Friday, October 01, 2010

Member of SIPC Task Force Sees Flaws in SIPA Reform Legislation

As the SIPC Modernization Task Force explores the legislative reforms to the Securities Investor Protection Act, there is already a legislative vehicle available. The Ponzi Scheme Investor Protection Act of 2010, HR 5032, would amend the Securities Investor Protection Act with respect to the duties of a trustee appointed for a, SEC-registered broker or dealer undergoing liquidation. The Act would instuct the trustee to take specified actions if the trustee determines that the debtor is a Ponzi scheme.

HR 5032 would set up procedures for an indirect Ponzi scheme investor to file a claim. It would instruct the trustee to coordinate with Ponzi scheme investors to ensure proper payments to indirect Ponzi scheme investors and take specified actions to pay indirect Ponzi scheme investors. It would also prescribe the maximum aggregate amount of all cash and securities that may be awarded to each indirect Ponzi scheme investor.

The Act would prohibit the trustee of a Ponzi scheme from seeking to recover money and profits from any Ponzi scheme investor unless such investor's participation in the Ponzi scheme was either complicit or negligent. And the Securities Investor Protection Corporation (SIPC) would dvance to the trustee such moneys as may be required to pay claims and implement this Act.

In recent testimony before the Kanjorski Capital Markets Subcommittee, a member of the Task Force, Professor John Coffee, said that provisions in  HR 5032 would subordinate the interests of net lossers in Ponzi schemes to those of net winners. It does so in Sec. 8A(f) by restricting the ability of the SIPC trustee to recover the fictitious profits of the net winners. Under existing law, the trustee can recover these fictitious profits and place them in a fund where they can benefit all victims ratably. In some caes, said Prof. Coffee, sych recoveries by the trustee may exceed any SIPC payments.

The interests of Net Winners and Net Losers in Ponzi schemes are necessarily in conflict, he noted, and “reforms” that benefit the Net Winners injure the Net Losers. Thus, the Professor finds it particularly surprising that Congress should wish to apply its proposed rule retroactively (see Section 8A(h) of H.R. 5032) in order to benefit the Net Winners in the Madoff Ponzi scheme. The practical result is that a principal source of recovery to which the Net Losers in the Madoff Ponzi scheme can look will be denied them or be significantly reduced. 

The testimony noted that the Madoff trustee has indicated that he may sue some 1,000 investors who were Net Winners in the Madoff scheme. Moreover, fourteen avoidance actions have been filed as of April, 2010, and just these fourteen actions seek to recover $14.8 billion. Although the $14.8 billion sought in these actions will likely not be fully recovered, noted Prof. Coffee, and may yield substantially smaller settlements, this number dwarfs the $1.5 billion that the SIPC trustee has actually recovered from other sources.

The Adolph A. Berle Professor of Law at Columbia recognizes that Section 8A(f) of HR 5032 does not give complete immunity to the 

Net Winners. Under its terms, they can still be sued by the SIPC trustee if “such investor was either complicit or negligent in their participation in the Ponzi scheme.” But in reality, he explained, whenever one raises the legal standard for recovery, one reduces the likely recovery. Particularly in this context, cases tend to be settled, not litigated, and, in his view,  the proposed revised legal standard in Section 8A(f) will reduce the settlement value of avoidance actions against the Net Winners. This is so because the SIPC trustee cannot afford to try every case or conduct complete discovery against every Net Winner. Under existing law, if the trustee can show the Net Winners received fictitious profits, it can reclaim those profits for the injured victims as a whole. Proving negligence will be difficult because most Net Winners can argue that they relied on audited financial statements and had no obligation to inquire further.

The goal of the Bankruptcy Code is not to punish the Net Winners, said Prof. Coffee, but to share the losses equitably. Thus, it permits the trustee to recover “fictitious profits” in order to share these profits ratably among all the victims. If Congress thinks this is a bad policy, he continued, it should directly amend the Bankruptcy Code. But the draft legislation does not do that; instead, it only amends the Securities Investor Protection Act to limit the powers of a SIPC trustee.