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Second Circuit Rules Bankruptcy Code Section Section 546(e) Protects Fraudulent Transfers in Bernard Madoff Ponzi Scheme Case


In In re Bernard L. Madoff Investment Securities LLC, ___ F.3d ___, 2014 WL 6863608 (2d Cir. 2014), the U.S. Court of Appeals for the Second Circuit considered whether the “safe harbor” provision of Bankruptcy Code section 546(e) provides a defense against a trustee’s claims to avoid Ponzi scheme payments under state fraudulent transfer law made applicable by section 544(b), and under Bankruptcy Code provisions allowing the avoidance of “constructive” fraudulent transfers.  The court ruled that section 546(e) did apply, and affirmed the dismissal of such claims against the recipients of the transfers.

For a copy of the Second Circuit’s decision, please click here.


For some time, the bankruptcy trustee of a Ponzi scheme perpetrator has been able to recover from investors the "fictitious profits" paid to them in excess of their investments.  In Madoff, the trustee appointed to oversee the SIPA liquidation of Madoff Securities’ investment advisory unit (“BLMIS”) sought to avoid payments of fictitious profits to investors as “actual” and “constructive” fraudulent transfers under bankruptcy and state law. Certain customers defended on the ground that the transfers were protected by the safe harbor provision of section 546(e), prohibiting the trustee from clawing back their distributions because the payments were made by a stockbroker “in connection with a securities contract” or, alternatively, because they were “settlement payments” made by a stockbroker.

After withdrawing the reference in multiple adversary proceedings, the U.S. District Court for the Southern District of New York (the “District Court”) dismissed the trustee’s “constructive” fraudulent transfer claims under section 548(a)(1)(B) and his state law fraudulent transfer claims (asserted pursuant to section 544) due to the applicability of section 546(e)’s safe harbor. SIPC v. BLMIC, 476 B.R. 715, 722 (S.D.N.Y. 2012).  The District Court also ruled that section 546(e) did not bar the trustee from avoiding “actual” fraudulent transfer claims asserted under section 548(a)(1)(A).  Id.  The trustee appealed as to the first ruling, and the Second Circuit affirmed.


Section 546(e) provides, in part, that notwithstanding sections 544 and 548(a)(1)(B) of the Bankruptcy Code, a trustee may not avoid a prepetition transfer that is a “settlement payment” made by or to (or for the benefit of) a stockbroker, or that is a transfer made by or to (or for the benefit of) a stockbroker “in connection with a securities contract.”  This safe harbor has been steadily expanded to embrace more transactions. The Second Circuit and other courts interpreting section 546(e) have acknowledged the breadth of the coverage of this safe harbor and have largely applied the plain language of the provision to broadly immunize enumerated transactions from avoidance even where the transactions at issue arguably did not impact the financial markets.

In Madoff, the Second Circuit imposed a broad and literal interpretation of section 546(e) in examining whether the agreements between BLMIS and its customers constituted “securities contracts” as defined in section 741(7) of the Bankruptcy Code, and whether the payments were made “in connection with” a securities contract. The trustee argued, among other things, that section 546(e) did not apply because BLMIS never actually initiated, executed, completed or settled any securities transactions. But the Second Circuit found that section 546(e) does not require an actual purchase or sale of a security. Rather, the transfer need only be broadly related to a securities contract and not an actual securities transaction. The Second Circuit also concluded that the interpretation of section 546(e) espoused by the trustee would in that case risk the very sort of market disruption Congress was concerned with when it enacted the provision.  Noting that BLMIS’ clients had every reason to believe that BLMIS was engaged in actual securities transactions, the Second Circuit ruled that they had every right to avail themselves of the protections afforded by section 546(e) because their agreements were “securities contracts” and because the payments made to them were “settlement payments,” as defined in section 741(8). The Second Circuit also rejected SIPC’s argument that Ponzi scheme payments are, by definition, not made “in connection with” a securities contract.


This is the latest in a string of decisions from the Second Circuit that broadly construe the section 546(e) safe harbor in accordance with the statute’s plain language.  There is a certain irony in the court’s holding, given that the profits of the Ponzi scheme were fictitious because the investment account was itself fictitious. This decision should provide comfort to recipients of transfers made in connection with both actual or purported securities transactions.

These materials were written by Iain A. Macdonald, the senior partner of MACDONALD | FERNANDEZ LLP in San Francisco, California.  Editorial contributions were provided by John N. Tedford, IV, of Danning, Gill, Diamond & Kollitz, LLP, in Los Angeles, California.