Davis+Polk+Reply+Brief

10-2378-bk(L)

IN THE

United States Court of AppealsFOR THE SECOND CIRCUIT

IN RE: BERNARD L. MADOFF INVESTMENT SECURITIES LLC

ON APPEAL FROM THE UNITED STATES BANKRUPTCY COURTFOR THE SOUTHERN DISTRICT OF NEW YORK

REPLY BRIEF FOR APPELLANTS STERLING EQUITIES ASSOCIATES, ARTHUR FRIEDMAN,

DAVID KATZ, GREGORY KATZ, MICHAEL KATZ, SAUL KATZ, L. THOMAS OSTERMAN, MARVIN TEPPER, FRED WILPON, JEFF

WILPON, RICHARD WILPON, AND METS LIMITED PARTNERSHIP

10-2676-bk(CON), 10-2677-bk(CON), 10-2679-bk(CON),10-2684-bk(CON), 10-2685-bk(CON), 10-2687-bk(CON),10-2691-bk(CON), 10-2693-bk(CON), 10-2694-bk(CON),10-2718-bk(CON), 10-2737-bk(CON), 10-3579-bk(CON),

10-3675-bk(CON)

d

KAREN E. WAGNER, ESQ.BRIAN S. WEINSTEIN, ESQ.JONATHAN D. MARTIN, ESQ.DAVIS POLK & WARDWELL LLP450 Lexington AvenueNew York, New York 10017(212) 450-4000

Attorneys for Appellants SterlingEquities Associates, ArthurFriedman, David Katz, GregoryKatz, Michael Katz, Saul Katz, L. Thomas Osterman, MarvinTepper, Fred Wilpon, Jeff Wilpon, Richard Wilpon, and Mets Limited Partnership

Case: 10-2378 Document: 338 Page: 1 10/11/2010 121939 26

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TABLE OF CONTENTS

PAGE TABLE OF AUTHORITIES ................................................................................. ii

PRELIMINARY STATEMENT ............................................................................1

ARGUMENT ............................................................................................................2

POINT I. ACCOUNT STATEMENTS ESTABLISH BROKER OBLIGATIONS AND “SECURITIES POSITIONS” FOR NET EQUITY CLAIMS......................................................................2

POINT II. SECTION 78fff-2(b) IS IRRELEVANT ............................................9

POINT III. NEW TIMES I SUPPORTS NET EQUITY IN THIS CASE .......11

POINT IV. APPELLEES’ “EQUITY” ARGUMENTS ARE IRRELEVANT AND WRONG ..................................................................12

POINT V. NEITHER THE SEC NOR SIPC IS ENTITLED TO DEFERENCE ........................................................................................15

POINT VI. AVOIDANCE POWERS ARE IRRELEVANT TO NET EQUITY .......................................................................................16

CONCLUSION.......................................................................................................19


ii

TABLE OF AUTHORITIES

Cases PAGE

In re A.R. Baron Co., 226 B.R. 790 (Bankr. S.D.N.Y. 1998) .................................10

In re Adler, Coleman Clearing Corp., 263 B.R. 406 (S.D.N.Y. 2001)....... 14, 17-18

In re Bayou Group, LLC, 362 B.R. 624 (Bankr. S.D.N.Y. 2007) ...........................17

In re Bernard L. Madoff Inv. Secs., 424 B.R. 122 (Bankr. S.D.N.Y. 2010) ..........................................................11

In re Bevill, Bresler & Schulman, Inc., 59 B.R. 353 (D.N.J. 1986) ........................10

Butner v. United States, 440 U.S. 48 (1979)..............................................................3

Catskill Mountains Chapter of Trout Unlimited, Inc. v. City of New York, 273 F.3d 481 (2d Cir. 2001) ..........................................................................15

Chevron U.S.A., Inc. v. Natural Res. Defense Council, 467 U.S. 837 (1984).......................................................................................16

In re C.J. Wright & Co., 162 B.R. 597 (Bankr. M.D. Fla. 1993) ..............................7

Cmty. Health Ctr. v. Wilson-Coker, 311 F.3d 132 (2d Cir. 2002)...........................15

In re Cont’l Capital Inv. Servs., No. 03-3370, 2008 WL 6190251 (Bankr. N.D. Ohio Nov. 4, 2008)...................................10

In re Dairy Mart Convenience Stores, Inc., 351 F.3d 86 (2d Cir. 2003) ................13

In re Enron Corp., Nos. M-47 (GBD), 01-6034 (AJG), Adv. Nos. 03-92677 (AJG), 03-92682 (AJG), 2008 WL 281972 (S.D.N.Y. 2008) ...............................................................18

In re Grafton Partners, L.P., 321 B.R. 527 (B.A.P. 9th Cir. 2005) ........................17

John Hancock Mut. Life Ins. Co. v. Harris Trust & Sav. Bank, 510 U.S. 86 (1993).........................................................................................15


iii

In re Klein, Maus & Shire, Inc., 301 B.R. 408 (Bankr. S.D.N.Y. 2003).................10

In re MV Secs., Inc., 48 B.R. 156 (Bankr. S.D.N.Y. 1985) .....................................10

In re New Times Sec. Servs., Inc., 371 F.3d 68 (2d Cir. 2004).........................passim

In re Old Naples Sec., Inc., 311 B.R. 607 (M.D. Fla. 2002) .....................................7

Partridge v. Presley, 189 F.2d 645 (D.C. Cir. 1951) ..............................................14

Raleigh v. Ill. Dep’t of Revenue, 530 U.S. 15 (2000) ................................................3

SEC v. Packer, Wilbur & Co., 498 F.2d 978 (2d Cir. 1974) .....................................8

Skidmore v. Swift & Co., 323 U.S. 134 (1944) ........................................................15

Travelers Cas. & Sur. Co. of Am. v. PG&E, 549 U.S. 443 (2007) ...........................3

Wider v. Wootton, 907 F.2d 570 (5th Cir. 1990) .....................................................17

Statutes & Rules

11 U.S.C. § 546(e) ............................................................................................. 17-18

11 U.S.C. § 741(7)(A)(i)..........................................................................................18

11 U.S.C. § 741(7)(A)(vii).......................................................................................18

15 U.S.C. § 78ccc(b)(4)(A)......................................................................................15

15 U.S.C. § 78fff-2(b).................................................................................... 9-10, 16

15 U.S.C. § 78fff-3(a) ........................................................................................10, 16

15 U.S.C. § 78lll(11)..................................................................................................2

NASD Rule 2340 .......................................................................................................4

NYSE Rule 409(a) .....................................................................................................4

NYUCC § 8-501(b)....................................................................................................3

NYUCC § 8-501(b)(3) ...............................................................................................3


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NYUCC § 8-501(c)....................................................................................................4

NYUCC § 8-501 cmt. 1 .............................................................................................6

NYUCC § 8-501 cmt. 2 .........................................................................................3, 6

NYUCC § 8-501 cmt. 3 .........................................................................................4, 6

NYUCC § 8-503 cmt. 2 .............................................................................................3

SEC Rule 17a-3........................................................................................................10

Other Authorities

FINRA, If a Brokerage Firm Closes Its Doors ..........................................................5

Letter from Stephen P. Harbeck, SIPC President, to Hon. Paul E. Kanjorski and Hon. Scott Garrett (Sept. 7, 2010)................13

SIPC, How SIPC Protects You (1994).......................................................................7


PRELIMINARY STATEMENT

The Trustee, SIPC, and the SEC, each of whom is charged with protecting

investors, take positions on this appeal that are utterly contrary to the very laws

enacted for that purpose.

All three ask this Court to affirm the Decision, which holds that the

customer is at the mercy of its fraudulent broker. If a broker breached his contract

to purchase the securities reflected on the customer’s statements and confirmations,

these documents become retroactively worthless – even though customers have the

legal right to rely on them. If, in retrospect, it appears that their broker engaged in

a Ponzi scheme, customers who have neither the obligation nor the ability to

uncover such a scheme find that the legal framework upon which their investments

were structured has become inoperative.

If Appellees were correct, no investor could rely on the only tangible

evidence they possess of their securities transactions – their statements and

confirmations. Nor could customers rely on SIPC insurance, because no investor

can really know what its broker is doing behind the scenes.

But Appellees are not correct. SIPA protects customers and requires that

customers’ “net equity” claims for the securities on their statements and

confirmations be honored. The Decision must be reversed.


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ARGUMENT

POINT I.

ACCOUNT STATEMENTS ESTABLISH BROKER OBLIGATIONS AND “SECURITIES POSITIONS” FOR NET EQUITY CLAIMS

Both before and after a SIPA filing, customer statements and confirmations

establish a broker’s obligation to customers for securities positions.

Appellees contend, to the contrary, that in this case customer statements are

of no consequence. They argue that Madoff neither bought nor traded any

securities during his Ponzi scheme, causing customer statements to be “fictitious,”

and therefore the customer statements that established claims prior to bankruptcy

are no longer valid after bankruptcy. But the legal significance of customer

statements does not depend upon whether the broker bought any securities,

precisely because no customer could ever confirm a broker’s compliance with its

duty to make such purchases.

Under SIPA, customers have claims for their “net equity” – “the dollar

amount of the account or accounts of the customer, to be determined by . . .

calculating the sum which would have been owed by the debtor to such customer if

the debtor had liquidated, by sale or purchase on the filing date, all securities

positions of such customer[.]” 15 U.S.C. § 78lll(11). This “net equity” definition

controls in this case.


3

Like every federal insolvency statute, SIPA looks to non-bankruptcy law to

determine the existence and nature of a creditor’s claim – here, what the debtor

owed a customer on the filing date. “Property interests are created and defined by

state law. Unless some federal interest requires a different result, there is no

reason why such interests should be analyzed differently simply because an

interested party is involved in a bankruptcy proceeding.” Butner v. United States,

440 U.S. 48, 55 (1979); see also Travelers Cas. & Sur. Co. of Am. v. PG&E, 549

U.S. 443, 450 (2007); Raleigh v. Ill. Dep’t of Revenue, 530 U.S. 15, 20 (2000).

Under New York law, a customer has a “securities entitlement” against its

broker when the broker acknowledges the customer’s interest on a statement or

confirmation. See NYUCC § 8-501(b); Sterling Br. at 10-12. A “securities

entitlement” is “a package of rights and interests that a person has against the

person’s securities intermediary and the property held by the intermediary.”

NYUCC § 8-503 cmt. 2.

The customer’s statement both establishes and evidences the customer’s

rights, and the broker’s obligation, with respect to the customer’s securities

positions. Thus, Article 8 creates such rights “once [the broker] has acknowledged

that it is carrying a position for the customer,” NYUCC § 8-501 cmt. 2, and also

when the broker “becomes obligated under other law, regulation, or rule to credit a

financial asset to the person’s securities account.” NYUCC § 8-501(b)(3).


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The rules governing the stock exchanges similarly require that brokers issue

account statements and confirmations to reflect customers’ securities positions.

See, e.g., NASD Rule 2340 (requiring for each customer quarterly account

statements “containing a description of any securities positions”); NYSE Rule

409(a) (requiring quarterly account statements “showing security and money

positions”).

The statements required by all of these rules confirm to customers what

securities positions their broker owes them, and an elaborate federal regulatory

system exists to ensure that brokers honor their obligations. However, the rules do

not cease to apply if the broker fails to do so. Article 8 specifies that once a broker

has acknowledged the customer’s interest, “a person has a security entitlement

even though the securities intermediary does not itself hold the financial asset.”

NYUCC § 8-501(c).1

And it is precisely where customer securities are missing that the SIPC Fund

provides the last line of defense. As the SEC acknowledges, SIPA’s purpose is “to

assure that customers get back the securities and cash that should be in their

accounts when a brokerage firm fails.” (SEC Br. at 8; see also Tr. Br. at 19; SIPC

Br. at 51.) Similarly, FINRA advises customers to invest with confidence because

1 “The duty of a securities intermediary to maintain sufficient assets is governed by Section 8-504 and regulatory law. Subsection (c) is included only to make it clear the question whether a person has acquired a security entitlement does not depend on whether the intermediary has complied with that duty.” NYUCC § 8-501 cmt. 3.


5

“SIPC insurance comes into play in those rare cases of firm failure where customer

assets are missing because of theft or fraud.”2

Article 8 and the federal securities regulatory system both use customer

statements to establish a broker’s obligation to its customer. Article 8 therefore

serves the same federal interests that are protected by SIPA. Nevertheless, each

Appellee attempts in its own different way to escape the legal conclusion that SIPA

and Article 8 mandate that a customer’s “net equity” claim be determined by

reference to the customer’s statements and confirmations.

SIPC states that Article 8 is preempted by SIPA to the extent it provides

different “relief” on customer claims, pointing to the Official Comment of

NYUCC Section 8-503. (See SIPC Br. at 31 n.10.) But there is no dispute on that

point. As confirmed by the comment, Article 8 governs the establishment of a “net

equity” claim, and SIPA governs the priority of, and recovery on, that claim.

The SEC does not quarrel with the application of Article 8 but contends that

Article 8 creates a “book entry” obligation only if the broker creates entries on

particular internal books to which customers have no access. (SEC Br. at 11 n.5.)

On the contrary, Article 8 expressly rejects any particular recording requirement.3

2 See FINRA, If a Brokerage Firm Closes Its Doors,

http://www.finra.org/Investors/protectyourself/investoralerts/P116996 (last visited Oct. 11, 2010).

3 The Official Comment to NYUCC § 8-501 states that “[i]n the indirect holding system, the significant fact is that the securities intermediary has undertaken to treat the customer as entitled to the financial asset,” and “[p]aragraph (1) does not attempt to specify exactly what


6

A securities entitlement arises when the broker acknowledges such an entitlement

to its customer, and when the broker becomes obligated to the customer under

other law or regulation, as was the case here. (See Sterling Br. 11 n.4, 12-13 n.6.)

The Trustee simply ignores Article 8 and contends that where securities are

missing, under the “net equity” definition, a customer’s claim is calculated at

“zero.” “[A]s nonexistent securities cannot be reduced to cash,” “what ‘would

have been owed’ to customers had the purported ‘securities positions’ on their last

[BLMIS] statements been ‘liquidated’ is zero.” (Tr. Br. at 24-25.)

SIPA would be a strange statute indeed if it obligated SIPC promptly to

replace missing securities owed to a customer, yet calculated the customer’s “net

equity” claims at zero when the securities were missing. What then would be the

purpose of the SIPC Fund? It is precisely because the broker does not possess the

securities that SIPA protection is necessary. See In re New Times Sec. Servs., Inc.,

371 F.3d 68, 73 (2d Cir. 2004) (“New Times I”) (“To the extent that a customer’s

net equity exceeds his ratable share of customer property, the trustee may use SIPC

accounting, record-keeping, or information transmission steps suffice to indicate that the intermediary has credited the account.” NYUCC § 8-501 cmts. 2, 3. For the same reason, the SEC’s argument, by reference to a dictionary, that ownership of book-entry securities must be reflected on a “book of original entry,” is unavailing. (SEC Br. at 11 n.5.) “[T]he question whether a given arrangement is a securities account should be decided not by dictionary analysis of the words taken out of context, but by considering whether it promotes the objectives of Article 8[.]” NYUCC § 8-501 cmt. 1.


7

advances from this fund to pay customers in cash or to purchase replacement

securities for a customer.”) (emphasis added).

Not surprisingly, neither SIPC nor the SEC made this argument in New

Times I, even though no securities were purchased.4 Indeed both promote SIPA’s

coverage of missing securities:

“Will a customer get back all of the securities in the [customer’s] account? Usually, yes; but sometimes no. Here’s why: For various reasons, a failed firm may not have all customer securities on hand. The trustee attempts to purchase such missing securities in the market, providing a fair and orderly market for the securities can be found. When missing securities cannot be replaced by market purchases, the customer receives cash based on the market value of the securities as of the value date . . . .” SIPC, How SIPC Protects You (1994) (J.A. Vol. II at 156-57).

“SIPA covers claims of customers who deposit cash with a broker for the purpose of purchasing securities, but the broker never makes the purchases. In this situation, the trustee typically satisfies claims by giving customers the filing date value of the securities that should have been purchased for their accounts.” (SEC Br. at 12.)

Appellees jointly contend that SIPC does not cover claims for securities

missing due to particular types of fraud, such as Ponzi schemes. In such cases,

they say, customer statements are fictitious, reflecting securities never purchased

4 The SEC also rejects the arguments by the Trustee and SIPC that cases such as In re

Old Naples Sec., Inc., 311 B.R. 607 (M.D. Fla. 2002), or In re C.J. Wright & Co., 162 B.R. 597 (Bankr. M.D. Fla. 1993) can be read to support the net investment approach in a SIPA case just because a broker was engaged in a Ponzi scheme. (Compare SEC Br. at 16, with Tr. Br. at 33; SIPC Br. at 27-28.) Like New Times I, both involved fake or worthless securities that could not be valued on the filing date. See Old Naples, 311 B.R. at 610-11; C.J. Wright, 162 B.R. at 601. Here, customer statements reflect blue chip securities that are easily valued as of the filing date.


8

and for which customers “did not pay.”5 Any claims are for “damages,” not

securities.6 (Tr. Br. at 27; SEC Br. at 13; SIPC Br. at 52-53.) Appellees justify

this exclusion of Madoff victims from SIPA protection by lengthy descriptions of

the size and mechanics of Madoff’s fraud – as if such details were legally relevant.

(Tr. Br. at 9-16; SIPC Br. at 7-14; SEC Br. at 2-4.)7

But they are not. Nothing in the statute provides that SIPC protection

depends on the precise nature of a broker’s fraud. If Congress had wanted to

exclude victims of Ponzi schemes from SIPC coverage, Congress would have done

so. Congress did not, surely recognizing that SIPA’s purpose of creating customer

confidence in the markets would be fatally undermined if investors were told that

the availability of SIPC coverage would be determined, retroactively, after a

lengthy forensic analysis of the type of fraud that caused a broker’s failure.

5 Appellees argue that customers did not pay for securities on their last statements because they paid with proceeds from securities on prior statements, and since BLMIS’ obligations to customers were invalid, the proceeds are also invalid, and therefore do not constitute valid consideration for the purchase of securities. The argument is entirely circular. Each statement created valid obligations under Article 8 and other laws, and the payments on those obligations were valid to support the obligations on subsequent statements.

6 “Net equity” claims are claims for securities, or their value, owed to customers on the filing date – they are not claims for damages. SIPA was designed precisely to protect investors whose brokers failed to hold the securities on their statement. See, e.g., SEC v. Packer, Wilbur & Co., 498 F.2d 978, 984 (2d Cir. 1974); Sterling Br. at 14. Consequently, cases holding that SIPA does not cover fraudulent promises of gain, or market loss, are completely inapposite. (Tr. Br. at 27; SIPC Br. at 50-53; SEC Br. at 12.)

7 The Trustee states that the Sterling Customers concede these facts. (Tr. Br. at 7.) They do not. The Bankruptcy Court limited briefing in this case to “the proper interpretation of ‘net equity.’” J.A. Vol. I at 267. Facts relating to the mechanics, scope, and degree of malice associated with Madoff’s fraud are not relevant to the statutory interpretation of “net equity.”


9

Here, BLMIS contracted with customers to purchase securities; BLMIS

issued statements reflecting real, blue chip securities; and BLMIS was obligated to

its customers for those securities. The day before the SIPC filing customers could

have sued, and won, on a claim for those securities. BLMIS could not have

alleged its own fraud as a defense. SIPA does not change that result. Whatever

Madoff did behind the scenes, BLMIS was obligated to customers for the securities

on their statements, and those statements remain the operative legal documents for

establishing “net equity” claims.

POINT II.

SECTION 78fff-2(b) IS IRRELEVANT

Appellees continue to point to Section 78fff-2(b) as a basis for their

contention that the Trustee’s ad hoc “net investment” approach trumps SIPA’s “net

equity” definition where BLMIS’ internal books and records reveal a Ponzi scheme

in which the real securities reflected on BLMIS customer statements were never

purchased. (Tr. Br. at 28; SIPC Br. at 31; SEC Br. at 10.)

But Section 78fff-2(b) does not take away from customers what the “net

equity” definition gives. On the contrary, Section 78fff-2(b) has nothing to do with

the calculation of customer claims – it directs the trustee to “promptly discharge”

those claims. Appellees’ argument has never been adopted by any court, and was


10

never presented in New Times I, where the broker’s internal books could not have

evidenced the purchase of securities, since none were purchased.

Indeed, courts have consistently understood that Section 78fff-2(b) deals

only with the threshold question of whether claimants are customers and whether

their claims are for securities or cash.8 There is no dispute that customers must

provide evidence of their status, which evidence – according to Section 78fff-2(b) –

can come from the broker’s “books and records,” or, if those records are lacking,

from any other source that may “otherwise establish[] to the satisfaction of the

trustee” the broker’s obligations to its customers.9

The same account statements that evidence customer status also establish

customers’ net equity claims for securities, consistent with Article 8 and the SEC’s

own rules, which recognize that the confirmations and statements are required

broker “books and records.” (See SIPC Br. at 31, citing SEC Rule 17a-3.)

Appellees accept that the securities positions on customer statements entitle

BLMIS claimants to customer status, and claims for advances up to $500,000. See

15 U.S.C. § 78fff-3(a) (providing $500,000 SIPC advance when a customer’s “net

8 See, e.g., In re Klein, Maus & Shire, Inc., 301 B.R. 408, 418 (Bankr. S.D.N.Y. 2003); In re A.R. Baron Co., 226 B.R. 790, 795 (Bankr. S.D.N.Y. 1998); In re Cont’l Capital Inv. Servs., No. 03-3370, 2008 WL 6190251, at *4 (Bankr. N.D. Ohio Nov. 4, 2008); In re Bevill, Bresler & Schulman, Inc., 59 B.R. 353, 362-63 (D.N.J. 1986).

9 To the extent Section 78fff-2(b) allows the trustee to find customer status even when the broker’s books and records are lacking or in disarray, so long as such status is “otherwise established to the satisfaction of the trustee,” it is intended to broaden the scope of SIPA coverage, not narrow it. See In re MV Secs., Inc., 48 B.R. 156, 159 n.5 (Bankr. S.D.N.Y. 1985).


11

equity claim . . . is . . . a claim for securities”). Consequently, Appellees long ago

conceded that Appellants are BLMIS customers with claims for securities. See In

re Bernard L. Madoff Inv. Secs., 424 B.R. 122, 135 n.28 (Bankr. S.D.N.Y. 2010).10

They can offer no convincing explanation as to why the same securities positions

do not provide the basis for “net equity” claims.

POINT III.

NEW TIMES I SUPPORTS NET EQUITY IN THIS CASE

Appellees next posit that this Court’s decision in New Times I mandates that,

where a broker issues statements reflecting real securities not purchased in the

course of a Ponzi scheme, the Trustee may replace the statutory definition of “net

equity” with the ad hoc “net investment” approach. But in New Times I this Court

accepted the “net investment” approach only because the “net equity” definition

could not be applied to fake securities not susceptible to market valuation.

As in this case, the broker in the New Times I Ponzi scheme bought no

securities. The statements of one set of customers reflected real securities with an

ascertainable value, so the SIPA net equity valuation was used. The statements of

another set of customers reflected fake securities with no ascertainable value, so

10 SIPC appears now to argue that BLMIS customers are not “customers” because

Madoff defrauded them. (SIPC Br. at 17 n.6, 34.) SIPC’s contention, with which the SEC and the Trustee disagree, is contrary to SIPA.


12

the SIPA net equity calculation could not be accomplished, and another approach

was required. See New Times I, 371 F.3d at 76.

No party argued that the failure to buy securities was a ground for replacing

the “net equity” definition with “net investment” where securities on customer

account statements, though missing, had an ascertainable market value. Nor did

any party argue that the “net equity” definition was superseded when a broker’s

demise was caused by a “fraudulent trading scheme” – the New Times I trading

scheme was itself fraudulent. That it was in some respects different than Madoff’s

is irrelevant. New Times I simply addressed a statutory void – how to calculate a

claim based on securities having no ascertainable market value. Since that void

does not exist here, the statute must be followed.

POINT IV.

APPELLEES’ “EQUITY” ARGUMENTS ARE IRRELEVANT AND WRONG

SIPA governs this case. If the “net equity” definition can be applied, it must

be applied. Appellees try to justify their invitation to abandon the statute by

implying that only “net investment” will be “fair” and “equitable” to customers in

the “zero-sum game” created by Madoff’s Ponzi scheme. Even were such ad hoc

considerations permissible, Appellees are quite wrong. SIPA effects an entirely

equitable balance among the objectives of investor protection, market certainty,

and ratable distribution to customers based on their filing date claims.


13

First, where a statute like SIPA governs distribution on a claim, bankruptcy

courts do not have “a roving commission to do equity” by varying the terms of that

statute. In re Dairy Mart Convenience Stores, Inc., 351 F.3d 86, 92 (2d Cir. 2003);

Sterling Br. at 21-22.

Second, this is not a “zero-sum game” with respect to SIPC advances. Every

customer is entitled to recover up to $500,000 from the SIPC Fund, and no

customer’s recovery will reduce the SIPC payment to any other customer. By

contrast, under the net investment method, more than $1 billion that should be paid

to Madoff’s victims will be retained by the SIPC Fund.11 Nearly half or more of

all Madoff victims will receive nothing.12

While Appellees contend that distribution of customer property based on

customer statements is unfair, that view is also unfounded. Customers must rely –

and are legally entitled to rely – on their statements. Premising “net equity” claims

11 See Letter from Stephen P. Harbeck, SIPC President, to Hon. Paul E. Kanjorski and

Hon. Scott Garrett, at 4 (Sept. 7, 2010) (“Harbeck Letter”), http://www.sipc.org/pdf/2010%2009-07%20Cong.%20Kanjorski%20Garrett%20reply%20to%2008-20-10%20letter.pdf (last visited Oct. 11, 2010) (reporting that if the final account statements were used rather than net investment, “an additional $1,122,429,096.82 in SIPC advances could be made”).

12 See Harbeck Letter at 3-6. In many cases, “net losers” would be worse off as well. Because their claims would be reduced, they would not recover all of the SIPC advance to which they otherwise would be entitled, and their pro rata share of customer property may also be reduced. Suppose, for example, that a customer deposited $400,000 ten years ago, withdrew $300,000 during that period, and had an account balance of $1 million on December 11, 2008. Under the Trustee’s methodology that “net loser” has a claim to the SIPC Fund of $100,000. Under SIPA’s “net equity” definition, the customer’s claim is $1 million, entitling the customer to $500,000 from the SIPC Fund. The Trustee’s approach saves $400,000 for the SIPC Fund, but benefits no other customer. (See also SIPC Br. at 23 (chart demonstrating Fund savings).)


14

on those statements is entirely fair, as Congress recognized when it enacted SIPA,

and deviating from SIPA is not. Madoff’s victims relied upon these rules when

they were induced to invest. They were grievously defrauded. Now, Appellees are

completely pulling the rug out from under them – by tearing up account

statements, denying SIPC coverage, and attacking decades of transactions that

formed the economic foundation for customers’ lives. SIPA does not sanction this

treatment of Madoff’s victims, let alone render it fair.

Nor does SIPA sanction SIPC’s extraordinary accusations that Madoff’s

victims are chargeable with his fraud because he was their “agent,” and seek to

benefit from that fraud by asserting “net equity” claims based on their “illegal”

contracts with BLMIS. (SIPC Br. at 38-46.)13 These claims are asserted against

the victims’ own faithless fiduciary. The proposition that “the guilty party cannot

take advantage of his own fraud to avoid his obligation under the contract should

the innocent party choose to enforce it” is “so elementary that a citation of

secondary authorities is sufficient.” Partridge v. Presley, 189 F.2d 645, 651 (D.C.

Cir. 1951) (citing 5 Williston, Contracts § 1488 (rev. ed.); 12 Am. Jur., Contracts

§ 146; 17 C.J.S., Contracts 166). SIPC’s position is legally incomprehensible and

utterly lacking in equity.

13 Appellees’ citation of In re Adler, Coleman Clearing Corp. [a/k/a Ensminger], 263

B.R. 406 (S.D.N.Y. 2001), is completely inapposite. (SIPC Br. at 35-36.) The debtor there was a victim, not a perpetrator, of the fraud. See Adler, Coleman, 263 B.R. at 440, 442, 445, 462-64.


15

POINT V.

NEITHER THE SEC NOR SIPC IS ENTITLED TO DEFERENCE

Because the statutory “net equity” definition controls, SIPC and the SEC are

entitled to no deference. See John Hancock Mut. Life Ins. Co. v. Harris Trust &

Sav. Bank, 510 U.S. 86, 109 (1993); Chevron U.S.A., Inc. v. Natural Res. Defense

Council, 467 U.S. 837, 842-43 (1984).

Deference in any event is unwarranted – not only because of SIPC’s patent

interest in protecting the SIPC Fund, but because the position violates SIPA.

Appellees are seeking to amend – indeed eviscerate – the “net equity” definition.

But SIPA expressly prohibits any amendment of the “net equity” definition, even

to protect the SIPC Fund. 15 U.S.C. § 78ccc(b)(4)(A).

For the same reason, neither SIPA nor the SEC has, or could have, issued

regulations to limit the scope of the “net equity” definition. On the contrary, their

arguments here contravene their public advertisement of SIPC protection. (See

Sterling Br. 12-14 and nn. 5, 8.) These arguments are not premised upon any

specialized agency “expertise,” and lack the “power to persuade.” No Skidmore

deference is appropriate. Skidmore v. Swift & Co., 323 U.S. 134, 140 (1944);

Cmty. Health Ctr. v. Wilson-Coker, 311 F.3d 132, 138 (2d Cir. 2002).

And, contrary to the Trustee’s suggestion, the position here is not that

advanced in New Times I. There, SIPC and the SEC did not argue that securities


16

positions on customer account statements can be disregarded even when they are

real securities with a discernable liquidation value, and they did not argue that

Section 78fff-2(b) is relevant to the calculation of customer claims. Deference is

not afforded positions advanced for the first time in litigation. See New Times I,

371 F.3d at 81-82; Catskill Mountains Chapter of Trout Unlimited, Inc. v. City of

New York, 273 F.3d 481, 491 (2d Cir. 2001).

POINT VI.

AVOIDANCE POWERS ARE IRRELEVANT TO NET EQUITY

Two Appellees argue that the Trustee’s refusal to give effect to the “net

equity” definition is “consonant” with the Trustee’s avoidance powers. The SEC

correctly disagrees.

First, the “net equity” definition is independent of any avoidance power.

Linking “net equity” to avoidance, and delaying SIPC advances to undertake an

endless forensic exercise, is completely inconsistent with SIPA’s command that the

Trustee use the SIPC Fund to advance “prompt payment and satisfaction of net

equity claims of customers of the debtor.” 15 U.S.C. § 78fff-3(a) (emphasis

added).

Second, “net investment” is not justified by “consonance” with any

avoidance powers. “Net investment” treats all transfers over two decades as


17

voidable.14 But avoidance powers against BLMIS customers are very

circumscribed – even the Trustee says only that “even if certain transfers cannot be

avoided, some can.” (Tr. Br. at 40.) Finally, while the Trustee argues that these

transfers may be avoided because of Madoff’s Ponzi scheme, the SEC rightly notes

that non-SIPA Ponzi scheme cases have no relevance to interpreting the statute.

(SEC Br. at 16.)15

Finally, Section 546(e) of the Bankruptcy Code, as amended, is the most

recent legislation addressing the balance between competing Congressional

objectives – the certainty required in the securities markets, and the avoidance of

pre-petition transactions.16 In Section 546(e) Congress placed extremely stringent

14 Appellees’ objective is to level all customers’ recoveries, but not based on filing date

claims. There exists no legal sanction for that objective. The preference provision is the only mechanism for preventing one creditor from being preferred over another. As set forth in Sterling’s opening brief at 27-28, Congress has narrowly circumscribed the temporal scope of preference avoidance – to ninety days at most. Preference law therefore cannot support the vast sweep of Appellees’ desired outcome, and there is no other legal foundation for this exercise.

15 The Trustee argues for the first time that this was an “equity-based Ponzi scheme[],” so BLMIS customers should be treated like the limited partners in In re Bayou Group, LLC, 362 B.R. 624, 635 (Bankr. S.D.N.Y. 2007) (distinguishing the status of customers from those of limited partners in a hedge fund). (Tr. Br. at 39 n.14.) The Trustee cannot seriously suggest that a customer’s contract claim is equivalent to a limited partner’s “equity” claim against a failed broker.

16 The Trustee’s contention that Section 546(e) does not limit avoidance in Ponzi scheme cases is wrong. (Tr. Br. at 42.) Section 546(e) only excepts from its scope intentionally fraudulent transfers within two years of a filing. Nothing in Section 546(e) otherwise limits its scope in Ponzi scheme cases. Further, the cases cited by the Trustee are irrelevant because they focus on the “settlement payment” limitation, as Section 546(e) now encompasses any payment in connection with a securities contract. See In re Grafton Partners, L.P., 321 B.R. 527, 535-39 (B.A.P. 9th Cir. 2005); Wider v. Wootton, 907 F.2d 570, 571-72 (5th Cir. 1990); In re Adler,


18

restrictions upon avoidance of any transaction “in connection with a securities

contract.” 11 U.S.C. § 546(e). “Securities contract” is defined very broadly to

include not only “a contract for the purchase, sale, or loan of a security . . . or

option on any of the foregoing, including an option to purchase or sell any such

security,” 11 U.S.C. § 741(7)(A)(i), but also “any other agreement or transaction

that is similar to an agreement or transaction” listed in Section 741(7)(A)(i)-(vi).

11 U.S.C. § 741(7)(A)(vii).

On its face, Section 546(e) precludes most avoidance claims against BLMIS

customers. Appellees have no response except to repeat the mantra that, in this

case, because BLMIS never executed any trades, Section 546(e) – like every other

statute – is inapplicable. But each payment to and from BLMIS was in connection

with a contract to buy and sell securities. These contracts did not vaporize because

Madoff breached them. Under applicable law, transfers between BLMIS and its

customers are statutorily protected from avoidance, and no potential for avoidance

justifies the abandonment of the “net equity” definition.

Coleman, 263 B.R. at 478-81; In re Enron Corp., Nos. M-47 (GBD), 01-6034 (AJG), Adv. Nos. 03-92677 (AJG), 03-92682 (AJG), 2008 WL 281972, at *2-*5 (S.D.N.Y. 2008).


19

CONCLUSION

For the reasons stated above, the Sterling Customers respectfully request that

this Court reverse the Decision and Order and hold that the Sterling Customers’

“net equity” under SIPA is what BLMIS owed the Sterling Customers, which is the

securities on their statements, or their value, as of the filing date.

Dated: New York, New York October 11, 2010 DAVIS POLK & WARDWELL LLP

By: /s/ Karen E. Wagner Karen E. Wagner

Brian S. Weinstein Jonathan D. Martin

450 Lexington Avenue New York, New York 10017 (212) 450-4000 [email protected] [email protected] [email protected]

Attorneys for Sterling Equities Associates, Arthur Friedman, David Katz, Gregory Katz, Michael Katz, Saul Katz, L. Thomas Osterman, Marvin Tepper, Fred Wilpon, Jeff Wilpon, Richard Wilpon, and Mets Limited Partnership


CERTIFICATE OF COMPLIANCE WITH TYPE-VOLUME LIMITATION, TYPEFACE REQUIREMENTS AND TYPE STYLE

REQUIREMENTS

This brief complies with the type-volume limitation of Fed. R. App. P.

32(a)(7)(B) because it contains 4834 words, excluding the parts of the brief

exempted by Fed. R. App. P. 32(a)(7)(B)(iii).

This brief complies with the typeface requirements of Fed. R. App. P.

32(a)(5) and the type style requirements of Fed. R. App. P. 32(a)(6) because this

brief has been prepared in a proportionally spaced typeface using Microsoft Word

2003 in size 14 Times New Roman font.


Dated: New York, New York October 11, 2010 DAVIS POLK & WARDWELL LLP

By: /s/ Karen E. Wagner Karen E. Wagner

Brian S. Weinstein Jonathan D. Martin

450 Lexington Avenue New York, New York 10017 (212) 450-4000 [email protected] [email protected] [email protected]

Attorneys for Sterling Equities Associates, Arthur Friedman, David Katz, Gregory Katz, Michael Katz, Saul Katz, L. Thomas Osterman, Marvin Tepper, Fred Wilpon, Jeff Wilpon, Richard Wilpon, and Mets Limited Partnership


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