply because:

BLMIS never initiated, executed, completed or settled the securities transactions contemplated by the customer agreements.
The transfers were not "made in connection with a securities contract" or "settlement payments" as those terms are defined in section 741 of the Bankruptcy Code.
Applying section 546(e) in this case would amount to giving legal effect to Madoff's fraud.

Outcome

The Second Circuit affirmed the District Court, and held that section 546(e) protected the transfers from avoidance because the transfers were both:

Made in connection with a securities contract.
Settlement payments.

Transfers Were Made in Connection With Securities Contracts

In concluding that the transfers were made in connection with a securities contract, the Second Circuit focused on the expansive definition section 546(e) gives to the terms:

Securities contract.
In connection with.

Expansive Definition of "Securities Contract"

The Second Circuit first focused on the "extraordinary breadth" of the term "securities contract" as it is defined in section 546(e). It reasoned that the term "securities contract" encompasses "contracts for the purchase or sale of securities, as well as any agreements that are similar or related to contracts for the purchase or sale of securities." The Second Circuit concluded that, here, BLMIS customers entered into "securities contracts" when they opened up customer accounts by executing the following three documents (collectively, Account Documents):

A "Customer Agreement," which authorized BLMIS to open or maintain one or more accounts. The Second Circuit found that the Customer Agreement established the broker-customer relationship.
A "Trading Authorization," which appointed BLMIS to be the customer's agent to buy, sell and trade in securities. The Second Circuit found that the Trading Authorization authorized BLMIS to trade in securities for the customer's account.
An "Option Agreement," which authorized BLMIS to engage in options trading for the customer's account.

First, the Second Circuit reasoned that the Account Documents fell within section 741(7)(A)(i)'s broad definition of the term "securities contract" because they specified the terms by which BLMIS could acquire and dispose of securities for the customer. The Second Circuit concluded that whether BLMIS actually transacted in securities was not determinative, because section 741(7) and section 546(e) of the Bankruptcy Code do not contain a purchase or sale requirement. Rather, section 546(e) requires only that a covered transfer be broadly related to a "securities contract," not that it be connected to an actual securities transaction.

Next, the Second Circuit rejected the Trustee's argument that the Account Documents were not securities contracts because they did not specifically "identify any security, issuer, quantity, price, or other terms necessary to describe a security transaction." The Second Circuit found that section 741(7)(A) of the Bankruptcy Code does not require any greater specificity than what the Trading Authorization provided by identifying a specific category of public securities.

Finally, the Second Circuit rejected the Trustee's argument that the Account Documents were not securities contracts because they merely authorized, but did not expressly obligate, BLMIS to conduct securities transactions on behalf of its customers. The Second Circuit found that the definition of "securities contract" is not so limited, and to the contrary, encompasses the relationship created by the Account Documents because it includes "any other agreement . . . that is similar to" a "contract for the purchase, sale or loan of a security." Here, the Account Documents established that BLMIS and its customers "manifested their mutual assent" that BLMIS would conduct securities transactions on the customers' behalf. The Second Circuit concluded that this agreement was sufficiently "similar to" a contract for the purchase or sale of a security.

"In Connection With" Language

The Second Circuit then concluded that the payments BLMIS made to its customers were made "in connection with" the securities contracts.

Under section 546(e), a transfer is "in connection with" a securities contract if it is "related to" or "associated with" the securities contract. The Second Circuit found that, in this case, the customer withdrawals from their accounts following the creation of the securities contracts were related to, and associated with, the securities contracts.

In rejecting the Trustee's argument that Ponzi scheme payments, by definition, are not "in connection with" a securities contract, the Second Circuit noted that section 546(e) sets a "low bar" for the required relationship between the securities contracts and the transfer. Further, the Second Circuit explained that payments made in connection with a Ponzi scheme, while fraudulent, may at the same time also be made in connection with a securities contract, even if that contract was "flagrantly" breached.

Transfers Constituted Settlement Payments

Finally, the Second Circuit concluded that, as an alternative basis to shield the transfers from avoidance under section 546(e), the transfers also constituted "settlement payments" made by a "stockbroker." The Second Circuit again rejected the Trustee's argument that the transfers were not "settlement payments" because BLMIS never engaged in actual securities trading. Rather, relying on its previous decision in Enron Creditors Recovery Corp. v. Alfa S.A.B. de C.V., the Second Circuit held that the statutory definition of settlement payment should be broadly construed to apply to the transfer of cash or securities to complete a securities transaction (see 651 F.3d 329, 334 (2d Cir. 2011) and Legal Update, Second Circuit Holds that "Settlement Payment" Safe Harbor Insulates Early Redemptions of Enron Commercial Paper from Fraudulent Transfer and Preference Attack). In this case, each time a customer requested a withdrawal from BLMIS, he or she intended that BLMIS dispose of securities and remit payment to the customer. The Second Circuit agreed with the District Court that customers granting this discretion to BLMIS to sell or liquidate securities in their accounts to implement their sell orders or withdrawal requests was sufficient for these customer payments to constitute a "settlement payments."

Practical Implications

This decision continues the Second Circuit's trend of broadly interpreting the plain language of the section 546(e) safe harbor. For example, see the following Legal Updates:

The decision also continues the trend of the Circuit courts applying the section 546(e) safe harbor to Ponzi scheme cases. For example, see the following Legal Updates:

For more information on the section 546(e) safe harbors, see Practice Note, Bankruptcy Code Avoidance Action Safe Harbors and on the Bankruptcy Code's safe harbors generally, see Guide to Bankruptcy Code Safe Harbors for Financial Contracts: Checklist.

In re Bernard L. Madoff Investment Securities LLC: Second Circuit Applies Section 546(e) Safe Harbor to Protect Madoff Ponzi Scheme Payments | Practical Law