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
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.