Robbing Peter to Pay Paul: Irving Picard’s Quest to Repay Bernie Madoff’s Victims

Author: Dan Stroh, Associate Member, University of Cincinnati Law Review

Charles Ponzi did not intend to have his name become synonymous with financial fraud; he intended to get rich quickly. While he was not the first to perpetrate such a scheme, Ponzi’s name is attached to a type of fraud in which a fund pays its first investors with the money contributed by later investors—a Ponzi scheme. In 2008, Bernie Madoff was discovered to have been running a Ponzi scheme with investments estimated at $17.5 billion[1] and claimed returns in excess of $65 billion.[2] While Ponzi’s name is still mentioned frequently, many people now view Madoff as the face of Ponzi schemes due to his decades-long run as a famous investment professional all while never actually investing client funds.

When Madoff’s scheme unraveled, Irving Picard was assigned as trustee for Bernard L. Madoff Investment Securities LLC under the Securities Investor Protection Act (SIPA) and was given the task of attempting to recover as much money as possible to repay the initial investments of Madoff clients.[3] Six years later, the victims of Madoff’s fraud are still seeking repayment of their initial investments.[4] Picard has successfully recovered approximately 60% of the stolen assets to distribute to victims, but he continues to seek more.[5] Recently, the Second Circuit placed a major obstacle in his path when it determined that investors who withdrew more from their accounts than they initially invested were protected by the stockbroker defense in § 546(e) of the Bankruptcy Code.[6] Picard argued that these investors profited from Madoff’s scheme and whether they knew of the scheme or not, the profits they enjoyed should be shared by all of the defrauded investors.[7] On March 17, 2015 he filed a petition for certiorari with the Supreme Court, which has the potential to increase the amount of recovered assets by at least $2 billion and possibly up to $4 billion. With the holders of these funds currently protected by the “stockbroker defense” under the Second Circuit’s ruling,[8] Picard hopes that the Supreme Court will take the case and rule that this defense should only apply when actual securities are involved, not fictitious ones as is the case with Ponzi schemes. While some see the efforts of Picard as simply robbing Peter to pay Paul,[9] the return of these funds would allow for all defrauded investors to be treated equally and fairly without conveying benefits on those who were lucky enough to withdraw their money from Madoff’s Ponzi scheme first.

Two Peas in a Pod: SIPA and the Bankruptcy Code

In the late 1960s, the financial failure of multiple securities broker-dealers spurred Congress to enact the Securities Investor Protection Act (SIPA).[10] As securities brokers and dealers often hold large sums of money for their customers, SIPA intended to protect investors from suffering significant losses due to such financial failures.[11] The protections of SIPA are triggered whenever the Securities and Exchange Commission or the Securities Investor Protection Corporation becomes aware of facts that lead either of these organizations to believe a broker is in danger of being unable to meet its obligations to customers and files an application with the district court to intervene.[12] Once the application for protection is granted, a trustee is appointed to liquidate and distribute the remaining community property under the broker’s control to try to make restitution to all investors as fairly as possible.[13]

Included with the powers to distribute community property is the power to “claw back” funds from preferential or fraudulent transfers made by the broker-dealer prior to the appointment of the trustee.[14] SIPA provides these powers by specifically referencing the Bankruptcy Code and states: “the trustee may recover any property transferred by the debtor . . . to the extent that such transfer is voidable or void under the provisions of Title 11.”[15] Avoidance powers invalidate a transfer made within a statutorily defined time period prior to a trustee’s action.[16] This gives a trustee either the ability to keep the funds, if they have yet to be transferred, or the right to recover the funds, if they have already been transferred.[17] The ability to keep or retrieve these funds increases the size of the asset pool that the trustee is able to pay out to investors, but there is an important exception to these claw back powers. The “stockbroker exception” of the Bankruptcy Code blocks the ability of a trustee to recover funds that were transferred “in connection with a securities contract” or are classified as “settlement payments.”[18] As the provisions of SIPA are linked to bankruptcy trustee powers, the exception also prohibits a SIPA trustee from avoiding this type of transfer when attempting to recover community property to distribute to all investors.

The Second Circuit’s Decision: Picard is Barking Up the Wrong Tree

In the Madoff case, Picard is attempting to claw back funds from investors who received funds from Madoff that exceeded the amounts they invested.[19] Picard claims that these funds were preferentially paid to those early exiting investors and instead should be distributed on an equal basis to all investors.[20] In order to block the claw back, the stockbroker exception requires that the payments to investors be “made in connection with a securities contract” or be “settlement payments.”[21] In its decision in December 2014, the Second Circuit stated that three documents executed by all Madoff clients established a “securities contract,” and that any payments made to investors were “in connection with” that contract.[22] The court held that the three documents authorized Madoff to make securities transactions; therefore, the authorization was “sufficiently similar” to a securities contract, establishing a contract under a broad construction of the statute.[23] Once deemed a securities contract, payments made are assumed to be “in connection with” that contract.[24] Thus, because the Madoff scheme met both of these requirements, the court held that under SIPA these payments were not recoverable by the trustee.

In addition, the court held that the payments qualified as “settlement payments” for purposes of the stockbroker exception.[25] A settlement payment is a payment that is “the transfer of cash or securities made to complete [a] securities transaction.”[26] Using this definition, the court held that the payments from the pool of funds supplied by all investors were made to clients as payment for the “securities contract.”[27] The customer’s intent was key, in that customers believed the payments were returned upon request for the sale of securities and thus were intended to be “settlement payments” for their accounts.[28] Because Madoff’s customers intended and believed that these payments were a settlement of all or part of their investment accounts with Madoff, these payments qualified as settlement payments under the exception. For both of these reasons, the court held that the monies sought by Picard were protected by the stockbrokers defense and thus the clients who had made money off of Madoff’s “investments” prior to insolvency were allowed to keep their funds.

Crying Over Spilt Milk? Picard’s Petition to the Supreme Court

Picard petitioned the Supreme Court to overturn the Second Circuit’s “securities contract” and “settlement payments” rationales for protecting the payments to Madoff’’s “investors” under § 546(e).[29] There are two reasons why Madoff’s agreements should not be considered “securities contracts.” First, as Picard shows, prior to this decision, a “securities contract” required an actual purchase or sale, not just an anticipated one.[30] Madoff, despite soliciting money from investors on the theory that he was investing, actually made no purchases or sales of securities. Every payment made back to investors was simply the money of later investors. Second, the “sufficiently similar” language used by the court in determining that a securities contract existed was not intended to create a contract out of simple authorization for Madoff to conduct trades without his ever actually doing so.[31] This language was added in an effort to catch all contracts that were used for actual purchases of complicated stock options, swap transactions, and other securities contract not thought of at the time.[32]

Regarding the court’s determination that the payments were “settlement payments,” Picard argues the funds given to investors requesting a cash-out do not qualify. Settlement, by definition, contemplates the completion of a transaction.[33] Here, just as there was no transaction to meet the “sufficiently similar” reasoning, without an actual transaction, the payments cannot be “settlement payments.”[34] Also, for something to qualify as a “settlement payment” under the § 546(e) exception and thus not be recoverable by the trustee, it must be something that is “commonly used in the securities trade.”[35] Thus, because no actual transaction took place and because payments for non-existent profits are not common in the securities trade, the payments to investors would not qualify under this part of the stockbroker exception. For these reasons, Picard argues that, with a proper reading of the statute, the decision should be overturned, which would allow him to void the transfers and recover the additional funds for defrauded investors.

The Supreme Court Should Grant Cert and Kill Two Birds with One Stone

The Second Circuit’s interpretation of the definition of “securities contract” improperly broadened the term’s previous understanding by removing the requirement that an investment transaction actually occur.[36] Under the Second Circuit’s standard, no longer is any real investment required for payments between a stockbroker and his client to be considered “in connection with” a securities contract, thus defeating the purpose of this exception. Without requiring an actual investment, as the Second Circuit read it, SIPA no longer protects the actual brokerage industry; rather, it protects anyone purporting to be a broker. Furthermore, by decoupling the requirement that payments be made “in connection with” actual or considered transactions in securities, the validity of this exception now relies almost solely on the intent and belief of investors. An investor no longer has an incentive to ask how his investment increases in value. To illustrate the interworking of these two points: an investor can now sign a general authorization that allows a stockbroker to consider investing into securities and later request the funds be returned with a profit all without proof of any transaction taking place. As this profit is being paid directly from the funds of other investors in a scheme like Madoff’s, someone—and likely a large number of people—are guaranteed to lose their investments to other investors, whereas in most investment scenarios, the group as a whole loses or gains together. Once the investor receives this money, according to the Second Circuit, it is protected from any trustee action under SIPA or bankruptcy law, whether or not any fraudulent conduct by the broker was involved. By allowing such a tenuous relationship between a broker and an investor to be considered “in connection with” a document purporting to be authorization for securities, the stockbroker definition now consists of almost any transaction a broker and investor might have, regardless of its relation to the securities industry. This expands the stockbroker exception to cover a wide range of scenarios that it was not intended to and also disincentivizes an investor from keeping a close eye on profits as there is no need to monitor so long as an investor cashes out early.

The Second Circuit’s broad definition also means that settlement payments do not need to be connected to any specific transaction, negatively restricting a trustee’s powers of recovery. Payments exceeding an investor’s initial investment have no relation to any sort of securities settlement. The initial money was never invested and the funds above that amount are simply someone else’s money. By stating that the payment of one investor’s money to another investor is a settlement payment, the court seems to accept fraud as a type of transaction “commonly used in the securities trade.”[37] Specific types of fraud are now a way to defeat laws aimed at recovering money from fraudulent transfers. By categorizing the payments in this case as “settlement payments,” the court extended application of the stockbroker defense beyond of its intended scope of payments made to investors regarding real transactions made with their invested funds.

A Silver Lining: The Supreme Court Should Step In

SIPA was enacted to protect investors and the securities market from an ensuing loss of public confidence after a broker’s failure.[38] By broadening several definitions of the “stockbroker defense,” the Second Circuit has placed the interests of investors who cash out early above the interests of those whom SIPA was intended to protect. The exceptions are intended to protect innocent investors from improper management of funds, rather than to protect those who innocently profit from a fraud at the expense of other victims. With the Second Circuit’s ruling, those who are not participants in a securities markets are protected. In order to bring the definitions and defenses back to their narrow intended scope, the Supreme Court should grant Picard’s petition and rule that fictitious and fraudulent transactions are not covered by SIPA, and thus return the focus of SIPA to protecting innocent investors who are actual participants in the securities markets.

[1] Jonathan Stempel, Madoff Feeder Fund Settles; Victims’ Recovery Tops $10.6 Billion, Reuters (Mar. 23, 2015, 6:49 PM),

[2] Grant McCool & Martha Graybow, Madoff Pleads Guilty, Is Jailed for $65 Billion Fraud, Reuters (Mar. 13, 2009),

[3] Irving H. Picard, A Message from SIPA Trustee Irving H. Picard, The Madoff Recovery Initiative, (last visited Mar. 27, 2015).

[4] The victims in the case were actually defrauded by Bernie L. Madoff Investment Securities LLC, but for simplicity’s sake Madoff will be used when referring to the broker-dealer in question.

[5] Stempel, supra note 1.

[6] 11 U.S.C.S. § 546(e) (LEXIS through PL 114-6, 2015).

[7] In re Bernard L. Madoff Investment Securities LLC, 773 F.3d 411, 414 (2d Cir. 2014).

[8] 11 U.S.C.S. § 546(e) (LEXIS through PL 114-6, 2015).

[9] Amy J. Sepinwall, Righting Others’ Wrongs: A Critical Look at Clawbacks in Madoff-Type Ponzi Schemes and Other Frauds, 78 Brook. L. Rev. 1, 1 (2012).

[10] Validity, Construction, and Application of Securities Investor Protection Act of 1970 (15 U.S.C.A. § 78aaa et seq.), 23 A.L.R. Fed. 157 (1975) [hereinafter Validity].

[11] Id.

[12] 15 U.S.C.S. § 78eee (LEXIS through PL 114-6, 2015). Specifically this can happen through one of five conditions enumerated in 15 U.S.C.S. § 78eee(b)(1) (LEXIS through PL 114-6, 2015).; Daniel J. Morse, When a Securities Brokerage Firm Goes Broke: A Primer on the Securities Investment Protection Act of 1970, 25 Am. Bankr. Inst. J. 34, (2006).

[13] Validity, supra note 10. Community property may include cash that is under control of the broker as well as any remaining investments that have been made on behalf of customers.

[14] 15 U.S.C.S. § 78fff-2(c)(3) (LEXIS through PL 114-6, 2015).

[15] 11 U.S.C.S. § 544 (LEXIS through PL 114-6, 2015).

[16] Id. at § 548 (limiting avoidance period to two years in federal bankruptcy law); see also id. at § 544(b) (LEXIS through PL 114-6, 2015) (allowing a trustee to avoid transfers pursuant to state laws where fraudulent transfer laws may have a longer time period recognized by statute making it possible to avoid transfer made more than 2 years in advance).

[17] 25 Am. Jur. 3d Proof of Facts 591(1994).

[18] 11 U.S.C.S. § 546(e) (LEXIS through PL 114-6, 2015). It is also important to note that this exception does not apply to payments that were “actual fraud.” Therefore, those payments made to investors or firms that knew or should have known Madoff was operating a Ponzi scheme are recoverable and in many instances significant amounts of money have been recovered for these situations. The stockbroker defense only applies to those investors who “cashed out” or withdrew money from the fund without knowledge of the fraud but who did not actually give reasonable value for their gains, known as constructive fraud. As the money was never invested any profits in excess of the amounts invested was not for reasonably equivalent gain. See id. at § 548(a)(1)(A)-(B).

[19] See id.

[20] In re Bernard L. Madoff Investment Securities LLC, 773 F.3d 411, 414 (2d Cir. 2014).

[21] Id. at 417. There are other exceptions but these two are the ones at issue with Ponzi scheme payments. See 11 U.S.C.S. § 546(e) (LEXIS through PL 114-6, 2015).

[22] In re Madoff, 773 F.3d at 418. The three documents that combined to create the contract were a “Customer Agreement,” a “Trading Authorization,” and an “Option Agreement.” Id.

[23] Id. The decision also states that the agreements could be considered a master agreement, but as the Petition discusses in detail, this would require individual contracts for each sale which do not exist. Without having any other connection, there is no connection to a master agreement and thus would not be a securities contract for the purposes of the avoidance exception. Id. See Petition for a Writ of Certiorari, Irving H. Picard v. Ida Fishman Revocable Trust, 773 F.3d 411 (2014), No. 14-___.

[24] In re Madoff, 773 F.3d at 418.

[25] In re Madoff, 773 F.3d at 422.

[26] Enron Creditors Recovery Corp. v Alfa, S.A.B. de C.V., 651 F.3d 329, 334 (2d Cir. 2011) (citations omitted).

[27] In re Madoff, 773 F.3d at 422.

[28] Id.

[29] See generally Petition for a Writ of Certiorari, supra note 23.

[30] Reply Brief for Plaintiff–Appellant Irving H Picard at 8, In re Madoff, 773 F.3d 411 (2014) (No. 12-2557); see also In re Quebecor World (USA) Inc., 480 B.R. 468, 479 (S.D.N.Y. 2012) aff’d 719 F.3d 94 (2d Cir. 2013).

[31] Reply Brief for Plaintiff, supra note 30 at 11.

[32] H.R. Rep. No. 108-40, pt. 1, at 232-233 (2003).

[33] Brief of Appellant Securities Investor Protection Corporation at 15, In re Madoff, 773 F.3d 411 (2014), (No. 12-2557).

[34] Id.

[35] Petition for Writ of Certiorari, supra note 23 at 17.

[36] See supra note 26. Previous definitions required that an actual transaction occur.

[37] 11 U.S.C.S. §741(8) (LEXIS through PL 114-6, 2015). See also In re Grafton Partners, L.P., 321 B.R. 527, (B.A.P. 9th Cir. 2005) (“In short, the statutory protection of settlement payments presupposes that securities laws are not being offended.”)

[38] See Validity supra note 8


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