Restructuring

Recently, in Picard v. JPMorgan Chase & Co. (In re Bernard L. Madoff Invest. Secs. LLC), Chief Judge Dennis Jacobs of the Second Circuit shed light on many of the parallels between the rights of a trustee to assert claims on behalf of the debtor as compared to its creditors pursuant to SIPA and the Bankruptcy Code.  In the decision, the Second Circuit held that the doctrine of in pari delicto barred a SIPA trustee from bringing certain state law claims against various financial institutions on behalf of an insolvent brokerage firm and that the SIPA trustee also could not assert such claims on behalf of the brokerage’s customers because he lacked standing to bring such claims.
Background
After Bernard L. Madoff was arrested and plead guilty to securities fraud in March 2009 for using his brokerage firm Bernard L. Madoff Investment Securities LLC (“BLMIS”) to conduct the largest Ponzi scheme yet uncovered, the Securities Investor Protection Corporation (“SIPC”) filed an application under the Securities Investor Protection Act (“SIPA”) for the protection and liquidation of BLMIS.  The district court appointed Irving Picard as the SIPA trustee, and the case was referred to the United States Bankruptcy Court for the Southern District of New York.
SIPA was enacted in 1970 to facilitate the return of customer property to investors after a firm’s collapse.  In contrast to a traditional bankruptcy, under a SIPA liquidation each customer shares ratably in any remaining customer property according to their net equity.  Notably, among other powers, a SIPA trustee has the authority to investigate the circumstances surrounding the firm’s insolvency and, if funds remain after customer distributions, to distribute such funds to deserving creditors.  For more blog entries discussing SIPA proceedings and related issues, click here.
Pursuant to such authority, and an investigation of the circumstances surrounding the insolvency of BLMIS, Picard commenced several adversary proceedings in the bankruptcy court on behalf of BLMIS’s customers and against numerous major financial institutions — JPMorgan Chase & Co., UBS AG, and Access International Advisors LLC, among others.  Picard alleged that the financial institutions aided and abetted the fraud perpetrated by Madoff and BLMIS by ignoring obvious warning signs of the Ponzi scheme in order to continue collecting handsome fees.  In addition to common law claims, Picard also asserted a contribution claim pursuant to New York law for SIPA payments advanced to the brokerage’s customers because there were insufficient assets to satisfy the customers’ claims.  On motion, the district court withdrew the reference to the bankruptcy court and dismissed Picard’s claims, holding that Picard could not bring claims on behalf of Madoff or BLMIS because he stood in the shoes of those entities and, therefore, was in pari delicto with the defendants.  Moreover, the district court concluded that Picard lacked standing to assert common law claims on behalf of BLMIS’s customers and did not have a right to contribution. The Second Circuit affirmed.
For more background on other recent developments in the Madoff case click here.
Claims on Behalf of BLMIS
In a SIPA proceeding (like a bankruptcy proceeding), state law determines whether a right to sue belongs to the debtor or to individual creditors.  Under New York law, the Second Circuit explained, “one wrongdoer may not recover against another.”  This is the doctrine of in pari delicto, which has long been applied by New York’s Appellate Division, First Department.  Under this doctrine, the debtor’s conduct is imputed to the trustee and the trustee “stands in the shoes” of the debtor, precluding the trustee from asserting claims against third parties for their alleged participation in the debtor’s fraud.  Picard argued that the “adverse interest” exception to the in pari delicto doctrine applied, and, thus, he should be permitted to assert common law claims on behalf of BLMIS.  Pursuant to the “adverse interest” exception, a court cannot impute the bad acts of a corporation’s agents to the corporation itself when the fraud was conducted for the agent’s personal benefit.  The court, however, characterized this exception as the “most narrow of exceptions,” reserved for cases of outright theft against a corporation rather than on the corporation’s behalf.  Because it would be impossible to separate BLMIS from Madoff and his Ponzi scheme, the court declined to apply the exception and held that Picard’s state law claims could not escape the bar of in pari delicto.
Although Picard’s claim for contribution for the SIPA payments was the only claim that could survive the doctrine of in pari delicto, the Second Circuit held that Picard did not have such a right.  Pursuant to New York law, when “two or more persons who are subject to liability for damages for the same personal injury [or] injury to property . . . [they] may claim contribution among them whether or not an action has been brought or a judgment has been rendered against the person from whom contribution is sought.” N.Y. C.P.L.R. § 1401 (McKinney).  Importantly, the party seeking contribution must have been compelled in some way to make the payment against which contribution is sought.  The SIPA payments made to the customers, though, were not compelled by BLMIS’s state law claims of fraud liability to its customers, but rather by Picard’s obligation to pay BLMIS’s customers their ratable share pursuant to SIPA.  Because SIPA does not provide a right to contribution, the Second Circuit held that the district courts properly dismissed Picard’s contribution claims.
Claims on Behalf of BLMIS’s Customers
Picard fared no better by attempting to stand in the shoes of the BLMIS customers because the Second Circuit held that he lacked standing to assert state law claims on behalf of the customers.  Picard argued that Second Circuit precedent allows for third-party standing in SIPA liquidations and that SIPA itself confers standing by creating a bailment between the SIPA trustee and customers and by authorizing SIPC to pursue subrogation claims on the customers’ behalf.  The court rejected both of these arguments.
Citing Supreme Court precedent in Caplin v. Marine Midland Grace Trust Co. of N.Y., the court explained that federal bankruptcy law does not empower a trustee to collect money owed to creditors.  Instead, a trustee is charged with collecting property of the estate and reducing it to money.  Accordingly, the court explained, creditors can make their own determination of whether they want to litigate their claims and, if so, what theories to litigate under and the amount of damages to seek; the Bankruptcy Code does not suggest otherwise.
The court distinguished Madoff from Redington v. Touche Ross & Co., 592 F.2d 617 (2d Cir. 1978, rev’d, 442 U.S. 560 (1979), and St. Paul Fire & Marine Insurance Co. v. PepsiCo., Inc., 884 F.2d 688 (2d Cir. 1989), on which Picard relied heavily in making its third-party standing arguments.  In Redington, a SIPA trustee sued the accountant of an insolvent brokerage firm for violations of record-keeping provisions in section 17(a) of the Securities Exchange Act and violations of common law.  The Redington court held that section 17(a) creates a private right of action, a SIPA trustee, as a bailee, is a real party in interest, and SIPC is subrogated to a right of action in favor of brokers’ customers against third parties such as accountants.  The U.S. Supreme Court, however, granted certiorari in Redington and held that section 17(a) does not create a private right of action, declining to reach the standing issue.  The Second Circuit vacated its original judgment for lack of subject matter jurisdiction.  Accordingly, the court held that Redington has no precedential effect, and, even if it did, Madoff was distinguishable and completely inapposite to Redington.
Moreover, the court found that the holding in St. Paul was inapplicable to Madoff.  Picard relied on St. Paul for the premise that a trustee may assert creditors’ claims if they are generalized in nature and not particular to any individual creditor.  St. Paul decided the specific question of whether a creditor may bring an alter ego claim against the debtor’s parent when the debtor itself also possesses such a claim.  The court in St. Paul explained that a trustee may bring a claim against a third party if the “claim is a general one, with no particularized injury arising from it, and if that claim could be brought by any creditor of the debtor.”  First, in contrast to the claims brought by the trustee in St. Paul, Picard was seeking to assert claims that were only property of the creditors, not of the debtor, and it is well settled that a trustee cannot assert creditors’ claims against third parties.  Second, the customers’ claims against the defendant financial institutions in Madoff were not “common” or “general.”  Instead, Picard sought to assert claims on behalf of thousands of customers for the defendants’ mishandling of individual investments made on different dates and in different amounts.  Accordingly, the court held that the customers’ claims were not “general” or derivative of the claims held by the BLMIS estate.
The Second Circuit also rejected arguments by Picard and SIPC that, for SIPA purposes, the customers of a broker-dealer are bailors and a SIPA trustee and/or the broker-dealer is a bailee, thus providing Picard with a possessory interest in the customers’ property sufficient to permit him to recover for the wrongful act of a third party that resulted in a loss or injury to the subject of the bailment.  The court held that SIPA does not create a bailment relationship between a SIPA trustee and customers, and, even if Picard and SIPC were relying on the common law of bailment, their rationale was flawed.  Among other things, the court explained that much like a thief is not a bailee of stolen property, so too Madoff and by extension, BLMIS, was not a bailee of the customers’ property.  Moreover, Madoff’s commingling of customer funds would defeat any bailment analogies:  Under New York law, commingling funds destroys a potential bailment.
As to the subrogation arguments, the court explained that neither was supported by the plain language of the statute or its legislative history.  “SIPA only creates a narrow right of subrogation — for SIPC to assert claims against the fund of customer property and thereby recoup any funds advanced to customers once the SIPA trustee has satisfied those customers’ net equity claims.”  Picard sought an expansion of those rights by asserting that because SIPC advanced funds to customers at the outset of the liquidation, SIPC is subrogated to those customers’ claims against the defendants and, thus, Picard may assert those claims as subrogee on SIPC’s behalf.  This was a result that the Second Circuit would not allow.
The court was unmoved by Picard’s equitable arguments that, unless he could “spearhead the litigation on behalf of defrauded customers, the victims will not be made whole,” noting that, as suggested by the U.S. Supreme Court in Caplin, it is better to leave such “intractable policy judgments to Congress”:

Congress might well decide that reorganizations have not fared badly in the 34 years since Chapter X was enacted and that the status quo is preferable to inviting new problems by making changes in the system. Or, Congress could determine that the trustee . . . was so well situated for bringing suits . . . that he should be permitted to do so.  In this event, Congress might also determine that the trustee’s action was exclusive, or that it should be brought as a class action on behalf of all [creditors], or perhaps even that the [creditors] should have the option of suing on their own or having the trustee sue on their behalf.  Any number of alternatives are available.  Congress would also be able to answer any questions regarding subrogation or timing or law suits before these questions arise in the context of litigation.  Whatever the decision, it is one that only Congress can make.

Madoff demonstrates the important policy considerations behind a SIPA trustee’s powers vis-à-vis the broker-dealer and its customers, considerations that similarly define the powers of a trustee in a chapter 11 case.  Paramount to these considerations is the overriding dichotomy between a trustee as a representative and extension of the broker-dealer or debtor and as an advocate of creditor rights.  If this historical dichotomy is to ever change, Chief Judge Dennis Jacobs of the Second Circuit carefully explains, it is a change that may only be effected by Congress.