Calculation of Madoff Investor Losses Will Not Include Fictitious Profits, Second Circuit Holds
Susan M. Greenwood | Bloomberg Law
In re Madoff Investment Securities LLC, Nos. 10-BK-02378; 10-BK-02676; 10-BK-02677; 10-BK-02679; 10-BK-02684; 10-BK-02685; 10-BK-02687; 10-BK-02691; 10-BK-02693; 10-BK-02694; 10-BK-02718; 10-BK-02737; 10-BK-03188; 10-BK-03579; 10-BK-03675, 2011 BL 211741 (2d Cir. Aug. 16, 2011)
The U.S. Court of Appeals for the Second Circuit held that the calculation of net equity for distributing customer property to victims of Bernard L. Madoff’s Ponzi scheme should be based on the amount of cash a customer deposited with Bernard L. Madoff Investment Securities LLC (BLMIS), minus any withdrawals made by the investor.
Fictitious Account Statements
As the Second Circuit explained, Madoff never made any investments on behalf of his clients. Instead, he used monies from later investors to pay earlier ones. However, he did issue account statements that purported to reflect significant equity increases. The account statements, the Court continued, “were generated based on after-the-fact stock ‘trades’ using already-published trading data to pick advantageous historical prices.” Moreover, “the dreamt-up rates of return Madoff assigned to different customers’ accounts varied significantly and arbitrarily.”
Trustee’s Net Equity Calculation
Irving H. Picard was appointed trustee under the Securities Investor Protection Act (SIPA) and charged with, among other things, liquidating BLMIS and creating a fund of “customer property” for distribution to Madoff’s clients. Under SIPA, customer property comprises securities and cash held by a broker-dealer on behalf of its clients. Clients are entitled to a pro rata share of customer property based on each client’s “net equity.” Picard calculated net equity by crediting investors with the amount of money deposited with BLMIS, minus any withdrawals (Net Investment Method). Accordingly, only clients with a positive net equity—or those who deposited more than they withdrew—would have allowable claims. Over objections of investors who argued that the net equity calculation should be based on their final BLMIS customer statements (Last Statement Method), the U.S. Bankruptcy Court for the Sothern District of New York agreed with Picard. The bankruptcy court explained that basing net equity on “‘entirely fictitious’” account statements would “‘legitimiz[e], the fraudulent scheme.’”
For more on the bankruptcy court decision, see Bloomberg Law Reports®—Securities Law, U.S. Bankruptcy Court Affirms Madoff Trustee’s Net Equity Calculation for Determining Recovery Amounts for Victims (Mar. 8, 2010).
No Single Method for Calculating Net Equity
On appeal, the Second Circuit noted that the “statutory language does not prescribe a single means of calculating ‘net equity’ that applies in the myriad circumstances that may arise in a SIPA liquidation.” The Net Investment Method, however, serves SIPA’s dual purpose to protect both investors and the market. Conversely, “[u]se of the Last Statement Method in this case would have the absurd effect of treating fictitious and arbitrarily assigned paper profits as real and would give legal effect to Madoff’s machinations.”
The Second Circuit first determined that Madoff investors are customers with claims for securities under SIPA even though Madoff did not actually purchase any securities. According to the Second Circuit, the “‘critical aspect of the ‘customer’ definition is the entrustment of cash or securities to the broker-dealer for the purposes of trading securities.’” (emphasis added by the Court). Otherwise, investors’ “‘legitimate expectations’” of protection under SIPA would not be met. The Court, however, disagreed that legitimate expectations of protection extended to calculating net equity under the Last Statement Method. It found support in the plain language of SIPA, which requires net equity to be considered in connection with a trustee’s duty to discharge a debtor’s obligations that are ascertainable from the debtor’s books and records.
The books and records of BLMIS, however, were a fiction of “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.” Thus, the Second Circuit said, there are “powerful reasons” for Picard’s rejection of the Last Statement Method:
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.
The Second Circuit, however, emphasized that it was not rejecting the use of customer account statements to calculate net equity under different circumstances. Indeed, the Court observed that “a customer’s last account statement will likely be the most appropriate means of calculating ‘net equity’ in more conventional cases,” for example where a broker-dealer purchases securities, but converts the proceeds for his or her own use. Madoff, however, never purchased any securities so the only viable investment history, the Second Circuit concluded, was the cash deposits and withdrawals that can be confirmed by BLMIS’s books and records.
SIPA Is Not an Insurance Guarantee
While SIPA has been called “‘a form of public insurance,’” the Second Circuit explained that it does not guarantee full recovery for all investors. SIPA only “expedite[s] the return of customer property.” Customer property is shared pro rata and, the Court said, if investors are paid for fictitious profits under the guise of insuring against all losses, the pool of customer property could be diminished for investors “who have not recouped even their initial investment.” The Second Circuit therefore concluded that the Last Statement Method threatened the “fair allocation of available resources.”
The return of fictitious profits, the Second Circuit concluded, should be avoided at all costs. It cited a previous ruling that “‘basing customer recoveries on fictitious amounts in the firm’s books and records would allow customers to recover arbitrary amounts that necessarily have no relation to reality . . . [and would] leave the SIPC fund unacceptably exposed.’” Moreover, allowing investors the legitimate expectation of fictitious profits “‘would lead to the absurdity of ‘duped ‘ investors reaping windfalls as a result of fraudulent promises made on fake securities.’” The Second Circuit concluded that Picard is not obligated “to treat the customer statements as reflections of reality.”
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