On February 22, 2013, the United States Court of Appeals for the Second Circuit in In re Bernard L. Madoff Investment Securities LLC held that certain individuals who had invested indirectly in Bernard L. Madoff Investment Securities LLC ("BLMIS") through certain limited partnerships (the "Investors") were not "customers" of BLMIS under the Securities Investor Protection Act ("SIPA"). The significance of this decision is that because the Investors are not customers of BLMIS, they will not be eligible to have their investment losses compensated up to the $500,000 cap authorized by the Securities Investor Protection Corporation ("SIPC"). The Investors had invested in certain limited partnerships, which limited partnerships had invested in certain hedge funds (or "Feeder Funds"). The Feeder Funds in turn invested with BLMIS. The Investors had no direct financial dealings with BLMIS. The Second Circuit affirmed the decisions of the bankruptcy trustee, the Bankruptcy Court and the U.S. District Court for the Southern District of New York, effectively eliminating the individuals' chances of recouping their investment losses.
The Second Circuit's holding in this case reaffirmed its prior ruling in Stafford v. Giddens (In re New Times Security Services, Inc.), 463 F.3d 125, 127 (2d Cir. 2006), that "judicial interpretations of 'customer' status support a narrow interpretation of the SIPA's provisions," as well as its prior determination in In re Bernard L. Madoff Investment Securities LLC, 654 F.3d 229, 236 (2d Cir. 2011), that the key aspect of the definition of customer is the entrustment of cash or securities to the broker-dealer for the purpose of trading. The Second Circuit found that the Investors: (1) had no direct financial relationship with BLMIS (as a result of the investment through the Feeder Funds); (2) had no property interest in the assets that the Feeder Funds invested with BLMIS (because the limited partnership interests sold by the Feeder Funds did not confer an ownership interest in the money that was invested in BLMIS by the Feeder Funds); (3) had no securities accounts with BLMIS, as demonstrated by the record; (4) lacked control over the Feeder Funds' investments in BLMIS (as demonstrated by the Feeder Funds' offering memorandum); and (5) were not identified or otherwise reflected in BLMIS's books and records.
The Second Circuit's affirmation of the narrow interpretation of customer under SIPA is likely to have a broad impact on the remaining Madoff cases before Judge Rakoff in the Southern District of New York, as well as the various SIPA cases currently working their way through courts across the United States.