Second Circuit Affirms Protection of the Section 546(e) Safe-Harbor Shield for Certain Madoff Investors

The answer is no. Irving H. Picard, the trustee (the Trustee) for Bernard L. Madoff Investment Securities LLC (BLMIS), appointed pursuant to the Securities Investor Protection Act (SIPA), may not clawback money paid out by BLMIS to hundreds of its customers. This was the recent decision reached by the United States Court of Appeals for the Second Circuit in Picard v. Ida Fishman Revocable Trust (In re Bernard L. Madoff Investment Seurities LLC), 773 F.3d 411 (2d Cir. 2014), and the decision continues the recent trend of extending the reach of Bankruptcy Code section 546(e)'s safe harbor protections. But, why not? Potentially hundreds of millions of dollars could be recovered and then paid out ratably to all BLMIS customers? Simply put, a SIPA trustee can only avoid and recover transferred funds that are voidable under the Bankruptcy Code, and section 546(e) provides an important exception to a trustee's clawback powers, which was triggered in this case. This article explores the arguments advanced in support of, and in opposition to, avoiding the payments made by BLMIS to its customers.

The Relevant Madoff Facts

We know the general story, but here are some of the key facts underlying this latest Madoff decision. When investors wanted to open accounts with BLMIS, they were required to execute the following three documents: 1) a “Customer Agreement,” which authorized BLMIS to open or maintain an account for the customer's benefit; 2) a “Trading Authorization,” pursuant to which each customer appointed BLMIS to be the customer's agent, and to, among other things, buy, sell and trade in any securities; and 3) an “Option Agreement” (together with the Customer Agreement and the Trading Authorization, the “Account Documents”) pursuant to which each customer authorized BLMIS to engage in options trading for the customer's account. Unfortunately, BLMIS did not conduct any actual securities or options trading. Instead, customer investments were deposited into a single commingled account, and BLMIS prepared customer statements to evidence fictitious securities trading activity. When customers wanted to withdraw their funds, BLMIS simply sent them cash from the commingled account.

After Madoff's Ponzi scheme collapsed, the Trustee sued hundreds of BLMIS customers, who apparently withdrew more from their accounts than they had invested, in an attempt to recover the funds in order to repay all BLMIS customers ratably in proportion to each customer's net equity. District Court Judge Rakoff, in the Southern District of New York, considered and ultimately dismissed the clawback claims in one particular test case, holding that: 1) Bankruptcy Code section 546(e) applied because BLMIS was a stockbroker; 2) the Account Documents were “securities contracts”; and 3) the customer withdrawals were payments made in connection with securities contracts or were settlement payments. Picard v. Katz, 462 B.R. 447 (S.D.N.Y. 2011). The Katz dismissal opened the floodgates, as hundreds of clawback defendants filed motions to dismiss on 546(e) grounds. And, Judge Rakoff dismissed those clawback claims for the same reasons, with the exception of actual fraud claims under 548(a)(1)(A).

The Safe Harbor of Bankruptcy Code Section 546(e)

Bankruptcy Code section 547(b)(4)(A)(B) enables a Chapter 11 debtor or trustee to avoid a transfer made within 90 days of its bankruptcy filing ' one year if the transferee was an insider ' if certain statutory conditions are satisfied. However, even when all such conditions have been satisfied, the disputed transfer may be protected from any avoidance attack by the safe harbor shield of Bankruptcy Code section 546(e). Section 546(e) provides, in relevant part, that a debtor or trustee may not avoid a transfer ' other than an actual fraudulent transfer under Bankruptcy Code section 548(a)(1)(A) ' made by, among others, a stockbroker, if such transfer: 1) was a “settlement payment” as defined in Bankruptcy Code section 741; or 2) was made in connection with a “securities contract” as defined in Bankruptcy Code section 741(7)(i). See 11 U.S.C. 546(e). Bankruptcy Code section 741(8) defines “settlement payment” as a “preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, or any other similar payment commonly used in the securities trade.” 11 U.S.C. 741(8). A “securities contract” is broadly defined in Bankruptcy Code section 741(7) to include not just contracts for the purchase or sale of securities, but any other agreements that are similar or related thereto. 11 U.S.C. 741(7)(A). Because none of the parties disputed that BLMIS was a stockbroker for the purposes of section 546(e), the appeal turned on whether the transfers were “settlement payments” or were made “in connection with a securities contract.”

Did the Account Documents Constitute a 'Securities Contract'?

Yes. The clawback defendants argued that the Account Documents, together, created a “securities contract,” and the Second Circuit agreed. In opposition, the Trustee advanced three ultimately unpersuasive arguments. Citing the Second Circuit's decision in Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.), 651 F.3d 329 (2d Cir. 2011) ' i.e., that the purpose of 546(e) is to “minimize[] the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries ' ” ' the Trustee first argued that 546(e) simply did not apply, since BLMIS never initiated, executed, completed or settled the securities transactions it promised to engage in and, therefore, there was no disruption in the securities markets. The Second Circuit rejected this argument on two grounds: 1) neither section 741(7) nor 546(e) contain a purchase or sale requirement; and 2) in fact, the Trustee's interpretation, if accepted, could cause the very market disruption Congress sought to minimize in enacting 546(e) ' i.e., the recovery of hundreds of millions of dollars, if not more, from BLMIS clients who had every reason to believe that BLMIS was actually engaged in the trading of securities.

The second argument advanced by the Trustee was that the Account Documents were not “securities contracts” because they did not specifically identify the terms necessary to describe a security transaction including any security, issuer, quantity, or price. But the Second Circuit correctly concluded that the argument constructed a specificity requirement that the law does not contain. The Trading Authorization identified a specific category of public securities to be traded and that, concluded the Second Circuit, was sufficient. No greater specificity was required.

Finally, the Trustee argued that because the Account Documents only authorized BLMIS to conduct securities transactions rather than expressly obligating BLMIS to carry out any such transactions, the Account Documents merely established, if anything, an agency relationship between BLMIS and its customers, similar to that between a real estate broker and a home buyer, but under no circumstances did they establish a “true” contractual obligation.

Once again, the Second Circuit concluded that the statutory definition of a “securities contract” is not limited in the way the Trustee interpreted it, and, in fact, encompassed exactly the relationship created by the Account Documents. First, pursuant to the catch-all provision of Bankruptcy Code section 741(7)(A)(vii), the Account Documents were “similar to” a contract for the purchase or sale of a security because they established that BLMIS and its customers manifested their mutual assent that BLMIS would conduct certain approved securities transactions. Second, the payments BLMIS made to its customers were certainly made “in connection with” the Account Documents because the customer's withdrawals from their accounts were related to, and associated with, such documents. In light of the foregoing, the Second Circuit concluded that the investor withdrawals from BLMIS were made “in connection with a securities contract” and therefore those payments should be shielded from the Trustee's clawback action pursuant to section 546(e).

Did the Investor Withdrawals Constitute 'Settlement Payments'?

Yes. Once the Second Circuit concluded that the customer withdrawals were transfers made in connection with a “securities contract,” the decision could have ended there, as 546(e) effectively shields such transfers from the Trustee's clawback actions. The Second Circuit continued its analysis, however, and concluded that not only did the Account Documents constitute a “securities contract,” but that the investor withdrawals constituted “settlement payments” and, for that reason as well, could not be avoided by the Trustee.

The Second Circuit once again rejected the Trustee's contention that the transfers weren't settlement payments because BLMIS never actually traded any securities, citing to its earlier Enron decision. In Enron , the Second Circuit held that the statutory definition of “settlement payments” should also apply to “the transfer of cash or securities made to complete [a] securities transaction,” and that is exactly what the BLMIS clients received. Because the Account Documents granted BLMIS sufficient discretion to liquidate securities to the extent necessary to implement a customer's sell orders or withdrawal requests, the Second Circuit held that each BLMIS payment made in respect of such sell orders and withdrawal requests constituted a settlement payment and was therefore shielded from the Trustee's clawback action pursuant to the section 546(e) safe harbor provision.

Inconsistent BLMIS Decisions?

In In re BLMIS, 654 F.3d 229, 235 (2d Cir. 2011), the Second Circuit refused to use BLMIS's fictitious account statements in order to calculate each BLMIS customer's “net equity,” as that term is defined in SIPA, because it concluded that doing so would have given “legal effect to Madoff's machinations.” Seizing on that conclusion, the Trustee advanced the argument that allowing the BLMIS customers to retain the fictitious profits they received would similarly give “legal effect to Madoff's machinations.” While the Second Circuit acknowledged the compelling argument, it ultimately rejected it, noting the key distinction between the two cases. Namely, that in the prior BLMIS decision, the Second Circuit was called upon to interpret “net equity” within the SIPA statutory framework. In other words, no Bankruptcy Code section was at issue. In its latest BLMIS decision, however, the Second Circuit acknowledged the careful balance Congress struck between the need for an equitable result, on the one hand, and the need for finality, on the other, and, as a result, concluded that except as to actual fraudulent transfers under 548(a)(1)(A), Congress intended to protect transfers like the BLMIS investor withdrawals from being avoided by a bankruptcy trustee when it enacted 546(e). As a result, the Second Circuit rejected the Trustee's contention that there would be inconsistent decisions.

A Significant Roadblock, for Now

For years, courts seemed unwilling to extend the section 546(e) safe harbor shield to Ponzi scheme victims. For example, in In re Slatkin, 525 F.3d 805 (9th Cir. 2008), the Ninth Circuit refused to apply the safe harbor because it concluded that the particular Ponzi scheme operators were not “stockbrokers” under 546(e). The Fifth Circuit reached a similar result in Wider v. Wooton (In re Wider), 907 F.2d 570 (5th Cir. 1990). But then along came Enron in 2011, and the Second Circuit's landmark ruling that certain redemption payments were shielded from avoidance as “settlement payments” under section 546(e).

While the Second Circuit did not consider the “securities contract” prong of section 546(e) in Enron ' because the bankruptcy cases were commenced prior to the enactment of the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act ' it did so in 2013, for the first time, in Official Comm. of Unsecured Creditors of Quebecor World (USA) Inc. v. Am. United Life Ins. Co. ( In re Quebecor World (USA) Inc.), 719 F.3d 94 (2d Cir. 2013). There, the Second Circuit held that the 546(e) safe harbor applied because the disputed payment was a transfer made “in connection with a securities contract,” finding that certain note purchase agreements were in fact securities contracts because they provided for the purchase and repurchase of the notes.

Also in 2013, the Fourth Circuit held that certain commission payments to a stockbroker were “settlement payments” and therefore shielded from recovery under 546(e). In re Derivium Capital LLC , 716 F.3d 355 (4th Cir. 2013). The Seventh Circuit has also interpreted 546(e) broadly in two of its recent decisions; Grede v. FCStone, LLC (In re Sentinel Management Group, Inc.), 746 F.3d 244 (7th Cir. 2014) (transfer to a commodity broker was a “settlement payment” made “in connection with a securities contract”), and Peterson v. Somer Dublin Ltd., 729 F.3d 741 (7th Cir. 2013)(redemption payments made to investors by Ponzi scheme operators were shielded from avoidance).

Conclusion

The Second Circuit's latest decision on this issue should therefore come as no surprise, as it simply continues the trend of expanding the scope of the section 546(e) safe harbor. No doubt, the decision is, at least for the time being, a significant roadblock for the Trustee, with the result being that at least certain of the Madoff investors may have realized more money than they had invested, to the detriment of later investors. It remains to be seen if and when the Supreme Court will be called upon to resolve the circuit split on this important issue.

Steven B. Smith is counsel in the Financial Restructuring & Bankruptcy practice of Dickstein Shapiro LLP in New York. A member of this newsletter's Board of Editors, he focuses on complex corporate restructuring and creditors' rights. He can be reached at [email protected].

The answer is no. Irving H. Picard, the trustee (the Trustee) for Bernard L. Madoff Investment Securities LLC (BLMIS), appointed pursuant to the Securities Investor Protection Act (SIPA), may not clawback money paid out by BLMIS to hundreds of its customers. This was the recent decision reached by the United States Court of Appeals for the Second Circuit in Picard v. Ida Fishman Revocable Trust (In re Bernard L. Madoff Investment Seurities LLC), 773 F.3d 411 (2d Cir. 2014), and the decision continues the recent trend of extending the reach of Bankruptcy Code section 546(e)'s safe harbor protections. But, why not? Potentially hundreds of millions of dollars could be recovered and then paid out ratably to all BLMIS customers? Simply put, a SIPA trustee can only avoid and recover transferred funds that are voidable under the Bankruptcy Code, and section 546(e) provides an important exception to a trustee's clawback powers, which was triggered in this case. This article explores the arguments advanced in support of, and in opposition to, avoiding the payments made by BLMIS to its customers.

The Relevant Madoff Facts

We know the general story, but here are some of the key facts underlying this latest Madoff decision. When investors wanted to open accounts with BLMIS, they were required to execute the following three documents: 1) a “Customer Agreement,” which authorized BLMIS to open or maintain an account for the customer's benefit; 2) a “Trading Authorization,” pursuant to which each customer appointed BLMIS to be the customer's agent, and to, among other things, buy, sell and trade in any securities; and 3) an “Option Agreement” (together with the Customer Agreement and the Trading Authorization, the “Account Documents”) pursuant to which each customer authorized BLMIS to engage in options trading for the customer's account. Unfortunately, BLMIS did not conduct any actual securities or options trading. Instead, customer investments were deposited into a single commingled account, and BLMIS prepared customer statements to evidence fictitious securities trading activity. When customers wanted to withdraw their funds, BLMIS simply sent them cash from the commingled account.

After Madoff's Ponzi scheme collapsed, the Trustee sued hundreds of BLMIS customers, who apparently withdrew more from their accounts than they had invested, in an attempt to recover the funds in order to repay all BLMIS customers ratably in proportion to each customer's net equity. District Court Judge Rakoff, in the Southern District of New York, considered and ultimately dismissed the clawback claims in one particular test case, holding that: 1) Bankruptcy Code section 546(e) applied because BLMIS was a stockbroker; 2) the Account Documents were “securities contracts”; and 3) the customer withdrawals were payments made in connection with securities contracts or were settlement payments. Picard v. Katz , 462 B.R. 447 (S.D.N.Y. 2011). The Katz dismissal opened the floodgates, as hundreds of clawback defendants filed motions to dismiss on 546(e) grounds. And, Judge Rakoff dismissed those clawback claims for the same reasons, with the exception of actual fraud claims under 548(a)(1)(A).

The Safe Harbor of Bankruptcy Code Section 546(e)

Bankruptcy Code section 547(b)(4)(A)(B) enables a Chapter 11 debtor or trustee to avoid a transfer made within 90 days of its bankruptcy filing ' one year if the transferee was an insider ' if certain statutory conditions are satisfied. However, even when all such conditions have been satisfied, the disputed transfer may be protected from any avoidance attack by the safe harbor shield of Bankruptcy Code section 546(e). Section 546(e) provides, in relevant part, that a debtor or trustee may not avoid a transfer ' other than an actual fraudulent transfer under Bankruptcy Code section 548(a)(1)(A) ' made by, among others, a stockbroker, if such transfer: 1) was a “settlement payment” as defined in Bankruptcy Code section 741; or 2) was made in connection with a “securities contract” as defined in Bankruptcy Code section 741(7)(i). See 11 U.S.C. 546(e). Bankruptcy Code section 741(8) defines “settlement payment” as a “preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, or any other similar payment commonly used in the securities trade.” 11 U.S.C. 741(8). A “securities contract” is broadly defined in Bankruptcy Code section 741(7) to include not just contracts for the purchase or sale of securities, but any other agreements that are similar or related thereto. 11 U.S.C. 741(7)(A). Because none of the parties disputed that BLMIS was a stockbroker for the purposes of section 546(e), the appeal turned on whether the transfers were “settlement payments” or were made “in connection with a securities contract.”

Did the Account Documents Constitute a 'Securities Contract'?

Yes. The clawback defendants argued that the Account Documents, together, created a “securities contract,” and the Second Circuit agreed. In opposition, the Trustee advanced three ultimately unpersuasive arguments. Citing the Second Circuit's decision in Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.), 651 F.3d 329 (2d Cir. 2011) ' i.e., that the purpose of 546(e) is to “minimize[] the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries ' ” ' the Trustee first argued that 546(e) simply did not apply, since BLMIS never initiated, executed, completed or settled the securities transactions it promised to engage in and, therefore, there was no disruption in the securities markets. The Second Circuit rejected this argument on two grounds: 1) neither section 741(7) nor 546(e) contain a purchase or sale requirement; and 2) in fact, the Trustee's interpretation, if accepted, could cause the very market disruption Congress sought to minimize in enacting 546(e) ' i.e., the recovery of hundreds of millions of dollars, if not more, from BLMIS clients who had every reason to believe that BLMIS was actually engaged in the trading of securities.

The second argument advanced by the Trustee was that the Account Documents were not “securities contracts” because they did not specifically identify the terms necessary to describe a security transaction including any security, issuer, quantity, or price. But the Second Circuit correctly concluded that the argument constructed a specificity requirement that the law does not contain. The Trading Authorization identified a specific category of public securities to be traded and that, concluded the Second Circuit, was sufficient. No greater specificity was required.

Finally, the Trustee argued that because the Account Documents only authorized BLMIS to conduct securities transactions rather than expressly obligating BLMIS to carry out any such transactions, the Account Documents merely established, if anything, an agency relationship between BLMIS and its customers, similar to that between a real estate broker and a home buyer, but under no circumstances did they establish a “true” contractual obligation.

Once again, the Second Circuit concluded that the statutory definition of a “securities contract” is not limited in the way the Trustee interpreted it, and, in fact, encompassed exactly the relationship created by the Account Documents. First, pursuant to the catch-all provision of Bankruptcy Code section 741(7)(A)(vii), the Account Documents were “similar to” a contract for the purchase or sale of a security because they established that BLMIS and its customers manifested their mutual assent that BLMIS would conduct certain approved securities transactions. Second, the payments BLMIS made to its customers were certainly made “in connection with” the Account Documents because the customer's withdrawals from their accounts were related to, and associated with, such documents. In light of the foregoing, the Second Circuit concluded that the investor withdrawals from BLMIS were made “in connection with a securities contract” and therefore those payments should be shielded from the Trustee's clawback action pursuant to section 546(e).

Did the Investor Withdrawals Constitute 'Settlement Payments'?

Yes. Once the Second Circuit concluded that the customer withdrawals were transfers made in connection with a “securities contract,” the decision could have ended there, as 546(e) effectively shields such transfers from the Trustee's clawback actions. The Second Circuit continued its analysis, however, and concluded that not only did the Account Documents constitute a “securities contract,” but that the investor withdrawals constituted “settlement payments” and, for that reason as well, could not be avoided by the Trustee.

The Second Circuit once again rejected the Trustee's contention that the transfers weren't settlement payments because BLMIS never actually traded any securities, citing to its earlier Enron decision. In Enron , the Second Circuit held that the statutory definition of “settlement payments” should also apply to “the transfer of cash or securities made to complete [a] securities transaction,” and that is exactly what the BLMIS clients received. Because the Account Documents granted BLMIS sufficient discretion to liquidate securities to the extent necessary to implement a customer's sell orders or withdrawal requests, the Second Circuit held that each BLMIS payment made in respect of such sell orders and withdrawal requests constituted a settlement payment and was therefore shielded from the Trustee's clawback action pursuant to the section 546(e) safe harbor provision.

Inconsistent BLMIS Decisions?

In In re BLMIS, 654 F.3d 229, 235 (2d Cir. 2011), the Second Circuit refused to use BLMIS's fictitious account statements in order to calculate each BLMIS customer's “net equity,” as that term is defined in SIPA, because it concluded that doing so would have given “legal effect to Madoff's machinations.” Seizing on that conclusion, the Trustee advanced the argument that allowing the BLMIS customers to retain the fictitious profits they received would similarly give “legal effect to Madoff's machinations.” While the Second Circuit acknowledged the compelling argument, it ultimately rejected it, noting the key distinction between the two cases. Namely, that in the prior BLMIS decision, the Second Circuit was called upon to interpret “net equity” within the SIPA statutory framework. In other words, no Bankruptcy Code section was at issue. In its latest BLMIS decision, however, the Second Circuit acknowledged the careful balance Congress struck between the need for an equitable result, on the one hand, and the need for finality, on the other, and, as a result, concluded that except as to actual fraudulent transfers under 548(a)(1)(A), Congress intended to protect transfers like the BLMIS investor withdrawals from being avoided by a bankruptcy trustee when it enacted 546(e). As a result, the Second Circuit rejected the Trustee's contention that there would be inconsistent decisions.

A Significant Roadblock, for Now

For years, courts seemed unwilling to extend the section 546(e) safe harbor shield to Ponzi scheme victims. For example, in In re Slatkin, 525 F.3d 805 (9th Cir. 2008), the Ninth Circuit refused to apply the safe harbor because it concluded that the particular Ponzi scheme operators were not “stockbrokers” under 546(e). The Fifth Circuit reached a similar result in Wider v. Wooton (In re Wider), 907 F.2d 570 (5th Cir. 1990). But then along came Enron in 2011, and the Second Circuit's landmark ruling that certain redemption payments were shielded from avoidance as “settlement payments” under section 546(e).

While the Second Circuit did not consider the “securities contract” prong of section 546(e) in Enron ' because the bankruptcy cases were commenced prior to the enactment of the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act ' it did so in 2013, for the first time, in Official Comm. of Unsecured Creditors of Quebecor World (USA) Inc. v. Am. United Life Ins. Co. ( In re Quebecor World (USA) Inc.), 719 F.3d 94 (2d Cir. 2013). There, the Second Circuit held that the 546(e) safe harbor applied because the disputed payment was a transfer made “in connection with a securities contract,” finding that certain note purchase agreements were in fact securities contracts because they provided for the purchase and repurchase of the notes.

Also in 2013, the Fourth Circuit held that certain commission payments to a stockbroker were “settlement payments” and therefore shielded from recovery under 546(e). In re Derivium Capital LLC , 716 F.3d 355 (4th Cir. 2013). The Seventh Circuit has also interpreted 546(e) broadly in two of its recent decisions; Grede v. FCStone, LLC ( In re Sentinel Management Group, Inc. ), 746 F.3d 244 (7th Cir. 2014) (transfer to a commodity broker was a “settlement payment” made “in connection with a securities contract”), and Peterson v. Somer Dublin Ltd. , 729 F.3d 741 (7th Cir. 2013)(redemption payments made to investors by Ponzi scheme operators were shielded from avoidance).

Conclusion

The Second Circuit's latest decision on this issue should therefore come as no surprise, as it simply continues the trend of expanding the scope of the section 546(e) safe harbor. No doubt, the decision is, at least for the time being, a significant roadblock for the Trustee, with the result being that at least certain of the Madoff investors may have realized more money than they had invested, to the detriment of later investors. It remains to be seen if and when the Supreme Court will be called upon to resolve the circuit split on this important issue.

Steven B. Smith is counsel in the Financial Restructuring & Bankruptcy practice of Dickstein Shapiro LLP in New York. A member of this newsletter's Board of Editors, he focuses on complex corporate restructuring and creditors' rights. He can be reached at [email protected].