On Aug. 16, 2011, the U.S, Court of Appeals for the Second Circuit affirmed Hon. Burton R. Lifland’s order that the Securities Investor Protection Act (SIPA) trustee may use the net investment method rather than the last statement method to determine a customer’s net equity under SIPA.[1] Irving Picard, the SIPA trustee for Bernard L. Madoff Investment Securities LLC (BLMIS), is charged with administering claims filed by BLMIS customers who ratably share in a pool of customer property according to their net equity. Picard determined that net equity should be calculated according to the net investment method, which credits the amount of cash deposited by the customer into its BLMIS account, less any withdrawn amounts. Some customers objected to this method and argued they were entitled to a calculation of net equity based on the market value of the securities reflected on their BLMIS customer statements (the “last statement method”). Adoption of the last statement method over the net investment method would benefit those customers who had withdrawn imaginary profits exceeding their initial investment over those customers who had not withdrawn funds before the fraud was discovered.
Net Equity May Be Determined on Case-by-Case Basis
SIPA does not prescribe a single means of calculating “net equity.” The term “net equity” is not defined by the statute to refer to a customer’s last account statement. Instead, “[w]hen reading the terms of the statute together, [it] directs that a SIPA trustee should 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.” Net equity is defined as “calculating the sum [that] would have been owed by the debtor to such customer if the debtor had liquidated, by sale or purchase, on the filing date all securities positions of such customer, minus, any indebtedness of such customer to the debtor on the filing date.”[2] SIPA further requires the trustee to make payments to customers based on “net equity” as long as the amount owed to the customer is “ascertainable from the books and records of the debtor or [is] otherwise established to the satisfaction of the trustee.”[3]
The profits recorded in the BLMIS accounts 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.” The net investment method allows a trustee to make payments based on the withdrawals and deposits into BLMIS accounts, which can be verified from the debtor’s books and records. The last statement method would have the effect of treating fictitious and arbitrarily assigned paper profits as real and “would give legal effect to Madoff’s machinations.” Accordingly, the court found that the net investment method was consistent with the purpose of SIPA, i.e., “to protect investors against financial losses arising from the insolvency of their brokers.”
Finally, the court held that the last statement method, while not adopted in this case, is still a useful tool for SIPA trustee’s to use in determining a customer’s “net equity.” In more conventional cases, the last statement method will be the most appropriate means of calculating “net equity.” While two competing methods of calculating “net equity” are at issue in this decision, the court “does not hold that they are the only possible approaches to calculat[ing] ‘net equity’ under SIPA.”
Net Investment Method Is Consistent with New Times I & II
The New Times[4] case involved a Ponzi scheme and a corresponding SIPA proceeding that produced two groups of claimants. The first group were misled to believe that they were investing in existing mutual funds, and their account statements mirrored what would have happened had their funds actually been invested. The second group were fraudulently induced to buy shares in fictitious mutual funds and their account statement were entirely fictitious. The bankruptcy court upheld the SIPA trustee’s determination that the first group of claimants had claims for securities, even though none were ever purchased. The SIPA trustee applied the last statement method to determine the first group’s “net equity.” As to the second group, the SIPA trustee determined that the second group of claimants only had claims for cash because the mutual funds and account statements were fictitious.
The Second Circuit overruled and instead held that the second group of claimants had claims for securities, but that their “net equity could not be calculated by reference to the fictitious securities positions reflected in the Claimant’s account statements.” The “net equity” of the second group was determined by the amount of money originally invested, excluding fictitious interest or dividend reinvestments. The objecting BLMIS claimants are “similarly situated to the New Times appellants in a crucial respect: assessing ‘net equity’ based on their customer statements would require the Trustee to establish each claimant’s ‘net equity’ based on a fiction created by the perpetrator of the fraud.”
Whether Net Investment Method Is Adjusted to Account for Either Inflation or Interest is Unresolved
The Securities and Exchange Commission (SEC) and Securities Investor Protection Corp. both filed briefs in the bankruptcy court supporting Picard’s application of the net investment method. The SEC further argued that the net investment method should be applied using inflation-adjusted dollars. Picard took no position on the issue and the bankruptcy court reserved ruling on the issue for another day. The Second Circuit also expressed no view on whether the net investment method should be adjusted to account for inflation or interest. Whether the net investment method is adjusted for either inflation or interest will have an effect on a BLMIS claimant’s “net equity.” This effect will become more pronounced the longer a customer invested with Madoff.
1. All quotations herein are from In re Bernard L. Madoff Investment Securities LLC, 2011 WL 3568936 (2d Cir. Aug. 16, 2011).
2. 15 U.S.C. § 78lll(11).
3. 15 U.S.C. § 78fff-2(b).
4. See In re New Times Sec. Servs. Inc., 371 F.3d 68 (2d Cir. 2004) (“New Times I”); In re New Times Sec. Servs. Inc., 463 F.3d 125 (2d Cir. 2006) (“New Times II”).