Contributed by Andrea Saavedra
The recent decision by the Second Circuit Court of Appeals affirming the bankruptcy court’s decision in In re: Bernard L. Madoff Inv. Sec. LLC (previously reported about here) reaffirms one of the fundamental legal principles of U.S. bankruptcy law: the resolution of business failures sometimes requires flexibility and creativity to achieve the most equitable result possible in what is often the worst of circumstances. Upholding the use of the “Net Investment Method” for determining customer claims by Irving Picard, the Madoff estate trustee, the Second Circuit held that the Securities Investment Protection Act (SIPA) permits a SIPA-appointed trustee to employ his or her sound judgment in determining the appropriate methodology for calculating customer claims in a broker-dealer liquidation. The decision emphasizes that no single formula is “one size fits all” when it comes to unwinding these often complicated entities.
For those who are not familiar with SIPA, a brief primer may be helpful. First, a SIPA trustee is vested with the general powers of a bankruptcy trustee, but also is charged with additional duties in relation to the recovery and distribution of customer property of a failed broker-dealer. 15 U.S.C. § 78fff-l. Unlike in a typical, non-stockbroker liquidation under chapter 11 or chapter 7 of the Bankruptcy Code, SIPA provides customers with special protections, inclusive of granting them a priority claim against a fund of “customer property” that is established for distribution exclusively among customers and is not otherwise considered part of the general estate of the failed broker-dealer. This “customer property” fund consists of cash and securities received or held by the broker-dealer on behalf of customers, except securities registered in the name of individual customers. 15 U.S.C. § 78lll(4). Each customer shares ratably in this fund of assets to the extent of the customer’s “net equity.” 15 U.S.C. § 78fff-2(c)(1)(B). Under SIPA:
The term ‘net equity’ means the dollar amount of the account or accounts of a customer, to be determined by –
(A) calculating the sum which would have been owed by the debtor to such customer if the debtor had liquidated, by sale or purchase on the filing date, all securities positions of such customer . . . ; minus
(B) any indebtedness of such customer to the debtor on the filing date…
15 U.S.C. § 78lll(11). All customer claims must be filed with the trustee, who is granted authority to resolve and allow such claims. To the extent a customer disagrees with a trustee’s determination, it must file its objection with the bankruptcy court. 15 U.S.C. § 78fff-2(a)(2).
The controversy in Madoff stemmed from how Picard chose to calculate certain Madoff customers’ “net equity.” Specifically, Picard used the “Net Investment Method,” which credited “the amount of cash deposited by the customer into his or her . . . account, less any amounts withdrawn from it.” Under the Net Investment Method, only customers who had deposited more cash into their investment accounts than they had withdrawn (and, thus, would have a positive “net equity” in their accounts) would be able to have allowable claims against the customer property fund. Certain customers objected to the trustee’s approach and argued before the bankruptcy court (Lifland, J.) that their net equity should be determined by the market value of the securities reflected on their most recent customer statements, which methodology is known as the “Last Statement Method.”
Finding that the most recent customer statements were unreliable, “entirely fictitious” and did not “reflect actual securities positions that could be liquidated,” the bankruptcy court upheld Picard’s methodology. The bankruptcy court reasoned that the definition of “net equity value” had to be read along with other provisions of SIPA that require a trustee to discharge net equity claims only “insofar as such obligations are (1) ascertainable from the books and records of the debtors or (2) are otherwise established to the satisfaction of the trustee.” Because the debtor’s books and records revealed a fraud where “no securities were ever owed, paid for or acquired” and use of the Last Statement Method would “legitimize” the fraudulent scheme, Picard’s use of the Net Investment Method was appropriate.
The bankruptcy court certified its decision for immediate appeal to the Second Circuit. The Securities and Exchange Commission and Securities Investor Protection Corporation filed briefs in support of Picard’s position. On appeal, the customers argued that: (i) the statutory language of SIPA mandated the use of the Last Statement Method; (ii) they had a legitimate expectation their customer statements were accurate; (iii) SIPA was “designed to protect this legitimate expectation” as a form of statutory insurance for failed broker-dealers; and (iv) the Net Investment Method “undermined” SIPA’s purpose. The court rejected each of the customers’ arguments. Agreeing that the appellants were customers under SIPA, the Second Circuit found that SIPA did not “prescribe a single means of calculating ‘net equity’” that could apply to the “myriad [of] circumstances that may arise in a SIPA liquidation,” and that “[w]hen the terms of the statute are read together, the statute directs that a SIPA trustee should determine a customer’s entitlement to recover ‘net equity’ based both on the statutory definition of that term and by reference to the books and records of the debtor.” Because nothing in the statute directed the use of the Last Statement Method, especially where the debtor’s books and records were entirely unreliable, the court found that Picard had properly exercised his discretion in utilizing the Net Investment Method.
Further, the court noted that, although a primary role of SIPA is to protect customers, SIPA was also established to “protect the securities market as a whole.” Permitting the customers to recover for fictitious profits would not further that goal, but, instead, would “give legal effect to Madoff’s machinations.” With respect to the customer’s expectations, the court rejected the concept that SIPA was an insurance scheme developed to backstop the failures of broker-dealers. The court also rejected the argument that the Net Investment Method undermined the purpose of SIPA given that the “main purpose of determining ‘net equity’ is to achieve a fair allocation of the available resources among the customers.” Under the facts of the Madoff case, had Picard used any other method, he would have “undermined this [main] objective” of the statute. Lastly, the Second Circuit distinguished previous decisions in which it had upheld use of the Last Statement Method by a SIPA trustee unwinding a similar Ponzi scheme, finding the facts of those cases were not analogous to those before it.
In emphasizing that SIPA vests a trustee with certain discretion and judgment in deciding how to calculate “net equity” claims and as well as the flexibility of SIPA’s procedures, the Second Circuit concluded that Picard was not obligated to regard the customer statements as accurate.
The court accorded substantial deference to Picard in affirming his use of the Net Investment Method, noting that:
Fraud is endlessly resourceful and the unraveling of weaved-up sins may sometimes require the grant of a measure of latitude to a SIPA trustee. It therefore appears to us that in many circumstances a SIPA trustee may, and should, exercise some discretion in determining what method, or combination of methods, will best measure ‘net equity.’ We have no reason to doubt that a reviewing court could and should accord a degree of deference to such an exercise of discretion so long as the method chosen by the trustee allocates ‘net equity’ among the competing claimants in a manner that is not clearly inferior to other methods under consideration.
Ultimately, the Second Circuit affirmed the principle that, in messy wind-downs, both discretion and flexibility should be accorded to a trustee so long as the trustee exercises such powers within the boundaries of fairness. The Second Circuit’s decision is a substantial win for Picard and also an important reminder to those looking to create legislation that deals with business failures. Although human judgment may not be scientifically perfect, it is, at times, required so as to provide an equitable remedy where inequities would otherwise arise if only a single path of resolution were permitted.