Settlement Payments Exempted from Avoidance

Utilizing the required “holistic approach” to the construction of the Bankruptcy Code under the United States Supreme Court's recent decision in Koons Buick Pontiac GMC, Inc. v. Nigh, 125 S.Ct. 460, 466-67 (2004), the BAP held that non-public transactions in illegally unregistered securities are not “settlement payments” that are “commonly used in the securities trade” within the meaning of 11 U.S.C. 741(8) and thus are not immunized from trustee avoiding powers by 11 U.S.C. ' 546(e). Such illicit trades cannot qualify as settlement payments under the Bankruptcy Code because “[t]o construe a transaction in an illegally unregistered security as 'commonly' occurring in the securities trade would amount to an absurd contradiction of the securities laws … [and] would undermine the statutory scheme harmonizing the Bankruptcy Code and the securities laws.”

As noted by the BAP, courts had tended to rely on rhetorical generalizations to describe the term “settlement payment,” depicting it vaguely as “broad” or as any payment “in completion of a securities transaction.” The result was a tangled thicket of case law with seemingly inconsistent rulings and circuit splits. In Grafton, the BAP delved into the thicket of case law and successfully integrated the seemingly disparate holdings from the various circuits. Indeed, the BAP's own analysis of the decisions that had found protected settlement payments to exist revealed that the courts' rhetoric did not match reality: Although the definition of a settlement payment was broad, it was not boundless.

The difficulty with the definition of “settlement payment” is that the term under 11 U.S.C. ' 741(8) relies on a conclusory laundry list of securities industry terms of art that contain the words “settlement payment” without articulating the elements of what that is. The BAP recognized, however, that the definition could be “rescued from its apparent circularity” by reference to the statute's own essential delimiter: “or any other similar payment commonly used in the securities trade.” 11 U.S.C. ' 741(8) (emphasis added). The key to a coherent construction of the statute was therefore found within the elemental principle that a provision that is ambiguous in isolation may be clarified by the remainder of the statutory scheme. Koons Buick Pontiac GMC, Inc., 125 S. Ct. at 468. As such, the BAP recognized that the statute itself prescribed that “[w]hatever else a settlement payment may be, it is restricted to the securities trade and must be 'commonly used.'”

Grafton has thus finally produced a coherent, usable test for whether a transaction is a protected settlement payment. Furthermore, this test adheres to congressional intent and thereby strikes the proper balance between the competing, yet inextricably linked, interests of the Bankruptcy Code and the federal securities laws.

In re Grafton

Grafton arose out of the bankruptcy of PinnFund USA, Inc. and its affiliates, collectively a $270 million “Ponzi scheme” that had collapsed into bankruptcy 12 days after the Securities Exchange Commission (SEC) took action leading to a receivership and to federal criminal prosecution of the principals.

PinnFund USA, Inc. had engaged in the mortgage banking business, originating, purchasing, and selling so-called non-conforming, or sub-prime, mortgage loans in California. Funds to make the loans came from investors in limited partnerships and a limited liability company formed for that purpose. Although PinnFund was required under its agreement with the affiliates to maintain the investors' funds in a trust account to be used solely to fund loans, about $100 million of the approximately $270 million raised was diverted to pay its operating losses and to finance lavish lifestyles for insiders.

The enterprise was a classic Ponzi scheme — much, if not all, of the return provided to the investors monthly under the guise of “interest” or participation fees actually came from the investors' contributions, rather from any actual underlying business activity. Indeed, the principals themselves confessed to running PinnFund as a Ponzi scheme during the course of the criminal prosecution in the SEC action. Circle Trust, the defendant in this action, had invested a total of $29 million in Six Sigma, a California limited liability company and one of PinnFund's funding entities, by purchasing Six Sigma “membership interests.” The membership interests were not registered, were limited to 99 “qualified purchasers” as defined by the Investment Company Act of 1940, were not transferable absent permission of the LLC manager, and were otherwise illiquid, allowing withdrawal by a member generally on 60 days' prior notice. Circle Trust represented to Six Sigma that it was acquiring its interest directly and without a compensated intermediary.

Circle Trust decided to withdraw from Six Sigma in late 2000, allegedly after doing “due diligence.” In April 2001, shortly after completing a series of payments to Circle Trust for redemption of its membership interests, and 12 days after the SEC sued, Six Sigma and the funding entities filed Chapter 7 cases. Richard M Kipperman, the trustee, sued Circle Trust to avoid and recover $4 million transferred within 90 days of the petition as a preference. Circle Trust moved for summary judgment, arguing that the transfer was a “settlement payment” under ' 741(8), and therefore protected under ' 546(e) from avoidance as a preference. The Bankruptcy Court for the Southern District of California agreed. The trustee appealed.

The BAP Decision

The BAP framed the issue in the case concisely and simply, ie: whether a non-public, non-market transaction involving an illegally unregistered security constituted a settlement payment commonly used in the securities trade. The BAP, in a unanimous decision, reversed the bankruptcy court's grant of Circle Trust's motion for summary judgment under 11 U.S.C. ' 546(e), finding that Circle Trust's withdrawal of capital from the Six Sigma Ponzi scheme 89 days before bankruptcy was not a settlement payment within the meaning of ' 741(8) and hence was not protected from the trustee's avoidance by ' 546(e). The BAP grounded its reversal of the Bankruptcy Court on three alternative analytical bases.

First, the BAP ruled that a settlement payment must involve a transaction linked to the legitimate public securities markets. Analyzing the universe of cases interpreting 11 U.S.C. ' 741(8), the BAP noted that all courts previously having found a protected settlement payment uniformly involved transactions in: 1) public markets; 2) publicly traded securities; and 3) where an intermediary (such as a broker or securities clearing agency) had played a role. As such, the BAP rejected protection under ' 546(e) for any transaction having no connection to the national system for the settlement and clearance of securities. Scrutinizing Circle Trust's private redemption of its privately placed membership interest, the BAP concluded in Grafton that because the transaction in question did not occur on a public market and did not involve the process of clearing trades, it therefore could not qualify as a statutorily protected settlement payment.

Second, it ruled that any transaction “steeped in fraud” was structurally inconsistent with the concept of a settlement payment that was commonly used in the securities trade. Thus, in this case where the transfer involved a distribution from an admittedly fraudulent Ponzi scheme, the particular transactions could not be “normally regarded” as part of the settlement process.

Third, and most importantly, the BAP ruled that where a transfer involved an illegal sale of unregistered securities, that fact alone per se barred the transaction from protection as a settlement payment under principles of statutory construction, because “an illegally unregistered security can hardly be described as a 'payment commonly used in the securities trade.'” The BAP's analysis was anchored by its exhaustive discussion of and citation to the legislative history, which revealed the “precise congressional intent” underlying the enacting legislation for the statute, Public Law 97-222, a package of 1982 amendments to the Bankruptcy Code that was precisely designed to protect the carefully-regulated mechanisms for clearing trades in securities and commodities in the public markets from vulnerability to a bankruptcy attack that could potentially destabilize the financial markets. See H.R. No. 420, 97th Cong., 2d Sess. 1 (1982).

The BAP reviewed the various facets of Public Law 97-222, including not only the limitation on avoiding powers under ' 546(e), but also its creation under 11 U.S.C. ' 555 of a power for a stockbroker or securities clearing agency to exercise a contractual right to liquidate a securities contract, and its provision codified under 11 U.S.C. ' 362(b)(6), excepting from the automatic stay any setoff made by a stockbroker or securities clearing agency on account of claims against a debtor for a margin or settlement payment arising out of a securities contract against property held by or due from that stockbroker or securities clearing agency. The BAP concluded from its analysis of the legislative history of each of these interrelated provisions of the Act that “Public Law 97-222 was designed to enhance enforcement of the securities laws and rules assuring the integrity of securities markets.” It was therefore axiomatic that Congress intended to create a statutory scheme designed to protect trades that complied with the securities laws — not trades in contravention of those laws.

Expanding on its holding, the BAP explained the essential policy need for such an integrated, coherent approach to the bankruptcy and securities laws: “If integrity and compliance with securities laws are to be preserved as the hallmark of the brand name of the United States securities markets, then trades in illegally unregistered securities must flunk the common usage test. An essential purpose of the federal securities laws is to ban trafficking in illegally unregistered securities so as to promote the reputation of American securities markets as safe for investment.”

Conclusion

Grafton is a carefully reasoned, exhaustively researched, meticulously crafted opinion. It is sure to become an important and oft-cited precedent, as it clarifies the appropriate interplay between the federal securities laws and the Bankruptcy Code in an area of growing importance to the securities markets, which have been impacted of late by the bankruptcy filings of large companies engaged in questionable securities transactions.

Under ' 546(e) of the Bankruptcy Code (the so-called “stockbroker defense” to select voidance actions), Congress has exempted from avoidance any “settlement payment” that is made “by or to a commodity broker, forward contract merchant, stockbroker, financial institution, or securities clearing agency, that is made before the commencement of the case,” except where the transfer is fraudulent under ' 548(a)(1)(A) of the Bankruptcy Code. 11 U.S.C. ' 546(e). So what exactly is a “settlement payment”? Prior to the BAP decision in In re Grafton Partners, the answer to this question was surprisingly unclear.

Recently, the Bankruptcy Appellate Panel of the Ninth Circuit in Kipperman v. Circle Trust (In re Grafton Partners, L.P.), 321 B.R. 527 (BAP 9th Cir. 2004), carefully elucidated the proper construction of the term, thereby demonstrating the manner in which the federal securities laws intersect with the Bankruptcy Code. The BAP's conclusion? Payments for illegally unregistered securities are not “settlement payments” as the term is defined for purposes of the securities trade in ' 741(8) of the Bankruptcy Code.

The Protected 'Settlement Payment'

Utilizing the required “holistic approach” to the construction of the Bankruptcy Code under the United States Supreme Court's recent decision in Koons Buick Pontiac GMC, Inc. v. Nigh , 125 S.Ct. 460, 466-67 (2004), the BAP held that non-public transactions in illegally unregistered securities are not “settlement payments” that are “commonly used in the securities trade” within the meaning of 11 U.S.C. 741(8) and thus are not immunized from trustee avoiding powers by 11 U.S.C. ' 546(e). Such illicit trades cannot qualify as settlement payments under the Bankruptcy Code because “[t]o construe a transaction in an illegally unregistered security as 'commonly' occurring in the securities trade would amount to an absurd contradiction of the securities laws … [and] would undermine the statutory scheme harmonizing the Bankruptcy Code and the securities laws.”

As noted by the BAP, courts had tended to rely on rhetorical generalizations to describe the term “settlement payment,” depicting it vaguely as “broad” or as any payment “in completion of a securities transaction.” The result was a tangled thicket of case law with seemingly inconsistent rulings and circuit splits. In Grafton, the BAP delved into the thicket of case law and successfully integrated the seemingly disparate holdings from the various circuits. Indeed, the BAP's own analysis of the decisions that had found protected settlement payments to exist revealed that the courts' rhetoric did not match reality: Although the definition of a settlement payment was broad, it was not boundless.

The difficulty with the definition of “settlement payment” is that the term under 11 U.S.C. ' 741(8) relies on a conclusory laundry list of securities industry terms of art that contain the words “settlement payment” without articulating the elements of what that is. The BAP recognized, however, that the definition could be “rescued from its apparent circularity” by reference to the statute's own essential delimiter: “or any other similar payment commonly used in the securities trade.” 11 U.S.C. ' 741(8) (emphasis added). The key to a coherent construction of the statute was therefore found within the elemental principle that a provision that is ambiguous in isolation may be clarified by the remainder of the statutory scheme. Koons Buick Pontiac GMC, Inc., 125 S. Ct. at 468. As such, the BAP recognized that the statute itself prescribed that “[w]hatever else a settlement payment may be, it is restricted to the securities trade and must be 'commonly used.'”

Grafton has thus finally produced a coherent, usable test for whether a transaction is a protected settlement payment. Furthermore, this test adheres to congressional intent and thereby strikes the proper balance between the competing, yet inextricably linked, interests of the Bankruptcy Code and the federal securities laws.

In re Grafton

Grafton arose out of the bankruptcy of PinnFund USA, Inc. and its affiliates, collectively a $270 million “Ponzi scheme” that had collapsed into bankruptcy 12 days after the Securities Exchange Commission (SEC) took action leading to a receivership and to federal criminal prosecution of the principals.

PinnFund USA, Inc. had engaged in the mortgage banking business, originating, purchasing, and selling so-called non-conforming, or sub-prime, mortgage loans in California. Funds to make the loans came from investors in limited partnerships and a limited liability company formed for that purpose. Although PinnFund was required under its agreement with the affiliates to maintain the investors' funds in a trust account to be used solely to fund loans, about $100 million of the approximately $270 million raised was diverted to pay its operating losses and to finance lavish lifestyles for insiders.

The enterprise was a classic Ponzi scheme — much, if not all, of the return provided to the investors monthly under the guise of “interest” or participation fees actually came from the investors' contributions, rather from any actual underlying business activity. Indeed, the principals themselves confessed to running PinnFund as a Ponzi scheme during the course of the criminal prosecution in the SEC action. Circle Trust, the defendant in this action, had invested a total of $29 million in Six Sigma, a California limited liability company and one of PinnFund's funding entities, by purchasing Six Sigma “membership interests.” The membership interests were not registered, were limited to 99 “qualified purchasers” as defined by the Investment Company Act of 1940, were not transferable absent permission of the LLC manager, and were otherwise illiquid, allowing withdrawal by a member generally on 60 days' prior notice. Circle Trust represented to Six Sigma that it was acquiring its interest directly and without a compensated intermediary.

Circle Trust decided to withdraw from Six Sigma in late 2000, allegedly after doing “due diligence.” In April 2001, shortly after completing a series of payments to Circle Trust for redemption of its membership interests, and 12 days after the SEC sued, Six Sigma and the funding entities filed Chapter 7 cases. Richard M Kipperman, the trustee, sued Circle Trust to avoid and recover $4 million transferred within 90 days of the petition as a preference. Circle Trust moved for summary judgment, arguing that the transfer was a “settlement payment” under ' 741(8), and therefore protected under ' 546(e) from avoidance as a preference. The Bankruptcy Court for the Southern District of California agreed. The trustee appealed.

The BAP Decision

The BAP framed the issue in the case concisely and simply, ie: whether a non-public, non-market transaction involving an illegally unregistered security constituted a settlement payment commonly used in the securities trade. The BAP, in a unanimous decision, reversed the bankruptcy court's grant of Circle Trust's motion for summary judgment under 11 U.S.C. ' 546(e), finding that Circle Trust's withdrawal of capital from the Six Sigma Ponzi scheme 89 days before bankruptcy was not a settlement payment within the meaning of ' 741(8) and hence was not protected from the trustee's avoidance by ' 546(e). The BAP grounded its reversal of the Bankruptcy Court on three alternative analytical bases.

First, the BAP ruled that a settlement payment must involve a transaction linked to the legitimate public securities markets. Analyzing the universe of cases interpreting 11 U.S.C. ' 741(8), the BAP noted that all courts previously having found a protected settlement payment uniformly involved transactions in: 1) public markets; 2) publicly traded securities; and 3) where an intermediary (such as a broker or securities clearing agency) had played a role. As such, the BAP rejected protection under ' 546(e) for any transaction having no connection to the national system for the settlement and clearance of securities. Scrutinizing Circle Trust's private redemption of its privately placed membership interest, the BAP concluded in Grafton that because the transaction in question did not occur on a public market and did not involve the process of clearing trades, it therefore could not qualify as a statutorily protected settlement payment.

Second, it ruled that any transaction “steeped in fraud” was structurally inconsistent with the concept of a settlement payment that was commonly used in the securities trade. Thus, in this case where the transfer involved a distribution from an admittedly fraudulent Ponzi scheme, the particular transactions could not be “normally regarded” as part of the settlement process.

Third, and most importantly, the BAP ruled that where a transfer involved an illegal sale of unregistered securities, that fact alone per se barred the transaction from protection as a settlement payment under principles of statutory construction, because “an illegally unregistered security can hardly be described as a 'payment commonly used in the securities trade.'” The BAP's analysis was anchored by its exhaustive discussion of and citation to the legislative history, which revealed the “precise congressional intent” underlying the enacting legislation for the statute, Public Law 97-222, a package of 1982 amendments to the Bankruptcy Code that was precisely designed to protect the carefully-regulated mechanisms for clearing trades in securities and commodities in the public markets from vulnerability to a bankruptcy attack that could potentially destabilize the financial markets. See H.R. No. 420, 97th Cong., 2d Sess. 1 (1982).

The BAP reviewed the various facets of Public Law 97-222, including not only the limitation on avoiding powers under ' 546(e), but also its creation under 11 U.S.C. ' 555 of a power for a stockbroker or securities clearing agency to exercise a contractual right to liquidate a securities contract, and its provision codified under 11 U.S.C. ' 362(b)(6), excepting from the automatic stay any setoff made by a stockbroker or securities clearing agency on account of claims against a debtor for a margin or settlement payment arising out of a securities contract against property held by or due from that stockbroker or securities clearing agency. The BAP concluded from its analysis of the legislative history of each of these interrelated provisions of the Act that “Public Law 97-222 was designed to enhance enforcement of the securities laws and rules assuring the integrity of securities markets.” It was therefore axiomatic that Congress intended to create a statutory scheme designed to protect trades that complied with the securities laws — not trades in contravention of those laws.

Expanding on its holding, the BAP explained the essential policy need for such an integrated, coherent approach to the bankruptcy and securities laws: “If integrity and compliance with securities laws are to be preserved as the hallmark of the brand name of the United States securities markets, then trades in illegally unregistered securities must flunk the common usage test. An essential purpose of the federal securities laws is to ban trafficking in illegally unregistered securities so as to promote the reputation of American securities markets as safe for investment.”

Conclusion

Grafton is a carefully reasoned, exhaustively researched, meticulously crafted opinion. It is sure to become an important and oft-cited precedent, as it clarifies the appropriate interplay between the federal securities laws and the Bankruptcy Code in an area of growing importance to the securities markets, which have been impacted of late by the bankruptcy filings of large companies engaged in questionable securities transactions.