* Court says indirect investors are not Madoff customers
* Investors had put money in "feeder" funds
By Jonathan Stempel
Feb 22 (Reuters) - People who lost money by investing in funds that funneled their money to Bernard Madoff's Ponzi scheme are not entitled to recover for their losses, in the manner that direct victims of the massive fraud can recover, a federal appeals court ruled on Friday.
The decision by the 2nd U.S. Circuit Court of Appeals in New York is a victory for Irving Picard, the trustee liquidating Bernard L Madoff Investment Securities LLC and seeking money for its former customers.
Picard, a partner at Baker & Hostetler, persuaded the court that "indirect" investors who lost money in the fraud were not Madoff customers who could recover from the bankruptcy estate.
Madoff, 74, is serving a 150-year prison sentence, and Picard had estimated that customers lost $17.3 billion of principal in the fraud.
The appeal was brought by 17 investors who had invested in limited partnerships known as Spectrum Select. These in turn sent their money to two Rye Select hedge funds overseen by Tremont Group Holdings Inc.
Tremont was one of the largest Madoff "feeders," and settled with Picard for $1.025 billion in July 2011.
Prior to the appeal, two lower court judges had found that the 17 indirect investors could not recover from the estate because they had not been Madoff customers, unlike the feeder funds that dealt directly with him.
That distinction matters because it is customers, not indirect investors, who may draw up to $500,000 each from a fund overseen by the Securities Investor Protection Corp, to the extent they cannot recover losses from a bankruptcy estate.
SIPC is a nonprofit created by Congress and funded by the brokerage industry.
Writing for a three-judge 2nd Circuit panel, Circuit Judge Reena Raggi said there were several reasons that the indirect investors did not qualify as Madoff customers.
She said they had no direct relationship or accounts with his firm, were not identified in the firm's books and records, had no property interest in the assets sent there by the feeder funds, and lacked control over the feeder funds' investments.
"We have identified the critical aspect of the 'customer' definition to be the entrustment of cash or securities to the broker-dealer for the purpose of trading securities," Raggi wrote. "Appellants fail to satisfy this critical requirement."
William Chapman, who argued the indirect investors' appeal, did not immediately respond to a request for comment.
A spokeswoman for Picard did not immediately respond to a similar request.
The decision does not affect the ability of indirect investors to sue the feeder funds, or share in any recovery by those funds from the SIPC fund.
Friday's decision is the second this week by the 2nd Circuit in a Madoff-related appeal.
On Wednesday, the court refused to let former investors pursue claims against Madoff's brother Peter, as well as Madoff's son Andrew and the estate of his late son Mark, over the family members' roles in the fraud.
The court said allowing such claims would impede Picard's effort to maximize payouts from the estate.
Among the investors who had challenged the trustee was a charitable foundation for New Jersey Senator Frank Lautenberg.
Separately, Picard on Feb. 13 asked U.S. Bankruptcy Judge Burton Lifland in Manhattan for permission to distribute another $505 million to customers, boosting the total to $5.44 billion.
The case is Kruse et al v. Securities Investor Protection Corp et al, 2nd U.S. Circuit Court of Appeals, Nos. 12-410, 12-437, 12-483 and 12-529.