Debtor's 'Stock Loan' Lending Program Transfers Not Fraudulent Conveyances

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By  Diane Davis

A district court did not err in affirming the bankruptcy court's determination that a debtor's transfer of assets into brokerage accounts at Wachovia through a “stock loan” lending program, and the payment of commissions, fees, and margin interest to Wachovia were not fraudulent conveyances under Bankruptcy Code Sections 544 and 548, the U.S. Court of Appeals for the Fourth Circuit held May 24 (Grayson Consulting Inc. v. Wachovia Securities LLC (In re Derivium Capital LLC), 4th Cir., No. 12-1518, 5/24/13).

Affirming the district court's judgment, Judge James A. Wynn Jr. concluded that (1) $161 million in securities that customers transferred into Wachovia Securities LLC's At-Issue Accounts (Customer Transfers) were not transfers of the debtor's property; (2) Wachovia was not the initial transferee of the cash transfers; (3) the stockbroker defense applied to the commission, fees, and margin interest paid to Wachovia; and (4) in pari delicto barred the appellant's tort claims against Wachovia.

In pari delicto, the court explained, is an affirmative defense that precludes a plaintiff who participated in the same wrongdoing as the defendant from recovering damages from that wrongdoing. Appellant Grayson Consulting Inc.'s status as the trustee's assignee does not afford it protection from the application of in pari delicto, the court said. Further, because Grayson's complaint alleged that the debtor engaged in the alleged torts, Grayson, standing in the shoes of the debtor, is barred from suing Wachovia for those torts, the court concluded. 

'Stock-Loan' Lending Program

Debtor Derivium Capital LLC filed for Chapter 11 protection after the collapse of its “stock loan” lending program, which was alleged to be a Ponzi scheme. Under the debtor's 90 percent Stock-Loan Program, the debtor's customers transferred stocks to the debtor in exchange for three-year non-recourse loans worth 90 percent of the stocks' market values. When the loans matured, the customers had the option of repaying the principal plus interest and recovering the stock, surrendering the stock, or refinancing the loan for an additional term.

Customers participating in the program put their stocks into Wachovia At-Issue brokerage accounts in the debtor's name and also in the names of Bancroft Ventures, Optech Limited, and WITCO Services Ltd. Customers were told that the debtor would hedge their collateral using a confidential, proprietary formula. Instead, the debtor's owners directed Wachovia to immediately transfer the stocks into other accounts and liquidate them. The debtor used the proceeds from the stock sales to fund customers' loans and the debtor's owners' start-up ventures. 

Avoidance Claims

When the debtor had difficulty satisfying its obligations to return customers' stocks when the loan matured, Wachovia closed the At-Issue Accounts, and the debtor filed for Chapter 11 protection. The court later converted the case to Chapter 7 and appointed a trustee. The trustee filed a complaint against Wachovia alleging nine tort claims and two claims under Sections 544 and 548, seeking to avoid and recover three categories of transfers: (1) the customer transfers; (2) the cash transfers; and (3) commissions, fees, and margin interest paid to Wachovia. The trustee subsequently assigned these claims to appellant Grayson Consulting Inc., which was substituted as the plaintiff in December 2007.

The bankruptcy court dismissed the tort claims and the fraudulent conveyance claims initially with leave to amend. Grayson filed second and third amended complaints with the fraudulent conveyance claims.

The bankruptcy court determined that (1) Grayson could not avoid the customer transfers because they were not transfers of debtor property as required by Section 548; (2) Grayson could not avoid the cash transfers because Wachovia was not the “initial transferee” of the assets as required by Section 550; and (3) Wachovia's commissions, margin interest payments, and fees claimed under Section 544 were protected from recovery by the “stockbroker defense” under Section 546, provided they were customary and reasonable in the securities industry, which the court later found to be so.

The district court affirmed. Grayson appealed to the Fourth Circuit, arguing that the district court erred in affirming the bankruptcy court's determinations that (1) the customer transfers were not transfers of debtor property; (2) Wachovia was not the initial transferee of the cash transfers; (3) the stockbroker defense applies to commissions; and (4) the in pari delicto barred Grayson's tort claims against Wachovia. 

'Customer Transfers' Not Transfers of Debtor Property

Grayson argued that when the debtor acquired an interest in the securities through the transfers, Wachovia simultaneously acquired an interest in the securities under the agreements governing the accounts into which the securities were transferred. The appeals court, however, rejected this argument, saying that the transferred securities came to the debtor, not from or through the debtor.

The purpose of the Bankruptcy Code's avoidance provisions is to prevent a debtor from making transfers that diminish the bankruptcy estate to the detriment of creditors, the court explained. There is no dispute that the debtor had no rights to the securities until after the transfers were effectuated. According to the court, the customer transfers at issue in this case were not transfers of debtor property and, thus, the transfers in no way diminished the bankruptcy estate. Thus, the district court did not err in affirming the grant of summary judgment for Wachovia on Grayson's customer transfers claim, the appeals court said. 

Wachovia Not 'Initial Transferee.'

Section 550(a), the court explained, provides that to the extent a trustee may avoid a transfer under the Code, the trustee can recover the fraudulently transferred property from only the “initial transferee.” Although the Code does not define “initial transferee,” the appeals court determined that the correct test is the “dominion and control” test to determine whether an entity qualifies as the “initial transferee.”

Under this test, the court explained, an initial transferee must have legal dominion and control over the property--the right to use the property for its own purpose--and exercise this legal dominion and control. Wachovia neither had nor exercises legal dominion and control over the cash transfers and therefore was not the initial transferee of these funds, the court said. The court also rejected Grayson's argument that Wachovia exercised control by removing from the At-Issue Accounts “commissions, margin interests, and prepayment fees.” 

Settlement Payments Not Within 'Stockbroker Defense.'

Chapter 11 defines “settlement payment” as “a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, or any other similar payment commonly used in the securities trade,” the court explained. Congress amended Section 546(e) in 2006, the court explained, to add settlement payments made to or for the benefit of stockbrokers.

The purpose of Section 546 is to preserve the stability of settled securities transactions, the appeals court explained. Specifically, the purpose behind the provision was “to clarify and, in some instances, broaden the commodities market protections and expressly extend similar protections to the securities market to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries,” the court said. The court also looked to standard practices of the securities industry to inform the definition of “settlement payment.”

According to the court, not all payments to brokers labeled “commissions” are protected as settlement payments under Section 546. The court found that Section 546(e) does not exclude commissions and fees commonly paid to stockbrokers as part of settling a regular securities transaction. Thus, the bankruptcy court did not err in determining that commissions shown to be reasonable and customary parts of settling stocks sales come within the stockbroker defense as “settlement payments,” the court said. 

Margin Payments

Section 741(5), the appeals court explained, defines “margin payment” as a “payment or deposit of cash, a security, or other property, that is commonly known to the securities trade as original margin, initial margin, maintenance margin, or variation margin, or as a mark-to-market payment, or that secures an obligation of a participant in a securities clearing agency.” Like “settlement payment,” courts have interpreted this term broadly, the court said.

The parties agreed that “whether a margin interest payment constitutes a “margin payment” turns on whether it reduces a deficiency in a margin account, the court said. The bankruptcy court determined that because accrued interest increases the total debt owed, margin payments reduce the deficiency in a margin account, and qualify as “margin payments” under Section 546(e). Nothing in the record or the bankruptcy court's reasoning suggests that this was an error, the appeals court said. 

Actual Fraud Question Remains Unanswered

Grayson further argued that the court should find an exception to the stockbroker defense because applying it in the context of an alleged Ponzi scheme would allow “a broker to retain ill-gotten profits” and undermine the “equitable goals of the Bankruptcy Code.”

The appeals court noted that because the district court simply affirmed the bankruptcy court's order, whether Grayson can recover commissions, fees, and margin interest payments under Section 548(a)(1)--upon establishing actual fraud by Wachovia--remains unanswered. 

In Pari Delicto Bars Tort Claims

Finally, the court determined that the district court and bankruptcy court were correct that Grayson's status as the trustee's assignee does not afford it protection from the application of in pari delicto. According to the court, because Grayson's complaint alleged that the debtor engaged in the alleged torts, Grayson, standing in the debtor's shoes, is barred from suing Wachovia for those torts.

The court rejected Grayson's alternative argument that the “adverse interest” exception to in pari delicto applied in this case. Under the “adverse interest” exception, the court explained, the wrongs of an agent are not imputed to the principal if the agent acted adverse to the principal's interests. Grayson contended that because the debtor's owners engaged in the alleged misconduct and their misdeeds were adverse to the debtor, their conduct should not be imputed to it. The appeals court noted, however, that the bankruptcy court rejected this argument on the basis of the “sole actor rule,” which provides that an agent's conduct is imputed to the principal if that agent is the principal's sole representative.

According to the appeals court, Grayson's complaint alleged that the debtor's owners completely controlled the debtor and operated the 90 percent Stock Loan Program. Thus, even under the facts as Grayson alleged them, the debtor's owners were “sole actors.” Their actions can be imputed to the debtor, the court said. Therefore, the district court did not err in affirming the bankruptcy court's ruling that in pari delicto bars Grayson's tort claims against Wachovia, the court said.

Judges Robert B. King and Albert Diaz joined the opinion.

Tucker Harrison Byrd of Morgan & Morgan PA, Orlando, Fla.; and Alisa J. Roberts of Grayson Law Center PC, Falls Church, Va., represented the appellant. Stephen Leonard Ratner and David A. Picon of Proskauer Rose LLP, New York, represented the appellees.
Copyright 2013, The Bureau of National Affairs, Inc.

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