A customer of a liquidated broker-dealer will not have a general unsecured claim if the broker goes into liquidation before transferring securities in the customer’s account to a solvent broker, according to District Judge William H. Pauley III of Manhattan.
The issue arose in the bankruptcy of Lehman Brothers Inc., whose liquidation under the Securities Investor Protection Act, or SIPA, led to a collapse of stock prices. Evidently foreseeing the impending bankruptcy, the customers had instructed Lehman to transfer securities in their accounts to another broker.
On Sept. 18, 2008, Lehman acknowledged receipt of the transfer instructions, but the SIPA liquidation proceedings began on Sept. 19 before Lehman could complete the transfers. Rather than complete the transfers to the new broker designated by the customers, Lehman’s SIPA trustee instead transferred customers’ accounts to Barclays Capital Inc. as part of a bulk transfer of all customer accounts on Sept. 29.
The customers filed general unsecured claims for more than $117 million, claiming they could have sold out their positions at higher prices before the markets collapsed had Lehman or the SIPA trustee immediately completed the transfer of their accounts to their designated new broker.
Bankruptcy Judge Shelley C. Chapman of Manhattan disallowed the general unsecured claims and was upheld by Judge Pauley in his March 22 opinion. He framed the question as whether the customers could “assert claims against [Lehman’s] estate for market losses arising from the failure to execute the account transfer request before the filing date even though the [Lehman] trustee subsequently transferred the accounts to another solvent broker.”
Undermining their own position, the claimants were compelled to concede that the SIPA trustee had the power “to reverse the account transfer requests and re-route claimants’ accounts elsewhere.” Instead, the customers contended that they would have suffered smaller losses had Lehman transferred their accounts sooner.
Judge Pauley said it was “doubtful” that Lehman breached its duty of care to the customers under Section 8-508 of the Uniform Commercial Code, or UCC. That section, he said, provides that a broker’s duties are subject to other statutes, regulations and rules. In turn, FINRA rules gave Lehman three days to complete the transfer.
Since the three-day clock started to run for Lehman on Sept. 18, the commencement of the SIPA liquidation on Sept. 19 led Judge Pauley to say “there is nothing to suggest that [Lehman] breached its duty of care to the claimants under UCC § 8-508.” Judge Pauley did say that the customers “would likely have had a breach of duty claim” had the three-day window to transfer elapsed before Lehman went into liquidation.
“More importantly,” Judge Pauley said, the Lehman trustee “did exactly what he is authorized to do.” The judge cited 15 U.S.C. § 78fff-2(f) to say that the trustee has power to transfer the accounts to another broker “without the consent of any customer.” SIPA, he said, “expressly authorizes such actions in exigent circumstances such as those surrounding [Lehman’s] collapse.”
Allowing the claims, Judge Pauley said, “could result in disastrous consequences of the kind SIPA was created to avoid.” Allowing the claims, he said, “would also encourage a mad dash of customers seeking to effect account transfers,” thus fomenting a “run on the bank.”
Judge Pauley held that the customers’ general unsecured claims were properly disallowed because the Lehman trustee’s “bulk transfer of the [claimants’] accounts satisfied [Lehman’s] pre-insolvency duty to honor the account transfer requests.” He then explained why the result would be the same purely under the UCC.
But even if the result were different under the UCC, Judge Pauley said that SIPA has a “displacing effect on the UCC,” meaning that the bankruptcy court properly disallowed the claim under Section 502(b)(1) of the Bankruptcy Code, which permits disallowance of a claim that is unenforceable under “applicable law.”
Judge Pauley also dismissed the claimant’s argument that disallowance of their claims somehow offended the U.S. Constitution.