[authors: Casey Servais, Nicole M. Stephansen]
On July 10, 2012, Judge James M. Peck of the Bankruptcy Court for the Southern District of New York ruled that so-called “soft dollar” claims do not qualify for treatment as customer claims under the Securities Investor Protection Act. The decision represents the first time that any court has been asked to determine the status of “soft dollar” claims under SIPA. In re Lehman Brothers Inc., No. 08-01420, 2012 Bankr. LEXIS 3103 (Bankr. S.D.N.Y. July 10, 2012).
In the securities industry, “soft dollar” credits are amounts allocated from brokerage commissions and held for clients in a separate account to pay for the research component of a broker-dealer’s array of services. Generally speaking, the soft dollar component of a brokerage commission consists of the difference between the commission rate a money manager pays to a broker-dealer for executing a trade and providing additional services, and the lowest available rate the money manager could have paid solely for the execution of that trade without the services.
Without the institution of “soft dollars,” money managers would face liability for a breach of their fiduciary duty to obtain “best execution” any time they paid a commission rate higher than the lowest available commission rate for the execution of a particular trade. The concept of “soft dollars,” however, allows money managers to consider factors other than the commission rate in choosing a broker-dealer. Specifically, section 28(e) of the Securities Exchange Act creates a safe harbor that permits money managers to select a broker-dealer charging higher commission rates based on the “brokerage and research services” the more expensive broker-dealer provides. See 15 U.S.C. § 78bb(e). Credits reflecting the “soft dollar” portion of the brokerage commission are often held in special accounts at the broker-dealer, where they can only be used to pay for research and other services falling within the section 28(e) safe harbor.
Prior to its liquidation, the debtor in the case, Lehman Brothers Inc. (“LBI”), was the U.S. broker-dealer arm of Lehman Brothers Holdings. On September 15, 2008, Lehman Brothers Holdings filed for bankruptcy, and a few days later the United States District Court for the Southern District of New York entered an order commencing a SIPA liquidation of LBI. Following the commencement of the SIPA case, money managers who had paid commissions to LBI asserted claims against the LBI estate for soft dollar credits held for their benefit in segregated LBI accounts. A small percentage of these claimants filed their soft dollar claims as “customer claims,” which are entitled to a higher priority than general unsecured claims under SIPA.
Protection under SIPA only extends to those creditors who meet the definition of “customer,” a term that is construed narrowly under SIPA. After reviewing these soft dollar claims, the SIPA trustee for the LBI estate issued letters of determination that the holders of soft dollar claims were not “customers” under SIPA and thus, the soft dollar claims could not be treated as customer claims. The trustee then filed a motion with the Bankruptcy Court seeking an order confirming this determination. Fifteen soft dollar claimants filed objections to the trustee’s motion.
In confirming the trustee’s determination that the soft dollar claims are not customer claims, the Bankruptcy Court focused its analysis on SIPA’s definition of “customer.”
Under SIPA, the definition of “customer” primarily encompasses two types of creditors: (i) any person 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 certain specified purposes, and (ii) any person who has deposited cash with the debtor for the purpose of purchasing securities. See 15 U.S.C. § 78lll. The court acknowledged that in applying the definition of “customer” under SIPA, a particular creditor of an insolvent broker-dealer might qualify as a “customer” with respect to some of its claims but not with respect to others. Thus, even though the soft dollar claimants indisputably qualified as customers with respect to some of their transactions with LBI, the court found that in their capacity as holders of soft dollar credits, these claimants did not fit into either prong of the “customer” definition.
The court found that the soft dollar credits are “plainly not securities,” so the soft dollar creditors did not have a claim “on account of securities.” Additionally, the court held that in order to qualify for standing as a customer, “purpose matters and cash must have been deposited with the broker-dealer for the purpose of purchasing securities.” (emphasis in original). The Section 28(e) safe harbor explicitly states that the soft dollar credits have a particular purpose – to obtain research – and under no circumstances could the credits be used to purchase securities. Accordingly, the court held that “credits that only may be applied to cover the cost of market research are too remote, indirect and tangential to satisfy the customer definition in SIPA.”
The soft dollar claimants asserted several other arguments to get around the SIPA definition of “customer,” but the court found each of these arguments unpersuasive. For example, the claimants argued that the soft dollar claims meet the SIPA definition of “customer property.” Under SIPA, “customer property” includes “cash and securities . . . at any time received, acquired or held by or for the account of a debtor from or for the securities account of a customer.” See 15 U.S.C. § 78lll. The court found that the soft dollar credits did not qualify as securities, and that they were not cash or cash equivalents. Instead, the court found that “[s]oft dollars function something like frequent flyer miles: they are a specialized form of currency that may be redeemed solely as a means to pay for research services and other services provided by a broker-dealer to its customers. They are a kind of credit available to a customer, not unrestricted cash that can be spent freely.” Accordingly, the soft dollar claims also did not meet the SIPA definition of “customer property.”
The court held:
Because soft dollar credits are an accepted method to allocate and account for incremental commission expenses charged by a broker-dealer in executing securities trades and because these credits cannot ever be used to purchase securities, credit balances held in soft dollar accounts do not qualify for the enhanced customer protection afforded by SIPA. Customers with claims based on soft dollars instead have claims for breach of contract (on account of the failure to apply the credits as promised to pay for services) and are only able to recover on these claims as unsecured creditors of LBI.
LBI had promised to provide research services in exchange for these credits and then had failed to do so. The court looked to existing case law that clearly establishes that in a SIPA case, breach of contract claims have the status of general unsecured claims rather than customer claims. Consequently, the Court held that the soft dollar claims were not customer claims entitled to priority under SIPA, rather they were general unsecured claims.
The status of soft dollar claims under SIPA is a matter of first impression for any court, and this decision relegates these claims to general unsecured status. This ruling limits the claims entitled to higher priority customer treatment under SIPA, increasing the potential pool of unsecured claims.