In In re Bernard L. Madoff Investment Securities LLC, Nos. 11-5044, 11-5051, 11-5175, 11-5207, 2013 WL 3064848 (2d Cir. June 20, 2013), the United States Court of Appeals for the Second Circuit held that the Trustee of Bernard L. Madoff Investment Securities LLC (“BLMIS”) appointed under the Securities Investor Protection Act (“SIPA”), 15 U.S.C §§ 78aaa, et seq., lacked standing to pursue common law claims on behalf of Madoff’s customers against various banks that maintained checking accounts, created feeder funds, and collected investments from abroad for BLMIS. The Trustee sued under SIPA — which gives a SIPA trustee the “same powers and title with respect to debtor and the property of debtor . . . as a trustee in a case under Title 11” of the bankruptcy code — and alleged that when the defendants “were confronted with evidence of Madoff’s illegitimate scheme,” banking fees from BLMIS provided an incentive to look away, or “at least caused a failure to perform due diligence that would have revealed the fraud.” The Second Circuit affirmed decisions of the United States District Court for the Southern District of New York holding that the doctrine of in pari delicto — the principle that a wrongdoer may not profit from his own misconduct — barred the Trustee’s claims. The ruling significantly restricts the Trustee’s ability to pursue billions of dollars’ worth of claims against alleged aiders and abettors of Madoff’s Ponzi scheme, offers clarity on the issue of a SIPA trustee’s standing to bring actions on behalf of a defunct broker-dealer’s estate or the estate’s creditors.

In 2009, the Trustee initiated a proceeding in the United States Bankruptcy Court for the Southern District of New York against more than thirty-five major international banks, alleging unjust enrichment, breach of fiduciary duty, aiding and abetting fraud, negligence (collectively, the “common law claims”) and contribution, and seeking recovery of $2 billion in preferential or fraudulent transfers. The district court dismissed the common law claims and the contribution claim on the grounds that Trustee was in pari delicto with the defendants, lacked standing to assert the common law claims on customers’ behalf and could not demonstrate a right to contribution. See Picard v. HSBC Bank PLC, 454 B.R. 25 (S.D.N.Y. 2011). Similarly in 2010, the Trustee commenced adversary proceedings against two other major international banks, seeking billions more on behalf of the customers of BLMIS. The district court dismissed these claims, concluding that the Trustee lacked standing to bring an action on behalf of third parties and had no valid claim for contribution. See Picard v. JPMorgan Chase & Co., 460 B.R. 84 (S.D.N.Y. 2011). The Trustee appealed the dismissals.

The Second Circuit affirmed and held that the doctrine of in pari delicto barred the Trustee’s claims because the Trustee, standing in the shoes of BLMIS, could not “assert claims against third parties for participating in the fraud that BLMIS orchestrated.” The Court noted that the New York Supreme Court, Appellate Division, has long applied the doctrine of in pari delicto to bar a debtor from suing third parties for a fraud in which he participated because “a wrongdoer should not profit from his own misconduct.” The Court relied upon Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114 (2d Cir. 1991), which held that a “claim against a third party for defrauding a corporation with the cooperation of management accrues to creditors, not to the guilty corporation” (the “Wagoner Rule”). The Court explained further that the debtor’s misconduct is attributed to the trustee, even if the trustee is innocent, because the trustee acts as the debtor’s representative. The Court rejected the Trustee’s “scattershot” arguments, as the Trustee provided no authority demonstrating that a SIPA trustee was exempt from the Wagoner Rule.

The Court also declined to apply the “adverse interest” exception, which directs a court not to impute to a corporation the bad acts of its agent when the fraud was committed for personal benefit. The “adverse interest” exception, the Second Circuit held, is the “most narrow of exceptions” that applies only to situations where “the fraud is committed against the corporation rather than on its behalf.”

The Trustee also sought contribution for payments made to BLMIS’ customers under SIPA, and the Second Circuit likewise affirmed district courts’ dismissals. The Court held that the Trustee’s payment obligations were imposed by federal law (SIPA), and that SIPA does not provide the right to contribution. As the Court observed, settled law in the Second Circuit holds that there is no right of contribution under a federal statute unless the statute provides one expressly.

The Court also reviewed the Trustee’s claims asserted on behalf of BLMIS’ customers. Citing Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416 (1972), the Second Circuit held that the Trustee lacked standing because a bankruptcy trustee could only collect money owed to the estate. The Trustee’s first argument, that existing Second Circuit precedent allowed third party standing for SIPA liquidation, was ruled inconsistent with Supreme Court precedent.

The Court rejected the Trustee’s second argument, that SIPA confers standing by creating a bailment relationship between the Trustee and the debtor’s customers, because SIPA was not written in terms of bailment. Moreover, (1) the supposed bailment pre-dated the Trustee’s appointment; (2) augmenting the general fund of customer property is not a bailment; (3) Madoff, and by extension BLMIS, defrauded customers, and under the law a thief is not a bailee; and (4) a bailment was impossible because Madoff comingled the customer funds by depositing them into a general account.

The Court likewise rejected the Trustee’s third argument, that SIPA authorized the Securities Investor Protection Corporation to pursue subrogation claims on customers’ behalf, holding that neither the language of the statute nor its legislative history supported the Trustee’s position.

The Second Circuit’s decision restricts the power of a SIPA (and bankruptcy) trustee to bring common law claims against third parties. The opinion clarifies which parties can bring common law claims in SIPA and bankruptcy proceedings and suggests that only creditors can bring claims on behalf of themselves. Furthermore, the decision means that Madoff’s customers will have a smaller amount of money from which they can recover their losses.

For further information, please contact John Stigi at (310) 228-3717 or Tyler Baker at (212) 634-3048.