Second Circuit Deals Another Blow to Madoff Victims: Investors in Feeder Funds Held Not to Be “Customers” for Purposes of SIPC Compensation

By Katie Chaverri

by Katie Lane Chaverri
Tayman Lane Chaverri LLP; Washington, DC

(reprinted with the permission of the American Bankruptcy Institute; original article may be accessed here: http://www.abiworld.org/committees/newsletters/cftf/vol10num4/blow.html

On Feb. 22, 2013, a three-judge panel of the Second Circuit Court of Appeals affirmed the rulings of the U.S. Bankruptcy and District Courts for the Southern District of New York and concluded that downstream investors in so-called “feeder funds” were not “customers” entitled to recover directly from the Securities Investor Protection Corporation (SIPC) damages incurred as a result of the massive Ponzi scheme perpetrated by Bernard L. Madoff Investment Securities LLC (BLMIS).[1] The Second Circuit’s decision dealt a devastating blow to investors who were hoping to fall within the definition of “customer” in order to receive compensation of up to $500,000 each from the SIPC fund. The court’s ruling has the effect of allowing only the feeder funds themselves to collect up to $500,000 each, diluting the investors’ return to only a fraction of that recovery.

The appellants were investors who owned interests in two limited partnerships, Spectrum Select LP and Spectrum Select II LP (collectively, the “Spectrum funds”). In turn, the Spectrum funds made investments in two hedge funds: Rye Select Broad Market Fund LP and Rye Select Broad Market Prime Fund LP (collectively, the “feeder funds”). The feeder funds pooled Spectrum funds’ capital with that of other investors and established securities accounts with BLMIS in the name of the feeder funds. The feeder funds were listed in BLMIS’ books and records, while the Spectrum funds were not, and BLMIS issued account statements and trade documentation directly to and in the name of the feeder funds. The offering memoranda and other agreements between the feeder funds and Spectrum funds provided that Spectrum funds yielded complete and exclusive control over investment decisions to the feeder funds.

Federal law provides that if an investor qualifies as a “customer”[2] of BLMIS, it may seek compensation for its unreimbursed investment losses — capped at $500,000 per customer[3] — from a special fund capitalized by the securities and brokerage community at large. Courts have narrowly construed the definition of “customer” to require that the investor entrusted the broker/dealer with cash or securities for the explicit purpose of trading those securities.[4] In reaching its conclusions, the Second Circuit reaffirmed and applied a five-part test developed by the court in SIPC v. Morgan, Kennedy & Co.[5] The court considered — and the record confirmed — that the appellants “(1) had no direct financial relationship with BLMIS, (2) had no property interest in the assets that the Feeder Funds invested with BLMIS, (3) had no securities accounts with BLMIS, (4) lacked control over the Feeder Funds’ investments with BLMIS, and (5) were not identified or otherwise reflected in BLMIS’s books and records.”[6]

Despite this standard, the appellant investors argued that they exercised a degree of control over the feeder funds’ investment decisions and intended that the money invested in the Spectrum funds would be used to purchase BLMIS securities. The investors further argued that the feeder funds were acting as agents of BLMIS. The Second Circuit disagreed and concluded that the Spectrum funds were merely limited partners in the feeder funds, which had no ownership interest in the feeder funds’ partnership property. Accordingly, the Spectrum funds lacked the authority to make investment decisions on the feeder funds’ behalf nor, according to the Second Circuit, did they “[entrust] their cash or securities to BLMIS.”[7] Similarly, the court rejected the appellants’ argument that the feeder funds were agents for BLMIS, noting that nothing in the record showed that the feeder funds were authorized to act on BLMIS’ behalf nor that BLMIS had exercised any control over the feeder funds.

This decision came only weeks before the Second Circuit issued another ruling that would prohibit Madoff victims from seeking recovery against the Securities and Exchange Commission, and has significant ramifications both within and outside of the Madoff case. Madoff’s fraud was broad and far-reaching and had a devastating effect on many private investors, as well as pension funds. Unfortunately, many charities, including the Simon Wiesenthal Center and other Jewish and Holocaust-related organizations, fell victim to Madoff’s fraud. This case essentially means that in order to be compensated under SIPC, hedge fund investors must satisfy the standard necessary to qualify as “customers.” In order to better protect themselves from future Madoff-like schemes, hedge funds and other investors should make their investments directly wherever possible or structure investments to conform to the Morgan, Kennedy & Co. standard to the greatest extent possible.


1. Kruse et al. v. SIPC et al. (In re: Bernard L. Madoff Inv. Sec. LLC), 708 F.3d 422 (2d Cir. 2013).

2. The Securities Investor Protection Act (SIPA) defines a “customer” of a debtor as:
[A]ny person (including any person with who the debtor deals as principal or agent) who has a claim on account of securities received, acquired, or held by the debtor in the ordinary course of its business as a broker or dealer from or for the securities accounts of such person for safekeeping, with a view to sale, to cover consummated sale, pursuant to purchases, as collateral, security or for purposes of effecting transfer.
15 U.S.C. § 78lll(2)(A).

3. See 15 U.S.C. §§ 78ddd and 78fff-3.

4. See In re Bernard L. Madoff Inv. Sec. LLC, 654 F.3d 229, 236 (2d Cir. 2011).

5. 533 F.2d 1314 (2d Cir. 1976).

6. Kruse at 427-28.

7. Id.