CarVal UK Ltd. v. Giddens ex rel. SIPA Liquidation of Lehman Bros.

Citations: 791 F.3d 277; 2015 WL 3938079Docket: Docket No. 14-890

Court: Court of Appeals for the Second Circuit; June 29, 2015; Federal Appellate Court

SummaryOriginalCytator Case TreatmentBackward CitatorAnalysis

EnglishEspañolSimplified EnglishEspañol Fácil

The Securities Investor Protection Act (SIPA), enacted in 1970, aims to protect investors by enabling the rapid return of their assets if their broker-dealer faces financial difficulties. However, this case examines whether SIPA protections apply to investors involved in repurchase agreements (repos), a common financial transaction where a seller sells securities to a buyer with the agreement to repurchase them later at a higher price. The court concludes that investors engaged in repos do not receive SIPA protection because they do not entrust their assets to the broker-dealer.

A repo involves two main actions: the seller sells securities to the buyer, who agrees to sell them back at a later date for a higher price, allowing the seller to convert securities into cash temporarily. Doral Bank and Doral Financial Corporation (Doral) participated in six repos with Lehman Brothers Inc., governed by Master Repurchase Agreements (MRAs) that explicitly defined their relationship as contractual, without any fiduciary elements. Under these MRAs, Lehman gained full legal title to the securities and could manage them freely, while Doral received cash to utilize as needed and maintained an economic interest in the securities.

The MRAs also included provisions to protect both parties from market value fluctuations of the securities. Doral was obligated to adjust its security or cash holdings based on market changes. The agreements facilitated transactions worth several hundred million dollars, with the expectation that Doral would repurchase the securities. However, the financial crisis occurred before Doral could complete the repurchase, leading to Lehman's financial collapse.

Doral retained cash from Lehman for securities that had appreciated, enabling potential profit had it repurchased them at the agreed price. After Lehman entered SIPA liquidation on September 19, 2008, Doral timely claimed entitlement to this profit. However, the SIPA Trustee denied the claims, determining Doral was not a "customer" under SIPA protections. Doral objected but later transferred its claims to CVF Lux Master S.a.r.l., managed by CarVal Investors UK Limited, the appellant in this case. On June 25, 2013, the bankruptcy court upheld the Trustee's determination, a decision affirmed by the district court on February 26, 2014. The core issue of the appeal is whether Doral qualifies as a "customer" under SIPA. If so, the appellant would be entitled to the return of securities held by Lehman on Doral's behalf, minus the repurchase price. If not, Doral's claim would proceed through Lehman's standard bankruptcy process. The analysis will consider SIPA principles, the treatment of repurchase agreements, and relevant case law, including the appellant's reliance on a prior decision regarding asset management firms and legislative changes affecting repurchase agreements since SIPA's enactment. SIPA was established in 1970 to protect investors following significant brokerage firm failures that left many unable to access their assets, thereby threatening market stability. It created specific liquidation procedures to address these issues and safeguard investor interests.

The trustee collects "customer property," allowing customers to share proportionally based on their net equity at the time of filing. If these assets are insufficient for full restitution, the trustee may utilize a special trust fund financed by fees from broker-dealers, managed by the Securities Investor Protection Corporation (SIPC), which provides protections only to "customers" of the broker-dealer. Under the Securities Investor Protection Act (SIPA), a "customer" is defined as anyone with a claim related to securities received or held by the broker-dealer in the ordinary course of business. Qualification as a customer is determined on a case-by-case basis, with a person potentially being a customer for some claims but not others. The definition requires that the investor must have "entrusted" property to the broker-dealer. 

In the case of Banff, a claimant who lent securities to a broker-dealer to improve its financial status was denied customer status since the securities were not entrusted for trading on the claimant's account. The court emphasized that the legislative intent of the "customer" definition is to protect those who have entrusted securities, indicating a fiduciary relationship. The claimant was deemed a creditor rather than a customer, highlighting a consistent judicial interpretation that requires entrustment for SIPA protections. Subsequent cases have reaffirmed this requirement, underscoring its critical importance in defining customer status under SIPA.

A claimant must demonstrate that property was entrusted to a broker-dealer to qualify as a customer under relevant legal precedents. Various circuits, including the Ninth, Eleventh, Sixth, and Seventh, emphasize that entitlement to compensation from the Securities Investor Protection Corporation (SIPC) arises only when an investor has entrusted cash or securities to an insolvent broker-dealer. The appellant argues that repurchase agreements inherently involve this entrustment, asserting that Doral fulfilled the requirement by delivering assets to Lehman during an incomplete repurchase process. However, mere delivery does not equate to entrustment; a fiduciary relationship must exist, where a broker manages assets for the customer’s benefit. Examples of such fiduciary behavior include selling assets for the customer or using them to facilitate trading. In this case, Doral sold securities to Lehman, transferring full legal ownership and retaining only a contractual right to repurchase, which does not fulfill the entrustment requirement. Lehman had the right to use the securities as it saw fit, and Doral had no expectation that Lehman would trade or utilize the securities on its behalf. Consequently, Doral did not entrust assets to Lehman according to established legal standards.

Lehman had the discretion to utilize the securities in a manner that could create adverse interests with Doral. For instance, if the securities’ market value fell below the contractual repurchase price at the time of buyback, Doral would incur a loss by repurchasing at an inflated price, while Lehman would profit from the transaction. Lehman was not obligated to prioritize Doral's interests, and its actions were driven by self-interest, reflecting an arms-length contractual relationship rather than a fiduciary duty. This relationship lacked the elements of a fiduciary relationship typically found between a broker and a customer, indicating that Doral did not entrust its securities to Lehman. 

The analysis aligns with the Eleventh Circuit’s findings in In re ESM Gov’t Sec. Inc., where the court denied customer status to a claimant in a failed reverse repo transaction, emphasizing that customer claims must demonstrate fiduciary characteristics. The court concluded that the broker-dealer did not hold cash or securities that belonged to the claimant, and thus, there was no entrustment or fiduciary relationship. This reasoning applies to Doral’s situation with Lehman, as Lehman retained ownership of the securities until the conclusion of the repurchase agreements, reinforcing that Doral's relationship with Lehman did not exhibit the necessary fiduciary traits. The appellant's argument suggesting a general fiduciary duty for Lehman to complete the repurchase agreement does not hold, as the agreements only imposed a contractual obligation to resell the securities, with no case cited to support a breach of fiduciary duty in such contexts.

A fiduciary relationship, as defined by Baroff, requires that one party holds assets on behalf of another, which is not established in this case. The appellant claims that Doral maintained an economic interest in the securities even after their sale to Lehman, citing several factors: Doral expected to repurchase the securities, accounted for them as if still owned, bore the market risk associated with their value changes, and received principal or interest payments from Lehman during the repos. The appellant argues that these factors indicate Doral's "practical ownership," suggesting that Doral entrusted the securities to Lehman. However, the retention of economic interests does not equate to entrustment, as it does not limit Lehman's discretion to manage the securities. Lehman held legal title and could dispose of the securities independently of Doral's interests. Doral's financial relationship with Lehman, including the obligation to pass on payments and to resell the securities, did not establish a duty for Lehman to act in Doral’s interest, as these obligations were contractual rather than fiduciary in nature.

Doral's economic interests in the securities stem from Lehman's fixed contractual obligations, not from any fiduciary duty Lehman had to use the securities on Doral's behalf. Consequently, Doral's interests do not establish that it entrusted the securities to Lehman, undermining any claim that Doral is a customer under the Securities Investor Protection Act (SIPA). The unrestricted ownership of the securities by Lehman supports this conclusion. The appellant's arguments include a reliance on the 1986 decision In re Bevill, Bresler, Schulman Asset Mgmt. Corp. v. Cohen, which recognized certain repo participants as customers under SIPA. Although this decision is from another circuit and typically carries limited weight, it has been influential in subsequent case law. The bankruptcy and district courts, as well as the parties involved, have extensively analyzed Bevill, Bresler. This case arose from the liquidation of the broker-dealer BBS, which engaged in repo transactions that were left incomplete after allegations of fraud. The court found that repo counterparties qualified as customers, noting that their transactions fell within the statutory definition of a customer under SIPA and highlighting the necessity of a fiduciary relationship typical in broker-dealer interactions. The court emphasized the market-related risks and rewards associated with repo transactions, ultimately concluding that BBS's counterparties were customers under SIPA, which the appellant cites as a pivotal case supporting their position.

Bevill, Bresler's analysis is found to conflict with the court's holding in Baroff, particularly concerning the requirement that customers must have entrusted securities to a broker for participation in securities markets. Bevill, Bresler fails to clarify how repo participants fulfill this requirement or demonstrate a fiduciary relationship with BBS, as outlined in Baroff. Although they attempt to distinguish repo participants from the claimant in Baroff by asserting that repo participants do not contribute to the capital of the broker-dealer, this distinction is deemed irrelevant since it does not address whether the repo participants entrusted their securities to the broker-dealer. Consequently, the court finds Bevill, Bresler inconsistent with existing case law and declines to follow it.

The appellant further argues that Congress has effectively settled the treatment of repos under SIPA by not excluding repo participants from the customer definition, implying their inclusion in SIPA's protections. The appellant cites the 1978 amendments to SIPA, which excluded certain securities lending but not repos, using the canon of expressio unius est exclusio alterius to support this claim. However, the court counters that the appellant has not established that Congress was considering repos at that time, thus rendering this argument insufficient. 

Additionally, the appellant points to the Dodd-Frank Act, asserting that Congress considered excluding repos from SIPA's customer protection but chose not to include this exclusion in the final version. The House version of Dodd-Frank explicitly excluded repos, but the enacted version retained the existing SIPA definitions, reinforcing that the term "customer" aligns with the original SIPA terminology.

The appellant argues that Congress’s failure to enact a specific exclusion for repos in the Dodd-Frank Act implies an intent to protect repos under the Securities Investor Protection Act (SIPA). However, since Dodd-Frank was enacted after the SIPA filing date for Lehman, it cannot retroactively confer customer status. The absence of a specific provision is considered marginal evidence of Congressional intent, and the rejection of the amendment may signify that Congress viewed it as unnecessary due to existing laws. The appellant fails to provide reasoning for the rejection of the proposed amendment, and the legislative history of Dodd-Frank does not address this issue.

Moreover, while Dodd-Frank amended the Bankruptcy Code to exclude repos from its definition of customer, this does not imply similar protections under SIPA, as the two statutes are distinct despite some similarities in definitions. Notably, SIPA includes features like the SIPC trust fund that the Bankruptcy Code lacks, undermining any inference drawn from changes made to the Bankruptcy Code regarding SIPA.

The court concludes that the lower courts correctly determined the appellant is not a SIPA customer, affirming their decisions. Additionally, the appellant claims the bankruptcy court erred by excluding a Prime Brokerage Account Agreement related to another claimant. However, the bankruptcy court justified the exclusion by stating that it should focus on documentation defining the relationship pertinent to the case at hand, deeming the excluded document irrelevant. The appellant's argument regarding the document's admission lacks merit, as the bankruptcy court did not abuse its discretion in its decision.

The broker in ESM was liquidated under Subchapter III, Chapter 7 of the Bankruptcy Code, rather than SIPA, which has distinct provisions for stockbroker liquidations. Although both SIPA and the Bankruptcy Code define "customer" similarly, it remains unresolved whether the entrustment requirement from the Baroff case applies to the Bankruptcy Code. In ESM, it was assumed that the Bankruptcy Code required entrustment, and the Eleventh Circuit analyzed this assumption concerning repurchase agreements. The broader conclusion that repo counterparties are not customers under the Bankruptcy Code was not relied upon, as it was not pertinent to the SIPA case at hand. The repo contract awarded title to Lehman to mitigate losses in case of Doral’s default, allowing Lehman to either sell or retain the underlying securities. The ruling is limited to situations where a claimant delivers cash or assets to a broker-dealer within a repo context, without addressing how SIPA would treat assets held in a custody repo. The appellant's argument regarding congressional awareness of existing law at the time of the 1978 SIPA amendment is weakened by the absence of relevant case law until 1986. The argument that congressional inaction implies endorsement of the Bevill, Bresler decision lacks a solid foundation, as the Baroff decision should be considered the relevant baseline. Furthermore, the Dodd-Frank Act did not amend the Bankruptcy Code's definition of "customer" but added a supplemental definition applicable only to specific swap transactions under the Securities and Exchange Act.