The opinion of the court was delivered by: Naomi Reice Buchwald United States District Judge
Adv. Pro. Nos. 01-02606 & 07 Civ. 2511 (NRB)
Before this court is Bear, Stearns Securities Corp.'s ("Bear Stearns") appeal of the Bankruptcy Court's January 9, 2007 Memorandum Decision Denying Defendant's Motion for Summary Judgment to Dismiss and Granting Trustee's Motion for Summary Judgment. The cross motions for summary judgment were addressed to Count I of the complaint brought by the Trustee of the Manhattan Investment Fund (the "Fund"). Gredd v. Bear Stearns Securities Corp. (In re Manhattan Fund Ltd.), 359 B.R. 510 (Bankr. S.D.N.Y. 2007). Count I seeks to avoid $141.4 million of transfers made by the Fund into its margin account at Bear Stearns in the year prior to Fund's bankruptcy.*fn1 The Bankruptcy Court ruled that the transfers should be avoided because (1) the transfers were made with "actual intent to hinder, delay, or defraud the Fund's creditors" as defined by Section 548(a)(1)(A) of the Bankruptcy Code (the "Code"); (2) Bear Stearns was an "initial transferee" under Section 550(a) of the Code; and (3) Bear Stearns failed to prove that it accepted the transfers in good faith under Section 548(e) of the Code. Bear Stearns maintains that each of these findings were erroneous.
For the reasons set forth below, we affirm in part and reverse in part.
As this is the fifth opinion we have issued in this case, we only briefly review the facts.*fn2 The Fund was a hedge fund controlled by Michael Berger, whose strategy of short selling technology stocks in the late 1990s, was financially disastrous.*fn3 Berger hid the losses -- which eventually totaled $394 million -- by fraudulently representing that the Fund was profitable. Concealing the Fund's status from its brokers, auditors, and other service providers, Berger persuaded new individuals to invest and paid off old investors with newly acquired funds.
The Prime Broker Relationship
Bear Stearns served as the Fund's prime broker. In that capacity, it facilitated the Fund's short selling activities by borrowing stocks from third parties, selling them for the Fund, and placing the proceeds in a "short account" which credited the proceeds to the Fund. See Appx. to Def. Br. at A656 (Expert Rep. of Michael T. Curley). To close out its short positions, the Fund would direct Bear Stearns to repurchase the stocks and return them to the lenders. However, because Bear Stearns had originally borrowed the stocks, it was the party that had the obligation to return the stocks while the Fund had open short positions. As a result, if the Fund failed to cover, Bear Stearns was itself exposed to a loss.
To support its trading activity, in addition to the short account, the Fund was required to keep a separate "margin account" at Bear Stearns, which is the account at issue in Count I and herein. Under Regulation T of the Board of Governors of the Federal Reserve Board ("Regulation T"), the Fund was required to deposit into this account 50% of the value of any short positions that were opened on a given day -- this is referred to as the "initial federal margin requirement." See id. at A655. In addition, Bear Stearns had its own "house" margin requirement of 35%, referred to as a "maintenance margin requirement."*fn4 This requirement meant that the Fund was obligated to maintain an amount equal to 35% of the value of its open short positions on deposit in its margin account at Bear Stearns at all times. During the year preceding the Fund's bankruptcy, the Fund transferred $141.4 million into this account to support its trading activity. Some of this amount was presumably transferred into the account to enable the Fund to establish new short positions and some of this amount was transferred to meet margin calls made by Bear Stearns to ensure compliance with its maintenance margin level.
The account agreement between Bear Stearns and the Fund contained provisions designed to protect Bear Stearns from the risk associated with the stock loans it made to the Fund. In addition to giving Bear Stearns a security interest in the money in the margin account, the agreement allowed Bear Stearns to:
1) Set any level of maintenance margin for the account;*fn5
2) Prevent the Fund from withdrawing money from its account while there were open short positions supported by the account; and
3) Use the funds in the account to liquidate the Fund's open short positions, with or without the Fund's consent.
SEC Rule 15c3-3 also applied to the arrangement between Bear Stearns and the Fund. It precluded Bear Stearns from using any monies in the account for purposes unrelated to the Fund's trading. See 17 C.F.R. § 240.15c3-3-(e)(2). It is undisputed that at all times Bear Stearns acted in accordance with the account agreement and SEC Rule 15c3-3.
Bear Stearns's Inquiry Into Berger's Fraud
Turning to the facts related to the notice Bear Stearns received about Berger's fraud and to Bear Stearns's response, we note at the outset that there is no suggestion that Bear Stearns had actual knowledge of or was a participant in Berger's fraud. The first inkling that there might be an issue with the Fund came in December 1998 when Fredrick Schilling, a Senior Managing Director at Bear Stearns had a conversation at a cocktail party with an individual from European Investment Management (EIM) who stated that the Fund was reporting a 20% profit for the year. Appx. to Def. Br. A971 (Dep. of Fredrik Schilling). At that time, Schilling believed the Fund was losing money and thus asked the individual to have his boss at EIM call Schilling the next day. The next day, Schilling received a call from Arpad Busson of EIM, who asked if the Fund's reported performance corresponded to Bear Stearns's records.*fn6 Id. at A1295-96 (Dep. of Arpad Busson). That same day, Schilling also discussed the matter with others at Bear Stearns and was told that the Fund was indeed losing money. In fact, the Fund had lost between $150 and $200 million in 1998 alone.*fn7 See Appx. to Pl. Br. A773-74 (Dep. of John Callanan).
After the call with Busson and internal discussions, Bear Stearns arranged a call with the Fund's introducing broker -- Financial Asset Management -- and Berger himself. Berger said that the discrepancy between the losses sustained in the Bear Stearns account and the Fund's reported performance was due to the fact that the Fund used as many as eight other prime brokers to carry out its investment activities. Appx. to Def. Br. A994 (Dep. of Fredrik Schilling).
While Bear Stearns apparently viewed Berger's explanation as reasonable, it nevertheless did not cease its inquiry into the Fund's activities. Bear Stearns contacted the Fund's administrator to make sure that it was receiving the Fund's daily trading activity reports produced by Bear Stearns. Id. at A1032. Schilling also contacted the Fund's auditor, Deloitte & Touche, to inform it of the inquiry into the Fund's performance and of Berger's explanation. Schilling also asked "Deloitte to be keen and careful with respect to the Fund's upcoming audit." Def. Br. at 36 (citing Appx. to Def. Br. A976 (Dep. of Fredrick Schilling)).
Months later, Schilling met Busson at a conference and was told that because Berger refused to release the Fund's financial information -- including the list of prime brokers being used by the Fund -- to EIM without a confidentiality agreement, EIM was in the process of redeeming its clients' investments in the Fund. Appx. to Def. Br. A1051-52 (Dep. of Fredrick Schilling). According to Bear Stearns, it was informed by Deloitte in the spring of 1999 that the Fund's audit had occurred without issue and that the Fund was in good standing.
In the fall of 1999, Schilling continued to have discussions with industry contacts about the Fund and also spoke with another Deloitte auditor to urge caution. By November 1999, Bear Stearns was making margin calls to the Fund almost daily and was considering raising the Fund's maintenance margin requirement. See Appx. to Pl. Br. A450-51, A592 (Dep. of Christopher Engdall). In December, a series of incidents led Bear Stearns to have renewed concerns about the accuracy of Berger's story.*fn8 Thus, Bear Stearns ran a credit check -- which did not show more than one prime broker -- and called a number of other prime brokers and learned that they had no relationship with the Fund. Id. at 1085-86. After accepting a confidentiality agreement, Bear Stearns was able to obtain the Fund's financial statements, which revealed that the Fund had only one prime broker. See id. at 1091. Bear Stearns then reported the Fund to the SEC, marking the beginning of the end for the Fund.
Our jurisdiction to hear this appeal of the Bankruptcy Court's order derives from 28 U.S.C. § 158(a).*fn9 We review the Bankruptcy Court's order of summary judgment de novo. Shimer v. Fugazy (In the Matter of Fugazy Express, Inc.), 124 B.R. 426, 430 (S.D.N.Y. 1991); see also Adelphia Business Solutions, Inc. v. Abnos, 482 F.3d 602, 607 (2d Cir. 2007). Summary judgment is appropriately granted to a party if "there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law."*fn10 Fed. R. Civ. P. 56(c); Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248 (1986); see also Celotex Corp. v. Catrett, 477 U.S. 317, 322 (1986). Thus, the Bankruptcy Court's ruling should be affirmed if, based on the evidence, a reasonable jury would have to conclude (1) that the transfers into the Bear Stearns account were made with "actual intent to hinder, delay, or defraud the Fund's creditors" as required by Section 548(a)(1)(A) of the Bankruptcy Code; (2) that Bear Stearns was an "initial transferee" under Section 550(a) of the Bankruptcy Code; and (3) that Bear Stearns did not accept the transfers in good faith. In making these determinations, we are required to "resolv[e] all conflicts in the evidence and draw all reasonable inferences in favor of" Bear Stearns.
Cuevas v. Hudson United Bank (In re M. Silverman Laces, Inc.), No. 01 Civ. 6209 (DC), 2002 WL 31412465, at *3 (S.D.N.Y. Oct. 24, 2002).
I. Actual Intent to Defraud
The Bankruptcy Code allows a Trustee to avoid certain types of transfers made by the debtor prior to the bankruptcy filing in order to return assets to the estate for the benefit of its creditors. See Christy v. Alexander & Alexander of NY, Inc. (In re Finley, Kumble, Wagner, Heine, Underberg, Manley, Myerson & Casey), 130 F.3d 52, 55 (2d Cir. 1997). The Trustee maintains that the transfers at issue here should be found to be fraudulent transfers. As the Bankruptcy Court explained below:
Specifically, section 548 of the Bankruptcy Code provides for the avoidance of any transfer of an interest in property made by the debtor in the year prior to the filing of its bankruptcy petition as a fraudulent conveyance provided that the transfer was made with an actual fraudulent intent or with the badges of fraud constituting constructive fraud of the debtor's creditors.
In re Manhattan Fund Ltd., 359 B.R. at 516 (citing 11 U.S.C. § 548(A) and (B)). More specifically, section 548(a)(1), mandates that in order for a transfer to be avoided, it must be made "with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted." 11 U.S.C. § 548(a)(1)(A).
In the decision below, the Bankruptcy Court held that the transfers at issue here fell squarely within the "actual fraud" provision because the Fund was a Ponzi scheme. In such a scheme, money from new investors is used to pay artificially high returns to earlier investors in order to create an appearance of profitability and attract new investors so as to perpetuate the scheme. See In re Manhattan Fund Ltd., 359 B.R. at 517 (citing Hirsch v. Arthur Andersen & Co., 72 F.3d 1085, 1088 n. 3 (2d Cir. 1995)). There is a general rule -- known as the "Ponzi scheme presumption" -- that such a scheme demonstrates "actual intent" as matter of law because "transfers made in the course of a Ponzi scheme could have been made for no purpose other than to hinder, delay or defraud creditors." In re Manhattan Fund Ltd., 359 B.R. at 517-18; see also Drenis v. Haligiannis, 452 F. Supp. 2d 418, 429 (S.D.N.Y. 2006) (citing cases). The Bankruptcy Court found that the "Ponzi scheme presumption" applied in this case because Berger collected millions in new investments and reported profits even as the Fund was losing huge amounts of money.*fn11
The Bankruptcy Court also relied on the fact that Berger pled guilty to securities fraud and on our earlier description of the fraud as a "massive Ponzi scheme." See In re Manhattan Fund Ltd., 359 B.R. at 518.
Bear Stearns first argues that the transfers cannot be fraudulent transfers because "they did not place assets outside the reach of creditors." Def. Br. 44. Second, Bear Stearns argues that the Bankruptcy Court erred by applying the "Ponzi scheme presumption" as a matter of law. Finally, Bear Stearns disputes that a Ponzi scheme existed as a matter of fact. We discuss each of these arguments seriatim.
A. Harm to the Fund's Creditors
In arguing that the transfers do not fall under § 548(a)(1)(A) because they did not remove assets from the reach of creditors, Bear Stearns relies on our prior decision in Gredd I, which addressed § 548(a)(1)(A) in the context of Bear Stearns's motion to dismiss Counts II and III of the complaint. In Count II, the Trustee sought to avoid as fraudulent transfers the proceeds of the short sales of the securities which Bear Stearns loaned to the Fund and, in Count III, the Trustee sought to recoup as fraudulent transfers the amounts the Fund paid to Bear Stearns to repurchase the securities and close its positions. The issue presented in Gredd I was whether these funds constituted "an interest of the debtor in property" within the meaning of § 548(a)(1)(A). We concluded that a definition of property that "requires the fraudulent transfer to have actually harmed at least one creditor" best served the purpose of the Bankruptcy Code. Gredd I, 275 B.R. at 195. Thus, we concluded that "§ 548(a)(1)(A) only permits a trustee to avoid a transfer of an interest of the debtor in property when, but for the transfer, such property interest would have been available to at least one of debtor's creditors." Id. at 196. Applying these principles, we found the short-sale trading funds were never available to the Fund's creditors because of Regulation T, which required Bear Stearns to maintain the proceeds of the short sales on deposit in the short account at all times. Id. at 197-98 (noting that the Count II money "remain frozen and in the control of Bear Stearns so that it would be available to repay Bear Stearns's loan"). Here, Bear Stearns argues that: "Just as the securities and funds in Counts II and III cannot be fraudulent transfers because they were never available for creditors, the funds in Count I (the Deposits) cannot be fraudulent transfers because they were equally available for creditors before and after they were made." Def. Br. 45 n. 121.
The facts do not support Bear Stearns's analogy: the funds at issue here were not "equally" available before and after each transfer. These transfers moved money from the Fund's account at the Bank of Bermuda to the margin account at Bear Stearns. Moreover, once the instant funds were transferred into the Bear Stearns account, the transfers were subject to numerous conditions that essentially wrested control of the money from the Fund, and by extension, its creditors. Bear Stearns had a security interest in the account's contents, Bear Stearns could prevent the Fund from withdrawing money as long as short positions were open, and Bear Stearns could actually use such monies to close out the Fund's short positions if it so decided. While the question of whether this gave Bear Stearns requisite control as an "initial transferee" is discussed infra, the powers vested in Bear Stearns through the account agreement clearly demonstrate that the Fund did not have access to its deposits once it placed them in the Bear Stearns account. Thus, Bear Stearns's (and the amici curiaes') argument that the transfers did not remove assets from the reach of creditors must be rejected.
The accounts involved are analytically and practically distinct in another way as well. It is not the case here -- as it was with the monies at issue in Counts II and III -- that the monies were never available to the Fund's creditors. The monies sought in Count II were the deposited proceeds from the initial short sales of borrowed stock, and the monies sought in Count III were those proceeds plus other deposited funds that were eventually used to purchase the equivalent securities to close out the short positions.*fn12 In contrast, the transfers at issue here came entirely from the Fund's capital reserves (since Berger used new investments to support his short selling activities at Bear Stearns). Thus, the funds used in the transfers were the contributions of creditors and once a transfer occurred, those contributions were no longer accessible to ...