A recent bankruptcy court decision in the Southern District of New York may raise concern among brokerage firms who execute and clear brokerage transactions for hedge funds and similar investment vehicles. The bankruptcy trustee of the Manhattan Investment Fund (which the court found to be a Ponzi scheme and whose principal Michael Berger pled guilty to criminal charges) obtained summary judgment against Bear Stearns requiring it to return to the bankruptcy estate all the margin payments the fund had made in the year before it imploded, totaling $141.4 million. Those funds were used to meet margin requirements during the year prior to the Fund’s bankruptcy filing. Bear Stearns had only earned $2.4 million in fees from the fund’s account during the relevant period. The decision casts doubt on what many broker-dealers have assumed: that margin payments are exempt from challenge as fraudulent conveyances under the Bankruptcy Code.

The decision (In re: Manhattan Investment Fund Ltd., Gredd v. Bear Stearns Securities Corp., 2007 WL 60843 (Bankr. S.D.N.Y. Jan. 9, 2007)) analyzed the interplay among a number of different sections of the Bankruptcy Code, but three aspects of the decision are particularly noteworthy.

First, the court held that because the fund was essentially a Ponzi scheme, virtually every payment it made to a third party to keep going was deemed to be infected with the fund’s overall fraudulent intent. The margin payments were viewed as intentionally fraudulent because they enabled the hedge fund to continue trading through the Bear account, thus keeping the Ponzi scheme alive. This characterization meant that the “stockbroker’s defense” of section 546(e) of the Bankruptcy Code (which makes margin payments and settlement payments more difficult for a trustee to recoup), was unavailable.

Second, despite the fact that Bear received the funds subject to numerous regulatory requirements and standard customer contract provisions requiring them to be used, in essence, only to satisfy the accountholder’s obligations to counterparties to its trades, the court held that Bear Stearns was not a “mere conduit” facilitating payments to others. Payees who have successfully asserted “mere conduit” defenses in similar situations include, for example, insurance brokers who received premium payments from a company just prior to a bankruptcy filing that they were required to then remit on the company’s behalf to an insurer. The court found that Bear Stearns retained considerable discretion as to when to increase or relax margin requirements, when to make calls, when to limit risk by closing out positions without waiting for calls to be met, and the like. The court also noted that margin calls are not merely for the benefit of the counterparties of the broker’s customer but are also for the broker’s own economic benefit since they reduce the risk that the broker itself will lose money as a result of having to make good on the client’s obligations and then seek reimbursement from a potentially insolvent client.

Finally, the court held that Bear Stearns could not establish that it had acted in good faith, which under the relevant provisions of the Bankruptcy Code was Bear’s burden to establish. The court found that Bear Stearns had failed to properly monitor the activities of the fund because it did not follow up with sufficient thoroughness on its suspicions about the fund. Briefly, Bear became initially suspicious after a Bear Stearns executive heard at a party that the fund was reporting a 20% profit for the year at a time when its Bear Stearns account showed substantial losses. Upon questioning, Berger alleviated these concerns by saying that the fund traded through numerous brokers, such that losses in the Bear account were more than offset by profits elsewhere. The court found that while this explanation could be “plausible,” it was not true and Bear was not “completely comfortable” with it. A year later, as the fund’s losses in its Bear account began to mount, Bear initiated further inquiries about the fund. When it was not satisfied with the answers it received, it notified the SEC that there was a potential problem with the fund. The fraud at the fund was then quickly revealed. To many, the court’s finding will seem harsh, because hedge funds rarely make their financials or full trading records available to one of their clearing firms and even a non-fraudulent customer might have reacted adversely to a request for copies of statements. Other steps Bear took (such as seeking reassurances from the fund’s auditors that everything was in order) were apparently deemed insufficient.

While this ruling surely will be challenged on appeal, brokers may wish to reevaluate their risk management policies in this area. The case highlights the importance of “knowing your customer” and the long-tail of risk that can continue even after a margin payment is received and the accounts apparently balanced. Furthermore, any investigation of suspicions will be judged, however unfair this is, in hindsight. Brokers may be faced with a difficult choice between potentially alienating customers who value discretion and privacy, on the one hand, and leaving themselves potentially exposed to new and uncertain risk on the other.