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SECURITIES INVESTOR PROTECTION CORP. v. EXECUTIVE

November 29, 1976.

Securities Investor Protection Corporation
v.
Executive Securities Corporation; Securities and Exchange Commission v. Executive Securities Corporation.



The opinion of the court was delivered by: TENNEY

TENNEY, District Judge: This is an appeal from the order of the Honorable John J. Galgay, Bankruptcy Judge, dated February 23 and filed February 24, 1976, jurisdiction in this Court being based on Section 39c of the Bankruptcy Act, 11 U.S.C. § 67(c) and Part VIII of the Bankruptcy Rules. The issue presented is whether Shearson Hayden Stone, Inc. and Yale University (referred to collectively herein as "claimants") are "customers" of Executive Securities Corporation ("Executive") within the meaning of the Securities Investor Protection Act of 1970 ("SIPA"), 15 U.S.C. §§ 78aaa et seq., and therefore entitled to the preferential treatment afforded to "customers" thereunder, or whether they are instead to be treated as general creditors of Executive.

The Bankruptcy Court made the following findings. Claimants, neither of whom maintained an account with Executive, were lenders of securities to Executive. In return, they received cash "collateral" equal to 100 percent of the market value of the securities on the day the securities were lent. The securities lent had not been purchased through Executive. Yale's loan was pursuant to a written agreement with Executive, called a "Security Loan Agreement"; Shearson's loan was pursuant to an oral agreement which did not vary in any material respect from the terms of Yale's agreement.

Transactions of this sort enable lenders such as claimants to increase their income by investing the cash collateral received from the broker in other income-producing investments (while at the same time the lender continues to receive payments from the broker equal to the dividends and any other distributions declared with respect to the loaned securities) (paragraph 5 of the Yale agreement). The benefit the lender hopes to derive is thus based on some later transaction concerning the cash which may not even involve the securities markets. From the point of view of a broker such as Executive, transactions of this sort enable it to obtain securities that it needs to meet various commitments, including covering short sales by its customers and fulfilling delivery commitments when its customers fail to make timely delivery of securities which they have sold.

 No interest was paid under the agreements, and the loans could be terminated upon short notice by either party. Each party to the loans had the right to "mark to market"; that is, upon one day's notice, claimants could demand additional cash collateral to the extent that the loaned securities increased in value, and Executive could demand a return of the cash collateral to the extent that the loan securities decreased in value. Claimants were therefore entitled to 100 percent collateral on their loans of securities, and, as Judge Galgay recognized, any loss they ultimately suffered relates to their failure to monitor the value of the loaned securities and insist upon additional cash collateral.

 Claimants had the right under their agreements to treat the loan as terminated in the event that proceedings were commenced by or against the borrower under, inter alia, SIPA (paragraph 4 of the Yale agreement). Claimants could then treat the loaned securities as having been purchased by the borrower and could retain out of the collateral an amount equal to the last sales price of the securities prior to the commencement of such proceedings (paragraph 4 of the Yale agreement).

 Yale claims that Executive owes it $66,700 - the difference between the $200,000 collateral it retained and the $266,700 value of the securities it loaned, as computed by Yale as of February 14, 1975 when liquidation proceedings were commenced against Executive. Shearson claims $38,000 in connection with its loans.

 In the order appealed from, Judge Galgay held that claimants' loans were not entitled under SIPA. Mr. Lubin argued that since he had made a loan of securities (which had been reflected in his account), he came within the language of SIPA and was entitled to its protection. Although the court recognized that "[in] the literal sense, that is what happened," that fact was not deemed sufficient or dispositive. Id. at 282.

 The court analyzed the legislative history of SIPA and concluded that only loans made by a customer in connection with trading through the broker being liquidated were meant to be protected as "customer" loans to that broker under that Act. Id. at 282-83. It noted that the House Report on the bill stated the bill's main purpose as protection of persons who deal in securities through a broker when that broker faces financial difficulties, and pointed out that the testimony on the bill corroborated the conclusion that it was the trading customer who was to be protected by SIPA. Id. at 283. The court further observed that "[there] was no actual or likely use of the shares as collateral for margin purposes by Lubin of other securities.... [There] was no reasonable expectation that the shares would be sold for Lubin's account in the near future." Id. at 284. The court then concluded that Mr. Lubin's loan did not have "the indicia of the fiduciary relationship between a broker and his public customer, but rather [had] the characteristics of, at most, an ordinary debtor-creditor relationship." Id. *fn1" Accordingly, the court held that

 Because [Mr. Lubin's] loan to the broker-debtor had no connection with his trading activity in the securities market, he cannot qualify by virtue thereof as a "customer" entitled to the benefits of the Securities Investor Protection Act. Id.

 Claimant Yale's brief advances two grounds for distinguishing the Baroff case. First, it argues that claimants' loans were related to their investment in the securities market because they received collateral in return for their loans, whereas the lender in Baroff did not receive consideration for his loan. (Yale's Brief at 36-37.) But the mere receipt of money in return for the use of securities does not provide the requisite connection between the loan of securities and trading activity. Claimants purchased securities elsewhere before loaning them to Executive; their claims fail, not because they are not investors in the securities market, but because their securities were not lent in connection with trading or investment through Executive.

 Claimant Yale's second ground for distinguishing the Baroff case is that because the lender in Baroff did not receive consideration for the loan, he made a contribution to capital, a transaction which is specifically excluded from SIPA's definition of "customer." Id. at 35. The court in Baroff, however, considered that argument and refused to base its holdings upon it. Baroff, supra, 497 F.2d at 284. Thus, this distinction is without merit.

 Claimants further suggest that their transactions fall squarely within the transactions listed in Section 6(c)(2)(A)(ii) of SIPA, 15 U.S.C. § 78fff(c)(2)(A)(ii), claiming that such provisions must be read literally. The Second Circuit rejected any such literal reading in Baroff. Indeed, even were SIPA read literally, a "customer" is clearly limited to persons who maintain accounts with a broker-dealer and who trade or invest through them. *fn2" Claimants had no account with Executive and clearly do not come within SIPA's definition of the word "customer." Nor would claimants have been protected by opening a nominal trading account, unless the loan was in connection with that account. As indicated above, the claimant in Baroff did have an account with the debtor, although it was not a "live" account at the time of the loan. However, what claimants might have done has no bearing on the issue; they did not in fact have accounts with Executive.

 Finally, claimant Yale makes reference to the legislative history of Section 60e of the Bankruptcy Act, 11 U.S.C. § 96(e), since SIPA's definition of "customer" was taken virtually verbatim from the definition contained in Section 60e. However, there is nothing in the legislative or legal history of Section 60e that suggests that it was intended to do more than eliminate the inequities among cash and margin customers arising from conflicting treatment in different jurisdictions and to provide protection to such customers who made loans of securities to brokers in connection with their participation in the securities markets and out of their trading accounts. There is nothing to suggest that Congress was concerned with broadening the protection that parties to secured loan agreements, such as those involved herein, would receive. Nor are there persuasive policy reasons to give special protection to securities lenders such as claimants. Indeed, they already enjoy greater protection than normal secured creditors, not only because their collateral is fully liquid cash, but also because of their right to demand additional to the protection given to "customer" claims under SIPA because the loans were not incidental to an existing investment or trading account with Executive. In so holding he relied principally on the opinion of the United States Court of Appeals for the Second Circuit in SEC v. F.O. Baroff Co., Inc., 497 F.2d 280 (2d Cir. 1974), in which, after analyzing the legislative history of SIPA, the court held that a lender of stock was not entitled to "customer" protection where the loan was not made in connection with investment or trading activity with the broker. Judge Galgay explained that "[here] the relationship between the named parties is even clearer" since, unlike the Baroff claimant, claimants did not invest or trade in securities through Executive and did not even have an account with Executive. (Opinion of Judge Galgay dated Feb. 23, 1976, at 6-7.) Accordingly, he affirmed the trustee's determination that claimants were to be treated as general creditors of Executive and not as "customers" within the meaning of SIPA. Id. at 7-8.

 Examination of the cases interpreting SIPA and its legislative history, the text of SIPA and Section 60e of the Bankruptcy Act, 11 U.S.C. § 96(e), from which it was derived, each confirms the correctness of Judge Galgay's conclusion that persons such as ...


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