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SIPC Prepares For "Net Equity" Battle In Madoff Case

April 6, 2009 4:56 PM EDT
The SIPC's role in the Bernard Madoff case is by far its most complicated and important to date. The broker-funded agency is charged with the Herculean task of trying to "make whole" victims of a fraud so massive it may never be topped. But some hard-line stances the SIPC is taking on what "net equity" is for Madoff clients could have widespread and long-lived ramifications.

Unlike the FDIC, the SIPC was not chartered by Congress to combat fraud; instead member firms fund the organization. The SIPC does not offer blanket protection like the FDIC does for bank deposits, but promises to replace missing stocks and other securities where it is possible to do so in the case of a failed brokerage firm. Under the SIPC's terms, if sufficient funds are not available in the firm's customer accounts to satisfy claims, which is the case in Madoff, the reserve funds of SIPC are used to supplement the distribution, up to a ceiling of $500,000 per customer, including a maximum of $100,000 for cash claims. In the Madoff case, there has been about $900 million collected from the firm's customer accounts and other assets recovered. With the size of the Madoff scam estimated at $50-$60 billion, this is clearly not enough to satisfy all the potential claims which would then require the SIPC reserve funds to kick in.

When we talked with the SIPC's general counsel Josephine Wang in mid-December she indicated to us that if a client was presented statements and had reason to believe that the securities were in fact owned, the SIPC will be required to buy these securities in the open market to make the customer whole up to $500K each. So if Madoff client number 1234 was given a statement showing that they owned 1000 GOOG shares, even if a transaction never took place, the SIPC has to buy and replace the 1000 GOOG shares. Well we learned from new conversations with Ms. Wang that this is not exactly the case. Instead of giving $500K in securities, the SIPC will give up to $500K in cash - with some conditions we will get into a little later.

Unlike most brokers, Madoff didn't use a traditional "buy and hold" strategy; instead he portrayed to clients that he was buying and selling various securities constantly, always showing solid and steady returns. Statements showed a number of transactions in various stocks and options. It has been learned that many of the transactions looked similar in the various accounts, just scaled up or down based on the size of the account. Of course, as we all learned, Madoff didn't make any trades in years and all the statements were entirely bogus.

In the Madoff case, the SIPC is taking the unusual step of extending the $500K protection provided on securities, versus $100K on cash balances. This seems like a generous extension of protection from the SIPC, but there is one important caveat - The SIPC said "net equity" for Madoff clients will be "money in" versus "money out". This means Madoff clients will only be able to lay claim to the money they put in. Fictitious profits made up by Madoff will not be able to be claimed. Any money pulled from a Madoff account will have to be netted against money put in, to get at the "net equity" value of the account.

Some examples, based on the SIPC's stance:

1. If a client put in $1,000,000 with Madoff in 2005, watched the fictitious Madoff account balance grow to $1.2 million, pulled out nothing, this client would be eligible to make a claim for $1 million of "money in." $500K from the SIPC insurance would be immediately available to this client and the client would be able to lay claim to the additional $500K on a prorated share of property left. The clients would not be able to lay claim on the extra $200K in fictitious profits. Money in = $1 million, Money out = $0, Net Equity available to claim = $1 million.

2. If a client put in $500,000 with Madoff in 1992, watched the fictitious Madoff account balance grow to $1.5 million then pulled out the original investment, leaving a $1 million account balance with Madoff, that customer would be able to claim zero. Money in = $500K, Money out = $500K, Net Equity available to claim = 0.

3. If a client put in $500,000 with Madoff in 1992, watched the fictitious Madoff account balance grow to $1.5 million then pulled out $1 million, leaving a $500K account balance with Madoff, that client would able to claim nothing and may in fact have a clawback of the $500K fictitious profit that was withdrawn over and above the original "money in." Money in = $500K, Money out= $1M, Net Equity = (-$500K).

From what we've been told, there are a number of Madoff "net winners", or those that withdrew more then they put in. In some instances, money was pulled out to pay taxes on fake gains, to live on for retired persons, or because of IRA-forced withdrawals. How the SIPC handles these victims could have widespread and long-lived ramifications.

As discussed, the current stance of the SIPC is that Madoff clients can only claim the money they put in. So in the case of example No. 2 above (Account Balance = $1M, Money in = $500K, Money out = $500K), even though the client showed an account balance of $1 million on his/her last statement, because they already pulled on the money put in they have "no claim."

Should this victim be able to lay claim to the $1M in fake Madoff profits? They got their original $500K back, right? They have been made whole, right? According to the SIPC and the trustee in the Madoff investigation, Irving Picard, they have been. But some don't think so. It can and likely will be argued that these victims lost the time value of money. If they had known that Madoff was a fraud they certainly wouldn't have invested the $500K with him. Even putting the $500K in a modestly yielding 2.5% money market account in 1992 would have given them a return of about $250,000. Based on the current stance, these victims can't claim time value of money.

What may be even more profound is the fact that the mandate of the SIPC is to insure securities that investors "reasonably" believe they own. If you had reason to believe that you owned 1000 shares of GOOG, then the SIPC mandate is to insure this. Not in the Madoff case. The SIPC's Wang argues that because the money used to buy the 1000 shares of GOOG was never really made, this security position can not be insured. Wang said paying out false profits would "further the fraud."

A SIPA case called New Times Securities is likely to be highly important to the "net equity" issue with the Madoff case. In the New Times Securities case, a man named Goren defrauded investors out of $32.7 million. In the case, Goren claimed he put some clients in "real" securities and some in "fictitious" securities, but like Madoff no money was ever invested.

The New Times Securities clients with statements showing the "real" securities had an easy time making claims for up to $500K; the clients last statement balance, inclusive of any accumulated interest was their "net equity."

The New Times Securities clients with "fictitious" securities, after appeal, were able to make claim for "securities" for the higher $500K amount, but "net equity" was to be computed by using their initial investment minus any withdrawals with no accumulated interest.

So the question is – Are Madoff clients like the New Times Securities clients with "real" securities or "fictitious" securities? The SIPC would argue the securities were "fictitious" because they were bought with other "fictitious" gains. Madoff clients would argue that their account statements showed that "real" securities were held.

Legal sources we've talked to suggest that the SIPC and trustee Picard will likely win this battle. The source suggested that because the broker relationship with Madoff was based on the Madoff "magic touch", versus a traditional broker relationship, which usually involves the client telling the broker what to buy, Madoff is more like the New Times Securities clients with "fictitious" securities. The result for the New Times "fictitious" clients was to claim only initial investments minus any withdrawals with no accumulated interest. The SIPC is already offering this for Madoff clients.

Based on this view, in the end Madoff 'net winners' will likely not be able to collect any more than they put in. In addition, trustee Picard has threatened to seek clawbacks for those Madoff clients that took out more than they put in. Susman Godfrey Partner, Harry Susman, suggests most of these victims will not even make claims due to the clawback fears. Susman asks, "Why would theses victims subject themselves to the bankruptcy court, waiving their right to a jury trial?" Under New York law, Picard can pursue false profits dating back six years.

It is unfortunate that the system that has failed Madoff victims once, will likely fail them again. But it is not expected that the victims will yield without a fight. We will continue to follow the developments on the "net equity" issue.

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