Gredd v. Bear, Stearns Securities Corp. (In Re Manhattan Investment Fund Ltd.)Gredd v. Bear, Stearns Securities Corp. (In Re Manhattan Investment Fund Ltd.)
MEMORAND UM DECISION DENYING DEFENDANT’S MOTION FOR SUMMARY JUDGMENT TO DISMISS AND GRANTING TRUSTEES MOTION FOR SUMMARY JUDGMENT
Before this Court are cross motions for summary judgment on Count I of a Complaint filed by Helen Gredd as Chapter 11 Trustee (the “Trustee”) for Manhattan Investment Fund Ltd. (the “Fund” or “Debt- or”), against Bear, Stearns Securities
Procedural History
“This adversary proceeding is an outgrowth of a massive Ponzi scheme executed by Michael Berger (‘Berger’) a convicted felon and fugitive,”
Gredd v. Bear Stearns Securities Corp. (In re Manhattan Investment Fund Ltd.),
On April 24, 2000, the Trustee commenced this adversary proceeding against Bear Stearns. In her complaint, the Trustee sought to avoid, pursuant to section 548(a)(1)(A) of the Bankruptcy Code, three categories of transfers that were made to Bear Stearns in connection with the Fund’s short selling activities during the last ten months of its operation. Count I of the complaint seeks to avoid $141.1 million in margin payments which Berger caused to be transferred to Bear Stearns from the Fund’s аccount with the Bank of Bermuda. Count II sought to recover approximately $1.7 billion in short sale proceeds as generated by the sale of stock that the Fund borrowed from Bear Stearns. Count III of the complaint sought to recover approximately $1.9 billion worth of securities that were purchased with the short sale proceeds (plus other monies in the Fund’s margin account), that were delivered to Bear Stearns to cover stock loans to the Fund. Count IV of the complaint seeks equitable subordination of any claim Bear Stearns may assert in the Fund’s chapter 11 case to all other claims.
In May 2001, Bear Stearns moved to withdraw the reference of this adversary proceeding from this Court to the District Court, and on July 25, 2002, the District Court granted Bear Stearns’ motion for the limited purpose of determining whether the Debtor had an interest in the alleged transfers subject to Counts II аnd III of the complaint.
See Bear Stearns v. Gredd (In re Manhattan Investment Fund Ltd.),
On May 10, 2002, Bear Stearns moved before this Court to dismiss both remaining counts pursuant to Bankruptcy Rules 7009(b) and 7012(a) arguing,
inter alia,
On October 17, 2002, Bear Sterns’ moved for an order granting interlocutory leave to appeal from this Court’s denial of the motion to dismiss. By memorandum opinion dated December 20, 2002, the District Court denied that motion.
See Bear, Stearns Securities Corp. v. Gredd (In re Manhattan Investment Fund Ltd.),
On March 10, 2006, Bear Steаrns once again moved for an order withdrawing the adversary proceeding from this Court. By memorandum opinion and order dated May 31, 2006, the District Court denied the motion based upon the law of the case doctrine, and alternatively, for untimeliness.
See Bear, Stearns Securities Corp. v. Gredd (In re Manhattan Investment Fund Ltd.),
Background
In the year prior to the Petition Date, the Fund made eighteen separate transfers totaling $141.4 million (collectively, the “Transfers”), from its account at Bank of Bermuda to an account maintained by Bear Stearns at Citibank. Those monies were then transferred to the Fund’s Bear Stearns account. The monies in the Fund’s Bear Stearns account were used by the Fund to engage in securities trading. The Bear Stearns account was subject to a Profеssional Account Agreement (the “Agreement”) between Berger and Bear Stearns which provided, in relevant part, that: (1) Bear Stearns had the right to set the level of maintenance margin;
2
(2)
After questions about the Fund and its activity arose and the SEC was investigating it, Bear Stearns put the Fund on “closing оnly” status in January 2000, meaning that no new positions could be opened by the Fund and no money withdrawn until all existing positions were closed out. (See Trustee’s Mem. in Supp. at 21, fn. 93). Following Berger’s confession of fraud Bear Stearns closed out all of the remaining short positions in the Fund’s account using the monies in the account to do so.
In March 2000, Trustee requested that Bear Stearns wire the remaining $16,288,746.46 in the Fund’s account to the Fund’s bank account at Chase Manhattan and in April 2000, Bear Stearns did so. As prime broker, Bear Stearns made approximately $2.4 million in revenue for its services over the course of its involvement with the Fund.
The Trustee now seeks summary judgment to avoid the Transfers under section 548(a)(1)(A) of the Bankruptcy Code. The Trustee contends that: (1) the Transfers were made with actual intent to hinder, delay or defraud the Fund’s creditors and without which the Fund could not have continued to operate and further pеrpetrate its fraud; (2) Bear Stearns is not a mere conduit and is therefore a “transferee” under section 550(a) of the Bankruptcy Code; and (3) that Bear Stearns cannot prove that it accepted the Transfers in good faith. In opposition, Bear Stearns contends that: (1) the Trustee may not recover the Transfers because Bear Stearns lacked legal dominion and control over the Transfers and was therefore not a “transferee” under section 550(a) of the
Discussion
Under
Avoiding Powers
The Bankruptcy Code bestows broad powers upon a trustee to avoid certain transfers of property made by the debtor before the filing of the bankruptcy petition. “In this way, the transferred property is returned to the estate for the benefit of all persons who have presented valid claims.”
See Christy v. Alexander & Alexander of NY, Inc. (In re Finley, Kumble, Wagner, Heine, Underberg, Manley, Myerson & Casey),
However, section 546(e) of the Bankruptcy Code, commonly known as the “stockbroker defense,” prevents the trustee from avoiding margin payments made to a stockbroker except where there is actual fraud.
See
Fraudulent Nature of the Transfers
The eighteen Transfers at issue in this matter were deposited by the Fund in its account at Bear Stearns to allow it to continue short selling activities within the yеar prior to the Petition Date. To engage in short sales, federal securities regulations required the Fund to maintain its margin account with Bear Stearns at a specified level. Bear Stearns, in turn, could, and did, make those requirements more stringent based on the level of risk at which it perceived the Fund’s trading to be. The Transfers were made in order to open new short positions or to comply with the requirements of its margin account in order to continue trading. As such, the Transfers fit squarely within the definition of a margin payment as defined in sections 101, 741, and 761 of the Bankruptcy Code. 5
The Trustee argues that the Transfers are within the exception to
Actual intent to hinder, delay or defraud may be estаblished as a matter of law in cases in which the debtor runs a Ponzi scheme or a similar illegitimate enterprise, because transfers made in the course of a Ponzi operation could have been made for no purpose other than to
Moreover, acts taken in furtherance of the Ponzi scheme, such as paying brokers commissions, are also fraudulent. “Every payment made by the debtor to keep the scheme on-going was made with the actual intent to hinder, delay or defraud creditors, primarily the new investors.”
Cuthill v. Greenmark, LLC (In re World Vision Entm’t, Inc.),
Bear Stearns argues that there was no fraud. However, this Court, along with the District Court has already determined that issue. In ruling on Bear Stearns’ motion to dismiss Counts I and IV, this Court explained that, “[w]hen a debtor operating a Ponzi scheme makes a payment with the knowledge that future creditors will not be paid, that payment is presumed to have been made with actual intent to hinder, delay or defraud other creditors-regardless of whether payments were made to early investors, or whether the debtor was engaged in a strictly classic Ponzi scheme.”
In re Manhattan Investment Fund,
Initial Transferee
Bear Stearns argues that it is a “mere conduit” and not an initial transferee. The Bankruptcy Code does not define the term “transferee” and as such the “mere conduit” defense has arisen as a defense to liability in avoidance actions.
Poonja v. Charles Schwab & Co., Inc. (In re Dominion Corp.),
Judge Easterbrook in the Seventh Circuit articulated the “dominion and control” test in
Bonded Financial Services, Inc. v. European American Bank,
Several courts including the Second Circuit Court of Appeals have adopted the dominion and control test.
See In re Finley, Kumble, Wagner, Heine, Underberg, Manley, Myerson & Casey,
The Ninth Circuit recently explained the “mere conduit” or “dominion and control” test as actually being two distinct tests: the dominion test and the control test.
Universal Service Administrative Co. v. Post Confirmation Committee of Unsecured Creditors of Incomnet Communications (In re Incomnet),
Bear Stearns contends that the Agreement relied upon by the Trustee to prove Bear Stearns’ dominion and control over the transfers is standard in the industry and that such boilerplate provisions cannot give rise to initial transferee status.
(See
Bear Stearns’ Mem. in Opp. at 13-16.) Bear Stearns further contends that because the SEC regulations set requirements on accounts such as the Fund’s account to protect against misuse or abuse of customer funds that these regulations by their nature preclude the Court from finding Bear Stearns an initial transferee.
(See
Bear Stearns’ Mem. in Opp. at 13, 14);
see also
“Often ... fiduciaries or agents are not considered initial transferees because their legal control over the assets received is circumscribed by their legal duties to their clients ... However, even entities that have special legal relationships with the debtor-transfer- or can be initial transferees when they do, in fact, take legal control of an avoidable transfer; for example when they receive assets directly from the debtor-transferor as compensation for services or in payment of a genuine debt... .Where a fiduciary, agent, or other entity with legal obligations to the debtor-transferor is the recipient of an avoidable transfer, the control test turns on the recipient’s legal rights and obligations toward the transferred assets, not simply their legal relationship with the debtor-trans-feror or the ultimate use of the assets. To ascertain these rights and obligations, and decide whether such a recipient is an initial transferee under11 U.S.C. § 550 , courts must look at all the circumstances of the transaction that resulted in the avoidable transfer.”
In re Pony Express Delivery Services,
Bear Sterns also argues that the dominion and control test requires full legal dominion and control such that the transferee must have the legal right “to put the money to one’s own purpose” and must be “free to invest the whole [amount] in lottery tickets or uranium stocks.” Bear Stearns contends that the fact that it could only use the monies in the Fund’s account for a limited purpose, as proscribed both under the terms of its Agreement with Berger and the SEC regulations, shows it did not have the requisite dominion and control to be an initial transferee.
Recently, however, the Ninth Circuit explained, “it is of no cоnsequence that the recipient cannot invest funds in — ‘to use the Seventh Circuit’s colorful phrase — ‘lottery tickets or uranium stocks ... ’ [The statutory] legal restrictions merely limit how [the recipient] will exercise its dominion over the funds; they do not preclude [it] from having dominion at all.”
In re Incomnet,
The caselaw finding that an entity is a mere conduit differ from the facts here. In most cases, the recipient was held to be a mere conduit primarily because it did not receive consideration or compensation for its services nor did it have any liability in the transaction as a whole if the transfers had been made to the recipient. In this case, Bear Stearns made $2.4 million profit on the Fund’s transactions during its tenure as the Fund’s primary brokеr. Moreover, Bear Stearns used the funds in the account to cover all open positions the Fund had with Bear Stearns for which Bear Stearns would have been liable if the Transfers had not been made.
See cf. Bonded Financial,
Under the terms of the Fund’s Agreement with Bear Stearns, Bear Sterns had a security interest in any monies transferred; held the monies transferred as
Bear Steams Public Policy Argument
Bear Stearns further argues that allowing recovery of margin payments relating to short sale securities transactions is contrary to public policy, an argument previously addressed by this Court in the decision denying Bear Stearns’ motion to dismiss.
See In re Manhattan Investment Fund Ltd.,
Good Faith Defense
Bear Stearns asserts that even should it be found to be an initial transferee within the meaning of
That an issue is factual does not necessarily preclude summary judgment.
See Rebel Oil Co., Inc. v. Atlantic Richfield Co.,
The Bankruptcy Code does not define good faith. However, courts have found that “good faith” includes not only “honest belief, the absence of malice and the absence of design to defraud or to seek an unconscionable advantage” but also “freedom from knowledge of circumstances which ought to put the holder on inquiry.”
In re M & L Business Mach. Co., Inc.,
In determining whether or not a transferee lacked the requisite knowledge so as to have been acting in good faith, “courts look to what the transferee objectively ‘knew or should have known’ in questions of gоod faith, rather than examining what the transferee actually knew from a subjective standpoint.... At least one court has held that if the circumstances would place a reasonable person
The record reflects undisputed facts demonstrating that Bear Stearns was on inquiry notice as of December 1998 after Mr. Fredrik Schilling, Senior Managing Director and salesperson for Bear Stearns, had a conversation regarding the Fund at a party. In that conversation, Schilling was told by an individual who represented that he was affiliated with European Investment Management “EIM” who had clients that invested in the Fund, that the Fund was- reporting a 20% profit for the year. At that time, Schilling was under the impression that the Fund was losing money based on his participation in risk-related conference calls in which the Fund had been mentioned, and consequently, what he was told by this investor did not “sound right.” See Bear Stearns Mem. in Opp. at 51-2. In fact, by December 1998, the Fund was down $180 million for 1998. Rather than respоnd to that individual, Schilling suggested that the individual have his boss call Schilling.
The day after this party conversation Schilling relayed the conversation with this investor to his boss, William Gangi, and the then-head of client services Michael Tumulty. See Bear Stearns Mem. in Opp. at 53. The same day, Schilling spoke with the EIM representative’s boss, Arpad Bus-son who inquired as to whether the Fund’s performance matched Bear Stearns’ books and records. Id. at 54.
Schilling informed Busson that he would need to make a written inquiry in order to receive a response to that question. Id. Thereafter, Schilling spoke with John Cal-lanan in Bear Stearns’ portfolio department about the Fund’s performance and the books and records and Callanan confirmed that the Fund was losing money in its account at Bear Stearns. Id. Schilling also passed on the written request from Busson to Bear Stearns’ legal department as well as discussing the situation with senior management at Bear Stearns. Id. at 54-5.
These discussions led to a conference call with two then managers in Bear Stearns’ relationship management department, Peter Murphy and Christopher Welsh, Financial Asset Management (“FAM”), the Fund’s introducing broker, and Michael Berger.
Id.
at 55. Michael Berger explained that the discrepancy in the Fund’s performance as described by
In February 1999, Schilling coincidentally met Busson at a conference in Geneva where he learned that Busson further inquired into the Fund with Berger who would not release any information without a confidentiality agreement. Id. at 60. Busson was advised by his counsel not to sign the agreement and told Schilling that EIM had either redeemed or was planning to redeem its clients’ investments in the Fund. Id. In the spring of 1999, Deloitte & Touche notified Schilling that the Fund’s audit was completed without problem. 11 Id. at 61. Even after this call was made, however, Schilling continued to have discussions with investors about investigating Berger and the Fund, and asked the auditors to investigate the Fund again. Id.
By August of 1999, the gap between the Fund’s purported performance, as reported by Berger, and what the actual performance was had grown to $367 million. A month later, the gap was at nearly $399 million. By the time of the last transfers, in mid-December, the gap stood at more than $423 million. Bear Stearns’ internal risk reports show an increase of concern about the Fund during November 1999 and the Fund received margin calls from Bear Stearns on almost a daily basis. “By late 1999” Bear Stearns raised the margin requirement on the Fund from 35% to 50%. 12 When the Fund continued to lose money and with one stock comprising 70% of the portfolio, an email to members of Bear Stearns’ risk department suggested that the Fund’s position “necessitates higher requirements than 50%.” 13
After another incidеnt Bear Stearns finally took steps to determine what was really going on. In December of 1999, Schilling, while attending a meeting on unrelated business, spoke with Mark Nichols, a former third-party marketer for the Fund, and was told about the termination of Nichols’ relationship with Berger and
Schilling requested, and “someone from Bear Stearns’ compliance or margin departments contacted two credit bureaus to inquire as to whether the Fund had relationships with other broker/dealers on the street, but they were only able to verify that thе Fund had a relationship with one other broker-a delivery versus payment account held with an executing broker.” Bear Stearns Memo in Opp. at 66. Then Schilling and one of his colleagues called several other prime brokers to ask whether or not they worked with the Fund and of those none did business with the Fund. Id. Thereafter, Schilling brought the Fund to the attention of senior management at Bear Stearns and met with Richard Lindsey, Co-President of Bear Stearns Securities Corp., bringing him entirely up to speed about the Fund. Id. at 67. At this point, Bear Stearns’ senior officials, including Lindsey, called Berger who responded with the same answer he gave them one-year prior. Id. “When Lindsey asked who the Fund’s other prime brokers were, Berger responded that it was none of Bear Stearns’ business.” Id. Eventually, Bear Stearns obtained the Fund’s financials by signing a confidentiality agreement. Id. After a ten-minute review of the financial statemеnts, the Bear Stearns’ people knew there was a problem. First, a footnote stated that “the activity of the [Fund] was predominantly or primarily exclusive at one prime broker.” 14 Second, the year-end equity disclosed on the financial statements was substantially greater than what Bear Stearns showed. 15
Finally, after a phone call from Deloitte indicating that Deloitte could no longer discuss the Fund, Bear Stearns’ senior management decided to notify the SEC that there was a potential problem with the Fund. Id. at 68. By December 22, the Fund was put on “Closing only” status and asked to leave the firm. 16 The following day, without Berger’s permission, Bear Stearns covered all of the Fund’s remaining open short positions at a realized loss to the Fund of more than $22 million.
It is clear from the record that Bear Stearns was on inquiry notice of Berger’s fraud from December 1998 and throughout the following year. • Basеd upon the information it had, Bear Stearns was required to do more than simply ask the wrongdoer if he was doing wrong.
See Securities and Exchange Comm. v. Credit Bancorp, Ltd.,
Conclusion
For all the reasons set forth above Bear Stearns’ motion for summary judgment is denied. The Trustee’s motion for summary judgment is granted.
SUBMIT AN ORDER CONSISTENT WITH THE FOREGOING.
Notes
. In that opinion the District Court noted
This is the fourth opinion this Court has issued in this case. See Bear, Stearns Sec. Corp. v. Gredd, 01 Civ. 4379(NRB),2001 WL 840187 (S.D.N.Y. July 25, 2001) (granting first motion to withdraw reference for Counts II and III of the complaint) ("Gredd I"); Bear, Stearns Sec. Corp. v. Gredd,275 B.R. 190 (S.D.N.Y.2002) (granting defendant's motion to dismiss Counts II and III) ("Gredd II"); In re Manhattan Investment Fund Ltd.,288 B.R. 52 (denying defendant’s motion for interlocutory appeal of Bankruptcy Court decision denying motion tо dismiss Counts I and IV) (“Gredd III”). The Bankruptcy Court has also issued an opinion in this matter, denying defendant’s motion to dismiss Counts I and IV, which are the counts defendant now seeks to have adjudicated before this Court. See In re Manhattan Investment Fund Ltd.,310 B.R. 500 (Bankr.S.D.N.Y.2002). Moreover, several other Southern District Judges have issued a total of twelve opinions and orders in civil and criminal cases arising out of the same underlying facts.
Id.
at 65;
see also United States v. Berger,
. Paragraph 17 of the Agreement provides, in relevant part, that
You hereby agree to deposit and maintain such margin in any of your margin accounts as Bear Sterns in its sole discretion requires....
Paragraph 4 of the Agreement provides, in relevant part, that
Whenever Bear Sterns, in its sole discretion, considers it necessary for its protection, it may require you, and you hereby agree, to deposit cash or collateral immediately in your account(s) prior to any applicable settlement date in order tо assure due performance of your open contractual commitments.
. Paragraph 3 of the Agreement provides, in relevant part, that
As security for the payment and performance of all your obligations and liabilities to any Bear Sterns entity, each Bear Sterns entity shall have a continuing security interest in all property in which you have an interest held by or through a Bear Sterns entity, including securities, commodity futures contracts....
. Paragraph 3 of the Agreement provides further that,
In addition, in order to satisfy any such outstanding liabilities or obligations, Bear Sterns may, at any time and without prior notice to you, use apply or transfer any such securities or property interchangeable including cash and fully-paid securities.
In addition, paragraph 5 provides in relevant part,
In the event of default, each Bear Sterns entity reserves the right to sell, without prior notice to you, any and all property in which you have an interest held by or through Bear Sterns ... to offset market risk, after whiсh you shall be liable to Bear Sterns for any remaining deficiency, loss....
. The term "margin payment” means, for purposes of the forward contract provisions of this title, payment or deposit of cash, a security or other property, that is commonly known in the forward contract trade as original margin, initial margin, maintenance margin, or variation margin including mark-to-market payments or variation payments.
See
. The defendant in that case, Angelo Haligian-nis, like Berger, also was indicted, fled the jurisdiction and remains a fugitive.
. In 1998, Berger collected nearly $200 million in investment principal, lost more than $197 million in trading while claiming gains of more than $33 million.
. Dan Schechter, Professor of Law at Loyola Law School in Los Angeles, recently commented on the Incomnet decision by observing that "[t]he doctrine of ‘dominion and control ...' is now in a state of hopeless confusion, both inside the Ninth Circuit and among the several circuits.” Dan Schechter, Preference Recipient Has "Dominion” over Funds, Even If Recipient is under Statutory Duty to Transmit the Funds to a Third Party. [In re Incomnet (9th Cir.)], 2006 Com. Fin. News 71 (Sept. 20, 2006).
.
. Note 6 of the Fund's Audited Financial Statements stated that "[a]ll security transactions of the Fund are primarily cleared by one broker which exposes the Fund to credit risk.” See Reynolds Affidavit, Fund Financial Statement, Ex. 93 note 6.
. It is disputed by the Trustee that this call occurred. See Trustee’s Reply Mem. at 22 ("... Mr. Schilling's purported receipt of a call from the auditors reporting the issuance of a clean audit- a call that neither of Mr. Schilling’s contacts at Deloitte has any recollection of making.”) Drawing the inferences in the light most favorable to the non-moving party, for the purpose of these motions, the Court assumes this call did in fact take place.
. See Reynolds Affidavit, Engdall Deposition, Ex. 67 at 29-30.
. See Reynolds Affidavit, Engdall Deposition, Ex. 67 at 192-93.
. See Reynolds Affidavit, Minikes Deposition, Ex. 92 at 62, 84.
. See Reynolds Affidavit, Minikes Deposition, Ex. 92 at 62.
. See Reynolds Affidavit, Arpino Memo, Ex. 73.