(Adds details from decision, comments from trustee and customers' lawyers)
By Jonathan Stempel
NEW YORK, Dec 8 (Reuters) - Victims of Bernard Madoff's Ponzi scheme may recover less money than they had hoped after a federal appeals court limited the ability of the trustee liquidating the swindler's firm to recoup "fictitious profits" and other payments from customers.
The 2nd U.S. Circuit Court of Appeals in New York on Monday said federal bankruptcy law did not let the trustee Irving Picard recoup a variety of payments that Bernard L. Madoff Investment Securities LLC made to some customers more than two years before the firm collapsed on Dec. 11, 2008.
Picard has been seeking to recoup money from customers who withdrew more from their accounts than they invested.
Circuit Judge Barrington Parker, however, said allowing the "clawbacks" sought risked the kind of "significant market disruption" that Congress sought to avoid by adopting protections for brokerage customers in the bankruptcy code.
"The magnitude of BLMIS's scheme, which included thousands of customers and billions of dollars under management, is unprecedented," Parker wrote. "Permitting the clawback of millions, if not billions, of dollars from BLMIS clients - many of whom are institutional investors and feeder funds - would likely cause the very 'displacement' that Congress hoped to minimize."
Amanda Remus, a spokeswoman for Picard, said the trustee is reviewing the decision by a unanimous three-judge panel.
The decision does not affect the $10.5 billion that Picard has recouped for former Madoff customers he calls victims, who lost about $17.5 billion of principal.
But it could stop him from recouping at least $1.8 billion more from "innocent" customers he targeted in more than 600 lawsuits, according to Richard Levy, a Pryor Cashman partner representing some of those customers.
"This is a huge victory for the 'innocent customer' defendants," Levy said in a phone interview. "I am delighted."
Madoff, 76, pleaded guilty in March 2009 and is serving 150-year prison term.
The decision was announced the same day that a federal judge sentenced Daniel Bonventre, a former back office director for Madoff, to a 10-year term. Four more former Madoff workers convicted with Bonventre will be sentenced over the next week.
Picard had sought to claw back money sent to various customers in the six years before Madoff's firm went bankrupt.
Those customers countered that clawbacks were limited to the last two years, and only if payments were made with fraudulent intent. They claimed not to have known Madoff was a fraud, and that taking money from them would provide a windfall to others.
"It adds insult to injury to cause customers who in good faith invested through Bernie Madoff to have to give money back years after the fact, when they may lack the wherewithal," said Bill Weintraub, a Goodwin Procter partner representing customers including former New York Islanders hockey player Bob Nystrom.
The case turned on section 546(e) of the bankruptcy code, a "safe harbor" provision that protects customers who receive transfers from stockbrokers that are made "in connection with a securities contract" or are "settlement payments."
While Madoff did not trade securities for many customers, U.S. District Judge Jed Rakoff in Manhattan ruled in a series of cases in 2011 and 2012 that transfers made more than two years before the bankruptcy could not be clawed back.
Picard's lawyer, David Sheehan, had argued that Madoff's shenanigans simply involved moving money from one customer to another, and was not what Congress meant to regulate.
Parker, however, said the Madoff firm's customer agreements were securities contracts, even if payments were made in connection with a Ponzi scheme.
"The clawback defendants, having every reason to believe that BLMIS was actually engaged in the business of effecting securities transactions, have every right to avail themselves of all the protections afforded to the clients of stockbrokers," including under section 546(e), Parker wrote.
Richard Breeden, a former U.S. Securities and Exchange Commission chairman, oversees a separate $4.05 billion fund to reimburse customers and third parties harmed by Madoff.
The cases are Picard v. Ida Fishman Revocable Trust et al, 2nd U.S. Circuit Court of Appeals, Nos. 12-2497, 12-2500, 12-2557, 12-2616, 12-3422, 12-3440, 12-3582 and 12-3585. (Reporting by Jonathan Stempel in New York; Editing by Tom Brown)