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 prompted Congress to enact the safe harbor." Along the same lines, in In re Quebecor World (USA) Inc,.4 the Second Circuit similarly applied a plain meaning approach to find that transfers under a Note Purchase Agreement to a financial institution acting as a conduit were transfers in connection with a securities contract made by or to a financial institution and thus protected by the section 546(e) safe harbor. Two other cases involving the interpretation of the scope of the section 546(e) safe harbor—In re Tribune Litigation (Case No. 13-3992) and Whyte v. Barclays Bank PLC (Case No. 13-2653)—are currently pending before the Second Circuit.

The Decision

In Madoff, the trustee appointed to oversee the SIPA liquidation of Bernard Madoff's fund ("BLMIS") sought to avoid transfers of fictitious profits to investors in connection with Madoff's Ponzi scheme as fraudulent transfers. Certain of BLMIS' customers sought to defend against avoidance on the ground that the transfers were protected by the safe harbor provision of section 546(e). The United States District Court for the Southern District of New York (the "District Court") ruled that such transfers made after two years prior to the commencement of Madoff's SIPA liquidation proceeding were not voidable as fraudulent transfers due to the applicability of section 546(e)'s safe harbor. The Trustee appealed such decision to the Second Circuit, which affirmed the holding of the District Court that section 546(e)'s safe harbor exempted the transfers at issue from avoidance. The Second Circuit's decision deals primarily with the broad definition of "securities contract" in the Bankruptcy Code and the expansive application of the safe harbor to any transfer made "in connection with" language of section 546(e). Guided by these two broad concepts, the Second Circuit had no difficulty in reaching its conclusion that the safe harbor applied.

The defendants argued that section 546(e) prohibited the Trustee from clawing back their distributions because the payments were made by a stockbroker "in connection with a securities contract" or, alternatively, because they were "settlement payments" made by a stockbroker. The defense relied on a suite of documents, including a "Customer Agreement," which authorized BLMIS to open or maintain one or more accounts, a "Trading Authorization," which appointed BLMIS to be the customer's agent to buy, sell and trade securities, and an "Option Agreement," which authorized BLMIS to engage in options trading for the customer's account (collectively, the "Account Documents").

The Second Circuit concluded that the Account Documents constituted a securities contract based on the types of agreements broadly described in the definition of "securities contract," which is found in section 741(7) of the Bankruptcy Code: section 741(7)(A)(x) (Account Documents were master agreements providing for the purchase, sale, or loan of a security); section 741(7)(A)(xi) (Account Documents qualified as "any guarantee or reimbursement obligation by or to a stockbroker" due to BLMIS' obligation to reimburse its customers upon request upon withdrawal from their accounts); and section 741(7)(vii) (Account Documents fell within the scope of "any other agreement ... that is similar to" "a contract for the purchase, sale or loan of a security"(emphasis added)).

Additionally, the court noted that the transfers at issue could not have been possible but for the relationship created by these agreements.

The Trustee argued that the Account Documents did not constitute a securities contract because (i) BLMIS never initiated, executed, completed or settled any securities transactions; (ii) the Account Documents never identified the specific terms of any securities transactions; and (iii) the Account Documents never expressly obligated BLMIS to carry out any specific transactions but merely authorized BLMIS to effect securities transactions. The Second Circuit acknowledged that the Trustee's observations were correct, but rejected these arguments in turn and found that the Account Documents created a "securities contract" as defined in section 741 of the Bankruptcy Code.

First, the Second Circuit found that section 546(e) does not require an actual purchase or sale of a security. Rather, the transfer need only be broadly related to a securities contract and not an actual securities transaction. The fact that BLMIS breached its obligations under the Account Documents did not vitiate the existence of those documents as a securities contract. Moreover, the Second Circuit found that the interpretation of the section 546(e) safe harbor espoused by the Trustee to require an actual securities transaction would risk the very sort of market disruption Congress was concerned with when enacting the provision, given that the defendant-customers of BLMIS had every reason to believe that BLMIS was engaged in actual securities transactions.

Second, the Second Circuit rejected the notion that the Account Documents were not securities contracts because they did not specify terms of securities transactions such as security, issuer, quantity or price. The court found that the language of section 546(e) imposes no such requirement and likewise found that the breadth of the definition of "securities contract" indicates that Congress intended no such requirement.

Third, the Second Circuit rejected the Trustee's argument that the Account Documents were not securities contracts because they merely authorized, but did not obligate, BLMIS to effect securities transactions for customers. The Second Circuit found that the definition of "securities contract" is not so limited, and that it encompasses the relationship created by the Account Documents. Specifically, the definition includes not only the enumerated types of contracts identified in section 741, but also "any other agreement ... that is similar to" "a contract for the purchase, sale or loan of a security."5 As the court noted, "[f]ew words in the English language are as expansive as 'any' and 'similar.'"

Once the Second Circuit concluded that the Account Documents constituted a securities contract, it had little difficulty concluding that the transfers to customers were made "in connection with" the securities contract. Relying on a plain language interpretation, the court viewed "in connection with" as a transfer "related to" or "associated with" the securities contract. Having concluded that the agreements constituted a securities contract, the Second Circuit quickly concluded that customer withdrawals from their accounts came within the scope of the safe harbor as being in connection with the Account Documents. The court noted that its conclusion was congruent with the broad interpretation of the "in connection with a purchase or sale of any security" requirement of Rule 10b-5 in the context of federal securities laws.

In rejecting the Trustee's argument that applying section 546(e) in the context of a Ponzi scheme would give legal effect to Madoff's fraud, and that Ponzi scheme payments by definition are not "in connection with" a securities contract, the Second Circuit noted that "[s]ection 546(e) sets a low bar for the required relationship between the securities contract and the transfer sought to be avoided." Payments made in connection with a Ponzi scheme may be made in connection with a securities contract, albeit one that has been breached.

Alternatively, the Second Circuit held that the transfers were also protected under section 546(e) because they were "settlement payments" made by a "stockbroker." Here the Second Circuit again rejected the Trustee's argument that there were no settlement payments because BLMIS never engaged in actual securities trading. Relying on its decision in Enron, the Second Circuit held that the Bankruptcy Code definition of settlement payment should be broadly construed to apply to the transfer of cash or securities to complete a securities transaction. The Second Circuit agreed with the District Court that, because the customer granted BLMIS discretion to liquidate securities in the customer's account to the extent needed to implement the customer's sell orders or withdrawal requests, each transfer in respect of such an order was a settlement payment.

In closing, the Second Circuit rejected the Trustee's contention that the court's holding was inconsistent with its prior decision interpreting how to calculate the "net equity" claim of a "customer" under SIPA.6 The Second Circuit reasoned that (i) section 546(e) is found in the Bankruptcy Code and not SIPA and was not an issue in its prior decision regarding the computation of a customer's claim and (ii) section 546(e) represents the careful balance Congress has struck between the need for an equitable result for the debtor and the need for finality, which the Second Circuit felt obligated to respect.


While the Bankruptcy Code safe harbors have come under attack from various commentators in recent years, Madoff demonstrates that the Second Circuit will continue to interpret section 546(e) in accordance with its literal language. This decision should provide comfort to recipients of transfers made in connection with actual or purported securities transactions.

The decision does not address whether there is any room to deny application of the section 546(e) safe harbor for transfers where the transferee is actually aware of the fraudulent Ponzi scheme and that no actual securities transactions were being effected. The District Court had previously ruled that section 546(e) would not apply in such an instance, even with respect to actual fraudulent transfer claims outside of the Bankruptcy Code's two-year reach-back period under section 548(a)(1)(A).


1 12-2557-bk(L) (2d Cir. December 8, 2014).

2 Section 548(a)(1)(A) of the Bankruptcy Code allows a trustee to avoid transfers made with the actual intent to hinder, delay or defraud creditors within two years of the petition date. Section 544 of the Bankruptcy Code allows a trustee to bring state law fraudulent conveyance and fraudulent transfer actions for the benefit of the estate. As under section 548(a)(1)(A) of the Bankruptcy Code, transfers made with the intent to hinder, delay or defraud creditors can also be avoided under state fraudulent conveyance and fraudulent transfer laws. The statute of limitations on such claims vary by state but can be considerably longer than the two-year reach-back period under section 548(a)(1)(A). Therefore, the Trustee in Madoff was generally not able to rely on the exception to non-avoidance under section 546(e) with respect to state law actual fraudulent conveyances and transfers that occurred more than two years prior to the commencement of Madoff's SIPA liquidation proceeding.

3 651 F.3d 329 (2d Cir. 2011).

4 719 F.3d 94 (2d Cir. 2013).

5 11 U.S.C.§ 741(7)(A)(i), (vii) (emphases in opinion).

6 In re BLMIS, 654 F.3d 229 (2d Cir. 2011) (rejecting notion that customer's net equity claim should be determined according to fictitious account statements and holding that, in the context of a Ponzi scheme, a customer's net equity claim must be calculated according to its actual net investment in the customer's securities accounts).

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