MANHATTAN (CN) - Fictitious profits paid to certain investors in Bernie Madoff's massive Ponzi scheme cannot be seized by the bankruptcy trustee overseeing liquidation of the business, the 2nd Circuit ruled Monday.
The preferred investors argued the money they received were securities-related payments shielded by U.S. Bankruptcy Code from the trustee's "clawback" powers, and the court agreed.
Irving Picard, appointed trustee for Bernard L. Madoff Investment Securities LLC after the business collapsed in late 2008, sued to recover billions of dollars paid to hundreds of preferred investors to make the money more widely available to all of Madoff's victims.
Madoff's business claimed to employ a "split strike conversion strategy" for investors whereby it timed the market to purchase a basket of stocks on the S&P 100 Index, then hedged those purchases with related options contracts.
In fact, no actual transactions occurred. Instead, Madoff deposited customer investments into a single checking account and fabricated statements showing fictitious trades that brought in returns of 10 percent to 17 percent annually.
When customers sought to withdraw "profits" shown on their statements, Madoff sent them money from the checking account.
Over time, some customers took out more money than they had invested with Madoff - money that Picard sued to recover for the bankruptcy estate.
But the defendant investors moved to dismiss the trustee's complaints, contending that Section 546(e) of the bankruptcy code shields securities-related payments made by a stockbroker.
U.S. District Judge Jed Rakoff of the federal court in Manhattan ruled in their favor in 2012, prompting Picard's appeal to the 2nd Circuit.
Section 546(e) often is called the stockbroker's safe harbor defense because it can be used to block fraudulent-conveyance claims by trustees.
Picard, who sought recovery under both federal and New York law, contended Section 546(e) should not apply because Madoff undertook no transactions for his customers.
But U.S. Circuit Judge Barrington Parker, writing for the three-judge appeals panel, rejected the argument that the section "would only apply if Madoff had actually completed the securities transactions he purported to effectuate."
Instead, "we conclude that Section 546(e) shields these transfers from avoidance because they were 'made in connection with a securities contract' and were also 'settlement payment[s]," he wrote, quoting from the bankruptcy code.
The term "securities contract" is expansive, according to Parker, including actual sales agreements and any others that are similar or related to such contracts.
Madoff customers signed three documents on opening an account that established a relationship under which securities were bought and sold on their behalf - even if no actually transactions occurred.
"The transfers at issue originated with, and could not have been possible but for the relationship created by the account documents," Parker wrote. "Accordingly, we conclude that they fall within the statute's broad definition of 'securities contracts.'"
The court also found that the transfers constituted "settlement payments," which also shielded them from clawback.
"Because the customer granted BLMIS discretion to liquidate securities in their accounts to the extent necessary to implement their sell orders or withdrawal requests, each transfer in respect of such an order or request constituted a settlement payment," Parker wrote, using an abbreviation for Madoff's firm.
The judge said the court rejected Picard's contention that "to allow customers to retain the fictitious profits Madoff arbitrarily bestowed on them amounts to giving legal effect to his fraud."
Yes, he said, the transfers were part of a Ponzi scheme and as such were fraudulent.
"Indeed, BLMIS's conduct was in flagrant breach of the agreements it made with its customers," Parker wrote. "But 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. After all, a transfer can be connected to, and can be made in relation to, multiple documents or purposes simultaneously."
Madoff pleaded guilty to 11 federal fraud counts in 2009 and was sentenced to 150 years in prison.
Greg Schwed, a partner in Loeb & Loeb in Manhattan, which argued for some of the investors at the appeal, praised the decision for allowing "good-faith" victims to retain about $1.6 billion threatened by clawback.
"We think the 2nd Circuit got it exactly right," Schwed said in a statement. "The court's ruling sharply restricts the trustee's litigation campaign against innocent victims of Madoff's fraud - many of them retirees whose savings were wiped out. ... This ruling respects the balance set by Congress between the trustee's goal of collecting money and the right of Madoff victims to keep amounts they received in good faith many years ago."
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