While the Bankruptcy Code’s safe harbor provision in section 546(e) previously provided comfort for brokerdealers, the Bankruptcy Court’s decision in Gredd v. Bear, Stearns Securities Corp. (In re Manhattan Investment Fund, Ltd.), 359 B.R. 510 (Bankr. S.D.N.Y. 2007), chips away at this provision and creates new risks for those providing brokerage account services. Always at risk as a deep pocket, new duties have been thrust upon brokerdealers that go far beyond the terms of the account agreement.

Factual Background

In Manhattan Investment Fund, the Bankruptcy Court found that monies deposited in a Bear Stearns Securities Corp. (“Bear Stearns”) brokerage account by the Manhattan Investment Fund (“MI Fund”)1 as margin payments and to cover short selling positions, could be recovered as fraudulent transfers. The Court relied primarily on the following three findings in reaching this conclusion. First, when a debtor operates a hedge fund so as to create a Ponzi scheme, the debtor makes transfers of the fund’s assets with actual intent to defraud creditors. Second, if an account agreement permits a brokerage firm to utilize funds in the account for various purposes, including to pay its fees and to make margin payments, the brokerage firm does not act as a mere conduit for monies deposited. Third, a good faith defense cannot be asserted if a brokerage firm has information, even if unrelated to its function as broker to the account party, that puts it on inquiry notice that fraud may be present. Based on these findings, the Court concluded that $141 million in payments could be recovered as fraudulent transfers.

In Manhattan Investment Fund, Bear Sterns maintained an account for MI Fund that was subject to a Professional Account Agreement (“Account Agreement”). The Agreement provided that Bear Stearns (a) had the right to establish a level of maintenance margin; (b) had a security interest in all monies held in the account; (c) had sole discretion to prevent withdrawals from the account as long as short positions remained open; and (d) could use monies in the account to liquidate the funds’ open short positions.

In the year before MI Fund filed for bankruptcy, the MI Fund made eighteen separate transfers totaling $141.4 million from its account at Bank of Bermuda to an account set up at Citibank for Bear Stearns. The monies were thereafter transferred into the MI Fund’s margin account at Bear Stearns to allow the MI Fund to continue short selling in the Bear Stearns account. The margin payments were necessary for accounts engaged in short selling activities in order for them to remain in compliance with federal securities laws. In addition, Bear Stearns determined that, because the securities in the account were particularly risky, additional margin payments over and above that required by securities laws should be made.

Interplay of Section 546(e) and Section 548(a)(1)(A)

Section 546(e) of the Bankruptcy Code exempts from avoidance transfers made as margin payments under constructive fraud theories. 11 U.S.C. § 546(e). This would include margin payments made when the debtor was in financial distress for which it received no reciprocal value. However, if the margin payments involve actual fraud by the participants, section 546(e) does not exempt the transfer from avoidance.

As a result, the chapter 11 trustee in MI Fund case sought to avoid the margin payments under the actual fraud sections of the Bankruptcy Code, namely section 548(a)(1)(A). The trustee argued that because the MI Fund was a Ponzi or Pyramid Scheme, actual fraud was present. Bear Stearns countered by stating that it was a mere conduit and that it accepted the transfer in good faith. Bear Stearns also argued that the transfers should not be recovered based on public policy grounds.

The District Court, in related rulings, had found that, because the MI Fund’s manager had sought to recover losses from ill-advised short sales with deposits made by new customers, the MI Fund was engaged in a Ponzi scheme. The Bankruptcy Court thus found that fraudulent intent was present. The Court explained, “[w]hen a debtor operating a Ponzi scheme makes a payment with the knowledge that future creditors will not be paid, that payment is presumed to have been made with actual intent to hinder, delay or defraud other creditors--regardless of whether payments were made to early investors, or whether the debtor was engaged in a strictly classic Ponzi scheme.” 359 B.R. at 518.

The Court also found that Bear Stearns was not a mere conduit and that it was an initial transferee pursuant to section 550(a) of the Bankruptcy Code. Because the Account Agreement permitted a high degree of dominion and control over the monies of the MI Fund, Bear Stearns was deemed to be a true transferee.

[E]ven entities that have special legal relationships with the debtor-transferor can be initial transferees when they do, in fact, take legal control of an avoidable transfer; for example when they receive assets directly from the debtor-transferor as compensation for services or in payment of a genuine debt . . . Where a fiduciary, agent, or other entity with legal obligations to the debtor-transferor is the recipient of an avoidable transfer, the control test turns on the recipient’s legal rights and obligations toward the transferred assets, not simply their legal relationship or the ultimate use of the assets.

Id. 521.

Because of the rights granted Bear Stearns in the Account Agreement, which rights were exercised by it (including that a security interest was granted to it, that it could prohibit withdrawals if short positions remained open, and that Bear Stearns could use the monies to purchase covering securities), Bear Stearns was deemed an initial transferee. The Court also noted that, because Bear Stearns realized a $2.4 million in revenues on the account, it was more than a mere conduit.

As a final avenue of defense, Bear Stearns argued that it received the transfer in good faith under section 548(c) of the Bankruptcy Code. The Trustee of the MI Fund contested this conclusion, arguing that Bear Stearns’ knowledge of the MI Fund’s questionable activities put it on notice of the Ponzi scheme one year before the MI Fund was shut down.

The notice to which the trustee referred was based on conversation between an investor in the MI Fund and a Senior Managing Director/Salesperson at Bear Stearns. In this conversation, the investor expressed his belief that the MI Fund was experiencing positive and significant returns in the 20% range. Bear Stearns’ experience with the MI Fund showed that it was actually losing money on its investments. After several internal discussions, Bear Stearns decided to investigate the situation. In response to a Bear Stearns inquiry, the Manager of the MI Fund explained that it used several prime brokers and presumably results in other accounts differed from that of the account at Bear Stearns. Bear Stearns continued to investigate the matter by warning the auditors to be “keen and careful” during the audit. The auditors nevertheless completed the audit allegedly without a problem. As the MI Fund continued to lose money and margin requirements increased, Bear Stearns furthered its due diligence and eventually learned that the MI Fund used only one broker, Bear Stearns. With knowledge of the massive losses in its account, Bear Stearns believed there was a problem and it alerted the Securities and Exchange Commission.

The Court concluded that Bear Stearns should have done more to discover the fraud. Despite its efforts, because it was on inquiry notice of the fraud “Bear Stearns [could not] satisfy its burden of showing that it acted with the diligence required to establish good faith under section 548(c) of the Bankruptcy Code.” 359 B.R. at 526-527. The Court also rejected public policy arguments made by Bear Stearns. Bear Stearns had argued that finding it liable would expose all broker-dealers to massive liability and would cripple the securities industry.


The decision of the court in Manhattan Investment Fund raises a host of questions. For starters, it begs the question of whether Bear Stearns was found liable merely because it was one of the deep pockets in the case. Bear Stearns far from ignored the problem that arose relating to the MI Fund, especially in light of the fact that an audit indicated the MI Funds’ activities were in order. Yet, the Bankruptcy Court found it should have done more. The Manhattan Investment Fund case thus opens a door most thought was closed by virtue of section 546(e)’s provision. It makes margin payments subject to avoidance even if an highly extenuated “actual fraud” case can be made.

The case also raises questions about who can utilize the “good faith defense.” Whether or not Bear Stearns could have done more, it certainly did not act in bad faith. It took some measures to assure that the account was being operated in a fair and law-complying manner. How far it should have delved into the internal operation of its account party was certainly a treacherous question. Having made certain inquiries and having received acceptable answers to its questions, it is difficult to say more should have been done to “investigate” its account party. Further, what then is the significance of an account agreement if the duties of the broker-dealer will go far beyond the terms of that agreement? And what about the sophisticated investors that sought high returns through the MI Fund’s aggressive investment strategy? Is Bear Stearns obligated to police its customers’ investments simply because it acts under a brokerage account arrangement with the MI Fund, albeit a profitable account arrangement?


Section 546(e) will do little to protect broker-dealers from recovery of margin payments if a creative fraud case, like that presented in the Manhattan Investment Fund case, can be made with success. While Bear Stearns might have done more, hindsight is always twenty-twenty. No such vision seems to have been required of the large investors who jumped into the MI Fund presumably with limited knowledge of the primary person involved. In the end, it is difficult to believe that the inquiry notice of which Bear Stearns was aware did not extend to the very investors who sought recovery against it.