Proposed Ponzi Legislation Seeks Sweeping and Controversial Reforms

A group of bipartisan lawmakers from the House of Representatives and Senate has proposed legislation that would enact a series of sweeping reforms designed to aid victims of Ponzi schemes - and at the same time, force the use of several methods that have typically been disfavored by courts and regulators.  The Restoring Main Street Investor Protection and Confidence Act (the "Bill"), co-sponsored by Louisiana Republican Sen. David Vitter, New York Democratic Sen. Charles Schumer, New Jersey Republican Rep. Scott Garrett and New York Democratic Rep. Carolyn Maloney, is specifically designed to provide additional relief to fraud victims involved in Securities Investor Protection Act ("SIPA") liquidations - such as the Ponzi schemes perpetrated by infamous fraudsters R. Allen Stanford and Bernard Madoff.  However, a closer look at the Bill also reveals that several of the envisioned reforms could have potentially troubling consequences on the current Ponzi jurisprudence.  

The History of SIPC and Recent Disputes

The Bill is the product of recent contention between the Securities and Exchange Commission ("SEC") and the Securities Investor Protection Corporation ("SIPC").  SIPC was formed in 1970 as a non-profit, non-government group funded through mandatory assessments on member broker-dealers.  In the event of the insolvency of a member broker-dealer, SIPC utilizes its accumulated reserves to provide compensation to afflicted investors -  limited to $500,000 per customer, including up to $250,000 for cash. Most recently, in the collapse of Bernard Madoff's broker-dealer, Bernard L. Madoff Investment Securities, SIPC provided hundreds of millions of dollars in advances to thousands of defrauded victims.  

However, it was the case of another notorious fraudster, R. Allen Stanford, that vaulted SIPC into the national spotlight.  Stanford, who masterminded a massive Ponzi scheme that purported to sell risk-free certificates of deposit worldwide, was arrested in June 2009.  A dispute soon arose as to whether Stanford's victims were entitled to SIPC fund disbursements, with SIPC successfully arguing to a Washington, D.C., federal court that Stanford customers did not meet the definition of "customer" espoused in SIPA.  The SEC recently argued to a federal appellate court that this result was incorrect.  

Proposed Changes to SIPA

Customer Definition

The Bill contains several notable changes to SIPA.  The most obvious change is the clarification of the definition of "customer," with Section 16(2)(B) amended to add two new clauses:

(iv) any person that had cash or securities that were converted or otherwise misappropriated by the debtor (or any person who controls, is controlled by, or is under common control with the debtor, if such person was operating through the debtor), irrespective of whether the debtor held or otherwise had custody, possession, or control of such cash or securities; and

(v) any other person that the Commission, in its discretion and without any need for court approval, deems a customer of the debtor.

Thus, the amendment would not only seek to eliminate any distinctions between whether a fraudster took control of or received investor funds, as has been cited by SIPC in denying coverage to Stanford victims, but also would enact a "catch-all" provision vesting the ultimate determination in the SEC.  Notably, the Bill explicitly seeks to insulate such a determination from the need for court approval.

In another change stemming from the Stanford dispute, Section 11(b) of SIPA would be amended to allow the SEC to require SIPC to discharge its obligations under the Act (i.e., permit fund distributions to victims) in the event that the SIPC initially refuses and without the need for court approval.  

Last Statement Method

One of the most contentious issues arising from the aftermath of Madoff's scheme was the fervent argument by victims that their losses should be based on the account values as reported in the last statement provided to them by Madoff.  The "Last Statement Method," as it became to be known, was opposed by Madoff bankruptcy trustee Irving Picard (whose decision was later approved by district and appellate courts) based on the fact that those figures were pure fiction and were simply an arbitrary determination made by Madoff and without any bearing on actual market data.  Picard argued that the "net investment method," which analyzed each investor's loss based on a "cash in, cash out" determination, was a more prudent calculation.  Indeed, the "net investment method" is the predominant method employed in Ponzi jurisprudence and used nearly universally. 

However, the Bill proposes amending Section 16(11) of SIPA to include a section titled "reliance on final customer statement" and reading:

(i) In General

In determining net equity under this paragraph, the positions, options, and contracts of a customer reported to the customer as held by the debtor, and any indebtedness of the customer to the debtor, shall be determined based on—

(I)  the information contained in the last statement issued by the debtor to the customer before the filing date;

Such a method is generally disfavored in Ponzi jurisprudence.  For example, it tends to favor those longer-term investors who have had their account balances artificially inflated through the steady flow of arbitrary returns, to the detriment of shorter-term investors.  Indeed, the method would essentially let the Ponzi schemer dictate the rise and fall in fortunes of his/her investors and tie the hands of a later-appointed trustee or receiver.  The method would also effectively allow investors to "profit" off a Ponzi scheme by forcing a trustee or receiver to recognize their phantom gains.    Because victims of a Ponzi scheme rarely recoup 100% of their losses (or anything close to 100%), those investors with "phantom" profits included in their allowed loss would receive a disproportionate share of distributions.

Prohibition on Clawback Recoveries 

The Bill also purports to enact a sweeping prohibition against "clawback" lawsuits.  In bankruptcy, a bankruptcy trustee is permitted to pursue certain transfers or redemptions made by the debtor to an investor within certain periods of time as measured by the bankruptcy filing date.  Known in bankruptcy parlance as "avoidance" actions, these lawsuits seek to "avoid" those transfers made within the enumerated period - even when that person may not have suffered losses.

The Bill proposes to amend Section 8 of SIPA by inserting Section (g), entitled "Prohibition on Certain Recoveries", which prohibits a trustee from recovering property transferred by the debtor to a customer before the filing date unless the customer (i) knew or should have known of the fraud and did not notify authorities; or (ii) was a broker-dealer or investment adviser under federal securities laws.  Thus, if an investor was not a broker-dealer or investment adviser, and is not acknowledged to have known or suspected knowledge of the fraud, the Bill seeks to effectively immunize that investor from any avoidance actions.  

Such a provision would have serious consequences on the recovery of assets for defrauded victims.  Indeed, Section (g) would favor an investor that withdrew significant sums of money before the fraud's collapse to the detriment of an investor that did not make any withdrawals over the life of their account.  This would result in significantly fewer assets added to the pool for investor distributions, and would likely result in much lower pro rata distributions to investors.  While Ponzi jurisprudence is founded upon equity principles, such an interpretation would result in a significant miscarriage of equitable considerations and instead establish a system of extremes.

Effective Date

Finally, the Bill envisions that the sweeping reforms would be applicable retroactively to SIPA liquidation proceedings (1) in progress as of the date of the enactment of the Bill; and (2) initiated after enactment of the Bill.  In the case of the current SEC/SIPC dispute over Stanford losses, this would likely result in another court date between the parties.

Conclusion

In short, the Bill seeks enactment of a significant set of reforms that would significantly alter many facets of Ponzi jurisprudence, including the determination of customer losses, definition of a customer, and the ability to seek the clawback of avoidance transfers.  While it is not yet clear as to whether all of the above-referenced reforms will actually be included in a final and enacted bill, a more extensive discourse regarding these changes is essential, especially given the likely conflict between the proposed reforms and those currently employed in Ponzi scheme litigation.  At a minimum, the Bill's proponents should provide guidance as to how the Bill's changes would apply to existing SIPA liquidations, including the Madoff case.  

According to www.govtrack.us, which tracks legislation, the Bill has currently been referred to committee, and has been given a 33% chance of getting past committee and a 5% chance of ever being enacted.  Interested parties can view the Govtrack progress page here.

A copy of the Bill is available here.