A recent decision by the Court of Appeals for the Second Circuit, Picard v. Ida Fishman Revocable Trust (In re Bernard L. Madoff Investment Securities LLC), sharply limits the remedies available to trustees in brokerage liquidations, provides significant protections for innocent customers of fraudulent brokers, and further shapes the ongoing debate over Bankruptcy Code safe harbors. For former customers of Madoff Securities, the decision means that Irving Picard, the Madoff Securities trustee, will be limited to a two year reach back period for fraudulent conveyances (he sought a six year reach back period), and will not be able to prosecute preference actions. For Picard, it means he will have to forego approximately $1.8 billion in potential recoveries, potentially reducing the amount that will be paid on Madoff
Section 546(e) Safe Harbor
Section 546(e) of the Bankruptcy Code provides a safe harbor for certain defendants from constructive fraudulent conveyance actions and preference actions. The section provides that a trustee may not avoid a transfer if it is (among other things) (1) a settlement payment, or a transfer made in connection with a securities contract, that was (2) made by or to or for the benefit of a stockbroker, financial institution, financial participant, or securities clearing agency.
The safe harbor of section 546(e) does not protect transfers avoidable under the federal “actual intent” fraudulent conveyance statute, that is, those made within two years before the petition date that are proven to have been made with actual intent to hinder, delay or defraud creditors.
The Fishman decision concerned actions brought by Picard against former customers of Madoff Securities who were not accused of any complicity in the Madoff fraud or other wrongdoing. Picard sought to recover from them all amounts withdrawn from their Madoff Securities accounts during the six years prior to the filing of the Madoff Securities liquidation petition to the extent that overall withdrawals from the account exceeded deposits.
The defendants argued that the payments they received should be protected by the section 546(e) safe harbor, which would limit Picard to a two year reach back period. They argued that the safe harbor applied in the Madoff Securities case, because the payments were made in connection with a securities contract, i.e., customers’ investment contracts with Madoff Securities. Alternatively, defendants argued that the safe harbor applied because the challenged payments
were “settlement payments.”
The district court withdrew the reference from the bankruptcy court to consider the safe harbor issue (among others) and ruled in favor of the defendants, finding the safe harbor applicable on both defense theories. The Court of Appeals heard Picard’s appeal on a consolidated basis for hundreds of defendants, resulting in the Fishman decision. Kleinberg Kaplan was a member of the steering committee for the defendants-appellees.
The Court of Appeals held for the defendants on all points. It rejected Picard’s position that “in connection with a securities contract” should be narrowly construed, concluding that Congress intended an extremely broad definition that includes the transactions at issue. It rejected Picard’s additional argument – that Madoff Securities in fact made no securities transactions – stating that a contract remains a securities contract even if the broker is in breach and does not make the promised securities transactions.
The Court also affirmed on the alternative ground that the challenged payments were “settlement payments,” because each payment settled the transaction that was initiated when a customer sought to make a withdrawal.
Finally, the Court rejected, as “compelling [but] ultimately not convincing,” Picard’s argument that the district court’s decision was inconsistent with the Second Circuit’s 2011 Net Equity Decision. That decision approved Picard’s methodology for calculating customer claims in the Madoff Securities liquidation proceeding based on the amounts of cash the customer deposited and withdrew and without regard to the amounts shown on the statements the customer received from Madoff Securities. But the Fishman panel held that the equitable principles underlying the Net Equity Decision should be limited to the narrow question of quantifying those customer claims and should not be applied broadly to avoidance actions. It instead emphasized the importance of other considerations, such as the reasonable expectations of the innocent customers and the finality of transactions, stating that the defendants, “having every reason to believe that [Madoff Securities] was actually engaged in the business of effecting securities transactions, have every right to all of the protections afforded to the clients of stockbrokers,” and that section 546(e) included in those protections the finality of the two year reach back period.
Picard will almost certainly seek Supreme Court review of Fishman, but it is unlikely that the Supreme Court will take Picard’s appeal, as there is no split among the circuit courts of appeal on the relevant issues.
Unless it is reversed by the Supreme Court, the Fishman decision directly affects approximately $1.8 billion of fraudulent conveyance and preference actions brought by Picard and therefore may reduce the amount available for Picard to distribute to creditors. There also likely will be further litigation regarding whether, in light of Fishman, the safe harbor applies to other defendants, such as institutions that engaged in transactions with feeder funds that were enmeshed in the Madoff fraud and defendants whom Picard has accused of knowledge of or complicity in the Madoff fraud.
Fishman also may support a more general and far-reaching defense in ongoing Madoff avoidance actions. Since the safe harbor does not apply to federal “actual intent” fraudulent conveyance cases, for which the reach back period is two years, many of the former Madoff Securities customers will have to continue to defend clawback actions brought by Picard regarding payments made during the two years before the beginning of the Madoff Securities liquidation case. However, the logic and language of the Fishman decision supports the alternative defense that Madoff Securities received value from customers in return for the challenged payments, because those payments satisfied “enforceable securities entitlements.” This defense was rejected by the district court in 2013, but it has been raised in several pending motions before the bankruptcy court, and it likely will be revisited in light of Fishman.
The Fishman decision may also affect future legislative action regarding the safe harbor. The recently released American Bankruptcy Institute Chapter 11 Reform Report contains a proposed amendment to section 546(e) that would effectively reverse the Fishman result by removing from the safe harbor state law-based actual intent fraudulent conveyance actions (which, when New York law applies, would entail a six year reach back period). However, given that congressional gridlock has blocked bankruptcy law reform for nearly a decade, it is uncertain whether the ABI’s proposals will be introduced, much less enacted, anytime soon.