On June 29, 2015, the United States Court of Appeals for the Second Circuit held that broker/dealer repurchase agreements (“Repos”) do not create fiduciary relationships and claims by Repo participants are not entitled to Securities Investor Protection Act (“SIPA”) customer claims. The Second Circuit is the first Circuit Court to address and resolve this issue. Writing for a unanimous panel in the case of CarVal Investors Ltd. v. Giddens (In re Lehman Bros.), Chief Judge Robert Katzmann held that a client that delivered securities in a Repo did not “entrust assets” to Lehman Brothers, Inc. (“Lehman”), instead finding Repos are a sale where the purchased securities are “unrestricted” and the buyer is able “to sell, transfer, pledge, or hypothecate the securities” as desired subject only to its obligation to resell them to the seller at a later date at a fixed price. Since the securities were not entrusted to Lehman, the sellers in a Repo do not receive SIPA customer protection, but are instead general unsecured creditors in the liquidation proceeding of the broker/dealer.
Implications
The ruling is an important clarification to all entities entering into repurchase agreements or other similar transactions with broker-dealers where its customer status is unclear under SIPA. Under the ruling, CarVal Investors (“CarVal”) cannot recover 100% of its claim, as SIPA customers typically do, and instead now will receive around 40% of the Repo’s value consistent with the claims of all general unsecured creditors of Lehman in the bankruptcy proceedings.
While most commentators have long ago concluded that SIPA customer protection is not available to Repo claimants, and indeed there is a statement in paragraph 20(a) of the standard form of Master Repurchase Agreement that the Securities Investor Protection Corporation has taken the position that SIPA does not protect Repo customers of broker dealers, this is the first Court of Appeals decision to come to this conclusion. It is probable that the same result will apply to claims by parties to securities lending transactions with broker/dealers.
Background
In the early 2000s, Doral Bank and Doral Financial Corporation (“Doral”), the seller of the securities, entered into six Repos with Lehman. While Lehman was still holding the securities, the financial crisis struck, and Lehman went bankrupt before Doral could repurchase them. The price of the securities had appreciated since Lehman bought them, meaning that Doral would profit substantially if they had been able to repurchase the securities. Doral transferred its claim to CarVal, which pursued litigation after the SIPA Trustee rejected its customer claim.
Decision
In affirming the District Court, the Second Circuit held that the Repos did not make Doral a customer of Lehman’s under SIPA, ruling that “mere delivery is not entrustment.” If the Repos created a customer relationship through entrustment under SIPA, CarVal would be “entitled to the prompt return of any property that Lehman was holding on Doral’s behalf.” However, because the securities were not entrusted as part of a fiduciary relationship, CarVal must pursue its claims for the value of the securities as a creditor, not a customer, in Lehman’s bankruptcy proceedings.
Judge Katzmann stressed that a fiduciary relationship arises out of the broker/dealer’s obligation to “handle the customer’s assets for the customer’s benefit.” Under the Repo at issue, however, Lehman held full legal title and Doral retained only a contractual right to repurchase the securities. Favorably citing its own decision in SEC v. F.O. Baroff Co. (“Baroff”)1, the Second Circuit listed several examples of what generally produces fiduciary obligations between customers and broker/dealers: “(1) selling the assets for the customer; (2) using the assets as collateral to make margin purchases of other securities for the customer; or (3) otherwise using the assets ‘to facilitate securities trading by’ the customer.” The panel recognized that “[b]ecause Lehman was acting [in the Repos] for its own interests, it had no obligation to use the securities on Doral’s behalf, and its relationship with Doral thus bore none of ‘the indicia of the fiduciary relationship between a broker and his public customer.'” Fundamentally, Doral’s right to repurchase identical securities at a later date did not hinder Lehman’s ability to buy, sell, or pledge the securities, because the Repos gave Lehman full legal title and thus no obligation to act in respect thereof in Doral’s interest.
If you have any questions concerning this Client Alert, please feel free to contact Ronald L. Cohen (212-574-1515).
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1 497 F.2d 280 (2d Cir.1974).
