United States Court of Appeals for the Second Circuit Holds that Section 546(e) Safe Harbor Protects from Avoidance Transfers of Fictitious Profits in Connection with Madoff Ponzi Scheme

In In re Bernard L. Madoff Investment Securities LLC ("Madoff"),1 the United States Court of Appeals for the Second Circuit reaffirmed its broad and literal interpretation of section 546(e) of the Bankruptcy Code, which provides a safe harbor for transfers made in connection with a securities contract that might otherwise be attacked as preferences or fraudulent transfers. The Second Circuit held that the section 546(e) safe harbor prohibited the trustee (the "Trustee") in Madoff's liquidation proceeding under the Securities Investor Protection Act of 1970 ("SIPA") from clawing back transfers of fictitious profits under state fraudulent transfer law made applicable in the SIPA proceeding by section 544(b) of the Bankruptcy Code. The fictitious profits had been transferred to customers in connection with the now infamous Ponzi scheme perpetrated by Bernard Madoff.

In so holding, the Second Circuit found that transfers of fictitious profits pursuant to account and other brokerage agreements were protected transfers because they were made "in connection with" a "securities contract" and were also "settlement payments," even though no actual securities trades were effected for the benefit of transferee customers by the brokerdealer that operated as a Ponzi scheme. The decision 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.

Section 546(e)—a Key Protection

Designed to minimize systemic risk in the financial markets, section 546 of the Bankruptcy Code contains safe harbors that limit a trustee's power to avoid certain transfers made by, to or for the benefit of certain identified financial market participants in connection with various types of financial transactions. These transactions include margin or settlement payments, securities contracts, swap agreements, forward contracts, repurchase agreements and commodity contracts. Section 546(e) protects "margin payments," "settlement payments" and transfers in connection with "securities contracts," "forward contracts" and "commodity contracts" made by, to or for the benefit of parties such as stockbrokers and financial institutions from avoidance by the trustee as preferences or fraudulent conveyances (whether under the Bankruptcy Code or under state law), except for actual fraudulent transfers under section 548(a)(1)(A) of the Bankruptcy Code.2

Section 546(e)'s financial contract safe harbors have been steadily expanded to embrace more transactions. Courts, including the Second Circuit, 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. By way of example, in Enron Creditors Recovery Corp. v. ALFA, S.A.B. de C.V. ("Enron"),3 the Second Circuit applied the plain meaning of section 546(e) and held that payments made to redeem commercial paper early were nonavoidable settlement payments under section 546(e) and rejected the notion that the safe harbor should be limited because the transactions at issue "did not involve a financial intermediary that took title to the transacted securities and thus did not implicate the risks that...

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