Second Circuit Affirms Decision Dismissing Certain Claims against Madoff Customers by the Madoff Trustee (with McDonnell Comment)

The Second Circuit upheld a decision by Judge Rakoff of the Southern District of New York in the Madoff case limiting the trustee’s ability to avoid (or "claw back") transfers of assets to Madoff's customers.

Applying the avoidance safe harbor contained in Section 546(e) of the Bankruptcy Code (which is incorporated into the Securities Investor Protection Act), the Second Circuit construed the term "securities contract" broadly to include the brokerage agreements entered into between Bernard L. Madoff Investment Securities LLC ("BLMIS") and its customers.

The court found that the brokerage agreements were contracts "for the purchase, sale, or loan of a security," even though no securities transactions actually were carried out under those agreements. Moreover, the court found that "because the Account Documents obligate BLMIS to reimburse its customers upon a request for withdrawal, they also fit the definition of 'securities contract' in § 741(7)(A)(xi), which includes, again quite expansively, 'any security agreement or arrangement related to any agreement or transaction referred to in this subparagraph, including any guarantee or reimbursement obligation by or to a stockbroker.'"

McDonnell Comment: The direct consequence of the ruling is that the trustee cannot avoid redemptions made prior to the two-year period before the filing date in BLMIS’s SIPA case. Payments made within that two-year period are not protected by Section 546(e) if they are avoidable under Section 548(a)(1)(A), which allows the avoidance of transfers made "with actual intent to hinder, delay, or defraud." However, the trustee can no longer avoid transfers that are avoidable under New York’s fraudulent conveyance statute, which has a statute of limitations of 6 years, but that are not avoidable under Section 548(a)(1)(A).The wider effect of the decision is to emphasize the breadth of the "securities contract" safe harbor. Although the specific facts in the BLMIS case are highly unusual, the court's approach supports a broad reading of that safe harbor. One limitation, though, is that in a smaller Ponzi scheme not conducted by a "stockbroker," there may be investors who do not qualify for the safe harbors because they are not among the entities protected by the Bankruptcy Code (such as "stockbrokers," "financial institutions,” or "financial participants"), and, in that case, the trustee may be able to claw back payments made during the full 6-year period provided by New York law (or whatever period is permitted by the law of the relevant state). This could lead to an inequitable result if large investors (which may qualify as "financial participants") are shielded from avoidance actions while retail investors are not.

See: Decision.