Comments on the Second Circuit's Decision on Net Equity
COMMENTS ON THE SECOND CIRCUIT’S DECISION
ON NET EQUITY
August 23, 2011
I have been asked to state my views on the Second Circuit’s decision on net equity in the Madoff case. Some of the matters I shall discuss are relevant to a request for rehearing en banc to the Second Circuit and/or a subsequent petition for certiorari to the Supreme Court.
1. The Court’s decision is based on its acceptance of the statutory language relied on by the Trustee rather than the language relied on by the victims. The victims said they had a right to their “securities positions” as reflected in their final statements. The Trustee said he had to and should give them only what the “books and records” showed they had put in and taken out, so that a person who took out more than he put in had no net equity. In these regards (and others), the Court, like the Trustee as well as many people not connected with the Madoff affair, thought it overriding that everything Madoff did was a fake and the final account statements represented fakery, so it was better, and necessary, to look at the books and records rather than rely on the phony securities positions set forth in the final statements.
To me it seems self evident that, in a case where things were faked, and there is rival statutory language for the Court to choose from in determining net equity, it is essential to present a court with strong and repeated policy statements as to why it should choose the counter intuitive position of using the faked statements to determine net equity rather than the reality reflected in the books and records. Those policy reasons are found in the intent of Congress repeatedly stated in the legislative history. This author vigorously and repeatedly urged upon the New York lawyers who controlled the case for the victims’ side that the policy arguments, found in the intent of Congress expressed in the legislative debates on the floor of the Senate and House at the beginning and near the end of the ’70s, should be the linchpin of the case. For (with some relatively minor exceptions we can overlook here) true securities positions were zero, since Madoff did not buy or sell stocks for the victims.
This author’s urgings were unsuccessful. It was decided early-on in New York that the dispositive point was that the statute said net equity was the securities positions reflected in statements from Madoff (less indebtedness to him). This writer disagreed, saying, as did judges at oral argument, that “securities positions” were zero because the whole deal was a fake in which securities were not purchased. This view was unpersuasive to the lawyers on our side, who said victims’ securities positions were what was shown on the final statements: Such was required by state law, it was said, is admittedly what Madoff would have been obligated to pay victims had they sued him before December 11, 2008, and for all these reasons is the measure of net equity under the statute.
The foregoing argument about securities positions, an argument about which our side was warned, was, and proved, a loser because, as said, in reality the victims’ securities positions were zero.
2. It was, as said, this writer’s view, unsuccessfully pressed on the New York lawyers orally and in writing, that the only way to persuade a court to rule that the final statements should be the measure of net equity though they were faked was to rely extensively and repeatedly on the intent of Congress as reflected in floor statements, many of them made by the leading Senators and Congressmen of the 1970s. (President Nixon and Treasury Secretary Kennedy also weighed in.) Those extensive and repeated statements made plain that the Congressional intent would be vitiated if CICO were used instead of the FSM. It is not that the legislative history ever discussed net equity explicitly. It did not. It is, rather, that the floor statements repeatedly stated Congressional goals that will be vitiated by the use of CICO, goals such as protecting small investors, giving them confidence in markets, paying investors promptly, and protecting them against non purchase and/or theft of securities. And not to be forgotten is that it was known that investors would have to rely on their statements because the securities industry was switching, and SIPA was part of the switch, from giving physical securities to investors to holding securities in street name. (The Madoff scam could not have been done if Madoff had had to give physical securities to investors.)
As readers will know very well, and for reasons most readers will likewise know very well, the goals sought by Congress are stymied by CICO. The Second Circuit discussed Congress’ goals only very scantily and paid no heed whatever to the abundant floor statements setting them forth. Fundamentally, the Circuit relied instead on what it thought the best reconciliation of the statutory provisions, with little regard to the goals shown on the floors of Congress. In this regard, it adopted the Trustee’s position.
Was the Circuit told of Congress’ goals and was it given the floor statements reflecting them? Yes. But only by one lawyer. What was said by an unknown lawyer from the New Hampshire/Massachusetts border, far from the Court’s location in New York City, did not move the Court. Would the Court have been moved by the legislative history had it been the linchpin argument, or even a major argument, of the Wall Street firms -- firms well known to the Circuit and doubtlessly respected by it? One cannot know for certain, but one might consider it common sense to think it might have made a big difference to the Circuit if the legislative history argument had been pushed by prominent Wall Street firms whom the Court knows very well rather than solely by an unknown lawyer living far from New York City.(1)
When one considers that the Court has chosen to ignore the legislative intent -- has chosen to ignore Congress’ intent for prompt payment, has overridden Congress’ desire to protect small investors, has paid virtually no mind to the legislative desire to build confidence in markets -- the question arises of whether the Trustee and the judiciary have violated separation of powers and engaged in judicial legislation by doing what they think most appropriate while not even considering the Congressional purpose underlying the statute. This question comes up in regard to other matters too, as discussed below.
2. Relying solely on the statutory wording -- i.e., relying on the statute’s books and records clause -- the Circuit gave Trustees wide discretion to use whatever method of calculating net equity they deemed best in the circumstances of their cases. The Court appears to believe that there can be several ways of calculating net equity, depending on the particular facts of cases, and only if a Trustee chooses a method “clearly inferior” to some other method will the Court strike down a Trustee’s choice.
Paradoxically, while giving the Trustee wide discretion, the Court likewise said that as a matter of law CICO had to be used here. So I guess Trustees have wide discretion except when they don’t have wide discretion -- as here apparently, because the Court seemed to feel that the FSM method was “clearly inferior” to CICO on the facts of this case.
The grant of wide discretion to a Trustee in measuring net equity (unless and until a court rules there was no discretion in a case and only one method was permissible) will result in Trustees choosing measures that will save the most money for SIPC. Trustees, after all, make good livings by being SIPC trustees, and want to continue to get such assignments. So of course they will measure net equity in ways that save money for SIPC. Their likely varying choices of measurements of net equity will at times cause extended, long litigations on the subject, thereby insuring there will not be the prompt payments desired by Congress. The Trustees’ efforts likewise will mean there will be no confidence built up on the part of investors, and far less protection given them. Investors will again take it in the ear because of the Circuit’s decision.
There is also another crucial aspect to the ruling that Trustees are pretty much free to define net equity in any way they choose. The statute defines net equity essentially as meaning one’s securities positions minus one’s obligation to the broker. The statute also provides, in the section defining SIPC’s powers, that SIPC cannot change the statutory definition of net equity. Yet if SIPC and its Trustees can pick whatever definition of “securities positions” that suits them in the circumstances, for practical purposes is this not changing the definition of net equity? When you change the definition of a critical phrase in the definition of net equity, are you not thereby changing the definition of net equity itself for practical purposes? I would think you are, and that the Circuit’s decision is a plain violation of separation of powers and is judicial legislation overturning the explicitly expressed will of Congress.
Perhaps the Circuit felt it had to say there could be lots of definitions of net equity, depending on the circumstances. For if there could be only one definition of it, how to explain approving CICO now after the final statement method previously was used in something like 319½ out of 321 prior cases and, as the Court itself recognized, necessarily will be used in a host of future cases where CICO would be absurd? So, having to say there can be many definitions of net equity, the Court did say it. But what it said seems to me, as said above, a plain violation of separation of powers and a piece of judicial legislation, because it provides for SIPC and its trustees changing the definition of net equity to suit their purposes although Congress said the definition is not to be changed by SIPC.
3. The Circuit fully accepted the Trustee’s position that CICO was the only way to achieve fairness. Since there were those who took out more than they put in (net winners) and those who didn’t (net losers), the former would be unfairly advantaged if they received more (from the Trustee) while the latter have not yet fully recouped. Furthermore, the Court claimed, every dollar given by the Trustee to a person who had taken out more than he put in is a dollar made unavailable to one who has not gotten out all that he put in.
In terms of general fairness, the Court’s view -- its echoing of Picard -- is dubious. If one says that fairness is controlled solely by dollar figures (a very simpleminded view), than I suppose it makes sense to say that it is fair to insure that those who took out more than they put in (the net winners) should get nothing more unless and until there is complete recoupment by the others (the net losers). But is this fair if one considers more than just dollar figures, if one considers the complete situation? Those who took out more than they put in are, by and large I would think (pace Wilpons), the small people, the people who often are now remitted to poverty or something close to it. Those who didn’t take out more than they put in are, by contrast, usually huge and wealthy institutions such as hedge funds (or wealthy individuals). They are, moreover, the particular institutions, and the kinds of institutions, whom the Trustee himself has said enabled Madoff to maintain his fraud for years longer than it otherwise would have lasted. They did this by investing many, many billions of dollars without which the scam would have collapsed -- and without doing the due diligence of which they were financially and professionally capable and which would have caused the whistle to be blown on the fraud. And, by keeping the scam going, these institutions caused the losses of the small people to continue and to increase as the small investors put in more money year after year, took out more year after year in order to live, and thereby increased their losses and the potential clawbacks against them year after year.
Now, when one considers the complete situation, does it still look like using CICO rather than the FSM is the fair method? Not to me it doesn’t. I think it is no surprise that, unless he has sued them or entered a settlement with them which the Bankruptcy Court must approve, the Trustee has never been willing to identify the institutions (or very wealthy individuals) who have not taken out more than they put in, therefore have positive net equity under CICO, and will get SIPC advances and customer property. To reveal the identity of these institutions would be to disclose how unfair is the Trustee’s method of determining net equity, now approved by the Second Circuit.
There is another and extraordinarily fundamental matter pertaining to the Court’s claim that fairness requires use of CICO lest money given to net winners reduce, dollar for dollar, the funds available to net losers. The case in the Second Circuit involved two separate funds -- as the Court was aware because the matter of there being two separate funds was not only mentioned in briefs, but was discussed several times in the oral argument. One fund is the SIPC fund. That fund is created by contributions from the securities industry, and can be augmented by lines of credit obtained by SIPC and by requested appropriations from Congress. This fund is used to pay a customer up to $500,000, depending on her net equity, if a bankrupt broker’s coffers, as is usually the case, are insufficient to pay off. The amount of up to $500,000 is an advance against the customer’s share of the second fund, the customer property fund, but must be paid even if not one dollar of customer property is recovered. This further shows that, as I say, the SIPC fund is separate from the customer property fund, as Congress made clear -- though the Trustee and his counsel have tried, and in the Second Circuit have succeeded, in tricking this all up by their apparent claim that the SIPC fund is only a part of the customer property fund – and that the SIPC fund must be used to pay up to $500,000 of net equity even if there is no fund of customer property because no such property is recovered.
As I say, the Court was aware that there were two funds. From reading the oral argument several times, I think the Court also knew that payments to victims from the SIPC fund did not subtract one dollar from payments that other victims would get from either the SIPC fund or the fund of customer property. Yet though there were two funds, the Court appears to have deliberately treated the case almost exclusively as if there were only one fund, the customer property fund, and as if the SIPC fund were nothing but a specific branch of customer property, since payments from the SIPC fund are advances against customer property.
The nearly exclusive treatment of the case as involving only one fund, a customer property fund, is inherent in a number of the Court’s statements. Strikingly in this regard, the Court said that a dollar going to a net winner was a dollar denied to a net loser. That is simply untrue with regard to the SIPC fund, and I do not grasp how the Court could not have known it was untrue in regard to that fund. Yet the Court said it. I find this incomprehensible.
Maybe the Court thought the following, although it gave no indication of it. If net equity is measured by the Final Statement Method, then net winners will receive money from the SIPC fund and, having a positive net equity, will also be eligible for money from the customer property fund. Their eligibility for money from the customer property fund will take money that net losers would otherwise get from this fund, i.e., will take money from those who haven’t yet recouped all the money they put in.
But if this is what the Court thought, it told nobody about it in its opinion and was mistaken. For money from the customer property fund must be distributed “ratably” in accordance with respective net equities. Though the word “ratably” may sound like it means proportionally, and can mean proportionally, it doesn’t have to and doesn’t always mean that. It can mean merely that something can be rated or appraised or estimated. So . . . . . . if the FSM were used, it would be consonant with ratability to deny net winners any share of money from the customer property fund until net losers have received back all the money that they put in. This would allow net winners, who, as I say, often had to take out money to live and are now often impoverished, to receive advances from the SIPC fund in order to live, and would insure that they thereafter get nothing more -- get nothing from the customer property fund -- until all -- even the wealthy banks and hedge funds -- get back all the money that they put in.
It is noteworthy, in regard to finding some way to get money to the small investors whom Picard and the courts ironically call net winners (though they are often impoverished while hedge funds with scores of billions of dollars and near-trillion-dollar banks are called the net losers), that in hundreds and hundreds of pages of legislative history, Congress almost never discussed customer property. Congress was deeply concerned, rather, with the SIPC fund. It was the SIPC fund that was to provide the protection small investors needed, not the customer property fund. Yet Picard and the courts have focused entirely on the customer property fund, and to insure that so-called net winners get none of that fund, which Congress cared little about, have defined net equity in a way that insures that many small investors, so-called net winners, will get nothing from the SIPC fund, which Congress cared everything about because it was the SIPC fund that was considered the main protection for investors. To say that this is a distortion of priorities by Picard and the courts is mild. It is a point which should be one of the foci for petitions for rehearing or certiorari, I think. And while I myself, being a lawyer, would feel constrained from putting the whole matter the way it was recently put by a woman whom I believe is a leading member of the victims’ community, I think it is fair to quote to you what she recently wrote: “The court just rescued SIPC and Wall Street but condemned thousands of victims to poverty. You call that justice? These judges had the opportunity to come up with a little more creative solution to this problem but they chose the easy way out by regurgitating Picard’s lies. They had an agenda and it’s clear.” The statement about an agenda may be might be right or wrong, but it is, I think, the way lots of people feel, and the rest of the quote strikes me as right even if a lawyer would feel constrained from using some of its language.
4. Though Congress wanted SIPA to give confidence to investors, and to stimulate investment in the market, the Second Circuit’s opinion can only have the opposite effect. For now no investor can rely on his statement to know what he owns and to receive money from the SIPC fund accordingly. One cannot know in advance, of course, whether one is being victimized by a fraud -- if one knew there was a fraud it would be the rare case in which one would invest anyway.(2) And now the investor, who cannot know whether she is being subjected to a fraud, cannot depend on her brokerage statement to tell her what she has at her broker’s, cannot know whether she will receive up to $500,000 from SIPC, and has to reckon with the fact that a Trustee, on SIPC’s behalf, could (and will) deliberately choose a method of measuring net equity that may result in her getting nothing from SIPC. For the small investor this is entirely a disaster. One could just imagine what the situation would be if the FDIC were to tell depositors that it will not honor their bank statements because there was embezzlement which caused the bankrupt bank not to have the money shown on their statements. The situation here is no different.
In this regard, there are people who say that what Picard and the court have done is okay because investors, by definition, take risks. Of course, they take risks. That is inherent in investing. But the risk is of a decline in the market, a decline in the price of the securities one owns. The risk is (called) market risk. It is not risk of fraud. Fraud happens -- both in securities houses and banks. But both the FDIC and SIPA are supposed to protect against the fraud risk, albeit not against market risk.
5. There are many of us who believe that SIPC and Picard chose to use CICO because SIPC thought it did not have enough money in its SIPC fund to handle the Madoff problem if it used the FSM. The Trustee and SIPC have always resisted providing any information about the deliberations which led them to choose CICO. Defacto their position has been -- although they of course would never put it this way -- that no information need be given about such deliberations, and there can be no discovery into the deliberations, even if CICO thwarts the intent of Congress to protect investors. In taking this position defacto, they have violated separation of powers and have engaged in judicial legislation.
The Second Circuit has now done the same by ignoring the will of Congress, upholding positions which it deems fair in the circumstances regardless of what Congress wanted, and declining to address the fact that one party asked it to order the discovery necessary to learn why SIPC and Picard chose CICO. It has thereby eliminated the possibility of learning, through the judicial process, why CICO was chosen. Such elimination will also be the consequence of the Circuit’s (contradictory) statements that, even though trustees have discretion in selecting the method for measuring net equity, CICO is the only proper method here. The Trustee will quote the latter half of the contradictory statements to argue, yet again, that discovery of the real reasons why CICO was chosen -- discovery of whether it was chosen because of SIPC’s lack of funds even though it thwarts Congressional intent -- is improper because, after all, the Second Circuit said CICO is the only proper method for determining net equity here.
There may, however, be non judicial ways of determining what many of us think are the real reasons CICO was chosen. Congress could find out through legislative subpoenas and investigation or through the inquiries that now have been undertaken by the GAO. And what would happen if Congress were to learn that a concern over lack of sufficient monies in the SIPC fund was the reason, or an important reason, that caused CICO to be used instead of the FSM? Would the Second Circuit’s decision still stand because it said CICO is the only proper method here and this remains true regardless of the reason CICO was used? Or, contrariwise, would the Circuit’s opinion have to fall because it is the product of a bill of goods sold to the Court as the reasons for using CICO and because the Court focused entirely on the effect of net equity on the customer property fund while entirely ignoring its effect on the SIPC fund, about which Congress was far more concerned? My own view would be the latter, but there will be others who feel differently.
I should add that this problem is another one that stems from the basic nature of the procedure that was used here. Lawyers will immediately grasp my meaning when I say that this case, from the Bankruptcy Court through the Second Circuit, was a summary judgment without any opportunity for discovery, a procedure I believe very rare if known at all. So called summary judgments, which end a case before trial, are given only when each side has had discovery to learn the facts supporting and opposing it. But here no discovery was allowed or had on crucial matters such as the underlying reasons of SIPC and the Trustee for using CICO, the extent to which huge banks and hedge funds are helped and small victims are hurt by using CICO rather than the FSM, and other matters. The judiciary denied discovery, simply took one side’s (the Trustee’s) word for things, and then ruled against the victims who were not permitted discovery. This is, I think, a pretty astonishing method of proceeding where anybody on the losing side has sought discovery, and in this case one victim did. Guess who that was. His requests for discovery were rejected in the Bankruptcy Court and ignored in the appellate court. And again, common sense causes one to believe the requests for discovery might have received more respect from the courts had they been made by the large Wall Street firms the Circuit knows and respects -- but who were so convinced of the infallibility of their argument from the words of the statute that they thought discovery irrelevant -- instead of by an unknown guy from the far-off New Hampshire/Massachusetts border.
6. There are three points, which I shall very briefly allude to, that caught my eye in studying the opinion.
One is that the Circuit accepted the idea that, though no securities were bought or sold (with minor exceptions), still the victims had a claim for securities, as reflected in their final statements, because they gave Madoff money to purchase securities. Yet, though victims had a claim for the securities shown in their final statements, the value of those securities was not the value for them shown in the final statements. This has always been Picard’s position, and has always struck me as bizarre. After all, have you ever heard of a person who thought he owned securities because they were shown on his statement but (barring a mistake) has not thought the value of the securities was what was shown on the same statement? As I say, bizarre.
A second point is the alleged concern -- the bill of goods sold to the Second Circuit by the SEC and SIPC in New Times and repeated in Madoff -- that, unless CICO is used, the fraudster will dictate who gets what; in particular he will dictate huge sums for his cronies and will break the SIPC fund. The Madoff case is in itself proof that this is untrue. Madoff’s cronies -- e.g., Levy, Picower, Chais -- have been caught and have been forced already to disgorge huge sums or have been sued for huge sums. Moreover, as I’ve said many times before (but as the Circuit did not care), it has been customary in the financial world for decades to use surrogate measurements to determine what would have been or will be made -- here what would have been made if the deal had been honest.
7. Finally, it must be noted that the Trustee is seeking huge sums from large institutions that should have known Madoff was a fraud because they knew of serious red flags but ignored them in order to reap profits from the Madoff fraud. If the courts allow the Trustee to sue for those sums, and if he wins them at trial or by settlement, then the victims will ultimately be made whole because they will recoup fraud damages from the general estate. The Trustee’s and the Circuit’s denial of net equity, and therefore of a share of customer property, to small victims who have a negative net equity under CICO, will ultimately not deny full recovery to the victims. But, and it is a very big but, for this to occur the courts will have to allow the Trustee to sue the huge institutions for the damages they caused, which at least currently is not looking all that likely after Judge Rakoff’s recent decision on the matter in the HSBC case. Also, the courts would have to agree that the huge banks will be liable if they, as charged, knew of but ignored red flags in service of making profits. How the courts will rule on this question is unknown. And finally, ultimately might be a long time -- it could possibly be years before the Trustee defeats or settles with the large banks (though one hopes for faster results).
(1) At an early point, before the legislative history had been researched, one of the major New York City lawyers told me definitively that it contained nothing helpful. The subsequent research showed the contrary to be true, but the New York lawyers stuck with the doomed statutory argument they had selected early on.
(2) Some such possibly rare cases are currently in litigation.