PURPOSE AND POLICY RELATED TO H.R.

757 AND PLANNED AMENDMENTS FOR THE IMPROVEMENT OF THE SECURITIES INVESTOR PROTECTION ACT OF 1970

Final Account Statement in Determination of Customer Net Equity H.R.757 amends the Definitions provisions of the Securities Investor Protection Act (Section 16) to provide that, in determining a customer’s “net equity,” the information in the last statement received by the customer, from the debtor before the (bankruptcy) filing date, shall be used. The bill imposes two fraud exceptions to this general rule a) actual knowledge of the debtor’s fraud by any customer and b) for customers registered as a broker or dealer under the Securities Exchange Act of 1934 or customers required to register under the Investment Advisers Act of 1940, because of their activities should have known of the fraudulent activity and failed to notify the SIPC, the SEC or other law enforcement. The amendment reaffirms the intent of Congress, in 1970, that SIPA’s financial protection is guaranteed for good faith customers and consistent with their “reasonable expectations.” This reaffirmation recognizes that in the modern securities marketplace, where securities ownership is maintained technologically through “book entry” registration rather than physical possession of certificates, customers have no choice but to rely on the account statements and trade confirmations provided by their broker or investment adviser. SIPA’s overarching purpose was to establish and maintain a protection scheme for good faith investors, particularly small investors, which, by engendering public confidence in the integrity of the securities markets, will contribute to the efficient and effective functioning of those markets. Of necessity, for investor protection to have credibility it must be unconditional for good faith customers.

Ponzi Frauds and the Madoff Case The SIPC, its Trustee, and the SEC have contended that in SIPA-administered liquidations of b/d bankruptcies involving a debtor Ponzi fraud that achievement of an equitable resolution among defrauded customers, “net equity” must be determined by a net investment methodology. This methodology limits eligibility for SIPA protection to those customers, who, prior to closing, had not recovered their “net investment” (total deposits minus total withdrawals). The fallacy of the “net investment” approach in a SIPA liquidation is that it totally ignores the reality that debtor’s fraud has destroyed the “reasonable expectations” of all good faith customers. Good faith customers, who have relied on the integrity of their account statements, conduct the financial affairs of their lives based on the values reflected in their account statements. To learn, in a Ponzi failure, that account values are meaningless is equally devastating to all good faith accountholders. No customer faced with such financial calamity

should be denied SIPA’s guaranteed protection up to $500,000, through SIPC ‘advance” payments. To refuse that protection is to make a mockery of the SIPA’s statutory commitments. However, the facts and circumstances of a particular case may validate the application of an equitable arrangement, with differential treatment among customers, for the distribution of “customer property,” those assets of the debtor belonging to no individual customer. With respect to “customer property,” the SIPA statute provides that distribution among customers shall be “ratable” based on relative “net equity” values. Because “ratable” has been consistently interpreted by the courts to mean pro rata, SIPC insists it deprives them of the legal authority to formulate a distribution arrangement which, for equitable reasons, takes account of differing customer circumstances. The amendments proposed to be offered to H.R.757 concede this deficiency in the 1970 Act, and provide that the Trustee has the express discretion to formulate a distribution plan for “customer property” which is “fair and reasonable;” and which is not bound by the “net equity” values. Such plan must have the full consultation of the SEC and be approved by the Court, after notice and hearing from interested parties. Had the SIPC and the SEC presented this statutory defect to the Congress in early 2009, the statute could have been promptly amended; all good faith Madoff customers could have been provided the SIPC ‘advances,’ rightfully theirs; tens of millions of legal costs could have been avoided; and, by now, customer property could have been distributed on an equitable basis and the liquidation largely completed. The “net investment” approach in Ponzi frauds is a creation of traditional commercial bankruptcy practice and equity receivership practice in which the sole resource for recovery are the assets assembled from the debtor’s estate. But SIPA liquidations are different (and meant to be) because of the added resource of the SIPC Fund, which is the foundational bulwark of SIPA’s guarantee of customer protection.

Additional Supporting Facts and Observations Despite SIPC’s oft-repeated contention that Congress never intended that SIPC protect customers in a b/d bankruptcy involving a Ponzi fraud, there is nothing in the SIPA statute to support that view. Commonsense dictates a contrary conclusion; and SIPC practice, in forty years of history, has included liquidations of seven Ponzi bankruptcies prior to Madoff. In fact, in the previously most prominent Ponzi case, New Times Securities, one category of customers with factual experiences nearly identical to the Madoff customers, the SIPC and the SEC concluded that SIPC protection should be provided with “net equity,” being determined using customer final account statements at closing. So, SIPC practice doesn’t comport with SIPC rhetoric. Application of the “net investment” methodology in the Madoff case has deprived over half of the customer accounts (2,500 of 4,900) any protection whatsoever and for another 850 accounts
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average SIPC advances of $200,000 against final account statements averaging $2,000,000. Of the 1550 accounts (approximately 32% of total) determined eligible by “net investment,” 138 accounts with approved claims over $10 million (less than 10% of the total) will receive 80% of the distributions of customer property. From SIPC documents, it appears that most of those 138 accounts belonged to hedge funds and other institutional investors. One tabular submission, from SIPC to the Capital Markets and GSE Subcommittee, reveals that 23 accounts had withdrawals averaging 100 or more per year, suggesting those firms were using the Madoff accounts as a high-yielding transaction account to park funds awaiting reinvestment. Responses to the Subcommittee, from SIPC, indicate that fulfilling SIPC’s guaranteed protection up to $500,000 would require aggregate additional advances from the SIPC Fund of $1.1 billion. SIPC currently has a balance of about $1.5 billion and current assessments are generating $400 million per year. According to the GAO, the current assessment level appears comfortably bearable by the member SIPC firms, with an average assessment of some $98,000 and a median assessment of $2,000. This would suggest that a special assessment, if necessary, could be easily accommodated. SIPC also has the proven capacity to negotiate private lines of credit. The Net investment approach has obliged extensive accounting work and has promoted an unusual volume of litigation. Total administrative costs already exceed one-half billion and SIPC forecasts they may reach over $1 billion, with over half that sum going to legal fees, most flowing to the Trustee’s own law firm.

Distribution of Customer Property Modifying SIPA’s provisions governing the distribution of customer property represents a significant improvement for future SIPC liquidations. So intent was the Congress in 1970 to provide the Nation’s securities markets with a stabilizing, confidence –building structure for customer protection in the event of a broker/dealer failure, it is not surprising that it failed to understand that circumstances of a particular case might dictate separate standards for advance protection from the SIPC Fund and equitable division of customer property. To understand the logic of the proposed amendment relating to customer property, it helps to recall that Congress viewed SIPA as creating for securities firm’s failures a modified bankruptcy process which, like the FDIC, would add limited direct support from an industry-supported fund coupled with a bankruptcy recovery process intended to give debtor-firm customers preferential rights ahead of general creditors, and to function with greater speed and efficiency that traditional bankruptcies. The distribution of SIPA’s guaranteed, but limited, financial protection from the Fund using “net equity” based on final account statements is quick, efficient and fair among all good faith customers of every b/d failure, irrespective of cause. But in the preferential distribution of the debtor’s assets determined to be “customer property,” it is appropriate, as in conventional
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bankruptcy practice, to take account of differing customer circumstances and experiences to achieve an equitable outcome. And there is no compelling reason that such a plan need conform to the relative “net equities” of the customers. Accordingly, the amendment proposed to be offered to H.R.757 expressly provides that with respect to customer property to achieve a “fair and reasonable” sharing of customer the property, the Trustee may ignore the definition of “net equity” and in full consultation with the SEC develop a separate and independent distribution plan. The amendment further provides that such a plan shall be submitted to the Court for approval, and the Court shall notify interested parties and grant them a hearing before passing on the adequacy of the plan. Had such a process been available at the outset of the Madoff liquidation, years of travail and customer suffering, along with needlessly astronomical costs, could have been largely avoided. It does not seem unfair to observe that over the course of forty years SIPC, an agency charged with an important, but single and narrowly defined mission, might have recognized the desirability of this discretionary flexibility.

Appointment of Trustee and Trustee’s Counsel and the Determination of Their Compensation The SIPA statute currently authorizes SIPC to select the Trustee and the Trustee’s Counsel, subject to approval by the Court, which is typically a pro forma action. Likewise, the SIPC determines the Trustee’s compensation, with the Court’s approval, and the Trustee employs his Counsel and his supporting legal team, essentially as the Trustee determines their service is needed, along with accounting and other consultative services. Since 1978, the statute expressly permits the Trustee and the Counsel to be associated with the same law firm. This arrangement is fraught with multiple, potential conflicts of interest, all of which are clearly avoidable without in any way disrupting or diminishing the quality of the liquidation process. If, in the opening years, there was a shortage of qualified lawyers to serve in these important functions, that certainly is not the case today. Repetitive reappointments of the same individuals as Trustees, accompanied by the services of their law firms, certainly raises legitimate concern for their independence from SIPC, the appointing agency. The Madoff case certainly presents circumstances that demonstrate a tension between SIPC’s financial interests and the optimal protection of the debtor’s good faith customers. Separating SIPC from the decisions on Trustee selection and compensation will eliminate any speculation as to financial conflict and will enhance the probity of the process. To that end, the provisions of H.R. 757, strengthened by proposed amendments, make the following changes regarding the Trustee and Counsel: 1) Trustee and Counsel shall be selected and appointed by the Court from panels of qualified individuals presented to the Court by the SEC, rather than the SIPC, 2) Trustee and Counsel may not be associated with same law firm, a practice currently permitted today, and 3) The Court shall determine the compensation for the
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Trustee and Counsel and shall assure that there are quarterly reports and public disclosure of their compensation, as well as quarterly reports of the SIPC allowances for legal, accounting and other administrative services. Not only do these changes rid the process of potential financial conflict of interest for the SIPC, they also assure that the Trustee’s fiduciary responsibilities to govern the liquidation process in the best interests of the debtor’s customers will in no way be adversely influenced by private contractual revenue-sharing arrangements with his law firm, if, as today, the firm is providing most the liquidation’s legal services. Recently, there have been occasions in which one individual has served contemporaneously as Trustee in more than one SIPA liquidation. This practice is expressly prohibited. The purpose should be apparent. Such multiple assignments raise clear questions of Trustee independence from the SIPC. If the Trustee has unique experience required by the second appointment, the earlier assignment should be terminated. The SIPC has clear financial interests related to the conduct of a SIPA liquidation. Every reasonable step should be taken in the appointment of Trustees to eliminate even the appearance of conflict.

Timing of SIPC Advances There are multiple instructions in the SIPA statute for actions to be taken promptly, including Section 9, which spells out the authorities for SIPC advances. Yet there are no time dimensions given to provide a practical requirement for fulfilling that statutory guidance. Certainly the timing of customer protection, in the form of SIPC advances, is a significant issue. Section 8 of SIPA establishes a deadline for the filing of customer claims, which is six-months after the date the Trustee files a public notice of the initiation of the liquidation preceding. The amendment to be proposed to H.R.757 establishes a general rule that SIPC advances should be made within the 90 days immediately following the claims deadline. SIPC may seek an extension of the permissible time for payment of advances, but payments after the 90-day period shall accrue interest from the 90th day. Should the Trustee conclude that SIPC has sufficient information needed for determining an advance and has not acted, the Trustee may seek a court order directing payment. The Madoff case represents a compelling example of the need to establish clear and specific guidelines for the payment of SIPC advances. Where broker/dealer bankruptcies result in customers losing all or most their life savings, as can occur in fraud cases, the justification for “prompt” action by the SIPC to help alleviate financial distress is self-evident. Based on data received by the Subcommittee from the SIPC, it appears that the preponderant portion of the SIPC advances to Madoff customers were made in the 4th quarter of 2010, roughly 20 months after the firm’s failure. Such an extended interval before the provision of relief is inexcusable – and another needless hardship caused by the “net investment’ methodology used for determining eligibility for assistance.
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Prohibition on Certain Recoveries Through Avoidance Actions The use of the Bankruptcy Code’s avoidance powers, to claw back withdrawals made by innocent individual customers, is a highly controversial practice. Avoidance is always a discretionary action in bankruptcy practice, most often arising in debtor fraud cases based on fraudulent conveyance. Avoidance actions against innocent customers have been a rarity in SIPA liquidations, arising out of debtor fraud. The SEC Inspector General’s report, in the David Becker matter, reveals that Chairman Shapiro was surprised to learn that Trustee Picard had filed hundreds of avoidance actions against innocent individual customers. Her understanding was that such actions would be reserved for professional institutional investors on the theory that with adequate due diligence such customers should have known of Madoff’s fraud. Indeed, the SIPA statute’s Section 8 (c) (3), which authorizes a Trustee’s discretionary use of avoidance recovery, contains language which certainly raises questions of legal propriety in an action against an innocent customer. The last sentence of that subsection reads: “For the purpose of such recovery, the property so transferred shall be deemed to have been the property of the debtor and , if such transfer was made to a customer or for his benefit, such customer shall be deemed to have been a creditor, the laws of any State to the contrary notwithstanding.” With those conditions applied, and absent any showing of complicity to fraud on the part of the customer, it would seem that the transfer would be treated as repayment of an antecedent debt, an established defense in a suit alleging fraudulent conveyance. The infrequent past use of avoidance actions in SIPA liquidations; the open interpretive issue raised by SIPA’s own language; and the considerations of compassion raised by “claw back” from customers already suffering financial devastation, all combine to suggest that the provisions of SIPA need to be clarified in favor of the innocent individual customer. H.R. 757 does exactly that. Its provisions prohibit avoidance actions against customers with two exceptions. The exceptions permit avoidance actions against any customer having actual knowledge of the debtor’s fraud, or any customer who is a registrant under the Securities Exchange Act of 1934 or the Investment Advisors Act of 1940 and because of their activities should have known of the debtor’s fraud and then failed to notify appropriate governmental authorities. This amendment to SIPA strikes an equitable balance.

Strengthening the SEC’s Plenary Authority Over SIPC Both the Madoff case and the Stanford case point to the need to add greater emphasis to the role that the SEC needs to play in overseeing SIPC’s activities in the proper administration of the Securities Investor Protection Act. Over the forty year history of SIPA, both the GAO and the
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SEC/IG have issued reports critical of SEC’s oversight of the SIPC and its actions. The time is past due to remedy that situation. The most effective action is to amend SIPA, by providing that the SEC has the clear authority to direct SIPC to discharge its obligations under SIPA for the protection of customers of a SIPC member firm. By making the SEC’s plenary authority clear and absolute, the Congress will be signaling its intent that the SEC take a more active role in SIPA liquidations and in the financial integrity of the SIPC. That greater responsibility will be accompanied by greater accountability.

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