Court Blocks DC Plan Participant Claims Against Madoff Trustee

U.S. Bankruptcy Judge Stuart Bernstein of the Unites States Bankruptcy Court for the Southern District of New York agreed with a lower court ruling finding that participants in the retirement plans were not “customers” of Bernard Madoff Investment Securities LLC (BLMIS) and thus, are not entitled to recovery. Bernstein cited another case in finding: “The fact that Individual Claimants participated in defined contribution plans, to which they could contribute their own money, does not change the fact that title to this money passed to their plan when they made such contributions. Participants’ ability to control the size of their investments, withdrawals, and rollover funds, and to choose among a limited set of investment alternatives is not equivalent to having a direct financial relationship with or directly entrusting one’s own funds to a broker/dealer, or exercising sole control over investment decisions. Nor is any awareness of or contact with the claimants on the part of BLMIS equivalent to the kind of ‘repeated business dealings’ associated with customer status.”

As explained in a 15-page memorandum decision written by U.S. Bankruptcy Judge Stuart Bernstein, some of the victims of Madoff’s record-breaking Ponzi scheme did not invest directly with Madoff’s firm. Instead, they invested in third-party funds, sometimes called feeder funds, and the feeder funds then invested some of all of their assets with Bernard Madoff Investment Securities LLC (BLMIS), the firm at the heart of the massive Ponzi scheme.

Despite the absence of a direct relationship with BLMIS, court documents show many of the feeder fund investors have submitted claims as “customers” of BLMIS to the trustee overseeing the ongoing liquidation of BLMIS. As judge Bernstein observes, the liquidation process is being conducted according to the Securities Investor Protection Act (SIPA), which provides certain options for recourse to defrauded customers of investment management firms.

In essence, SIPA allows defrauded customers to file claims with a SIPA-appointed trustee to get back some or all of their fraud-related losses. In this case, the federal government appointed Irving Picard as the trustee tasked with directing the liquidation of Madoff’s investment companies.

The current decision comes from trustee Picard’s request to the bankruptcy court to affirm his determination denying 308 claims filed by defined contribution (DC) plan participants who had invested in plans regulated by the Employee Retirement Income Security Act (ERISA). The participants belonged to one of four retirement plans: the Daprex Profit Sharing and 401(k) Plan, the Felsen Moscoe Company Profit Sharing TST DTD, Sterling Equities Employees Retirement Plan, and the Orthopaedic Speciality GRP PC Defined Contribution Pension Plan.

Picard originally denied the claims because the individuals did not have personal accounts with BLMIS, which led to some 210 outstanding docketed objections. Court documents show the trustee served discovery requests on each of the claimants’ objections, focusing on their alleged customer status and requesting key pieces of information.

According to court documents, none of the claimants associated with the Felsen Plan, the Sterling Plan or the Orthopaedic Plan responded to the trustee’s request, thereby forfeiting their SIPA claims. Claimants at the Daprex Plan did respond, however, and denied that they did not directly hold an account at BLMIS, which would preclude them from seeking a return of assets through the SIPA trustee.

Their argument was that the name of the Daprex Plan’s account at BLMIS indicated it was a profit sharing plan, and hence, that the funds in the account belonged directly to employees at Daprex. They also denied that they had never received correspondence directly from BLMIS.

As Judge Bernstein observed, the disposition of the current motion depended on whether the claimants could legally be considered “customers” of BLMIS within the meaning of SIPA. The text of SIPA defines customers as “any person (including any person with whom the debtor deals as principal or agent) who has a claim on account of securities received, acquired, or held by the debtor in the ordinary course of its business as a broker or dealer from or for the securities accounts of such person for safe keeping, with a view to sale, to cover consummated sales, pursuant to purchases, as collateral security, or for purposes of effecting transfer.”

The SIPA law further defines customers as “(i) any person who has deposited cash with the debtor for the purpose of purchasing securities; (ii) any person who has a claim against the debtor for cash, securities, futures contracts, or options on futures contracts received, acquired, or held in a portfolio margining account carried as a securities account pursuant to a portfolio margining program approved by the [Securities and Exchange] Commission; and (iii) any person who has a claim against the debtor arising out of sales or conversions of such securities.”

Bernstein suggested the customer status of persons who invest in feeder funds, whether as part of an ERISA plan or not, has already been addressed in a previous bankruptcy court ruling related to the Madoff Ponzi scheme, known as the Feeder Funds Decision, (708 F.3d 422). In that matter, another set of investors had purchased interest in funds organized under Delaware limited partnership law that subsequently invested assets with BLMIS. The investors did not have their own distinct accounts at BLMIS, but nevertheless filed customer claims, which trustee Picard denied.

The bankruptcy and district courts affirmed the trustee’s determination, and the investors appealed to the 2nd U.S. Circuit Court of Appeals (see "Participants in ERISA-Regulated Plans Cannot Recover Funds From Madoff"). The 2nd Circuit went on to affirm the decision, explaining that the “critical aspect” of the customer definition is “the entrustment of cash or securities to the broker/dealer for the purposes of trading securities.”

As explained by the 2nd Circuit, investors in the feeder funds failed to satisfy this critical requirement because they “(i) had no direct financial relationship with BLMIS; (ii) had no property interest in the assets that the feeder funds invested with BLMIS; (iii) had no securities accounts with BLMIS; (iv) lacked control over the feeder funds’ investments with BLMIS; and (v) were not identified or otherwise reflected in BLMIS’s books and records.”

This determination, according to court documents, depended on an earlier 2nd Circuit decision in SIPC v. Morgan, Kennedy & Co. In that case, employee-investors participated in a company profit sharing plan pursuant to which a trust fund was created and maintained through employer contributions. The trust established an account with the debtor in the name of the plan’s trustees, and the trustees controlled all investment decisions and communicated directly with the debtor. The trust maintained separate accounts for each employee in its own records, but crucially, the names of employee-beneficiaries did not appear on the debtor’s books and records.

The 2nd Circuit also denied in SIPC v. Morgan, Kennedy & Co. that each of the three trustees was a customer in the SIPA sense. Instead, the trust itself was determined to be the true customer. This was important, court documents show, because the maximum amount of SIPA-related recovery depends on the number of parties jointly holding an account.

In the Feeder Funds Decision, investors attempted to distinguish their situation from the SIPC v Morgan case by arguing that they maintained a higher degree of control over the feeder funds’ investments in BLMIS. The court disagreed on the merits, and also ruled that such control, even had it been established as fact, would be insufficient to confer customer status.

Judge Bernstein writes that the SIPC v. Morgan, Kennedy & Co. decision has important ERISA-related consequences that also apply in the current ruling. He notes ERISA funds are similar to feeder funds because the participant invests in a plan that subsequently invests some or all of the plan’s assets with a broker/dealer, here BLMIS.

In SIPC v. Morgan, Kenney & Co., the individual plan participants attempted to distinguish their employer-funded profit plans from the plans at issue in the Feeder Fund Decision. They argued that they had contributed their own money to their plans; they could control the size of their investments or withdraw or roll them over; their plans kept track of the precise value of their investments; they received statements reflecting the value of their investments; they were known to BLMIS due to its own reporting requirements; they had actual contact with BLMIS; and they could choose among alternatives when directing their plans to invest their respective shares of the plans’ assets.

The district judge concluded that even these true facts did not make the participants BLMIS customers and affirmed the trustee’s determinations denying their customer claims—a decision approved by the 2nd Circuit.

The text of the most recent bankruptcy court decision is here.