Restructuring

Contributed by Cristine Pirro
In In re Goldman Sachs Execution & Clearing L.P. v. Official Unsecured Creditors’ Committee, the United States Court of Appeals for the Second Circuit considered whether a panel of arbitrators manifestly disregarded the law when the panel found in favor of a creditors’ committee asserting that certain transfers were fraudulent conveyances and fraudulent transfers under applicable law.  Because the Second Circuit could not find that the arbitrators had “manifestly disregarded” an applicable and unambiguous law in granting the creditors’ committee’s request, the court upheld the award.

Background
In 1999, Goldman Sachs Execution & Clearing, P.C. started serving as the sole clearing broker for Bayou Group, LLC’s hedge fund “Bayou Fund, LLC” at Goldman Sachs.  In 2003, the Bayou Fund, LLC hedge fund manager opened four similar accounts at Goldman Sachs for four additional hedge funds in the Bayou family.  As it turns out, the Bayou Funds had been operated as a Ponzi scheme.  The Ponzi scheme collapsed in 2005, and the Bayou Funds filed petitions for bankruptcy protection in the United States Bankruptcy Court Southern District of New York in 2006.
Two years later, the bankruptcy court authorized the creditors’ committee to prosecute or settle any claims the debtors might have against Goldman Sachs.  The committee asserted that Goldman Sachs was jointly and severally liable with the Bayou Funds for certain fraudulent transfers and fraudulent conveyances because of Goldman Sachs’ alleged failure to diligently investigate the funds.  Honoring an arbitration agreement previously executed by Goldman and the Bayou Funds, the committee prosecuted its claims before the Financial Industry Regulatory Authority (FINRA) in an arbitration proceeding.  The arbitration panel found in favor of the creditors’ committee in an approximate amount of $20.5 million (equal to the total value of all the transfers).   Goldman Sachs appealed the panel’s award to the Southern District of New York, asking the district court to vacate it, and the committee cross-appealed the award, requesting affirmance of the award.  The district court agreed with the arbitration panel and affirmed its award.  Goldman Sachs and the committee appealed and cross-appealed the district court’s decision to the Second Circuit.
Holding
On appeal, Goldman Sachs argued that the panel’s decision was rendered in “manifest disregard” of the law.  Citing to the Supreme Court’s 2008 decision in Hall Street Associates, L.L.C. v. Mattel, Inc., 552 U.S. 576, 585 (2008) as creating uncertainty for the continued viability of the “manifest disregard” doctrine, the Second Circuit nonetheless concluded that the doctrine remains a valid basis to vacate an arbitration award.  The “manifest disregard” standard is somewhat intuitive – in applying the standard of review, a court considers (1) “whether the governing law alleged to have been ignored by the arbitrators was well defined, explicit, and clearly applicable,” and (2) “whether the arbitrator knew about the existence of a clearly governing legal principle but decided to ignore it or pay no attention to it.”[1]  The test implicitly recognizes that one cannot “manifestly disregard” a law that is unclear.  Thus, in considering whether the arbitration panel manifestly disregarded the law, the Second Circuit first looked to applicable case law to determine whether the governing law was ambiguous.  The Second Circuit observed that the “manifest disregard” standard is an “exceedingly difficult” standard to satisfy.
First examining alleged fraudulent transfers made between 2004 and 2005, the court noted that the sole issue there was whether Goldman Sachs was an “initial transferee” such that the fraudulent transfers would be recoverable from it under section 550(a) of the Bankruptcy Code. (Goldman Sachs apparently did not contest that the transfers were fraudulent).  The Second Circuit pointed to a recent case, Bear, Stearns Securities Corp. v. Gredd, 397 B.R. 1 (S.D.N.Y. 2007), (with facts substantially similar to the one before the panel), where the court allowed the bankruptcy trustee to recover from Bear Stearns amounts that the debtor hedge fund had transferred to its margin account in the year prior to filing for bankruptcy.  In coming to that conclusion, the district court in Gredd determined that Bear Stearns could be considered an “initial transferee” from which the trustee could recover transferred funds because Bear Stearns was not a “mere conduit” of those funds.  Although Bear Stearns could not use the transfers to make a profit, it could use the funds to protect itself from suffering losses.
The Second Circuit compared the case before it to the facts in Gredd.  Goldman Sachs not only possessed a security interest for the payment of all Bayou’s obligations and liabilities, but it also had several rights over the Bayou funds that gave it discretion over those funds, including the right to (1) require the debtor to deposit cash or collateral with the broker to assure performance of contractual commitments, (2) require the debtor to maintain certain positions or margins, (3) lend any of the debtor’s securities held by the broker in margin accounts, and (4) liquidate securities or other property in the account to ensure minimum maintenance requirements were satisfied.  The court stated that these rights allowed Goldman Sachs “to use the funds to protect itself” against losses, just as Bear Stearns was able to do in Gredd.
Despite identifying the similarities between Gredd and the facts before it, the Second Circuit made clear that it was neither endorsing nor rejecting Gredd.  Instead, the court viewed Gredd as revealing “considerable uncertainty as to whether cases like this one come within an exception to the ‘mere conduit’ principle on which Goldman relies.”  The court further explained that Goldman Sachs could not identify any clear, on-point authority governing its argument.  Because Goldman Sachs could not prove that the arbitration panel disregarded a clear law, the Second Circuit held that Goldman Sachs failed to satisfy the “manifest disregard” standard.  Similarly, with respect to Goldman Sachs’ argument that the arbitration panel manifestly disregarded the law with respect to another set of transfers because those transfers between the Bayou Funds could not constitute conveyances under New York law, the court found fatal the fact that Goldman Sachs did not cite to a decision by a New York court indicating that the transfers would not be considered conveyances to Goldman.
This decision exemplifies why the “manifest disregard” standard is “by design, exceedingly difficult to satisfy.”  Although the arbitration panel did not give a reason for its decision (a fact that the district court was sure to point out), the Second Circuit was still able to conclude that the arbitration panel did not ignore a clearly governing legal principle.  Thus, regardless of the merits of each side’s arguments had the Second Circuit been considering them de novo, the Second Circuit focused on whether the law was clear, or whether, as it eventually held, the law contained ambiguities.  The strict standard of review governing attempts to vacate arbitration awards should provide a warning to contract drafters inserting provisions requiring dispute resolution by arbitration.