Second Circuit Decision Establishes Framework for Valuing Madoff Investor Claims

In an August 16, 2011 decision that will likely remain the subject of some controversy for years to come, the U.S. Court of Appeals for the Second Circuit ruled that claims of customers of failed stock broker and investment advisor Bernard L. Madoff Investment Securities LLC (“BLMIS”) were limited to the amount of cash that they invested in BLMIS less the amount of cash withdrawn. In affirming the Bankruptcy Court’s decision on appeal, the Second Circuit endorsed this “Net Investment Method” to establish each customer’s claim or “net equity,” instead of the “Last Statement Method,” as advocated by a number of BLMIS investors, which would have fixed customers’ claims based on what their last customer account statements indicated.

Specifically, the court concluded that the Securities Investor Protection Act (“SIPA”) directs the court-appointed trustee in a broker-dealer liquidation to determine the amount of a customer’s claim, or “net equity,” based on both the statutory definition of “net equity” found in SIPA and by an essentially forensic review of the debtor’s books and records. As such, the court held that SIPA does not require a single method of calculating “net equity” that applies in all SIPA liquidations. In fact, the court was careful to point out that “differing fact patterns will inevitably call for differing approaches to ascertaining the fairest method for approximating ‘net equity,’ as defined by SIPA.”

While customers receive various assurances, including from the brokerage industry’s self-regulatory organizations and Securities Investor Protection Corporation (“SIPC”) itself, that they can rely on the transaction confirmations and account statements provided by their stockbrokers, that reliance may not be supported if the stockbroker perpetrated a major fraud. Customers who relied on the confirmations and account statements provided to them by BLMIS to pay taxes on gains, to plan and to live their lives apparently have no recourse for the money that they innocently believed they had earned on their investments.

As most people inside and beyond the financial community are aware, Bernard L. Madoff perpetuated a multi-billion dollar Ponzi scheme through BLMIS. BLMIS collected funds directly from investors and through domestic and international feeder funds and exercised complete discretion over the invested funds. In reality, however, BLMIS never invested the funds. It created fictitious paper customer account statements and trading records and used funds received from customers to satisfy withdrawals by other customers. At the time of Madoff’s arrest, BLMIS had 4,900 active customer accounts. The balance under management based on customer account statements as of the end of November 2008 was $64.8 billion. However, the principal amount actually invested in BLMIS was only $19.5 billion.

In the circumstances of the Madoff fraud, the court concluded that use of the Last Statement Method, was not helpful in determining net equity because it would result in giving legal effect to BLMIS’s arbitrary and unequal distribution of funds among customers.¹ Instead, it found that use of the Net Investment Method, netting the money invested against the money received by the customer from the fund, was most appropriate for achieving a fair allocation of available resources among the customers.²

The limitation on customers’ claims, based on this calculation of net equity, will ultimately prevent those who received more money from BLMIS than they invested, from recovering from the pool of “customer property” and from receiving advances of up to $500,000 from the SIPC. Generally, each customer shares ratably in the customer property fund and is entitled to a SIPC advance of up to $500,000 to the extent of its “net equity.”³ The existence of net equity serves as a gating threshold for recovery from the customer property fund and for receipt of a SIPC advance.

Investors should not place too much weight on the Second Circuit’s endorsement of the Net Investment Method over the Last Statement Method in the Madoff case as the court appeared to limit its decision to the unique facts before it:

In holding that it was proper for Mr. Picard to reject the Last Statement Method, we expressly do not hold that such a method of calculating “net equity” is inherently impermissible. To the contrary, a customer’s last account statement will likely be the most appropriate means of calculating “net equity” in more conventional cases. We would expect that resort to the Net Investment Method would be rare because this method wipes out all events of a customer’s investment history except for cash deposits and withdrawals. The extraordinary facts of this case make the Net Investment Method appropriate, whereas in many instances, it would not be.⁴ (emphasis added)

The Second Circuit went further in footnote 8 of its decision to explain that:

Fraud is endlessly resourceful and the unraveling of weaved up sins may sometimes require the grant of a measure of latitude to a SIPA trustee. It therefore appears to us that that [sic] in many circumstances a SIPA trustee, may, and should, exercise some discretion in determining what method, or combination of methods, will best measure “net equity.”⁵

While the Second Circuit stated a number of times that its decision was limited to the facts of this case, it appears that the court’s ruling could more broadly preclude application of the Last Statement Method when customer securities are missing. Unfortunately, the overwhelming fraud present in the Madoff case does not provide much guidance as to where the court will draw a line in future broker-dealer insolvencies when asked to endorse one method or the other for the determination of the size or amount of customer claims or net equity. The Second Circuit’s decision also expressly left open the question of how the trustee and the Bankruptcy Court should account for factors such as interest and inflation in the calculation of net equity as those matters were not before the appellate court.⁶

Ultimately, in this instance, the Second Circuit relied heavily on its view of fairness and equity in approving the Net Investment Method over the Last Statement Method rather than on a strict reading of the definition of “net equity.”⁷ Its decision suggests that a SIPA trustee will be afforded a fair degree of discretion in these matters based on the facts and circumstances of each case. As a result, it appears that the Second Circuit would not have investors place too much emphasis in future cases on its decision in the liquidation of BLMIS. Unless the decision is successfully appealed, investors should understand that the degree of fraud in an insolvency will dictate the determination of the amount of their respective claims and those of their fellow investors.