Kathy Bazoian Phelps
Senior Counsel in Ponzi Scheme Litigation
and Bankruptcy Matters

Kathy is a senior business trial attorney with more than 30 years experience prosecuting and defending claims for high net worth clients involved in Ponzi scheme matters and in bankruptcy proceedings. Kathy’s practice includes recovering assets for clients in complex fraud cases under standard fee and alternative fee arrangements. She also handles SEC and CFTC whistleblower claims. Kathy also serves as a mediator in bankruptcy matters, in complex business disputes, and in matters requiring detailed knowledge about fraud or Ponzi schemes.

Kathy’s Clients in Ponzi Scheme Cases and Bankruptcy Matters
Equity Receivers
Bankruptcy Trustees
High Net Worth Investors
Debtors in Bankruptcy
Secured and Unsecured Creditors

Wednesday, June 19, 2013

Fourth Circuit Makes New Fraudulent Transfer Law

Posted by Kathy Bazoian Phelps

   Determined not to hold a securities brokerage firm liable for fraudulent transfers in a Ponzi scheme case, the Fourth Circuit recently pushed the boundaries of fraudulent transfer law to affirm the lower court's dismissal of the trustee's claims against it. Grayson Consulting, Inc. v. Wachovia Securities, LLC (In re Derivium Capital LLC), 2013 U.S. App. LEXIS 10529 (4th Cir. May 24, 2013).

   Although several aspects of the decision applied established case law, two holdings explored new territory. The court affirmed the dismissal of claims to recover securities transferred to Wachovia on the grounds that they were not transfers of property of the debtor. The court also affirmed the dismissal of claims to recover commissions on the grounds that the safe harbor provisions of § 546(e) protected those payments.

The Scheme
   In Derivium's scheme, its customers were induced to transfer stocks in exchange for three-year non-recourse loans worth 90% of the stocks' market values. When the loans matured, customers had the option of repaying the principal plus interest and recovering the stock, surrendering the stock, or refinancing the loan for an additional term. Customers transferred their stocks into Wachovia brokerage accounts in Derivium's name. They were told that Derivium would hedge their collateral using a confidential, proprietary formula. Instead, Derivium's owners directed Wachovia to immediately transfer the stocks into other accounts and liquidate them. Derivium used the proceeds from the stock sales to fund customers' loans and start-up ventures of Derivium's owners.

The Collapse
   Derivium collapsed when it could no longer satisfy its obligations to return customers' stocks and Wachovia closed its brokerage accounts. After Derivium filed bankruptcy, the trustee filed a complaint against Wachovia asserting several claims, including fraudulent transfer claims to recover $161 million in securities that customers transferred into the Wachovia brokerage accounts, and commissions that Derivium paid to Wachovia.

The Property Issue
   The court found that the transfer of the customers' securities to an account in Derivium's name at Wachovia was not a transfer of Derivium’s property. The court stated:
Derivium had no rights to the securities until after the transfers were effectuated. Accordingly, the Customer Transfers at issue here simply were not transfers of debtor property, and thus the transfers in no way diminished the bankruptcy estate.   Id. at *9. In other words, because Derivium's customers transferred their securities directly into Derivium's accounts at Wachovia, rather than to Derivium first, there was no transfer of Derivium's property to Wachovia. The court cited no prior cases in support of this precise focus on the form and timing of the challenged transfers. Interestingly, the court did acknowledge on several occasions that the securities were Derivium's collateral for its loans to its customers. The decision raises the question of whether the court put form over substance since it was clear that the customers intended to transfer securities to Derivium, not to Wachovia.

The Commission Issue
   This decision is also the first appellate decision to hold that commission payments can be shielded from recovery by the "settlement payment" defense of § 546(e).

   The court reasoned:
Because Congress included in the definition of "settlement payment" "any other similar payment commonly used in the securities trade," we also look to standard practices of the securities industry to inform the definition of "settlement payment." Several industry texts suggest that "settlement payment" means the transfer of funds paid in connection with completing a securities transaction.   Id. at *18. The court then quoted two such industry texts, but neither quote asserts explicitly that commissions are included within the scope of "settlement payments." Id. at *18-19. The only text cited that explicitly so suggests is Black’s Law Dictionary, but the court does not explain why this is an "industry text" in the securities industry. Id.

   Nevertheless, the could held, "commissions shown to be reasonable and customary parts of settling stock sales come within the stockbroker defense as 'settlement payments.'" Id. at 20. The court then affirmed the bankruptcy court's factual finding that Wachovia's discounted commission rates were reasonable and customary. Id. at *21.

   The court did emphasize, however, that its holding does not apply to commissions that are "not part of the settlement of securities transactions, such as commissions paid for the solicitation of investors[.]" Id. at *19.

The Bottom Line
   The Fourth Circuit's narrow view that the debtor's property did not include securities that collateralized loans from the debtor to its customers, coupled with the court's expansive view of the "settlement payment" defense, gives brokerage firms substantial new armor against trustee's fraudulent transfer claims in Ponzi scheme cases. Will other courts follow?

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