February 23, 2010
Securities Investor Protection Corporation -- Battleground for Reform? Part II ("Net Winner" and "Direct Customer")
Posted by Christine Hurt

So, below, I introduced some of the valuation problems in the Madoff SIPC liquidation, where an investor who invested $100,000 in 1980 but took out $120,000 over the next 28 years might claim a total loss equal to his financial statement, which showed a fictitious $750,000 balance.  First, the $500,000 cap will limit the amount of SIPC recovery.  However, the SIPC trustee would also argue that the "net equity" claim would be $100,000 (presumably in current dollars), and furthermore that the recovery should be $0 because the investor is a "net winner." The post below discusses the definition of "net equity."

So, let's say that the court comes to a conclusion on the definition of net equity.  How then do we analyze the "net winner" claim?  Theoretically, it has some attraction -- you were entitled to your principal investment, and you've received that.  There were no real returns, so you've gotten out more than you put in.  Particularly because this was a Ponzi scheme and fraud restitution is generally limited to the amount given to the fraudster.  Again, this new-ish intersection of Ponzi scheme and SIPC liquidation presents new ground -- the SIPA doesn't talk about investors who profited (in the sense of taking out more than principal invested) before the collapse of the subject firm.  In a world of unlimited resources -- a bottomless pot of money in the bankruptcy estate and a bottomless pot of SIPC money, then this distinction might not matter.  However, in the zero-sum game of splitting up a small pie for many investors, fairness may dictate some set-off for distributions received.  This rule may also work as a proxy for complicity -- in Ponzi schemes, there is some sense that those who get back all their investment and more may know or should know of the nature of their "return."  The SIPC trustee has been judicious in using the clawback rule against Madoff victims, and set-off is surely more palatable than clawback.

The third issue in the Madoff SIPC liquidation is whether to exclude those who were not "direct customers."  The SIPA defines customer rather narrowly as the person with the account with the broker or dealer.  So, those who invested directly with Bernard L. Madoff Investment Securities are customers, but those who invested with "feeder funds" like Agile Funds in Colorado or Fairfield Greenwich Group in Connecticut or through a pension like that run by the Plumbers and Steamfitters Local 267 in New York are not direct customers.  The funds and pensions are, but that means the $500,000 cap applies to the entire feeder fund or pension fund.  Gulp.  The difference in the calculation of compensation between counting individual indirect investor accounts or fund accounts could be staggering.  What is the right result?

Our legal academy colleague John C. Coffee, Jr. testified in front of Congress in December that a compromise definition of "customer" could be inserted that counted "small pension plans."  Recognizing that a more expansive definition would bankrupt the system, Prof. Coffee also argued that larger institutional investors should not be sheltered from monitoring their investments.  Some of these feeder funds only invested in BLMIS, with very little investigation.  That type of investment strategy should not be encouraged.  But, defining "small pension plan" is the tricky part.  Of course, individual investors have claims against these funds for negligently handling their money, but because the funds held all of their monies in BLMIS, there isn't much there to fund any litigation recovery.  So, many Madoff victims may have no recourse at all.

So, how is this all going to come out in the wash?  On February 2, 2010, the Bankruptcy Trustee held a hearing and heard arguments about "net equity" and to some extent the "net winner" issue.  Though Judge Lifland did not tip his hand too much, he did seem to encourage populist arguments from victim counsel Helen Davis Chaitman, a Madoff investor and legal counsel for an investor group.  While making a seemingly irrelevant legal argument that compensating "net winners" would cost SIPC a tiny fraction of the bonuses Wall Street participants received "in the year they brought the global economy to its knees," Judge Lifland interjected "Wall Street could always look to the taxpayers to bail them out."  Perhaps Judge Lifland was just trying to acknowledge high emotions in a restless courtroom, or perhaps he was signalling a sympathy to the retail investor side of Wall Street.

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