By Karen Freifeld

NEW YORK (Reuters) - Lawyers for New York Attorney General Eric Schneiderman and the Bernard Madoff bankruptcy trustee are set to face off over $410 million recovered for victims of history's largest Ponzi scheme.

Irving Picard, the court-appointed trustee, is seeking to block a settlement reached between Schneiderman and hedge fund manager Ezra Merkin.

The agreement ended a 2009 lawsuit accusing Merkin of "recklessly" feeding $2.4 billion worth of client funds to Madoff.

Picard claims the settlement would return funds to select investors at the expense of the rest of Madoff's victims. He filed his own action against Merkin in 2009 to recover $500 million in fraudulent transfers made by Madoff to Merkin and his funds. That case is pending.

The two sides were scheduled to appear Tuesday before U.S. District Judge Jed Rakoff in Manhattan to argue over Picard's request for a preliminary injunction. However, a scheduling conflict led to a last-minute adjournment of the oral arguments. No new date has yet been set.

"The trustee has no right to enjoin or interfere with the Merkin settlement," David Ellenhorn, who will argue for the attorney general, said in court papers.

Ellenhorn, Schneiderman's senior trial counsel, said his office's claims had no bearing on the Madoff estate and weren't similar to Picard's. The New York suit claims Merkin deceived investors and breached his fiduciary duty.

Even if he had a right to the money, it was too late, Ellenhorn argued. He said Picard should never have waited until a settlement was reached to take action.

"The trustee has no justification for the three-year delay," the attorney general's office said in court papers. "Imposing the stay now would cause irreparable and irrevocable prejudice" to the investors.

AG's 'END-RUN'?

Bart Schwartz, the receiver for Merkin's Ariel and Gabriel funds, said in court papers he had expected to make the first distributions for Madoff-related losses in the first quarter of 2013.

David Sheehan, a lawyer who will argue the case for Picard, said in court papers that Merkin's assets were limited and he could not satisfy both the New York settlement and the trustee's claims.

The attorney general attempted an "end-run," the trustee said in court papers, "to benefit a select group of investors to the detriment of thousands of victims of Madoff's fraud."

Sheehan says, under Schneiderman's settlement, millions of dollars of settlement money also will be diverted "into New York state's coffers."

Five million dollars from the settlement will go to the state, according to Schneiderman.

Picard is the court appointed trustee under the Securities Investor Protection Act. His position is supported by the Securities Investor Protection Corp, a nonprofit established under SIPA that insures securities and cash in customer accounts if a brokerage goes bankrupt.

SIPC provides up to $500,000 to each direct Madoff investor.

The attorney general argues that Merkin's victims have no SPIC insurance. Indirect Madoff investors, such as those who invested through Merkin's Ariel, Gabriel and Ascot funds, are ineligible.

According to the attorney general's office, under its settlement, eligible investors will receive over 40 percent of their first $5 million in cash losses.

The settlement itself has not been made public.

Merkin resigned as non-executive chairman of GMAC LLC, the financing arm of General Motors, after the Madoff scandal. GMAC is now Ally Financial.

Madoff pleaded guilty in March 2009 to perpetrating the largest Ponzi scheme in U.S. history and is serving a 150-year prison sentence.

Picard has recovered more than $9.3 billion, over half the $17.3 billion in principal estimated to have been lost by Madoff customers who filed claims, according to the trustee's website.

The case is Irving Picard v. Eric Schneiderman, U.S. District Court, Southern District of New York, No. 12-cv-6733.

The related cases are New York v. Merkin, New York State Supreme Court, No. 450879/2009; Irving Picard v. Ezra Merkin, U.S. Bankruptcy Court for the Southern District of New York, No. 08-01789.

For the trustee: David Sheehan of Baker & Hostetler.

For the New York Attorney General: David Ellenhorn.

For Merkin: Andrew Levander of Dechert.

For SIPC: Kevin Bell.

For Ariel and Gabriel Funds Receiver Bart Schwartz: James McCarroll of Reed Smith.

For Ascot Partners Receiver David Pitofsky: Daniel Glosband of Goodwin Procter.

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