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Much Wrong With An Appellate Court Decision That Also Sets a Dangerous Precedent

Thousands of Madoff victims had pinned considerable hopes that the Court of Appeals of the Second Circuit would see the issue of “Net Equity” in a different manner than SIPC, Trustee Picard, and the Federal Bankruptcy Court...

I’m one of the many tremendously disappointed with what appears to have been a poorly thought through, ill-researched decision – one which ignores Congressional intent, eschews fairness, and threatens the viability of the use of investment statements for all investors for the future.  It is clear after reading this ruling and watching the legal proceedings closely, Congress must get involved to ensure investors have real protections, as they were intended to have.  Here, very briefly is a summary of my observations of the decision:

1.         The Second Circuit ignored the legislative history around the 1970 Securities Investment Protection Act (SIPA) and amendments, repeatedly expressed on the floor of Congress by many of the leading Senators and Congressmen of the day, who wanted to protect small investors and improve confidence in the financial markets. The Circuit thereby ignored, indeed, made no reference even to the intent of the legislation. As many of you know who have read both my and others’ writings on the subject, along with the elimination of the use of physical securities, Congress clearly sought to provide FDIC-like protection based on account statement values, putting all investors on an equal footing in terms of SIPC protection. Under FDIC, all customers of a bank are seen to have equal expectations based on their account statements, a cornerstone to permit customer confidence, otherwise those withdrawing from savings in their later years could see their FDIC protections wiped out.  

2.         SIPA – the Securities Investor Protection Act of 1970 -- gives the definition of Net Equity and says this definition cannot be changed by SIPC.  But SIPC and its Trustee did change it, and were upheld by the Appellate Court, which said other Trustees in other cases would be free to change it yet again.  This overriding of a specific statutory provision by SIPC, the Trustee, and the Circuit could be construed as a violation of separation of powers (and perhaps even judicial activism), and could be one of the points focused on in a petition for certiorari – a request for hearing of the case -- filed in the Supreme Court, the next and last possible legal stop.

3.         The Appellate Court held that CICO (the cash-in-minus-cash-out Net Investment Method used by the SIPC Trustee) was the only way to achieve fairness, choosing not to address any of the extensive arguments against this position. [See point #3 in my August 23rd blog  for my discussion of “fairness” in my blog. Or visit the Net Equity tab at www.investoraction.org  for NIAP’s discussions about net equity.]  Nor did it pay any attention to the fact that discovery was not allowed in the Bankruptcy Court below -- discovery which would likely show that SIPC and the Trustee chose CICO for the unlawful purpose of saving SIPC money at the expense of investors. Discovery would also show, almost to a certainty, that under CICO  the lion’s share of available money will go to huge banks and hedge funds which even the Trustee says were responsible for enabling Madoff to keep his fraud going for many years instead of running out of money, while small, now impecunious, admittedly innocent victims will get nothing.  All this constitutes fairness?  Not ordering the discovery which would show all this is fairness?

4.         The Circuit said that every dollar given to a “net winner” reduces the amounts available to give to net losers.  This is flatly, and utterly remarkably, wrong.  The Court ignored the fact that there are two funds, not one.  There are both the SIPC fund, consisting of money from the brokerage industry, and the customer property fund, comprised of funds which would be recovered by actions of the Trustee and remaining assets in the estate.  Money a customer receives from the SIPC fund, which provides up to $500,000 per customer, has no effect whatever on whether other customers can receive money from that fund.

With regard to the separate customer property fund, “net winners” need not be paid from it unless and until “net losers” are first made whole, as the language of the laws tells us that money from the customer property fund must be distributed “ratably” in accordance with respective net equities. Though the word “ratably” may sound like it means proportionally, and can mean proportionally, but it doesn’t have to. It can mean merely that something can be rated or appraised or estimated.  In other words, SIPC and the Trustee had the discretion to find method by which the “net losers” could receive preferential relief from the fund of customer property, and yet insure that all investors would receive promised SIPC protection in a way that wouldn’t injure the “net losers”.

5.         The Court’s decision tells us that statements received from brokers are now meaningless in SIPC cases whenever SIPC and the Trustee choose to disregard them, particularly on the ground that some methodology for determining net equity which was not chosen by Congress is fairer in their opinion than the method that was chosen by Congress.

There were other important problems as well. All in all, the decision was shoddy and rather than providing a fair solution or hint of compromise, dangerously amounts to an assault on the protections that Congress intended when it passed SIPA law in 1970, and needed now, more than ever. As terribly flawed as the decision was, what’s most evident and pressing is this: it begs for a swift response from Congress to make clear what should be so obvious – protect investors.  

For a far more extensive discussion on the subject, please refer to my August 23rd essay, posted at www.velvelonnationalaffairs.com.

Visit the Net Equity tab at www.investoraction.org for NIAP’s discussions about net equity.


-Lawrence R. Velvel