In In re Bernard L. Madoff Investment Securities LLC (“Madoff”),1 the United States Court of Appeals for the Second Circuit reaffirmed  its broad and literal interpretation of section 546(e) of the Bankruptcy Code, which provides a  safe harbor for transfers made in connection with a securities contract that might otherwise be  attacked as preferences or fraudulent transfers. The Second Circuit held that the section 546(e)  safe harbor prohibited the trustee (the “Trustee”) in Madoff’s liquidation proceeding under the  Securities Investor Protection Act of 1970 (“SIPA”) from clawing back transfers of fictitious  profits under state fraudulent transfer law made applicable in the SIPA proceeding by section  544(b) of the Bankruptcy Code. The fictitious profits had been transferred to customers in  connection with the now infamous Ponzi scheme perpetrated by Bernard Madoff.

In so holding, the Second Circuit found that transfers of fictitious profits pursuant to account  and other brokerage agreements were protected transfers because they were made “in connection with”  a “securities contract” and were also “settlement payments,” even though no actual securities  trades were effected for the benefit of transferee customers by the broker- dealer that operated as  a Ponzi scheme. The decision is the latest in a string of decisions from the Second Circuit that  broadly construe the section 546(e) safe harbor in accordance with the statute’s plain language.

Section 546(e)—a Key Protection

Designed to minimize systemic risk in the financial markets, section 546 of the Bankruptcy Code  contains safe harbors that limit a trustee’s power to avoid certain transfers made by, to or for  the benefit of certain identified financial market participants in connection with various types of  financial transactions. These transactions include margin or settlement payments, securities  contracts, swap agreements, forward contracts, repurchase agreements and commodity contracts.  Section 546(e) protects “margin payments,” “settlement payments” and transfers in connection with  “securities contracts,” “forward contracts” and “commodity contracts” made by, to or for the  benefit of parties such as stockbrokers and financial institutions from avoidance by the trustee as  preferences or fraudulent conveyances (whether under the Bankruptcy Code or under state law),  except for actual fraudulent transfers under section 548(a)(1)(A) of the Bankruptcy Code.2

Section 546(e)’s financial contract safe harbors have been steadily expanded to embrace more  transactions. Courts, including the Second Circuit, interpreting section 546(e), have acknowledged  the breadth of the coverage of this safe harbor and have largely applied the plain language of the  provision to broadly immunize enumerated transactions from avoidance even where the transactions at issue arguably did not impact the financial markets.

By way of example, in Enron Creditors Recovery Corp. v. ALFA, S.A.B. de C.V. (“Enron”),3 the Second  Circuit applied the plain meaning of section 546(e) and held that payments made to redeem  commercial paper early were non- avoidable settlement payments under section 546(e) and rejected  the notion that the safe harbor should be limited because the transactions at issue “did not  involve a financial intermediary that took title to the transacted securities and thus did not  implicate the risks that prompted Congress to enact the safe harbor.” Along the same lines, in In  re  Quebecor World (USA) Inc,.4 the Second  Circuit similarly applied a plain meaning approach to  find that transfers under a Note Purchase Agreement to a financial institution acting as a conduit  were transfers in connection with a securities contract made by or to a financial institution and  thus protected by the section 546(e) safe harbor. Two other cases involving the interpretation of  the scope of the section 546(e) safe harbor—In re Tribune Litigation (Case No. 13-3992) and Whyte  v. Barclays Bank PLC (Case No. 13-2653)—are currently pending before the Second Circuit.

The Decision

In Madoff, the trustee appointed to oversee the SIPA liquidation of Bernard Madoff’s fund (“BLMIS”)  sought to avoid transfers of fictitious profits to investors in connection with Madoff’s Ponzi  scheme as fraudulent transfers. Certain of BLMIS’ customers sought to defend against avoidance on  the ground that the transfers were protected by the safe harbor provision of section 546(e). The  United States District Court for the Southern District of New York (the “District Court”) ruled  that such transfers made after two years prior to the commencement of Madoff’s SIPA liquidation  proceeding were not voidable as fraudulent transfers due to the applicability of section 546(e)’s safe harbor. The Trustee appealed such decision to the Second Circuit, which affirmed the holding of the District Court that  section 546(e)’s safe harbor exempted the transfers at issue from avoidance. The Second Circuit’s  decision deals primarily with the broad definition of “securities contract” in the Bankruptcy Code  and the expansive application of the safe harbor to any transfer made “in connection with” language  of section 546(e). Guided by these two broad concepts, the Second Circuit had no difficulty in  reaching its conclusion that the safe harbor applied.

The defendants argued that section 546(e) prohibited the Trustee from clawing back their  distributions because the payments were made by a stockbroker “in connection with a securities  contract” or, alternatively, because they were “settlement payments” made by a stockbroker. The  defense relied on a suite of documents, including a “Customer Agreement,” which authorized BLMIS to  open or maintain one or more accounts, a “Trading Authorization,” which appointed BLMIS to be the  customer’s agent to buy, sell and trade securities, and an “Option Agreement,” which authorized  BLMIS to engage in options trading for the customer’s account (collectively, the “Account  Documents”).

The Second Circuit concluded that the Account Documents constituted a securities contract based on  the types of agreements broadly described in the definition of “securities contract,” which is  found in section 741(7) of the Bankruptcy Code: section 741(7)(A)(x) (Account Documents were master  agreements providing for the purchase, sale, or loan of a security); section 741(7)(A)(xi) (Account  Documents qualified as “any guarantee or reimbursement obligation by or to a stockbroker” due to  BLMIS’ obligation to reimburse its customers upon request upon withdrawal from their accounts); and  section 741(7)(vii) (Account Documents fell within the scope of “any other agreement … that is  similar to” “a contract for the purchase, sale or loan of a security”(emphasis added)). 

Additionally, the court noted that the transfers at issue could not have been possible but for the relationship created by these agreements.

The Trustee argued that the Account Documents did not constitute a securities contract because (i) BLMIS never initiated, executed, completed or settled any securities transactions; (ii) the Account Documents never identified the specific  terms of any securities transactions; and (iii) the Account Documents never expressly obligated  BLMIS to carry out any specific transactions but merely authorized BLMIS to effect securities  transactions. The Second Circuit acknowledged that the Trustee’s observations were correct, but  rejected these arguments in turn and found that the Account Documents created a “securities  contract” as defined in section 741 of the Bankruptcy Code.

First, the Second Circuit found that section 546(e) does not require an actual purchase or sale of  a security. Rather, the transfer need only be broadly related to a securities contract and  not an  actual securities transaction. The fact that BLMIS breached its obligations under the Account  Documents did not vitiate the existence of those documents as a securities contract. Moreover, the  Second Circuit found that the interpretation of the section 546(e) safe harbor espoused by the  Trustee to require an actual securities transaction would risk the very sort of market disruption  Congress was concerned with when enacting the provision, given that the defendant-customers of  BLMIS had every reason to believe that BLMIS was engaged in actual securities transactions.

Second, the Second Circuit rejected the notion that the Account Documents were not securities  contracts because they did not specify terms of securities transactions such as security, issuer,  quantity or price. The court found that the language of section 546(e) imposes no such requirement  and likewise found that the breadth of the definition of “securities contract” indicates that  Congress intended no such requirement. Third, the Second Circuit rejected the Trustee’s argument that the Account Documents were not securities contracts because they merely authorized,  but did not obligate, BLMIS to effect securities transactions for customers. The Second Circuit  found that the definition of “securities contract” is not so limited, and that it encompasses the  relationship created by the Account Documents. Specifically, the definition includes not only the  enumerated types of contracts identified in section 741, but also “any other agreement … that is  similar to” “a contract for the purchase, sale or loan of a security.”5 As the court noted, “[f]ew  words in the English language are as expansive as ‘any’ and ‘similar.’”

Once the Second Circuit concluded that the Account Documents constituted a securities contract, it  had little difficulty concluding that the transfers to customers were made “in connection with” the  securities contract. Relying on a plain language interpretation, the court viewed “in connection  with” as a transfer  “related to” or “associated with” the securities contract. Having concluded  that the agreements constituted a securities contract, the Second Circuit quickly concluded that  customer withdrawals from their accounts came within the scope of the safe harbor as being in  connection with the Account Documents. The court noted that its conclusion was congruent with the  broad interpretation of the “in connection with a purchase or sale of any security” requirement of  Rule 10b-5 in the context of federal securities laws.

In rejecting the Trustee’s argument that applying section 546(e) in the context of a Ponzi scheme  would give legal effect to Madoff’s fraud, and  that Ponzi scheme payments by definition are not  “in connection with” a securities contract,  the Second Circuit noted that “[s]ection 546(e) sets a  low bar for the required relationship between the securities contract and the transfer sought to be  avoided.” Payments made in connection with a Ponzi scheme may be made in connection with a  securities contract, albeit one that has been breached. 

Alternatively, the Second Circuit held that the transfers were also protected under section 546(e) because they were “settlement payments” made by  a “stockbroker.” Here the Second Circuit again rejected the Trustee’s argument that there were no  settlement payments because BLMIS never engaged in actual securities trading. Relying on its  decision in Enron, the Second Circuit held that the Bankruptcy Code definition of settlement  payment should be broadly construed to apply to the transfer of  cash or securities to complete a  securities transaction. The Second Circuit agreed with the District Court that, because the  customer  granted BLMIS discretion to liquidate securities in the customer’s account to the extent  needed to implement the customer’s sell orders or withdrawal requests, each transfer in respect of  such an order was a settlement payment.

In closing, the Second Circuit rejected the Trustee’s contention that the court’s holding was  inconsistent with its prior decision interpreting how to calculate the “net equity” claim of a  “customer” under SIPA.6 The  Second Circuit reasoned that (i) section 546(e) is found in the  Bankruptcy Code and not SIPA and was not an issue in its prior decision regarding the computation  of a customer’s claim and (ii) section 546(e) represents the careful balance Congress has struck  between the need for an equitable result for the debtor and the need for finality, which the Second  Circuit felt obligated to respect.


While the Bankruptcy Code safe harbors have come under attack from various commentators in recent  years, Madoff demonstrates that the Second Circuit will continue to interpret section 546(e) in  accordance with its literal language. This decision should provide comfort to recipients of  transfers made in connection with actual or purported securities transactions.

The decision does not address whether there is any room to deny application of the section 546(e) safe harbor for transfers where the transferee is actually aware of the fraudulent Ponzi scheme and that no actual securities  transactions were being effected. The District Court had previously ruled that section 546(e) would  not apply in such an instance, even with respect to actual fraudulent transfer claims outside of  the Bankruptcy Code’s two-year reach-back period under section 548(a)(1)(A).