pictureFocusing on the plain language provided in Bankruptcy Code section 546(e), the Court of Appeals for the Second Circuit this week held that customers of the now defunct Bernard Madoff Investment Securities LLC can retain funds they had withdrawn from their customer accounts before the Madoff firm was placed into liquidation.  Irving Picard, the trustee appointed under the Securities Investor Protection Act of 1970 (SIPA) to liquidate the Madoff investment firm, had sought to “avoid” or unwind customers’ withdrawals of funds that exceeded the amounts that the customers had deposited with the investment firm–their “profits”. Avoiding these transfers would have allowed the Trustee to more evenly distribute the “customer property” funds among customers, including those who had not withdrawn any of the funds they had deposited in their customer accounts. However, in its decision, the Second Circuit agreed with the district court and held that avoidance of such transfers was not permissible due to the safe harbor protection available to defendants pursuant to Bankruptcy Code section 546(e).


Madoff’s Ponzi scheme was uncovered in December 2008 and liquidation proceedings were commenced to wind down the Madoff investment firm. The Trustee was appointed to conduct the wind down and, as part of this process, to recover all “customer property” and distribute it ratably to the investment firm’s customers.

To that end, the Trustee sued hundreds of customers who had profited from Madoff’s scheme by withdrawing more from their accounts than they had invested. The Trustee relied on section 78fff-2(c)(3) of SIPA, which allows a SIPA trustee to avoid a transfer to the same extent such transfer would be voidable under the Bankruptcy Code. Under the Bankruptcy Code, avoidance action defendants may assert certain “safe harbor” defenses, which were adopted by Congress to protect the stability of the financial markets in the event that a financial firm fails and seeks to take actions that could cause ripple effects in the market. In this instance, the defendants argued that the transfers subject to the Trustee’s lawsuit were protected by Bankruptcy Code section 546(e).

Bankruptcy Code Section 546(e)

In relevant part, Bankruptcy Code section 546(e) protects (1) payments made from a stockbroker in connection with a securities contract and (2) settlement payments. The defendants argued that the payments they received could be described as either (1) or (2) and therefore were not subject to avoidance.

Second Circuit’s Analysis

The Second Circuit agreed with the defendants that the transfers qualified both as payments made in connection with securities contracts and as settlement payments and therefore were not subject to avoidance. In reaching this conclusion, the Second Circuit focused on the broad nature of the definition of a “securities contract,” noting that the term “expansively includes contracts for the purchase or sale of securities, as well as any agreements that are similar or related to contracts for the purchase or sale of securities.” (emphasis in original). In this case, customers had executed three documents in opening up customer accounts with the Madoff firm—a customer agreement, trading authorization, and option agreement. The fact that the Madoff firm did not actually buy or sell securities on behalf of its customers was of no import. The documents authorized the Madoff firm to engage in securities transactions on behalf of its customers and therefore established a “securities contract.”

Once a securities contract was identified, the Second Circuit needed to determine whether the transfers to the customers were “in connection with” that contract. Not persuaded by SIPC’s argument that Ponzi scheme payments could never be in connection with a securities contract, the Second Circuit concluded that section 546(e) sets a “low bar” for showing a relationship between the securities contract and the transfer subject to scrutiny. Here, the payments were “in connection with” a Ponzi scheme, but they were also “in connection with” the customers’ account documents with Madoff’s firm, bringing them within the protected scope of section 546(e).

To complete its analysis, the Court of Appeals noted that the transfers also qualified for protection under section 546(e) as “settlement payments.” (Fun fact: most transfers that qualify as transfers “in connection with a securities contract” will also qualify as “settlement payments.” The reverse is not necessarily true.) The Trustee again tried to argue the transfers did not qualify as “settlement payments” because no actual securities trading happened, but the circuit court, following its decision in Enron, held that the statutory definition of “settlement payment” is to be broadly construed to apply to the transfer to cash or securities to complete a securities transaction. Here, each time a customer sought to withdraw funds from its account, it intended that Madoff sell/liquidate securities in its account and remit the related payment to the customer. That intent was sufficient to turn the payment to the customer into a “settlement payment” subject to safe harbor protection.


Earlier this week, the American Bankruptcy Institute released its report on how Chapter 11 should be reformed and updated. The report reviewed the treatment of the Bankruptcy Code’s safe harbors and, with respect to section 546(e), concentrated its recommendation on narrowing the safe harbor protection in connection with leveraged buyouts. The Commission to Study the Reform of Chapter 11 did not recommend reducing the coverage of section 546(e) for securities purchases and sales, options, loans, and other transfers and transactions currently protected by section 546(e).

The Second Circuit’s decision in Madoff makes sense under section 546(e)’s current language and its intent to avoid significant market disruption that could be caused by the avoidance of certain types of transfers.  The decision will continue to make sense if the ABI Commission’s recommendations are eventually adopted. The Second Circuit focused, appropriately, on the language of Bankruptcy Code section 546(e), and held the customers’ account documents fit within the definition of a “securities contract” with the related transfers sufficiently in connection with the contract. The Court of Appeals also noted that protecting these transfers was in line with the intent of the safe harbor.  If the Trustee were able to pursue these avoidance actions to claw back “millions, if not billions of dollars”  from hundreds of customers, many of which are institutional investor and feeder funds, the lawsuits could have caused the “significant market disruption” that Congress enacted the safe harbors to avoid.