Wednesday, July 04, 2012

Finding CD Purchasers Were Not Customers of Stanford Broker-Dealer under SIPA, Federal Judge Denies SEC Request to Compel SIPC Proceeding


A federal judge denied an SEC request to compel the Securities Investor Protection Corporation (SIPC) to file an application for a protective decree and commence a liquidation proceeding in relation to the fraudulent activities of Robert Allen Stanford.  A federal court jury had convicted Stanford of conspiracy, wire fraud, mail fraud, obstruction of justice and money laundering in connection with the sale of fraudulent CDs issued by a foreign bank, that was not a SIPC member, and marketed by a broker-dealer, which was a SIPC member. The court found that the bank CD purchasers were not customers of the broker-dealer within the meaning of the Securities Investor Protection Act (SIPA). (SEC v. SIPC, DC of DC, Civil Action No. 11-mc-678 (RLW), July 3, 2012).

SIPC declined to file an application for a protective decree for the brokerage firm customers in the federal court, concluding that these customers are not covered by SIPA because the broker-dealer did not perform a custody function for the customers who purchased the bank CDs. The SEC delivered a formal analysis to SIPC arguing that the broker-dealer failed to meet its obligations to customers that were in need of the protections of the SIPA, and that SIPC should seek to commence a liquidation proceeding.   SIPC advised the SEC that it considered the SEC Analysis, that it disagrees with the SEC, and that it will not seek to commence a liquidation proceeding.  Hence, the SEC seeks an order from the court  compelling SIPC to commence such a liquidation proceeding. 

The SIPA statute provides protection, under certain specified circumstances, to the customers of SIPC members. Thus, in the view of Judge Wilkins, the key issue in dispute was whether the persons who purchased the bank CDs are customers of the broker-dealer within the meaning of SIPA, because if they are, then SIPC has refused to act for their protection and the SEC’s application should be granted.  On the other hand, if they are not customers, then the application must be denied.

Definition of Customer

According to the court, the critical aspect of the customer definition in SIPA is the entrustment of cash or securities to the broker-dealer for the purposes of trading securities. The customer definition has therefore been described as embodying the common-sense concept that investors are entitled to compensation from the SIPC only if they have entrusted cash or securities to a broker-dealer who becomes insolvent.  Investor that have not so entrusted cash or securities are not customers, reasoned the court, and therefore not entitled to recover from the SIPC trust fund. To prove entrustment, the claimant must prove that the SIPC member actually possessed the claimant’s funds or securities.

The SEC could not show that the broker-dealer ever physically possessed the investors’ funds at the time that the investors made their purchases.  The CD investors wrote checks that were deposited into bank accounts and/or filled out or authorized wire transfer requests asking that money be wired to the bank for the purpose of opening their accounts at the bank and purchasing CDs.  The investors’ checks were not made out to the broker-dealer and were never deposited into an account belonging to the broker-dealer.  Accordingly, said the court, under a literal construction of the statute, the investors who purchased bank CDs are not customers of the broker-dealer within the meaning of SIPA. The court refused to broaden the scope of SIPA liability well beyond the plain meaning of the statutory term deposited. Courts have consistently held that the “customer” definition in SIPA should be construed narrowly. 

In two federal appeals court opinions relied on by the SEC, the Eleventh and Tenth circuit expanded the meaning of deposited to hold that client funds were deemed deposited with an introducing broker where the client gave funds to the introducing broker or its agent for the purchase of securities that were never bought.  That is not what happened in the Stanford scheme, said the federal judge, who did not believe it  was appropriate to expand the meaning of “deposited” even further.  The court was not swayed by the SEC’s argument that some of the CD sales proceeds were used to pay expenses of  the broker-dealer and that some of the investors were told that the CDs were protected by SIPA.  Those assertions, even if true, run too far afield from the key issue, which is whether the investor entrusted cash to the broker-dealer for the purpose of effecting a securities transaction.

Evidentiary Standard

As a threshold issue, the court had first concluded that preponderance of the evidence was the proper standard to be applied to the request. Thus, the SEC had the burden of proving, by a preponderance of the evidence, that SIPC has refused to commit its funds or otherwise to act for the protection of  customers of any member of SIPC.

SIPA specifies that generally SIPA should be construed as if it were an amendment to and included as a section of the Securities Exchange Act of 1934. This interpretative guidance is noteworthy, said the court, because the Exchange Act contains a specific provision that authorizes the SEC to file an application for an order that commands a person or entity to comply with the 1934 Act. This provision is found in Section 21(e) of the 1934 Act. Such an application, commanding a person to comply with the 1934 Act, bears a remarkably close resemblance to an application by the SEC, pursuant to SIPA, requiring SIPC to discharge its obligations under SIPA.  The similarity between the two provisions is quite significant since SIPA is meant to be construed as if it were part of the 1934 Act

The DC Circuit Court of Appeals has held that the preponderance of the evidence standard is the appropriate burden of proof when the Commission seeks a permanent injunction pursuant to the 1934 Act. Thus, said the court, in the DC Circuit, the SEC must prove a violation of the 1934 Act by a preponderance of the evidence to obtain a permanent injunction. This compels the conclusion that the preponderance standard was the appropriate burden for the Commission to bear to obtain the relief sought here. This result seems particularly sound not only because Congress has directed  that SIPA be construed as if it were a part of the 1934 Act, but also because of the preference for the preponderance standard in civil litigation generally.   

In addition, the court noted that SIPC, a corporate body, is entitled to due process in the present proceeding even if the SEC is considered to be its plenary supervisor under the SIPA statutory scheme.  It was quite clear, said the court, that the initiation of a SIPA liquidation would potentially involve tens of thousands of claimants and entail millions of dollars in administrative costs, even if all of the claims were ultimately denied.  Such a cost would place a great burden upon SIPC  that is not eliminated by the SEC offer to loan funds to SIPC, reasoned the court, since SIPC ultimately would have to repay any such loan to the SEC, resulting in costs that would be ultimately borne by  SIPC members rather than the SEC.


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