Bloomberg News

Supreme Court Opinion Doesn’t Help Madoff Trustee: Bankruptcy

March 03, 2014

The Bernard Madoff trustee, who will try to reinstate hundreds of lawsuits through an appeal to be argued March 5 in Manhattan, had his chances of success dealt a blow last week when the U.S. Supreme Court decided a case involving R. Allen Stanford’s Ponzi scheme.

Madoff trustee Irving Picard is appealing a federal district court decision barring him from suing to recover transfers made more than two years before bankruptcy. Were Picard to succeed on appeal, he might eventually be able to pay defrauded customers in full. Customers’ recoveries currently are in the 56 percent range.

In last week’s decision, called Chadbourne & Parke LLP v. Troice, the Supreme Court ruled in favor of defrauded customers, allowing them to sue firms and individuals who helped sell Stanford’s fraudulent securities. At first blush, Troice seems to help the Madoff trustee because the high court allowed defrauded investors to sue. Looking at the Troice opinion in detail, though, it’s at best unhelpful for Picard and customers who are suing third parties to recover their losses.

The issue in the Madoff case is the so-called safe harbor in Section 546 of the Bankruptcy Code, which bars some types of suits when they involve transactions in securities. Picard contends the safe harbor doesn’t apply because Madoff never bought a single security with customers’ money.

Troice didn’t deal with the safe harbor. Instead, it turned on the 1998 Securities Litigation Uniform Standards Act, or SLUSA. That statute bars class suits under state law based on a misrepresentation “made in connection with a prior sale of a covered security.” A “covered security” is defined as a security traded on a national exchange.

In the Troice case, Stanford sold investors certificates of deposit issued by an offshore bank. The customers were told the bank would use their money to invest in covered securities.

The U.S. Court of Appeals in New Orleans allowed the Stanford suit to proceed because the customers bought certificates of deposit, which aren’t covered securities.

The Madoff and Stanford cases are similar in that customers’ money wasn’t used to purchase securities. Unfortunately for the Madoff trustee, the Supreme Court’s rationale for allowing the Stanford suits to proceed isn’t helpful.

The Supreme Court said SLUSA didn’t apply to Stanford because “no person actually believed he was taking an ownership position” in a covered security. With Madoff, the customers were told they were buying covered securities, and that’s what their fictitious account statements showed. Indeed, the district judge said the safe harbor was applicable because investors believed they were buying securities.

The Troice decision is possibly the death knell for a lawsuit by investors in feeder funds who in turn invested with Madoff. The investors contend JPMorgan Chase & Co. (JPM:US) and Bank of New York Mellon Corp. (BK:US) were aware of Madoff’s fraud and should be held liable because they continued to provide him with banking services. The district court dismissed the suits under SLUSA.

In September, a three-judge panel of the U.S. Court of Appeals in New York invoked SLUSA and upheld dismissal. The investors sought a rehearing by all active judges on the court.

In October, the appeals court said a decision on rehearing would await the Troice decision. Now that the Supreme Court said that SLUSA applies if investors thought they were buying covered securities, Troice suggests Madoff investors have slim a chance of winning rehearing and having their suits reinstated.

During oral argument in the Supreme Court in October in the Troice case, the justices several times asked questions showing an awareness that their ruling would affect Madoff cases working their way up the appellate ladder, in which judges said the ability to sue was curtailed by SLUSA.

This week’s appeal by Picard primarily involves the safe harbor, not SLUSA. The trustee wants the appeals court to focus on how investors’ money was actually invested, not what they were told.

Picard could argue that Troice has no bearing on his appeal because his issue is governed by the safe harbor, where courts may not give the same definition to securities as in SLUSA. He also can contend that just as customers’ expectations about buying securities didn’t carry the day in Troice, they shouldn’t govern in the Madoff case, where no securities ever were bought.

The Madoff firm began liquidating in December 2008 with the appointment of Picard as trustee under the Securities Investor Protection Act. Madoff individually went into an involuntary Chapter 7 liquidation in April 2009, and his case was later consolidated with the investment firm’s liquidation.

He’s serving a 150-year prison sentence following a guilty plea. So far, Picard has recovered about $9.5 billion, or some 56 percent of customers’ investments.

The Supreme Court decision is Chadbourne & Parke LLP v. Troice, 12-00079, U.S. Supreme Court (Washington). Picard’s appeal to be argued this week is Picard v. Ida Fishman Revocable Trust (In re Bernard L. Madoff Investment Securities LLC), 12-02557, U.S. Court of Appeals for the Second Circuit (Manhattan). The Madoff appeal up for rehearing in the circuit court is Trezziova v. Kohn (In re Herald, Primeo, and Thema), 12-00156, U.S. Court of Appeals for the Second Circuit. The Madoff liquidation in bankruptcy court is Securities Investor Protection Corp. v. Bernard L. Madoff Investment Securities LLC, 08-bk-01789, U.S. Bankruptcy Court, Southern District of New York (Manhattan). The criminal case is U.S. v. Madoff, 09-cr-00213, U.S. District Court, Southern District of New York (Manhattan).

Lehman Repo Customers Don’t Have Customer Claims

Creditors holding repurchase agreements with the brokerage subsidiary of Lehman Brothers Holdings Inc. don’t have customer claims, according to a Feb. 26 ruling by U.S. District Judge Denise Cote upholding a June opinion by the bankruptcy judge.

The opinion was in a test case involving Hudson City Savings Bank and the Federal Deposit Insurance Corp. as receiver for a failed bank, among others. The outcome is important because customers of the Lehman brokerage are being paid in full. With nothing other than general unsecured claims, parties to repurchase agreement may never receive anything.

James Giddens, the trustee for the Lehman brokerage liquidating under the Securities Investor Protection Act, prevailed in his argument that the creditors didn’t have any securities held by the Lehman broker at the time of bankruptcy and therefore don’t have customer status.

From Lehman’s point of view, the transactions were so-called reverse repos, with the creditors delivering securities to Lehman under an agreement where they were obligated to repurchase the securities at a later date at a specified price. The agreements didn’t require Lehman to hold or segregate the securities. Lehman was allowed to use the securities for its own purposes until the repurchase date.

Lehman’s right to use the securities as its own was the linchpin to Cote’s decision on Feb. 26. Citing a 1974 case from the U.S. Court of Appeals in New York called Baroff, Cote said that fiduciary relationships with brokers are the indicia of customer claims.

The repo customers had only contractual rights akin to a debtor-creditor relationship, she said, not rights arising from a fiduciary relationship.

Cote said a repo agreement is like a secured loan, not a customer’s claim for securities. If the repo were viewed as a purchase and sale of securities, she said, it was even less like a customer claim with an underlying fiduciary duty.

Similar to former U.S. Bankruptcy Judge James M. Peck’s opinion, Cote said “customer” must be given a narrow interpretation.

Lehman and its brokerage unit began separate bankruptcies in September 2008. The Chapter 11 plan for the Lehman companies other than the brokerage was confirmed in December 2011 and implemented in March 2012, with four distributions since.

The brokerage is being liquidated under the Securities Investor Protection Act. Giddens is yet to make a first distribution to non-customers, although customers are being paid in full.

The repo appeal is Carval Investors UK Ltd. v. Giddens (In Lehman Brothers Inc.), 13-5381, U.S. District Court, Southern District of New York (Manhattan).

The Lehman holding company Chapter 11 case is In re Lehman Brothers Holdings Inc., 08-bk-13555, while the liquidation proceeding under the Securities Investor Protection Act for the brokerage operation is Securities Investor Protection Corp. v. Lehman Brothers Inc., 08-bk-01420, both in U.S. Bankruptcy Court, Southern District of New York (Manhattan).

Dots Secured Lenders Settle with Creditor Committee

Even if the liquidation of retailer Dots LLC doesn’t fully pay secured claims, the lenders agreed to carve out some sale proceeds to pay claims and expenses of the Chapter 11 effort that began Jan. 20.

Last week, the bankruptcy court approved hiring liquidator Gordon Brothers Retail Partners LLC to run going-out-of-business sales at locations operated by the 400-store women’s-wear retailer. The liquidator guarantees Dots will recover 48.5 percent of the retail value of the merchandise, based on an assumption that the inventory ranges between $65 million and $75 million.

After the inventory sells for enough to cover the guaranteed amount, expenses of the sale and a 2 percent fee, Gordon Brothers will share the excess 50-50 with Dots. As a result of an auction, Gordon Brothers increased the guaranteed amount by 8 percent.

Up for approval on March 25 in U.S. Bankruptcy Court in Newark, New Jersey, the settlement bars any preference suits against creditors once financing for the bankruptcy is paid in full. Consequently, suppliers won’t face being called on to give back payments received within 90 days of bankruptcy.

In addition, a fund will be created into which secured creditors will deposit 1.5 percent of sale recoveries of $35 million or less. The percentage grows to 5 percent for recoveries of more than $45 million.

The fund will be used to pay expenses and professional fees in the Chapter 11 case. Once those costs are covered in accordance with priorities in bankruptcy law, the surplus will be available for unsecured creditors. Secured lenders waive deficiency claims they otherwise could make against the fund.

In return for the settlement, unsecured creditors agree not to challenge the validity of secured lenders’ claims.

With stores in 28 states, Dots targeted price-conscious 25-to 35-year-old women. It was acquired in January 2011 by Irving Place Capital Management LP.

Glenwillow, Ohio-based Dots has $36 million in bankruptcy financing from pre-bankruptcy lender Salus Capital Partners LLC. The loan required selling or liquidating the business by early March.

When bankruptcy began, Dots owed Salus $14.5 million on a revolving credit and $16.1 million on a secured term loan. Affiliates of Irving Place were owed $17 million on a second-lien loan.

Dots said there was $47 million in unsecured obligations, including $13.8 million owed to trade suppliers. Sales shrank to an estimated $293.7 million in 2013 from $346 million in 2011, according to a court filing.

The bankruptcy petition showed assets of less than $50 million and liabilities under $100 million.

The case is In re Dots LLC, 14-bk-11016, U.S. Bankruptcy Court, District of New Jersey (Newark).

Milwaukee Church Wins Appeal on Sexual-Abuse Claims

Using the Archdiocese of Milwaukee as a backdrop, the U.S. Court of Appeals in Chicago wrote an opinion last week that reads like a treatise on when a settlement can be revoked years later on the grounds of fraudulent inducement.

Although the opinion on Feb. 25 by U.S. Circuit Judge Diane Sykes will aid the archdiocese in reducing sexual-abuse claims and fashioning a plan to exit Chapter 11, last week’s ruling may be less important than two upcoming decisions from the Seventh Circuit appeals court in Chicago.

The Roman Catholic archdiocese filed a petition for Chapter 11 reorganization in January 2011 and filed a proposed Chapter 11 plan in February with $4 million earmarked for abuse victims. The case decided by the appeals court last week involved a claimant who settled his abuse claim in early 2007 for $100,000.

The same claimant filed a claim in the bankruptcy, saying his 2007 settlement should be rescinded because it was procured by fraudulent inducement. He said the church’s negotiator didn’t answer truthfully when asked if there were other allegations of abuse against the same priest.

The bankruptcy judge dismissed the claim without holding a trial and was upheld on a first appeal in federal district court. Sykes reached the same result, although on different grounds.

Sykes said the pivotal question was whether the alleged misrepresentation was “objectively material.” Although the Wisconsin Supreme Court hasn’t written its own opinion on when a misrepresentation induces a settlement, she said the state’s highest court has always followed the Restatement of Contracts, the leading treatise on contract law.

To rescind a settlement for fraud, the Restatement requires showing that the plaintiff actually relied on the misrepresentation and was justified in doing so. In turn, the misrepresentation must “substantially contribute” to the decision to settle, although it need not be the “predominant reason,” Sykes said.

Next, Sykes said a misrepresentation has both objective and subjective elements. She said the abuse claimant couldn’t show it was a “substantial factor” in early 2007 because state law at the time was against him. Consequently, taking $100,000 was principally motivated by adverse state law as it existed then.

Later in 2007, the Wisconsin Supreme Court reversed decisions by lower courts, expanding the ability of plaintiffs to sue for abuse occurring long before the statute of limitations otherwise would have run out.

In the church’s proposed Chapter 11 plan, claimants who settled before bankruptcy would have no new claims. Last week’s decision will aid the church in knocking out claims settled before July 2007.

There is another and potentially more important case already pending in the Chicago appeals court. It involves a decision by the bankruptcy court saying that Wisconsin law precludes introducing evidence about occurrences in mediation. Should the church win that appeal as well, claimants who already settled will have even more difficulty in showing new and valid claims in bankruptcy.

The Seventh Circuit will soon hear argument on another appeal, dealing with $55 million allegedly transferred to a cemetery trust to evade sexual-abuse claims. The $55 million would be the single largest source of recovery. The district court held that claimants are barred from clawing back the money.

For discussion of the archdiocese’s Chapter 11 plan, click here for the Feb. 13 Bloomberg bankruptcy report.

When the Roman Catholic archdiocese filed a petition for Chapter 11 reorganization in January 2011, it was the eighth diocese to seek bankruptcy protection from sexual-abuse claims. The Milwaukee church listed assets of $98.4 million and total liabilities of $35.3 million.

The Chapter 11 case is In re Archdiocese of Milwaukee, 11-bk-20059, U.S. Bankruptcy Court, Eastern District of Wisconsin (Milwaukee).

Peabody Hotel’s Belz Sets Hearing for Plan Approval

Martin S. Belz, president and chairman of Peabody Hotel Group, is hoping to emerge from his individual Chapter 11 case shortly after an April 16 confirmation hearing for approval of his plan.

Belz filed a petition for Chapter 11 protection in late December in Memphis, Tennessee, his hometown, after a creditor attached securities accounts. The plan up for approval in April is supported by more than two-thirds of creditors, whose claims total $84.7 million.

A hotelier and real-estate developer, Belz listed assets valued at $58.9 million in disclosure material explaining the plan. The disclosure statement was approved last week, allowing creditors to vote on the plan.

Guarantees that are only contingent, because there hasn’t been a default to touch off his individual liability, will remain in place.

Creditors holding guarantees where there has been a default are to receive 40 percent of their claims in cash.

Peabody is a division of Belz Enterprises Inc., the owner of more than 25 million square feet of developed real property, according to a company website. The Peabody Hotel in Memphis achieved notoriety for the Peabody ducks, who parade to and from a lobby fountain each day.

The case is In re Martin S. Belz, 13-bk-33888, U.S. Bankruptcy Court, Western District of Tennessee (Memphis).

Active Boarder is Approved to Buy Altrec in Oregon

Altrec Inc., an Internet retailer of outdoor apparel and equipment, won authority last week from the bankruptcy court in Portland, Oregon, to sell the business for $3.25 million to Active Boarder Corp.

There was no competing bidder, so an auction was canceled.

The company filed for Chapter 11 protection in early January. Active Boarder became the so-called stalking horse when Remington Outdoor Co. canceled an agreement to buy the business at the same price.

The contract calls for the bankrupt estate to retain $250,000, with the remainder going to secured creditors.

Remington provided bankruptcy financing and got the right to recover as much as $250,000 in expense reimbursement in return for continuing to provide the loan.

Redmond, Washington-based Altrec generated $59 million in sales on its Altrec.com website in 2011. Revenue fell after a denial-of-service cyber attack during the 2011 Christmas season and a possible theft of customer information by a hacker.

Altrec owed $5.7 million to secured lenders.

Altrec had revenue of $20.1 million during the first 11 months of 2011, producing a net loss of $5.1 million. Assets are on the books for $5.7 million against debt totaling $24.2 million.

The case is In re Altrec Inc., 14-bk-30037, U.S. Bankruptcy Court, District of Oregon (Portland).

Nirvanix Liquidating in Chapter 7 After Settlement

Nirvanix Inc., a cloud-based data-storage provider, had its Chapter 11 case converted to liquidation in Chapter 7 on Feb. 27, one month after the U.S. Bankruptcy Court in Delaware approved a settlement with secured lenders creating a trust exclusively for unsecured creditors.

The company and creditors concluded there was no ability to cobble together even a liquidating Chapter 11 plan. In the settlement, the lenders set aside between $100,000 and $200,000 for the trust.

The lenders, who got potential lawsuits as some of their collateral, also turned the suits over to the creditors for them to prosecute. On account of their deficiency claims, the lenders won’t participate in what the trust collects.

In November, Nirvanix won court approval to sell intellectual property to Acme Acquisition LLP for $2.8 million in cash, plus assumption of specified liabilities.

San Diego-based Nirvanix submitted official lists showing assets with a value of $4.2 million and debt totaling $25.1 million, including $23.4 million in secured debt.

Venture-capital investor Khosla Ventures IV LP owned more than 70 percent of the preferred stock, along with 15.5 percent of the common stock.

A venture-capital unit of Intel Corp. held more than 20 percent of the common stock and some of the preferred equity. Valhalla Partners II LP owns about 25 percent of the common stock, and Mission Ventures III LP has about 24 percent.

The case is In re Nirvanix Inc., 13-bk-12595, U.S. Bankruptcy Court, District of Delaware (Wilmington).

Bianchi Orchards System Converting to Liquidation

Bianchi Orchard Systems Inc. didn’t last long in Chapter 11.

The producer of harvesting equipment filed a Chapter 11 reorganization petition on Jan. 29 in Sacramento, California, and submitted papers last week voluntarily converting the reorganization to liquidation in Chapter 7 where a trustee will be appointed to sell the assets.

The petition listed assets of $6.1 million and liabilities totaling $6.5 million, including $2.67 million of secured debt.

The case is In re Bianchi Orchard Systems Inc., 14-20795, U.S. Bankruptcy Court, Eastern District California (Sacramento).

New Filing

Smoky Shadows Conference Center Back in Chapter 11

Smoky Shadows Motel, Tower & Conference Center near an entrance to the Great Smoky Mountain National Park is back in Chapter 11, once again in Knoxville, Tennessee.

The property filed for Chapter 11 reorganization originally in May 2011. The owners kept control by confirming a plan in March 2012 where the mortgage was recast and unsecured creditors were to be paid fully in installments over two years.

The hotel went back into Chapter 11 on Feb. 26, this time listing assets of $11.4 million and debt totaling $8.7 million. Secured claims aggregate $7.5 million, according to court papers.

The property generated $1.4 million of revenue in a year ended March 2013. From April 2013 until now, revenue was $940,000.

The new case is In re Smoky Mountain Motels Inc., 14-30557, U.S. Bankruptcy Court, Eastern District Tennessee (Knoxville). The prior case was In re Smoky Mountain Motels Inc., 11-32571, U.S. Bankruptcy Court, Eastern District Tennessee (Knoxville).

To contact the reporter on this story: Bill Rochelle in New York at wrochelle@bloomberg.net.

To contact the editor responsible for this story: Andrew Dunn at adunn8@bloomberg.net.


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