Bernard Madoff's mugshot (Photo credit: Wikipedia)

On February 22, 2013, the United States Court of Appeals for the Second Circuit issued its much anticipated Opinion In re: Bernard L. Madoff Inv. Sec. LLC / James L Kruse, et al., Debtors/Claimants/Appellants v. Securities Investor Protection Corporation, Irving H. Picard, Appellees; and Securities And Exchange Commission, Intervenor. (2^nd Cir., February 23, 2013).

On January 6, 2012,the Southern District of New York affirmed a June 28, 2011, Order of the district's bankruptcy court affirming Trustee Irving H. Picard's denial of appellants' claims against Bernard L. Madoff Investment Securities LLC ("BLMIS") under the Securities Investor Protection Act ("SIPA") because appellants do not qualify as BLMIS "customers" under SIPA. , see id. § 78lll(2).  The matter than moved to the 2^nd Circuit on appeal.

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None of the appellants invested directly with BLMIS; rather, they invested in two limited partnerships, Spectrum Select,L.P., and Spectrum Select II, L.P. ("Spectrum Funds"). Those Spectrum Funds then invested in two hedge funds, Rye Select Broad Market Fund, L.P., and Rye Select Broad Market Prime Fund, L.P. ("Feeder Funds"). Investors were advised in various documentation that by purchasing interests in the Feeder Funds, the investors had yielded exclusive control over investment decisions to those entities, which had invested the investors' pooled capital with BLMIS through securities accounts maintained only in the funds' names.

Ultimately, those who had invested in the Spectrum Funds - which, in turn, had invested in the Feeder Funds - had no direct financial dealings with BLMIS and were never identified as BLMIS investors on the Madoff firm's books and records.

Those victimized by the historic multi-billion dollar Madoff Ponzi fraud left no stone unturned in an effort to exhaust all opportunities to recoup their losses.  One such effort was to seek payments from SIPA as former BLMIS customers.  Any victimized customer claims that were not satisfied by BLMIS's assets, could receive Securities Investor Protection Corporation ("SIPC") coverage up to $500,000 per "customer." The question was whether the victims in this action had, in fact, established a customer relationship with BLMIS or whether the nature of their dealings precluded such a determination.

In rejecting legal theories advancing the existence of the critical BLMIS customer relationship, the bankruptcy court held that the claimants had purchased ownership interests in the Feeder Funds in contradistinction to having what would typically be characterized as a "customer" relationship with BLMIS. In sustaining the bankruptcy court's declination of coverage under SIPA, the 2^nd Circuit noted that it had generally  identified a critical aspect of being a "customer" to be "the entrustment of cash or securities to the broker-dealer for the purposes of trading securities." In applying that test to the present appeal, the 2^nd Circuit found that:

The record shows that they: (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.

The 2^nd Circuit affirmed the judgment of the district court, affirming the bankruptcy court's order granting the Trustee's motion.