While the Securities Investor Protection Act does not prescribe a single means of calculating net equity that applies in the myriad circumstances that may arise in a SIPA liquidation, a Second Circuit panel ruled that the Madoff Trustee’s selection of the Net Investment Method was more consistent with the statutory definition of net equity than any other method advocated by the parties, including the Last Statement Method. Both SIPC and the SEC submitted briefs supporting the Trustee’s use of the Net Investment Method, and the panel said that the views of the SEC and SIPC were entitled to respect. The SEC further argued that the Net Investment Method should be applied using inflation-adjusted dollars. The Trustee argued that the issue whether the Net Investment Method should be adjusted to account for inflation or interest was beyond the scope of the briefing and took no position on it. (In re Bernard L. Madoff Securities, LLC, CA-2, Aug. 16, 2011.)
SIPA liquidation is a hybrid proceeding, noted the appeals court, and SIPA and the Bankruptcy Code intersect to grant a SIPA Trustee the power to avoid fraudulent transfers for the benefit of customers. The Net Investment Method is also more harmonious with provisions of the Bankruptcy Code that allow a trustee to avoid transfers made with the intent to defraud.
Fraud is endlessly resourceful, noted the court, and the unraveling of weaved-up sins may sometimes require the grant of a measure of latitude to a SIPA Trustee. In many circumstances, a SIPA Trustee may, and should, exercise some discretion in determining what method will best measure net equity. A reviewing court should accord a degree of deference to such an exercise of discretion so long as the method chosen by the Trustee allocates net equity among the competing claimants in a manner that is not clearly inferior to other methods under consideration. According to the panel, SIPA serves the dual purpose of protecting investors and protecting the securities market as a whole. In the Madoff case, calculating net equity based on the Net Investment Method effectuates these purposes
The Madoff Trustee had concluded that each customer’s net equity should be calculated by the Net Investment Method, which credits the amount of cash deposited by the customer into his or her Madoff account, less any amounts withdrawn from it. The use of the Net Investment Method limits the class of customers who have allowable claims against the customer property fund to those customers who deposited more cash into their investment accounts than they withdrew, because only those customers have positive net equity under that method. Some customers objected to the Trustee’s method of calculating net equity and argued that they were entitled to recover the market value of the securities reflected on their last customer statements. The panel said that the use of the Last Statement Method in the Madoff Ponzi scheme would have had the absurd effect of treating fictitious and arbitrarily assigned paper profits as real and would have given legal effect to Madoff’s machinations.
SIPA directs a Trustee to determine a customer’s entitlement to recover net equity based both on the statutory definition of that term and by reference to the books and records of the debtor. While the language of the statute clearly requires a SIPA Trustee to distribute customer property based on net equity, the statute does not define net equity by reference to a customer’s last account statement. Nor does it say specifically how net equity should be calculated if a dishonest broker failed to place a customer’s funds into the security market, notwithstanding that the customer deposited cash with the debtor for the purpose of purchasing securities.
In the Madoff scheme, noted the panel, the profits recorded over time on the customer statements were after-the-fact constructs that were based on stock movements that had already taken place, were rigged to reflect a steady and upward trajectory in good times and bad, and were arbitrarily and unequally distributed among customers. These facts provide powerful reasons for the Trustee’s rejection of the Last Statement Method for calculating net equity. In addition, if the Trustee had permitted the objecting claimants to recover based on their final account statements, reasoned the panel, this would have affected the limited amount available for distribution from the customer property fund.
The inequitable consequence of such a scheme would be that those who had already withdrawn cash deriving from imaginary profits in excess of their initial investment would derive additional benefit at the expense of those customers who had not withdrawn funds before the fraud was exposed. Because of these facts, the Net Investment Method better measures net equity, as statutorily defined, than does the Last Statement Method
In this case, the Net Investment Method allows the Trustee to make payments based on withdrawals and deposits, which can be confirmed by the debtor’s books and records, and results in a distribution of customer property that is proper under SIPA. Here, there were no securities purchased and there were no proceeds from the money entrusted to Madoff for the purpose of making investments. Because the main purpose of determining net equity is to achieve a fair allocation of the available resources among the customers, the Trustee properly rejected the Last Statement Method as it would have undermined this objective.
Madoff constructed account statements retrospectively, designating stocks based on advantageous historical price information and arbitrarily distributing profits among his customers. It would therefore have been legal error for the Trustee to discharge claims upon the false premise that customers’ securities positions are what the account statements purport them to be. The Trustee properly declined to calculate net equity by reference to impossible transactions. Indeed, if the Trustee had done otherwise, the whim of the defrauder would have controlled the process that is supposed to unwind the fraud. The customer statements reflect impossible transactions and the Trustee is not obligated to step into the shoes of the defrauder or treat the customer statements as reflections of reality.
The Net Investment Method is also appropriate because it relies solely on unmanipulated withdrawals and deposits and refuses to permit Madoff to arbitrarily decide who wins and who loses. The extraordinary facts of this case make the Net Investment Method appropriate, whereas in many instances, it would not be. The Last Statement Method, for example, may be appropriate when securities were actually purchased by the debtor, but then converted by the debtor. Indeed, the Last Statement Method may be especially appropriate where, unlike with the Madoff accounts at issue, customers authorize or direct purchases of specific stocks.