Recently, I posted about SIPA liquidations of brokerage firms, prompted by the Securities Investor Protection Act (known as SIPA) liquidations of Lehman Brothers, Inc. and Bernard L. Madoff Investment Securities LLC. An interesting issue has come up in the Madoff case involving investors who redeemed their accounts before the Madoff bankruptcy was filed. In other alleged Ponzi scheme cases, trustees have sued such investors asserting fraudulent transfer or other claims. The investors in turn often raise defenses, including that they redeemed their accounts in good faith and without any knowledge of the alleged fraud, and lengthy and complex litigation usually results.

Resolution of such litigation can come long after the deadline set for filing proofs of claim (known as a "bar date"). This raises a question: if investors end up paying money back to the estate as a result of the trustee’s litigation, will they be able to file proofs of claim — after the bar date — for the amounts they have to return? Before turning to that question, let’s take a look at how such post-bar date claims are dealt with in non-SIPA bankruptcy cases.

Section 502(h) Of The Bankruptcy Code. Under the Bankruptcy Code, if a person or entity is sued by the bankruptcy estate (usually by a trustee, the debtor in possession, or a creditors’ committee) for receipt of an alleged preference or fraudulent transfer, they will be able to file a proof of claim if they end up paying money back to the bankruptcy estate in settlement or as a result of a judgment. Bankruptcy Code section 502(h) expressly covers this situation:

(h) A claim arising from the recovery of property under section 522, 550, or 553 of this title shall be determined, and shall be allowed under subsection (a), (b), or (c) of this section, or disallowed under subsection (d) or (e) of this section, the same as if such claim had arisen before the date of the filing of the petition.

Section 502(h) recognizes that resolution of avoidance actions may come long after the original bar date for filing proofs of claim has past and allows holders of these later-arising claims to share in the estate along with other creditors. The Bankruptcy Code treats these claims as having arisen at the time of the payment back to the bankruptcy estate and allows proofs of claim to be filed months or even years after the bar date. 

The Claims Bar Date In SIPA Liquidations. In a SIPA liquidation, there are generally two claims bar dates. The first bar date set is for customer claims, in which customers of the failed brokerage firm seek to recover the securities in their accounts (or more likely in the Madoff case, the securities that were supposed to have been in their accounts). The Securities Investor Protection Corporation insurance of up to $500,000 applies to customer claims. A second bar date, usually a few months later, is for general claims. General creditors may include customers with claims in excess of the $500,000 SIPC protection or those who have more traditional trade creditor or other claims. 

The Madoff Case. In the Madoff case, last month several investors filed a motion seeking to have the bar date order clarified with regard to their potential claims in the event that the Madoff trustee later sued them and they were forced to return funds under a fraudulent transfer or other avoidance (sometimes called a  "clawback") cause of action after the general claims bar date.

  • These investors had previously redeemed some or all of their investments, and were seeking an order holding that claims arising from avoidance actions could be filed within 30 days after the judgment giving rise to the claim became final, a provision common in non-SIPA bankruptcy bar date orders due to Bankruptcy Code section 502(h).
  • The moving parties were concerned that without this clarification, any such claims they filed after the bar date might be held to be barred. On the other hand, if they were forced to file a protective claim before the bar date, they would submit to the court’s equitable jurisdiction and may be held to have waived their right to a jury trial in any avoidance action brought against them.
  • The Madoff trustee filed an opposition to the motion (copy available at the prior link) arguing, among other things, that these investors were not creditors, had not been sued, and as a result did not present an actual case or controversy ripe for adjudication. In addition, the trustee argued that Section 502(h) of the Bankruptcy Code was inapplicable, contending that it was inconsistent with an absolute bar date provision under SIPA. (The SIPA statute provides that Bankruptcy Code provisions are generally applicable in SIPA cases to the extent consistent with SIPA.)
  • The SIPC also filed a response to the motion (copy available at the prior link) making arguments similar to those advanced by the trustee. In particular, the SIPC argued that Section 502(h) was inconsistent with what the SIPC called SIPA’s "immutable" bar date.

The Court’s Decision. In a five-page decision issued on February 24, 2009, U.S. Bankruptcy Judge Burton R. Lifland denied the motion, first holding that the Court did not have the discretion to extend the bar dates involved. (A copy of the decision is available by clicking on the link in the prior sentence.) The Court then stated that the motion essentially sought a determination of whether Section 502(h) of the Bankruptcy Code was applicable in SIPA liquidations. Because no avoidance action had yet been filed, the Court held that the requested relief, if granted, would amount to an improper advisory opinion.

  • As a result, the Court refused to decide whether Bankruptcy Code Section 502(h) applies in SIPA cases, commenting as follows: "Although section 78fff(b) of SIPA specifies that the provisions of the Bankruptcy Code shall apply in SIPA liquidation proceedings, to the extent that they are consistent with SIPA, it is unclear whether section 502(h) of the Code would apply. 15 U.S.C. § 78fff(b) (1981)."
  • The Court concluded by noting that the investors could file a protective proof of claim before the general claims bar date, although that would subject them to the Court’s equitable jurisdiction.

An Open Question. Although the Court denied the motion, it left open the ultimate issue involved — whether Section 502(h) of the Bankruptcy Code applies in SIPA liquidations and permits parties to file proofs of claim after the bar date if they are sued by a trustee and later have to return funds or other property. With the issue undecided for now, some investors may choose to file a protective proof of claim before the bar date passes.