In re Grafton Partners

• Decision Date: 17 February 2005
• Court: Bankruptcy Appellate Panels. U.S. Bankruptcy Appellate Panel, Ninth Circuit

321 B.R. 527

In re GRAFTON PARTNERS, L.P., a California Limited Partnership, and its Affiliates, Debtors Richard M. Kipperman, Chapter 7 Trustee, Appellant

v. Circle Trust F.B.O., Michele Montano, n/k/a Circle Trust, Trustee for The Stable Value Fund, Appellee.

BAP No. SC-04-1028-KMOS. Bankruptcy No. 01-10606-H7. Adversary No. 02-90555.

United States Bankruptcy Appellate Panel of the Ninth Circuit.

Argued and Submitted July 30, 2004.

Filed February 17, 2005.

Ali M.M. Mojdehi, Baker & McKenzie, San Diego, CA, for Richard M. Kipperman, Chapter 7 Trustee.

Margaret M. Mann, Heller, Ehrman, White & McAuliffe, San Diego, CA, for Circle Trust F.B.O. Michelle Montano, nka Circle Trust, Trustee for the Stable Value Fund.

Before: KLEIN, MONTALI, and SMITH, Bankruptcy Judges.

OPINION

KLEIN, Bankruptcy Judge.

The federal securities laws intersect with the Bankruptcy Code in this appeal arising from a "Ponzi scheme" that collapsed into federal criminal prosecutions and bankruptcy.

The essential question is whether nonpublic transactions in illegally unregistered securities can be the subject of "settlement payments" that are "commonly used in the securities trade" within the meaning of 11 U.S.C. § 741(8). If so, then such payments made to appellee "financial institution" are immunized from trustee avoiding powers by 11 U.S.C. § 546(e).

Before the collapse, appellee, the trustee of a pooled investment fund, sought to withdraw all $29 million of capital contributions it had made to a limited liability company that had funded the Ponzi scheme, the funds having been raised in violation of registration and anti-fraud provisions of the Securities Act of 1933 and Securities Exchange Act of 1934.

Although appellee actually withdrew $22 million before the collapse, the LLC's chapter 7 trustee attacked only the $4 million transfer that was received 89 days before bankruptcy, arguing it was a preference to be retrieved and shared with fellow fraud victims who did not withdraw before the collapse.

The trustee appeals the ruling that the withdrawal of capital was a "settlement payment" that is "commonly used in the securities trade" made to a "financial institution" and, hence, immune from recovery per 11 U.S.C. § 546(e). We hold that nonpublic transactions in illegally unregistered securities are not "commonly used in the securities trade" and REVERSE.

FACTS

PinnFund USA, Inc. ("PinnFund") engaged in the mortgage banking business, originating, purchasing, and selling socalled non-conforming, or sub-prime, mortgage loans in California.

Funds to make the loans came from investors in two limited partnerships (Allied Capital Partners and Grafton Partners) and Six Sigma, LLC ("Six Sigma"), that were formed for that purpose.

These funding entities were managed by Peregrine Funding, Inc. ("Peregrine"), owned by James L. Hillman and operated by Hillman and Piotr Kodzis, which acted as general partner to the partnerships and as managing member of Six Sigma.

PinnFund agreed, under its Spot Loan Funding Agreement, to pay the funding entities a premium return for the use of their capital: "interest" at 10 percent; plus a share of participation fees on sales of loans. This compensation, according to the Subscription Agreement, was expected to withstand usury attack because "the transactions are more appropriately characterized as either: (i) agreements to advance money in exchange for a share in profits; or (ii) loans in which the amount of the interest payment is contingent upon events within the borrower's control."

Although the Spot Loan Funding Agreement required that PinnFund maintain the investors' funds in a trust account to be used solely to fund loans, about $100 million of the $276 million raised was diverted to pay PinnFund's operating losses and to finance lavish lifestyles for insiders.

The Ponzi scheme ended in 2001 when the Securities and Exchange Commission ("SEC") took action leading to a receivership and to criminal prosecutions of the principals, who eventually confessed to running PinnFund as a Ponzi scheme.^[1]

What made it a Ponzi scheme was that much of the return provided to investors monthly under the guise of "interest" or participation fees actually came from the corpus of invested funds, rather than from profits derived from business activity.^[2] In such a scheme, it was inevitable that Pinn-Fund would run out of funds and plunge PinnFund, Peregrine, and the funding entities into bankruptcy. It was only a question of time.

One of the funding entities, Six Sigma, was a California limited liability company formed in 1999. Its operating agreement made Peregrine (controlled by Hillman) its manager, limited its business to providing funds for PinnFund loans, and precluded LLC members from participating in management.

Membership in Six Sigma was limited to 99 "qualified purchasers," as defined by the Investment Company Act of 1940. Six Sigma took the position that no registration statement under the Securities Act of 1933 was required. The membership interests could not be transferred without permission of the manager, who could involuntarily redeem an interest in order to continue to qualify as a partnership for purposes of taxation or to comply with securities laws.

Each Six Sigma member had a capital account, consisting of the sum of that member's capital contributions and pro rata share of profits and losses. The capital account, adjusted monthly, would rise or fall to reflect the fortunes of the business.

The operating agreement provided that a member could withdraw from Six Sigma by withdrawing its entire capital account on 60-day notice ("or any lesser period at the Manager's sole and absolute discretion").

Appellee Circle Trust Company ("Circle Trust"), a member of Six Sigma, is a limited purpose trust company chartered by the State of Connecticut to provide fiduciary services only. It may not accept deposits and is not insured by the Federal Deposit Insurance Corporation. It provides investment management, trust, custody, and administrative services.

Circle Trust's Six Sigma capital contributions totaled $29 million, made as trustee of the Stable Value Plus Fund. Circle Trust represented to Six Sigma that it was acquiring its interest directly and without a compensated intermediary.

When Circle Trust decided to withdraw from Six Sigma, allegedly after doing "due diligence,"^[3] it gave notice, by letter of September 28, 2000, to James L. Hillman and Peregrine, of its request to withdraw "all of its capital account in Six Sigma, LLC ('Capital Account'), as of the earliest permitted date." Three capital account payments ensued, totaling $22 million of the $29 million invested: (1) $10 million wire-transferred November 1, 2000, the 60-day notice requirement having been waived; (2) $8 million by check of December 1, 2000; and (3) $4 million by check dated January 2 and honored January 4, 2001, by the drawee bank.

When Six Sigma filed its chapter 7 case, Circle Trust still had $7 million of capital on the books, on which it received "interest" during 2001: $160,875.09 (January 10); $100,642.82 (February 12); and $98,273.73 (March 12).

The total "interest" that Circle Trust had received monthly from Six Sigma on account of capital contributions was $3,989,041.64. The source of funds to pay such "interest" was, consistent with the fraud's status as a Ponzi scheme, the capital provided by the LLC and the limited partnerships.

Six Sigma and the limited partnerships filed chapter 7 cases in the Northern District of California on April 2, 2001, twelve days after the SEC sued. They were transferred to the Southern District of California, where they were consolidated under the name "Grafton Partners, LP, and Affiliated Entities," with Richard Kipperman as case trustee.

The trustee sued Circle Trust to avoid and recover the $4 million transferred January 4, 2001, as a preference.

Circle Trust moved for summary judgment, arguing that the partial withdrawal was a "settlement payment" as defined by 11 U.S.C. § 741(8) and, thus, was immune from avoidance as a preference. The bankruptcy court agreed. This appeal ensued.

JURISDICTION

The bankruptcy court had core proceeding jurisdiction per 28 U.S.C. §§ 157(b)(2)(F) and 1334(b). We have jurisdiction under 28 U.S.C. § 158(a)(1) because the summary judgment order was intended to be the court's last word on the adversary proceeding.

ISSUE

Whether withdrawal of capital from a limited liability company, in a non-public, non-market transaction involving an illegally unregistered security, constitutes a "settlement payment" that is "commonly used in the securities trade," as defined by 11 U.S.C. § 741(8), and hence immune from avoidance as a preference in bankruptcy by 11 U.S.C. § 546(e).

STANDARD OF REVIEW

We review summary judgment de novo. Paine v. Griffin (In re Paine), 283 B.R. 33, 36 (9th Cir. BAP 2002).

DISCUSSION

The parties agree that a membership interest in an LLC that is required to be the subject of a registration statement filed with the SEC is a "security" under the Bankruptcy Code. 11 U.S.C. § 101(49)(A) (2000).

Our basic task is to construe the meaning of the definition of "settlement payment," which was first enacted in 1982. The current version of the definition reads:

(8) "settlement payment" means a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, or any other similar payment commonly used in the securities trade;

11 U.S.C. § 741(8) (2000).

If the $4 million withdrawal from Six Sigma 89 days before bankruptcy was a "settlement payment,"^[4] then § 546(e) insulates the transfer from avoidance as a preference.^[5]

Ascertaining the meaning of "settlement payment" is a "holistic endeavor" that requires us to consider the entire statutory scheme associated with its enactment and to reject plausible readings of isolated terms that are not compatible with the rest of the...