Second Circuit Expands Bankruptcy Code's Safe Harbor Protection for Transferees of Ponzi Scheme Payments

Sections 548(a)(1)(A) and (B) of the Bankruptcy Code (the "Code") give a bankruptcy trustee the power to avoid intentional and constructive fraudulent transfers.1 Section 546(e) of the Code prevents a bankruptcy trustee from recovering a variety of transfers, including ones that would otherwise be avoidable as constructive fraudulent transfers, if the transfers are either settlement payments made by or to a stockbroker or financial institution, or are payments by or to a stockbroker or financial institution in connection with a securities contract.2 In a recent decision, the Second Circuit Court of Appeals has expanded section 546(e)'s protection for recipients of constructive fraudulent transfers in Ponzi schemes.3 Notably, section 546(e) does not prevent a trustee from recovering intentional fraudulent transfers.

The Section 546(e) Safe Harbor's Limitations on Avoiding Powers

Section 546(e) was enacted as a means of "minimiz[ing] the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries"4 and is also designed to protect financial markets "from the instability caused by the reversal of settled securities transactions."5 Without such protection, attempts to avoid a debtor's securities transactions would discourage investors from investing and could potentially have a ripple effect on the entire market.6

Expanding the Scope of Section 546(e) in Ponzi Scheme Cases

In recent years, courts have applied section 546(e) to prevent avoidance of payments made in connection with leveraged buyouts of public7 and private corporations,8 early redemption of commercial paper,9 and redemption of investments in mutual funds that were operated as Ponzi schemes.10 Continuing the line of decisions applying section 546(e) to prevent recovery of Ponzi scheme payments, the Second Circuit Court of Appeals recently interpreted the phrases "securities contract" and "settlement payments" in sections 546(e) and 741 broadly to shield investors in Bernard Madoff 's Ponzi scheme who received payments in excess of their original investments.11 Following the collapse of Bernard L. Madoff 's notorious Ponzi scheme, Irving Picard was appointed as trustee (the "Trustee") of Bernard L. Madoff Investment Securities LLC ("BLMIS") pursuant to the Securities Investor Protection Act, 15 U.S.C. § 78aaa et seq., ("SIPA").12 BLMIS purported to execute a strategy for its customers which, if actually implemented, would have consisted of securities or options trading.13 In reality, however, BLMIS conducted no actual securities or options trading on behalf of its customers. 14 Instead, BLMIS deposited customer investments into a single commingled checking account. For years, BLMIS fabricated customer statements to show fictitious...