The SEC Weighs In on the Valuation of Net Equity for Madoff Victims
By: Richard A. Kirby and R. James Mitchell
On December 9, 2009, almost one year to the day that Bernard L. Madoff was revealed to have perpetrated the largest Ponzi scheme in history, the SEC revealed its position with respect to the approach that it believes the Securities Investor Protection Corporation (“SIPC”) should take in defining the net equity of Madoff claimants.
The SIPC Trustee has previously taken the position that net equity for Madoff’s victims should be measured on a cash-in/cash-out basis, rather than using the stated values on account statements fabricated by Madoff. This measure of net equity rejects all claims filed by victims whose net withdrawals equaled or exceeded their principal investments.
The SEC Supports the SIPC Trustee’s Position with an Added Twist
In his December 9, 2009 statement before the U.S. House of Representatives Financial Services Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises (“Subcommittee”), Securities and Exchange Commission (“SEC”) Deputy Solicitor Michael Conley previewed the SEC’s position that net equity for SIPC claimants in the Madoff bankruptcy should be measured on a cash-in/cash-out basis, index adjusted for the time value of money. On December 11, the SEC filed its brief in the bankruptcy litigation advocating this unprecedented position.
In support of its position that net equity should be valued on a cash-in/cash-out basis, the SEC observed that even though the securities positions reflected on the account statements could have theoretically been held by the customers, the Madoff account statements “showed the results of securities transactions selected by Madoff and ‘executed’ at prices calibrated after the fact to produce predetermined favorable returns—returns that were possible only because they were entirely divorced from the uncertainty and risk of actual market trading.” Brief of SEC at 8, Sec. Investor Prot. Corp. v. Bernard L. Madoff Investment Securities LLC, No. 08-1789 (Dec. 11, 2009).
Although arguments can be made regarding the uniqueness of the facts surrounding the Madoff victims, the SEC position is generally consistent with prior positions taken by the SEC in brokerage liquidations involving Ponzi scheme frauds. The unprecedented twist is the proposed constant dollar methodology advocated for valuing the positions.
Recognizing that the cash-in/cash-out valuation favors newer investors over longer-term investors, who are more likely to have exhausted their principal through periodic withdrawals, the SEC advances the argument that “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.” Hearing on Additional Reforms to the Securities Investor Protection Act Before the H. Subcomm. on Capital Mkts., Ins., and Gov’t Sponsored Enters., 111th Cong. (Dec. 9, 2009) (statement of Michael Conley) (available at http://www.sec.gov/news/testimony/2009/ts120909mac.htm).
With no precedent cited, the SEC looks to the legislative history of the Securities Investor Protection Act (“SIPA”) to contend that SIPC-covered investors victimized by a Ponzi scheme have the ability to reclaim more than their principal contributions, which would ordinarily limit the recovery of non-SIPC covered Ponzi scheme victims. “Customers in SIPA liquidations have claims for the net equity in their accounts. It is this remedy that fulfills the statute’s purpose of assuring that a customer ‘receive[s] what he believes is in his account at the time the stockbroker ceases business.’” Brief of SEC at 10, Sec. Investor Prot. Corp. v. Bernard L. Madoff Investment Securities LLC, No. 08-1789 (Dec. 11, 2009) (emphasis added).
SIPC Declines to Adopt the SEC Position
SIPC President and CEO Stephen Harbeck signaled that SIPC may not acquiesce in the SEC’s position on indexing for inflation. Addressing the issue during the Subcommittee’s December 9, 2009 hearing, Mr. Harbeck observed that the SEC’s constant dollar theory is not currently a part of SIPA, and that for that reason in proposed amendments SIPC has requested an index to inflation for the cash protection provided under SIPA. Mr. Harbeck noted that the SEC’s proposal would produce “arbitrary results – different arbitrary results from [those] that the statute now [produces].” Hearing on Additional Reforms to the Securities Investor Protection Act Before the H. Subcomm. on Capital Mkts., Ins., and Gov’t Sponsored Enters., 111th Cong. (Dec. 9, 2009) (statement of Stephen Harbeck). For example, he observed that customers who previously withdrew all principal would receive even more money at the expense of those who will never obtain the return of all principal invested. Notwithstanding his reservations, Mr. Harbeck stated that SIPC was continuing to evaluate the SEC’s position.
More Questions Raised than Answered
Neither the SEC’s brief nor Mr. Conley’s statements before the Subcommittee make clear exactly how this indexing formula would affect the calculation of the value of so-called fictitious profits sought by the SIPC Trustee in certain pending litigation in the bankruptcy court. Nor has the SEC pointed to any specific portion of SIPA that would support this expanded discretion with respect to valuing the net equity claims of Madoff victims.
Although it remains to be seen whether SIPC will support the SEC’s interpretation of the statute, it is equally uncertain whether SIPC’s position bears any further relevance in view of the Second Circuit’s conclusion in the New Times case that defers to the SEC’s interpretation of SIPA notwithstanding a contrary position taken by SIPC. In re New Times, 371 F.3d 68, 77-80 (2d Cir. 2004).
Estimated Recovery of Victims’ Assets Greater than Previously Anticipated
Mr. Conley’s prepared testimony revealed a glimmer of hope for Madoff victims, suggesting a possible recovery better than previously estimated. Mr. Conley stated that the SIPC Trustee is currently estimating that “he may be able to recover as much as $8 billion to distribute to claimants.” The SIPC Trustee’s expert in the net equity litigation has stated that the amount deposited less that withdrawn is less than $20 billion. Thus at current estimates, and depending on the net equity calculation used, customers may reasonably expect to see the return of as much as 40% of their principal investments. This potential recovery is higher than any previously projected estimates.
