Restructuring

In a recent decision by the Fourth Circuit, In re Derivium Capital LLC, the court affirmed the holdings of the lower courts, which held that a chapter 7 trustee could not recover from Wachovia Securities, LLC, Wachovia Securities Financial Network, LLC, and First Clearing, LCC (collectively, “Wachovia”) certain prepetition transfers of securities into, and cash transfers from, the debtor’s brokerage accounts at Wachovia as part of the debtor’s fraudulent customer “stock loan” program.  The Fourth Circuit also upheld the lower courts’ refusal to permit the chapter 7 trustee to recover the commissions, fees, and margin interest payments paid to Wachovia from such accounts.  The decision provides important guidance in construing the extent of property of the estate when the debtor is holding customer property, as well as the importance of the role played by the custodian bank in determining whether it is at risk for seemingly ordinary commercial transactions.
The debtor, Derivium Capital filed for bankruptcy after the collapse of its “stock loan” lending program, which was alleged to be a Ponzi scheme.  As part of this program, Derivium customers transferred equity securities to Derivium in exchange for three-year non-recourse loans worth ninety-percent of the securities’ market values.  At maturity, the customers had three options: (1) repay the principal plus interest and recover the securities; (2) surrender the securities; or (3) refinance the loans for an additional term.  Pursuant to an agreement with Derivium, the customers deposited their securities into Wachovia brokerage accounts in Derivium’s name (as well as in the name of several other stock loan entities).  Instead of hedging the customers’ collateral using a confidential, proprietary formula, as Derivium advised their customers it would, Derivium’s owners directed Wachovia to transfer the stocks into other accounts and liquidate them.  The proceeds from those stocks were then used to fund customers’ loans and the Derivium owners’ start-up ventures.  In late 2004 and early 2005, Derivium closed its accounts at Wachovia because it had difficulty returning customers’ securities when the loans matured.  Thereafter, Derivium filed for chapter 11 protection.  The court converted the case to a chapter 7 and appointed a trustee.
The trustee filed an adversary proceeding against Wachovia seeking, among other things, to avoid certain transfers as fraudulent transfers pursuant to sections 544 and 548 of the Bankruptcy Code.  Specifically, the trustee sought to avoid and recover from Wachovia the customers’ transfers of securities into the Wachovia accounts, the cash transfers into certain other accounts, and commissions, fees, and margin interest paid to Wachovia from such accounts.  These claims were later assigned to a substituted plaintiff, Grayson Consulting, Inc.
In granting summary judgment in favor of Wachovia, the bankruptcy court held that (1) the securities were not part of the Debtor’s estate and, thus, the transfers did not meet the avoidance requirements of section 548 of the Bankruptcy Code, (2) Wachovia was not the initial transferee of the cash funds pursuant to section 550(a) of the Bankruptcy Code because it lacked dominion and control over the funds, and (3) the commissions, fees, and margin interest payments fell within the stockbroker defense of section 546(e) of the Bankruptcy Code.
The Securities Transfers
The Fourth Circuit held that the securities transfers were not transfers of “an interest of the debtor in property or any obligation incurred by the debtor” as required by sections 544(b)(1) and 548(a).  The court explained that the purpose of the avoidance provisions in the Bankruptcy Code is to “prevent a debtor from making transfers that diminish the bankruptcy estate to the detriment of creditors.”  In that same vein, the court distinguished the securities transfers made by Derivium’s customers from those in Bear, Stearns Securities Corp. v. Gredd (In re Manhattan Investment Fund Ltd.), on which Grayson relied on heavily in its brief.  Unlike the transfers in Manhattan Investment Fund, which were made by a debtor into a broker’s margin account, the transfers in Derivium’s case involved transfers of securities owned by the debtor’s customers — third parties. “[T]he transferred securities came to Derivium, not from or through Derivium.”  Derivium only obtained rights in the securities after they were transferred into the accounts.  Thus, the securities transfers were simply not transfers of debtor property, could not diminish Derivium’s estate, and could not be avoided.
The Cash Transfers
Grayson sought to avoid the cash transfers made to the Wachovia account after the securities were liquidated on the grounds that Wachovia was the “initial transferee” of the property under section 550(a) of the Bankruptcy Code.  Because “initial transferee” is not defined by the Bankruptcy Code, the court applied the “dominion and control test” to determine whether Derivium was an initial transferee of the cash transfers of the liquidated securities.  Under the dominion and control test, an initial transferee must have legal dominion and control over the property (i.e., “the right to use the property for its own purpose”) and, in fact, exercise this legal dominion and control.
The Fourth Circuit, agreeing with the bankruptcy court, held that Wachovia neither had nor exercised legal dominion and control over the cash transfers.  In support of its position Grayson argued that Wachovia had legal dominion and control over the accounts at issue via the agreements governing the accounts and exercised such control by removing commissions, margin interest, and prepayment fees from those accounts.  The bankruptcy court explained that, even if the account agreements gave Wachovia legal dominion and control over the accounts, Wachovia did not control the flow of assets into or out of the accounts because it only did so at the direction and consent of the account holder.  Moreover, the removal of the commissions and fees was also at the direction of the account holder and, thus, did not exemplify control over the entire funds in the accounts.
The Commissions, Fees, and Margin Interest Payments
Whether the commissions, fees, and margin interest payments could be protected from avoidance as “settlement payments” and “margin payments” under section 546(e) of the Bankruptcy Code, known as the “stockbroker defense,” was a question of statutory interpretation.  Among other things, section 546(e) protects from avoidance as constructive fraudulent transfers (as opposed to transfers made with actual intent to defraud) “settlement payments” made to a financial institution in connection with a securities contract.  “Settlement payments” are defined somewhat tautologically in section 741(8) of the Bankruptcy Code as “a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, or any other similar payment commonly used in the securities trade.”  Although defined, the Fourth Circuit found the language to be ambiguous on the issue of whether commissions and fees fell within the definition of settlement payments.  Therefore, it turned to the legislative history to shed light on the issue.
The court noted, and the parties agreed, that the purpose of the section is to “preserve the stability of settled securities transactions.”  Specifically, Congress has explained that the purpose behind section 546 is “to clarify and, in some instances, broaden the commodities market protections and expressly extend similar protections to the securities market to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries.”  Agreeing with its sister circuit courts that the definition of settlement payment is extremely broad and looking to several securities industry texts and Black’s Law Dictionary for color, the court concluded that commissions and fees paid to a stockbroker as part of settling a regular securities transaction are protected settlement payments.  Importantly, the court noted that not all commission payments are protected settlement payments, such as when they are paid for the solicitation of investors, because they are not part of the settlement of securities transactions.
Grayson argued that the commissins and fees, even if settlement payments, were not customary and reasonable, and, therefore, should not be protected by section 546(e).  The Fourth Circuit, however, was satisfied with the evidence and testimony produced at the evidentiary hearing before the bankruptcy court.  Wachovia presented testimony from an account representative, an expert on industry standards and rules governing broker commissions, and the president of the company that calculated Wachovia’s commissions, which explained that many of Wachovia’s clients receive discounted rates, some steeper than others.  Moreover, the testimony revealed that such rates are not unusual but, instead, are fair, reasonable, and customary within the FINRA and NASD rules.  Thus, the Fourth Circuit upheld the bankruptcy court’s determination that the commissions were customary and reasonable under industry standards.
As to Grayson’s argument that the margin interest payments did not qualify as “margin payments” pursuant to section 546(e) and, therefore, were not protected payments, the court similarly upheld the bankruptcy court’s reasoning in concluding that they did qualify.  Bankruptcy Code section 741(5) of the Bankruptcy Code defines “margin payment” as “a payment or deposit of cash, a security, or other property, that is commonly known to the securities trade as original margin, initial margin, maintenance margin, or variation margin, or as a mark-to-market payment, or that secures an obligation of a participant in a securities clearing agency.”  This term is similarly defined broadly and the parties agreed that “whether a margin interest payment constitutes a margin payment turns on whether it reduces a deficiency in a margin account.”  Because accrued interest increases the total debt owed, the bankruptcy court reasoned, margin payments reduce the deficiency in a margin account and, thus, qualify as margin payments.  The Fourth Circuit agreed.
In a final attempt to exclude Wachovia’s commissions, fees, and margin interest payments from the protection of section 546(e), Grayson argued that the court should find that an exception to the stockbroker defense applies because “applying [the stockbroker defense] in the context of an alleged Ponzi scheme would allow a broker to retain ill-gotten profits and undermine the equitable goals of the Bankruptcy Code.”  In response, the Fourth Circuit explained that although section 546(e) does not include a Ponzi scheme exception on its face, it does, however, provide several exceptions to its application.  For example, claims brought under section 548(a)(1) — fraudulent transfers with actual intent to hinder, delay, or defraud — are exempt from the stockbroker defense.  This issue, however, was not ripe for determination and, thus, the courts did not reach the merits.
Take Away
Derivium Capital serves as a reminder that the purpose and policy behind the avoidance provisions of the Bankruptcy Code is to protect against diminution of the estate.  Even when property may be characterized as belonging to the estate, though, the Bankruptcy Code and case law provide additional protections.  For example, although unwitting initial transferees sometimes may find themselves the subject of a fraudulent transfer claim without the ability to invoke the “good faith transferee” defense that is available to subsequent transferees, courts have developed the “dominion and control” test to protect innocent intermediaries.  Moreover, as Weil’s Bankruptcy Blog has written about on several occasions the “settlement payment defense” has become a powerful and expansive weapon in defending against constructive fraudulent transfer claims.