Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Wednesday, December 9, 2009

SEC Proposes Some Increased Recovery for Early Madoff Investors

The House Capital Markets Subcommittee, chaired by Rep.Kanjorski, held another hearing today on the Madoff fraud, specifically dealing with SIPC.  In honor of the occasion, the New York Times today ran an article featuring the head of SIPC, Stephen P. Harbeck, whom critics have charged with being too conservative in his interpretation of the statute.  Critics object to the failure of SIPC to recognize claims from investors whose withdrawals at least equaled their deposits and from investors through feeder funds.    NYTimes, Protection Chief Struggles With Madoff Claims.  At the hearing Michael Conley, an SEC official, proposed that the claims of early investors be adjusted to reflect inflation, a recommendation it will make to the bankrupty court.  Here are excerpts from his testimony on this point:

The Madoff case raises difficult issues. Based on an analysis of SIPA, its legislative history, and cases that have applied it, the Commission is recommending to the bankruptcy court that customer claims should be determined through the cash-in/cash-out method advocated by the Trustee and SIPC — with an additional adjustment to ensure that the investors' claims in this long-running scheme are valued most accurately and fairly.

The Commission is basing its recommendation on the conclusion that the claims of the Madoff investors cannot be valued based on the balance shown on their final account statements. Although this approach would allow most Madoff account holders to receive payments on their claims, those payments would be based on account balances reflecting amounts that Madoff himself concocted that bear no relation to reality. ... Neither SIPA nor any of the cases interpreting that statute can be read to support an approach that would value claims based on the fictitious investment returns of such a scheme.

.... Therefore, the Commission has concluded that the most reasonable way to measure the value of the Madoff customers' net equity is to look to the money those customers invested with Madoff as a proxy for the unspecified investments in securities (the split-strike conversion strategy) Madoff told them he would make for their accounts.

The Commission's recommendation resembles what would likely be the outcome in a private suit by a customer challenging the distribution of assets on the same facts. Although the customer could establish that the broker had committed fraud, and could recover her initial investment (less withdrawals), she would not be able to recover as damages the amounts shown on the final account statements because they were based on fraudulent backdating of trades through hindsight. The fraud did not cause the customer to lose actual proceeds that were (or could have been) the product of legitimate trading. The same principles are relevant in calculating the Madoff customers' net equity under SIPA. In this case, the only reliably determinable transactions are the cash deposits and withdrawals those customers made to and from their brokerage accounts....

In addition, it is important to note that basing customers' net equity on the fictitious balances on their final account statements would do nothing to increase the fund of customer property — it would simply reallocate it. It is clear that there will not be enough money in the fund of customer property to pay out the $65 billion that Madoff falsely reported was in customer accounts when the firm failed. The Trustee has estimated that he may be able to recover as much as $8 billion to distribute to claimants. Using the final account statement approach would have the effect of favoring early investors-many of whom withdrew all or more than the principal they invested with Madoff — over later investors — some of whom withdrew little or none of what they invested and will not receive a distribution equal even to their principal.

While the final account statement approach favors earlier customers at the expense of later customers, the SEC is also sensitive to the corresponding fairness concerns under the cash-in/cash-out method. That method of calculating net equity favors later customers at the expense of earlier customers by treating a dollar invested in 1987 as having the same value as a dollar invested in 2007. ...

In the SEC's view, to achieve a fair and economically accurate allocation among Madoff customers who invested and withdrew funds in different historical periods, it is appropriate to convert the dollars invested into "time-equivalent" or constant dollars. This constant-dollar approach is rooted in the classic economic concept of the time value of money and will result in greater fairness across different generations of Madoff investors — in effect, treating early investors and later investors alike in terms of the real economic value of their investments.

The issue of calculating net equity in constant dollars has not arisen before in SIPA cases, probably because many Ponzi-type schemes are of relatively short duration, and the inequity among those who invested at different points in time is less striking. But the Madoff fraud — which lasted for 20-plus years — puts this issue into stark relief. ... Under the facts of this case, the Commission believes that the use of constant dollars can be distinguished from the payment of interest discussed in that Sixth Circuit case and that the best reading of SIPA and the cases interpreting it is that net equity here should be calculated in constant dollars.

It also is the Commission's view that the constant-dollar method will have limited application to the calculation of net equity in other liquidations under SIPA. ...

Here is the prepared testimony of Mr. Harbeck that does not address this damages calculation issue.

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