Prime Brokers, Take Note

However, in order to prevail, the trustee had to overcome the so-called 'stockholder defense' to constructive fraudulent transfers under ' 546(e) of the Bankruptcy Code by proving that the transfers were made with actual intent to hinder, delay or defraud one or more of the Debtor's present or future creditors under ' 548(a)(1)(A) of the Bankruptcy Code.

The Chapter 7 trustee moved for summary judgment. Bear Sterns opposed the motion, arguing that it was simply a 'conduit' for the margin payments rather than the 'initial transferee' of the funds since its use of the funds was strictly limited by the standard 'boilerplate provisions' of the brokerage agreement. According to Bear Sterns, it lacked dominion and control over the funds.

The Bankruptcy Court Decision

The Bankruptcy Court granted the Chapter 7 trustee's motion for summary judgment. Applying the Second Circuit's 'dominion and control' test, the Bankruptcy Court found that Bear Stearns was more than a mere 'conduit,' stating:

The caselaw finding that an entity is a mere conduit differ from the facts here. In most cases, the recipient was held to be a mere conduit primarily because it did not receive consideration or compensation for its services nor did it have any liability in the transaction as a whole if the transfers had been made to the recipient. In this case, Bear Sterns made $2.4 million profit on the [Debtor's] transactions during its tenure as the [Debtor's] primary broker. Moreover, Bear Sterns used the funds in the account to cover all open positions the [Debtor] had with Bear Sterns for which Bear Sterns would have been liable if the transfers had not been made (citations omitted). Gredd at *9.

Under the terms of the [Debtor's] Agreement with Bear Sterns, Bear Sterns had a security interest in any monies transferred; held the monies transferred as collateral for short sales; had the right to and did prohibit the [Debtor] from withdrawing any of the monies transferred as long as any short position remained open; and had the right to and did use the monies transferred to purchase covering securities, with or without the [Debtor's] consent. Thus, Bear Sterns had the ability to exercise control and use the Transfers to protect its own economic well-being and thus, is not a mere conduit with respect to those Transfers (citations omitted). Id.

Bear Sterns also invoked the 'good faith defense' under ' 548(c) of the Bankruptcy Code, claiming that it gave value to the Debtor (by paying off its liabilities) and did so in good faith. Under ' 548(d)(2)(b) of the Bankruptcy Code, a stockbroker or financial institution (like Bear Stearns) that receives margin payments such as the payments made
by the Debtor, takes those payments 'for value.' As to the issue of good faith, Bear Sterns asserted that it was unaware of the fraudulent nature of the scheme being perpetrated by the Debtor. The court noted that Bear Sterns had the burden of proof under this defense. The Bankruptcy Court concluded that Bear Sterns had not raised triable issue of facts sufficient to defeat the trustee's motion for summary judgment because Bear Sterns was on 'inquiry notice' of the fraudulent nature of the Debtor's scheme.

Overhead Remark

Bear Sterns was charged with inquiry notice because, among other things, of a remark overheard at a holiday party by a Bear Sterns' managing director to the effect that the Debtor had been earning large profits, while the managing director had been under the impression that the Debtor had been losing money. That inconsistency prompted the Bear Sterns managing director to ask a manager for the Debtor to confirm or deny what he had heard. The Debtor's manager said that the discrepancy was a result of the fact that the Debtor was using several different brokerage firms. This information, however, was false. Under these facts, the Bankruptcy Court determined that Bear Sterns could have discovered the truth by carefully reviewing the footnotes to the Debtor's financial statements, which stated that all of the Debtor's transactions were handled by a single brokerage firm. Bear Sterns eventually did investigate the Debtor, but only shortly before the Debtor's scheme collapsed. The Bankruptcy Court held that due diligence required Bear Sterns to investigate, stating:

Based upon the information it had, Bear Sterns was required to do more than simply ask the wrongdoer if he was doing wrong … Diligence requires consulting easily obtainable sources of information that would bear on the truth of any explanation received from the potential wrongdoer … The simple steps Bear Sterns finally performed one year later, demonstrate that Bear Sterns failed to act diligently in a timely manner and accordingly, Bear Sterns cannot satisfy its burden of showing that it acted with the diligence required to establish good faith under Section 548(c) of the Bankruptcy Code. Gredd at *14.

The Appeal

On appeal, Bear Stearns argues that the decision should be reversed because the Bankruptcy Court 'grossly misapplied the well-established 'dominion and control' test, dramatically expanding the scope of fraudulent transfer liability to mere financial intermediaries.' Bear Stearns further argues that '[i]t is undisputed that the federal securities law make it unlawful ' to use ' customer deposits for its own proprietary purposes.' In effect, the funds in question belonged to the Debtor, not Bear Stearns. Bear Stearns additionally states that '[t]he fact that boilerplate rights in the [Debtor's] standard account agreement gave Bear Stearns limited rights (at least theoretically) to apply the deposits to 'protect its own economic well-being by using the [Debtor's] money to meet the [Debtor's] obligation ' falls far short of the high standard of 'dominion and control' that the controlling case law requires.'

Two amici curae briefs have been filed seeking reversal of the Bankruptcy Court's decision, one
by the International Swaps and Derivatives Association, Inc. and Financial Markets Lawyers Group (collectively, 'ISDA') and by the Securities Industry and Financial Markets Association ('SIFMA').

ISDA argues that Bear Stearns was not an 'initial transferee' of the funds in the Debtor's accounts, stating:

[I]f a financial intermediary's contingent right to use customer funds to avoid depletion of its own capital were sufficient to transform the intermediary into an 'initial transferee' under the fraudulent transfer law, financial intermediaries could be subjected to limitations that not only vastly exceed the comparatively small fees earned from their customer's trades but could even exceed their own proprietary firm capital.

ISDA concludes that:

[i]t would impair rather than advance the interest of investors in having a sound and efficient securities clearance and settlement system to require intermediaries to investigate the propriety of the transactions they are processing (citation omitted).

In substance, ISDA suggests that the rule enunciated by the Seventh Circuit in Bonded Fin. Servs. Inc. v. European American Bank, 838 F.2d 890 (7^th Cir. 1988) (i.e., 'the minimum requirement of status as a 'transferee' is dominion over the money or other assets, the right to put the money to one's own purposes') as accepted by the Second Circuit in Finley, Kimble, Wagner, Heine, Underberg, Manley, Myerson & Casey, 130 F.3d 52, 55-58 (2^nd Cir. 1997) (following the 'widely adopted' logic of Bonded) should be followed. As such, ISDA argues the facts show that Bear Stearns was a financial intermediary with essentially no discretion over the Debtor's funds in its accounts and thus cannot be held to have received a fraudulent transfer.

SIFMA takes a slightly different approach, arguing that if the decision is not reversed, it will have an adverse effect on the securities industry by disrupting current precedent, standard industry practices, and the important balance the law has struck in order to allow millions of securities and commodities transactions to be processed quickly and cheaply, every day by competing securities clearing firms and prime brokers to undertake costly, time-consuming investigations into their accountholders' motives for issuing transaction restrictions, resulting in firms either raising costs or withholding financing, thereby reducing market liquidity and, as a result, raising the cost of capital.

Implications

What are the implications of the Bankruptcy Court's decision? If the decision is not reversed, prime brokers may need to structure accounts to avoid a finding by a court of 'dominion and control' over funds in the accounts to avoid liability as 'initial transferees.' The so-called boilerplate language currently used in account agreements will need to be modified. Further, prime brokers may have to reconsider the level of oversight they apply in order to meet the good faith test under ' 548(c) of the Bankruptcy Code. Bottom line, the shifting of risk for the conduct of their customers to prime brokers to protect investors when the broker is on inquiry notice of the customer's fraud imposes a potentially significant liability on prime brokers – a cost that will likely be passed through to investors either in higher transaction costs or delay in processing securities transactions. Unless reversed on appeal, the Bankruptcy Court's decision is likely to impose significant due diligence obligations on prime brokers to identify bad conduct of their customers or suffer substantial liability ' a result that is likely to have 'dramatic repercussions' for the securities industry.

Robert W. Dremluk, a member of this newsletter's Board of Editors, is a partner in the New York office of Seyfarth Shaw LLP. His work focuses on diverse interests in federal and bankruptcy court litigation and advice and risk assessment regarding transactional matters, including asset purchases and structured finance transactions. He may be reached at [email protected].. The author gratefully acknowledges the assistance of Sara E. Lorber, an associate at the firm, in the preparation of this article.

A recent decision issued by the Bankruptcy Court for the Southern District of New York (the 'Bankruptcy Court') in Gredd v. Bear, Stearns Securities Corp. (In re Manhattan Inv. Fund Ltd.), 2007 WL 60843 (Bankr. S.D.N.Y. Jan. 9, 2007) represents a significant event for securities firms, with potentially far-reaching implications for prime brokers.

In Gredd, Manhattan Investment Fund Ltd. (the 'Debtor') was engaged in a scheme involving 'shorting' technology stocks (i.e., it would bet that the stocks would decline in value). The Debtor established a brokerage account at Bear, Stearns Securities Corp. ('Bear Stearns') to facilitate the short-sale transactions. Under the terms of the Bear Stern account, money received from investors would be deposited into an account at Bear Sterns and would then be used by the Debtor for securities trading. Bear Sterns retained a security interest in the funds held in the account, and also had the right to prevent withdrawals from the account in order to cover any unsatisfied obligations stemming from the Debtor's trading activity.

The Debtor's short-sale scheme collapsed during the 'tech boom' of the late 1990s, leading to a Chapter 7 filing. The Chapter 7 trustee commenced an adversary proceeding against Bear Sterns pursuant to ' 548 of the Bankruptcy Code seeking to recover approximately $141 million in margin payments made during the year prior to the bankruptcy filing on the grounds that the payments constituted fraudulent transfers.

However, in order to prevail, the trustee had to overcome the so-called 'stockholder defense' to constructive fraudulent transfers under ' 546(e) of the Bankruptcy Code by proving that the transfers were made with actual intent to hinder, delay or defraud one or more of the Debtor's present or future creditors under ' 548(a)(1)(A) of the Bankruptcy Code.

The Chapter 7 trustee moved for summary judgment. Bear Sterns opposed the motion, arguing that it was simply a 'conduit' for the margin payments rather than the 'initial transferee' of the funds since its use of the funds was strictly limited by the standard 'boilerplate provisions' of the brokerage agreement. According to Bear Sterns, it lacked dominion and control over the funds.

The Bankruptcy Court Decision

The Bankruptcy Court granted the Chapter 7 trustee's motion for summary judgment. Applying the Second Circuit's 'dominion and control' test, the Bankruptcy Court found that Bear Stearns was more than a mere 'conduit,' stating:

The caselaw finding that an entity is a mere conduit differ from the facts here. In most cases, the recipient was held to be a mere conduit primarily because it did not receive consideration or compensation for its services nor did it have any liability in the transaction as a whole if the transfers had been made to the recipient. In this case, Bear Sterns made $2.4 million profit on the [Debtor's] transactions during its tenure as the [Debtor's] primary broker. Moreover, Bear Sterns used the funds in the account to cover all open positions the [Debtor] had with Bear Sterns for which Bear Sterns would have been liable if the transfers had not been made (citations omitted). Gredd at *9.

Under the terms of the [Debtor's] Agreement with Bear Sterns, Bear Sterns had a security interest in any monies transferred; held the monies transferred as collateral for short sales; had the right to and did prohibit the [Debtor] from withdrawing any of the monies transferred as long as any short position remained open; and had the right to and did use the monies transferred to purchase covering securities, with or without the [Debtor's] consent. Thus, Bear Sterns had the ability to exercise control and use the Transfers to protect its own economic well-being and thus, is not a mere conduit with respect to those Transfers (citations omitted). Id.

Bear Sterns also invoked the 'good faith defense' under ' 548(c) of the Bankruptcy Code, claiming that it gave value to the Debtor (by paying off its liabilities) and did so in good faith. Under ' 548(d)(2)(b) of the Bankruptcy Code, a stockbroker or financial institution (like Bear Stearns) that receives margin payments such as the payments made
by the Debtor, takes those payments 'for value.' As to the issue of good faith, Bear Sterns asserted that it was unaware of the fraudulent nature of the scheme being perpetrated by the Debtor. The court noted that Bear Sterns had the burden of proof under this defense. The Bankruptcy Court concluded that Bear Sterns had not raised triable issue of facts sufficient to defeat the trustee's motion for summary judgment because Bear Sterns was on 'inquiry notice' of the fraudulent nature of the Debtor's scheme.

Overhead Remark

Bear Sterns was charged with inquiry notice because, among other things, of a remark overheard at a holiday party by a Bear Sterns' managing director to the effect that the Debtor had been earning large profits, while the managing director had been under the impression that the Debtor had been losing money. That inconsistency prompted the Bear Sterns managing director to ask a manager for the Debtor to confirm or deny what he had heard. The Debtor's manager said that the discrepancy was a result of the fact that the Debtor was using several different brokerage firms. This information, however, was false. Under these facts, the Bankruptcy Court determined that Bear Sterns could have discovered the truth by carefully reviewing the footnotes to the Debtor's financial statements, which stated that all of the Debtor's transactions were handled by a single brokerage firm. Bear Sterns eventually did investigate the Debtor, but only shortly before the Debtor's scheme collapsed. The Bankruptcy Court held that due diligence required Bear Sterns to investigate, stating:

Based upon the information it had, Bear Sterns was required to do more than simply ask the wrongdoer if he was doing wrong … Diligence requires consulting easily obtainable sources of information that would bear on the truth of any explanation received from the potential wrongdoer … The simple steps Bear Sterns finally performed one year later, demonstrate that Bear Sterns failed to act diligently in a timely manner and accordingly, Bear Sterns cannot satisfy its burden of showing that it acted with the diligence required to establish good faith under Section 548(c) of the Bankruptcy Code. Gredd at *14.

The Appeal

On appeal, Bear Stearns argues that the decision should be reversed because the Bankruptcy Court 'grossly misapplied the well-established 'dominion and control' test, dramatically expanding the scope of fraudulent transfer liability to mere financial intermediaries.' Bear Stearns further argues that '[i]t is undisputed that the federal securities law make it unlawful ' to use ' customer deposits for its own proprietary purposes.' In effect, the funds in question belonged to the Debtor, not Bear Stearns. Bear Stearns additionally states that '[t]he fact that boilerplate rights in the [Debtor's] standard account agreement gave Bear Stearns limited rights (at least theoretically) to apply the deposits to 'protect its own economic well-being by using the [Debtor's] money to meet the [Debtor's] obligation ' falls far short of the high standard of 'dominion and control' that the controlling case law requires.'

Two amici curae briefs have been filed seeking reversal of the Bankruptcy Court's decision, one
by the International Swaps and Derivatives Association, Inc. and Financial Markets Lawyers Group (collectively, 'ISDA') and by the Securities Industry and Financial Markets Association ('SIFMA').

ISDA argues that Bear Stearns was not an 'initial transferee' of the funds in the Debtor's accounts, stating:

[I]f a financial intermediary's contingent right to use customer funds to avoid depletion of its own capital were sufficient to transform the intermediary into an 'initial transferee' under the fraudulent transfer law, financial intermediaries could be subjected to limitations that not only vastly exceed the comparatively small fees earned from their customer's trades but could even exceed their own proprietary firm capital.

ISDA concludes that:

[i]t would impair rather than advance the interest of investors in having a sound and efficient securities clearance and settlement system to require intermediaries to investigate the propriety of the transactions they are processing (citation omitted).

In substance, ISDA suggests that the rule enunciated by the Seventh Circuit in Bonded Fin. Servs. Inc. v. European American Bank , 838 F.2d 890 (7 th Cir. 1988) ( i.e. , 'the minimum requirement of status as a 'transferee' is dominion over the money or other assets, the right to put the money to one's own purposes') as accepted by the Second Circuit in Finley, Kimble, Wagner, Heine, Underberg, Manley, Myerson & Casey , 130 F.3d 52, 55-58 (2 nd Cir. 1997) (following the 'widely adopted' logic of Bonded) should be followed. As such, ISDA argues the facts show that Bear Stearns was a financial intermediary with essentially no discretion over the Debtor's funds in its accounts and thus cannot be held to have received a fraudulent transfer.

SIFMA takes a slightly different approach, arguing that if the decision is not reversed, it will have an adverse effect on the securities industry by disrupting current precedent, standard industry practices, and the important balance the law has struck in order to allow millions of securities and commodities transactions to be processed quickly and cheaply, every day by competing securities clearing firms and prime brokers to undertake costly, time-consuming investigations into their accountholders' motives for issuing transaction restrictions, resulting in firms either raising costs or withholding financing, thereby reducing market liquidity and, as a result, raising the cost of capital.

Implications

What are the implications of the Bankruptcy Court's decision? If the decision is not reversed, prime brokers may need to structure accounts to avoid a finding by a court of 'dominion and control' over funds in the accounts to avoid liability as 'initial transferees.' The so-called boilerplate language currently used in account agreements will need to be modified. Further, prime brokers may have to reconsider the level of oversight they apply in order to meet the good faith test under ' 548(c) of the Bankruptcy Code. Bottom line, the shifting of risk for the conduct of their customers to prime brokers to protect investors when the broker is on inquiry notice of the customer's fraud imposes a potentially significant liability on prime brokers – a cost that will likely be passed through to investors either in higher transaction costs or delay in processing securities transactions. Unless reversed on appeal, the Bankruptcy Court's decision is likely to impose significant due diligence obligations on prime brokers to identify bad conduct of their customers or suffer substantial liability ' a result that is likely to have 'dramatic repercussions' for the securities industry.

Robert W. Dremluk, a member of this newsletter's Board of Editors, is a partner in the New York office of Seyfarth Shaw LLP. His work focuses on diverse interests in federal and bankruptcy court litigation and advice and risk assessment regarding transactional matters, including asset purchases and structured finance transactions. He may be reached at [email protected].. The author gratefully acknowledges the assistance of Sara E. Lorber, an associate at the firm, in the preparation of this article.