Second Circuit Affirms Denial Of Claims Filed By Bernie Madoff Feeder Funds Investors

On Friday, the U.S. Court of Appeals for the Second Circuit affirmed the dismissal of claims filed by Feeder Funds investors against Bernard L. Madoff Investment Securities LLC (“BLMIS”).  The opinion was rooted in the Securities Investor Protection Act (“SIPA”), 15 U.S.C. § 78aaa et seq., and held that, because none of the investors invested directly with BLMIS, the investors did not qualify as “customers” under the SIPA. 

…courts must narrowly interpret the customer status component of the SIPA and “the critical aspect of the ‘customer’ definition” is “the entrustment of cash or securities to the broker-dealer for the purposes of trading securities.”

The investors provided capital for two limited partnerships, Spectrum Select, L.P., and Spectrum Select II, L.P., which, in turn, invested into two hedge funds, Rye Selected Broad Market Fund and Rye Select Market Prime Fund, known collectively as “Feeder Funds.”  The Feeder Funds invested in BLMIS through securities accounts maintained only in the funds’ names.  The Feeder Funds made deposits and withdrawals from their BLMIS accounts, and, all accounts documentation, including account statements and trade confirmations, were received from BLMIS by the Feeder Funds.

The investors in the Feeder Funds had no direct financial dealings with BLMIS and no BLMIS account information or records identified them as investors in BLMIS.  As a result, after the Feeder Funds investors filed claims with the bankruptcy court, both the bankruptcy trustee and the bankruptcy court concluded that the Feeder Funds investors were not “customers” under the SIPA.  The investors appealed to the district court, which affirmed the bankruptcy court ruling and gave rise to the Second Circuit opinion.

The Second Circuit found that Section 78lll(2)(A) of the SIPA defines a “customer of a debtor” as someone “who has a claim on account of securities received, acquired, or held by the debtor in the ordinary course of a business as a broker or dealer from or for the securities account of such a person.”  The court also noted that courts must narrowly interpret the customer status component of the SIPA and “the critical aspect of the ‘customer’ definition” is “the entrustment of cash or securities to the broker-dealer for the purposes of trading securities.”  In re: Bernard L. Madoff Inv. Sec. LLC, 654 F.3d 227, 236 (2d Cir. 2011).  The Feeder Funds investors, however, never entrusted their cash or securities to BLMIS directly and, as the Second Circuit observed, “fail to satisfy this ‘critical aspect of the ‘customer’ definition.”  The court also found no evidence that the Feeder Funds were BLMIS agents or that BLMIS somehow authorized the Feeder Funds to act on its behalf or exercise control over the Feeder Funds. 

The full text of the Second Circuit opinion can be found here.