February 23, 2010
Securities Investor Protection Corp. -- Battleground for Reform?, Part I ("Net Equity")
Posted by Christine Hurt

So, say you invested $100,000 with Bernie Madoff in 1980.  According to your statements, this principal grew at an average of 10% a year.  In 1995, when you thought you had $400,000, you take out $60,000 to send one child to college.  In 1998, you take out another $60,000 for the same reason.  In November 2008, your monthly statement reflects a balance of $750,000.  What is your loss?

a. $750,000

b. $500,000

c. $100,000

d. $0

Prior to the discovery of Bernard Madoff's $65 billion Ponzi scheme, few people gave much thought to SIPC.  However, just as the FDIC insures bank deposits, SIPC "insures" investment accounts.  Of course, money invested in equity securities is by definition put to market risk, and SIPC does not insure against market risk -- it insures against investment firm risk, the risk that the firm will go under because of fraud or bankruptcy.  (The fall of Lehman Brothers gave the SIPC folks something to do for awhile.)  And, just as the FDIC insures bank deposits up to a limit ($250,000 since 2006), SIPC insures investment accounts up to $500,000.  (I am using the word "insures" though the SIPC points out that it is not insurance; the $500,000 refers to the maximum "advance" a victim receives from SIPC in relation to an allowed claim under bankruptcy, before and regardless of the bankruptcy trustee gathering all funds for distribution.)

However, Madoff's investment fund presents the not quite rare, but sort of new-ish Ponzi scheme that takes the form of an investment account, registered with the SEC and under the protection of SIPC.  This isn't the case of someone pretending to put your money in account and taking off with it -- here, Madoff put the money in Bernard L. Madoff Investment Securities LLC and issued statements with fictitious returns.  Now, in the usual case of Ponzi schemes, our restitution rules treat victims almost as quasi-conspirators, allowing only return of principal, requiring victims to return distributions to re-distribute pro rata, and disallowing any recovery if the victim has any reason to suspect fraud.  SIPC also has provisions for clawbacks, requires the victim to be a direct customer of the fund, and has the $500,000 cap.  In addition, SIPC takes the position that victims are only entitled to the value of their principal, minus any distributions, and with no consideration to the phantom gains. 

So, SIPC takes the position that the answer to the question above is "d.  $0" because you are a "net winner."  If you had taken no distributions, SIPC would take the position that the answer is "c.  $100,000" because any gains were completely fictitious.  (SIPC Memorandum of Law here.)  As you might guess, Madoff victims have argued to both Congress in December 2009 and to the bankruptcy trustee in February 2010 that the loss above is $750,000 and should be recognized as such, and hopefully not capped at $500,000. (Milberg's Memorandum of Law here; Sonnenschein's MOL here.) The transcript of the February 2, 2010 hearing on this issue is here

So, this dispute centers around the definition of "net equity," the issue of the "net winner," and the issue of the "direct customer" and creates two questions:  What is the right result under the law as of December 2008 (which is the same as now), and what is the right result going forward?  The current state of the law regarding "net equity" is a bit murky.  In fact, you couldn't write better Moot Court facts than this.  The Deputy Solicitor of the SEC, which has disagreed with SIPC interpretations before, testified to Congress that "The Madoff liquidation does not fall neatly within the situations expressly addressed by SIPA or dealt with in cases interpreting the statute."  Both sides rely on a case called In re New Times Sec. Svcs., Inc., 371 F.3d 68 (2d Cir. 2004).  To say it is not on all fours with either side is obvious; each side can cite an opposing hindleg and foreleg, but that means neither side can stand for very long.

In New Times, a broker-dealer persuaded victims to invest both in bogus mutual funds offered by his firm and bona fide mutual funds, but no mutual fund securities were ever purchased.  The prevailing wisdom of SIPC was to give victims the securities they had asked to be bought in their name.  So, if you asked Mr. Fraudster to purchase 100 shares of Google with your money, and he absconded with it, then SIPC would advance to you 100 shares of Google.  Here, though, some investors had asked Mr. Fraudster to buy securities that didn't exist.  SIPC took the position, contrary to the SEC position, that those investors only had claims for cash, not securities, which would put a maximum on their advances of $100,000, not $500,000.  The Second Circuit said no, the distinction between claims for cash and claims for securities was meant to distinguish those who had cash sitting on deposit with broker-dealers from those who invested in securities.  So, all claimants were claimants for securities.  However, the Second Circuit said that no claimant had a claim for fictitious "interest and dividends."

So, in the Madoff scheme, investors put their money into BLMIS with no instructions to purchase any particular securities.  At the end of the month, Madoff created fictitious statements that showed money being moved in and out of real-world investments for modest gains, but no securities were ever bought and sold.  Moreover, the shares of real-world securities that BMLIS purported to buy and sell were in amounts that don't exist in the real world.  No one is arguing that these claims are not claims for securities, but the argument is whether the claims include the fictitious "balances" the investors thought they had.  The balances reflect fictitious gains on securities sales that were used to purchase other securities, sold for fictitious gains, and so on.  So, SIPC argues that New Times says that the balance can't be the claim, but plaintiffs argue that New Times says that claimants have the right to the securities that they thought they owned as of the filing date.  The statute doesn't help much, either:

the dollar amount of the account or accounts of a customer, to be determined by calculating the sum which would have been owed by the debtor to such customer if the debtor had liquidated, by sale or purchase on the filing date, all securities positions of such customer” corrected for “any indebtedness of such customer to the debtor on the filing date

In addition, these accounts have to be established by the books and records of the firm, which in the case of a fraudulent firm like Madoff, don't exist.  From the hearing transcript in front of the Bankruptcy Judge Burton R. Lifland, it's hard to read the tea leaves on net equity.  Early in the hearing, he seems to agree with SIPC's reading of New Times, only to be drowned out by what seems to be an angry audience in the courtroom:

THE COURT:   If there is going to be a kind of a reaction, I am going to have the marshal remove you. People ar ehere as observers to a proceeding and not as a cheering section one way or the other. I am not swayed by your reaction to the comments. If I were, I didn't need to have anybody here. I could just have relied on the briefs.

What is the right result going forward? If we amend the SIPC statute to make the outcome clear, how should it read? I would favor an approach based on investment in, in current dollars. Honoring fictitious returns subsidizes fraudsters by attracting the reassured. Honoring fictitious returns also disincentivizes investors from conducting due diligence or asking hard questions, which would have saved many of the Madoff investors. And the practical argument, which Madoff victims have held up for criticism, is that SIPC only has so much money. To compensate victims of fraud or firm bankruptcy, there are only two pots -- the fraudster's/insolvent's pot and the SIPC pot, neither of which are going to make everyone whole. So, SIPC premiums probably should be raised from the miniscule amounts as they currently exist ($150 per firm), but the fund seems to be envisioned as protecting investor's minimum losses.

Finally, what about losses?  A lot of people put money into the market in 2006.  If, in December 2008, Madoff Victim #1 has a claim not only for her January 2006 principal, but also for fictitious returns, then she is better off than if Madoff had actually invested her money.  Most people in December 2008 had much less than 100% of their January 2006 money.

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