Sections 548(a)(1)(A) and (B) of the Bankruptcy Code (the “Code”) give a bankruptcy trustee the power to avoid intentional and constructive fraudulent transfers.[1] Section 546(e) of the Code prevents a bankruptcy trustee from recovering a variety of transfers, including ones that would otherwise be avoidable as constructive fraudulent transfers, if the transfers are either settlement payments made by or to a stockbroker or financial institution, or are payments by or to a stockbroker or financial institution in connection with a securities contract.[2] In a recent decision, the Second Circuit Court of Appeals has expanded section 546(e)’s protection for recipients of constructive fraudulent transfers in Ponzi schemes.[3] Notably, section 546(e) does not prevent a trustee from recovering intentional fraudulent transfers.
The Section 546(e) Safe Harbor’s Limitations on Avoiding Powers
Section 546(e) was enacted as a means of “minimiz[ing] the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries”[4] and is also designed to protect financial markets “from the instability caused by the reversal of settled securities transactions.”[5] Without such protection, attempts to avoid a debtor’s securities transactions would discourage investors from investing and could potentially have a ripple effect on the entire market.[6]
Expanding the Scope of Section 546(e) in Ponzi Scheme Cases
In recent years, courts have applied section 546(e) to prevent avoidance of payments made in connection with leveraged buyouts of public[7] and private corporations,[8] early redemption of commercial paper,[9] and redemption of investments in mutual funds that were operated as Ponzi schemes.[10] Continuing the line of decisions applying section 546(e) to prevent recovery of Ponzi scheme payments, the Second Circuit Court of Appeals recently interpreted the phrases “securities contract” and “settlement payments” in sections 546(e) and 741 broadly to shield investors in Bernard Madoff’s Ponzi scheme who received payments in excess of their original investments.[11]
Following the collapse of Bernard L. Madoff’s notorious Ponzi scheme, Irving Picard was appointed as trustee (the “Trustee”) of Bernard L. Madoff Investment Securities LLC (“BLMIS”) pursuant to the Securities Investor Protection Act, 15 U.S.C. § 78aaa et seq., (“SIPA”).[12] BLMIS purported to execute a strategy for its customers which, if actually implemented, would have consisted of securities or options trading.[13] In reality, however, BLMIS conducted no actual securities or options trading on behalf of its customers.[14] Instead, BLMIS deposited customer investments into a single commingled checking account. For years, BLMIS fabricated customer statements to show fictitious securities trading activity and returns that provided for annual increases of 10 to 17 percent.[15] Thus, when customers sought to withdraw money from their accounts, they received cash from the commingled account. Many of those customers were “net winners,” who received payments that exceeded the amounts of their original investment.[16]
The Trustee sued “net winners” to avoid as constructive fraudulent transfers BLMIS’s payments to them of fictitious profits.[17] The defendants responded that the transfers they received were protected by Code section 546(e). The trial court ruled in favor of the defendants, and the Trustee appealed. In that appeal, the Trustee argued that section 546(e) did not shield those payments for three reasons, all of which were based on the premise that section 546(e) would only apply if Madoff had actually completed the securities transactions he purported to effectuate.[18] First, the Trustee argued that section 546(e) should not apply because BLMIS never initiated, executed, completed or settled the securities transactions contemplated by the agreements that BLMIS’s customers signed when they opened their accounts (“Account Documents”).[19] Next, the Trustee argued that the transfers were not “made in connection with a securities contract” nor were they a “settlement payment,” as those terms are defined in section 741 of the Code.[20] Finally, the Trustee asserted that applying section 546(e) to BLMIS’s payments would be tantamount to giving legal effect to Madoff's fraud.[21]
The Second Circuit rejected the Trustee’s arguments. The court held that the Account Documents were securities contracts even though they did not specifically “identify any security, issuer, quantity, price, or other terms necessary to describe a security transaction.”[22] Nothing in the Code indicated to the court that a “securities contract” required the degree of specificity argued for by the Trustee. The court also rejected the Trustee’s argument that the Account Documents were not securities contracts because they did not expressly require BLMIS to carry out securities transactions. The court held that the Account Documents were sufficiently “similar to” a contract for the purchase or sale of a security to be treated as securities contracts under Code section 741(7)(A)(vii).[23]
Notably, the court agreed with the Trustee that the transfers he sought to avoid were made in connection with a Ponzi scheme, and that “BLMIS’s conduct was in flagrant breach of the agreements it made with its customers.” Nevertheless, the court stated that “the fact that a payment was made in connection with a Ponzi scheme does not mean that it was not at the same time made in connection with a (breached) securities contract.”
In response to the Trustee’s second argument, the Second Circuit held that section 546(e) shielded BLMIS’s transfers from avoidance because those transfers were “made in connection with a securities contract” and were also “settlement payments.”[24] In reaching this decision, the Second Circuit noted the “extraordinary breadth” of the Code’s definitions of “securities contract”[25] and “settlement payment.”[26]
The court stated that the term “securities contract” is expansive and includes contracts for the purchase or sale of securities, as well as any agreements that are similar to contracts for the purchase or sale of securities.[27] The court also found that section 546(e) requires only that a covered transfer be broadly related to a "securities contract," not that it be connected to an actual transaction in securities.[28] Thus, the application of section 546(e) did not depend on whether BLMIS actually engaged in securities transactions.[29]
In rejecting the Trustee’s third argument, the court found compelling but ultimately not convincing the argument that allowing customers to retain their fictitious profits would give legal effect to Madoff’s fraud.[30] The court emphasized the need for finality even in light of countervailing equity considerations.[31] The court also held that the avoidance of millions, if not billions, of dollars of payments from BLMIS would likely cause the “very displacement” that Congress hoped to minimize.[32]
Conclusion
The Madoff case follows the decisions of other courts that have applied the section 546(e) safe harbor to protect Ponzi scheme payments from recovery as constructive fraudulent transfers. The Madoff case also expands the scope of section 546(e) in SIPA cases by interpreting the phrase “securities contract” broadly to encompass customer account documents that authorize brokers to trade on behalf of those customers, whether or not actual trading occurs. In the future, therefore, trustees seeking to avoid Ponzi scheme payments will have to prove that those payments were intentional fraudulent transfers in order to prevent application of Code section 546(e).[33]
[1] Intentional fraudulent transfers are those made with the actual intent to hinder, delay, or defraud creditors. Code §548(a)(1)(A). Constructive fraudulent transfers are those made in exchange for less than a reasonably equivalent value when a debtor is either insolvent, is left with unreasonably small capital, or intends to incur debts beyond its ability to pay those debts as they mature. Code §548(a)(1)(B).
[2] In re Bernard L. Madoff Inv. Sec. LLC, 773 F.3d 411, 414 (2d Cir. 2014).
[3] Id.
[4] Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.), 651 F.3d 329, 334 (2d Cir. 2011) (quoting H. R. Rep. No. 97-420, at 2 (1982), reprinted in 1982 U.S.C.C.A.N. 583, 583).
[5] Weisfelner v. Fund 1 (In re Lyondell Chem. Co.), 503 B.R. 348, 365 (Bankr. S.D.N.Y. Jan. 14, 2014).
[6] Kaiser Steel Corp. v. Charles Schwab & Co., 913 F.2d 846, 849 (10th Cir. 1990) (quoting H.R. Rep. 97-420, at 1 (1982), as reprinted in 1982 U.S.C.C.A.N. 583, 583).
[7] Official Comm. of Unsecured Creditors v. Fleet Retail Fin. Group (In re Hechinger Inv. Co. of Delaware), 274 B.R. 71, 87 (D. Del. 2002) (holding that LBO payments made to both insider and non-insider shareholders of a publicly held company by a financial institution are protected by section 546(e)).
[8] Cyganowski v. Lapides (In re Batavia Nursing Home, LLC) 2013 Bankr. LEXIS 3022, 1 (Bankr. W.D.N.Y. July 29, 2013) (applying section 546(e) to LBOs of privately held securities).
[9] In re Enron Creditors Recovery Corp, 651 F.3d at 334-335.
[10] Peterson v. Somers Dublin Ltd., 729 F.3d 741, 748 (7th Cir. Ill. 2013) (applying Code section 546(e) to prevent recovery of constructive fraudulent transfers in a Ponzi scheme, but noting that some courts have interpreted section 546(e) narrowly to prevent people who received money from a crooked enterprise from profiting, to the detriment of other investors who did not get out while the going was good).
[11] See generally In re Bernard L. Madoff Inv. Sec. LLC, 773 F.3d 411 (2d Cir. 2014).
[12] Id.at 414. Under SIPA, a trustee can “claw back” money paid by the debtor, as long as the money “would have been customer property” had the payment not occurred, and the transfers could be avoided under the Code. SIPA §78fff-2(c)(3).
[13] Id. at 415 (citing SIPC v. Bernard L. Madoff Inv. Secs. LLC (In re Bernard L. Madoff Inv. Secs. LLC), 424 B.R. 122, 129-30 (Bankr. S.D.N.Y. 2010)).
[14] Id.
[15] Id.
[16] Id.
[17] Id.
[18] Id. at 417-419 (“[b]ecause ‘there are no securities transactions to unwind,’ the Trustee argues that no such disruption would occur, and correspondingly, § 546(e) is inapplicable”).
[19] Id.at 416, 418. BLMIS customers were required to execute three documents when opening their accounts. The first, “Customer Agreement,” authorized BLMIS to open or maintain one or more accounts for the customers’ benefit. The second, “Trading Authorization,” appointed BLMIS as the customers’ “agent and attorney in fact” to “buy, sell, and trade stocks bonds, and other securities…” The third, “Option Agreement,” authorized BLMIS to engage in options trading for customer accounts.
[20] Id.
[21] Id.
[22] Id.
[23] Id. at 421 (“[o]f course, BLMIS secretly intended to violate the agreement by using the deposits to fund the ongoing Ponzi scheme. But this is of no moment, because “[a]n agreement is a manifestation of mutual assent,” and “[t]he conduct of a party may manifest assent even though he does not in fact assent”).
[24] Id. at 417.
[25] 11 U.S.C. §§ 741(7)(A)(i), (vii).
[26] See supra note 5.
[27] Id. at 418.
[28] Id. at 420.
[29] Id. at 418.
[30] Id. at 423.
[31] Id. (“…in enacting the Bankruptcy Code, Congress struck careful balances between the need for an equitable result for the debtor and its creditors, and the need for finality”) (internal citation omitted).
[32] Id. at 420.
[33] It may be difficult, however, for a trustee to prove that Ponzi scheme payments are made with the actual intent to hinder, delay or defraud the Ponzi schemer’s creditors.
Published February 19, 2015.
