Securities Law

2nd Cir. Backs Madoff Trustee: Victims of $20B Swindle May Get Principal Back, But Not Fake Profit

Many victims of the massive Ponzi scheme that Bernard Madoff operated under the guise of a profitable hedge fund got statements showing handsome investment returns via the basket of stocks supposedly being purchased on their behalf.

But “Madoff never invested those customer funds. Instead, Madoff generated fictitious paper account statements and trading records in order to conceal the fact that he engaged in no trading activity whatsoever,” recounts a federal appellate panel in an opinion (PDF) today.

Investors seeking restitution for their losses wanted reimbursement not only for some $20 billion in principal but the fake paper profits shown on the statements. However, the 2nd U.S. Circuit Court of Appeals today agreed a formula determined by trustee Irving Picard and approved by a bankruptcy judge was the better approach.

It provides for reimbursement of at least some lost principal, up to a $500,000 limit, via an industry group known as the Securities Investor Protection Corporation (SIPC), but none of the fictitious profit.

The Securities Investor Protection Act calls for reimbursement of “net equity,” and investors argued that the statute was intended to protect their legitimate reliance on account statements they received from Madoff’s securities brokerage. However, the 2nd Circuit panel agreed with Picard that the SIPA, read as a whole, “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.”

Doing otherwise and using a statement-based method to calculate losses “would have the absurd effect of treating fictitious and arbitrarily assigned paper profits as real and would give legal effect to Madoff’s machinations,” wrote Chief Judge Dennis Jacobs in the opinion.

Under the net equity approach, victims’ reimbursement is reduced by any prior withdrawals they have made. And those whose withdrawals exceed the amount of the principal they invested could owe money to the trustee, reports Bloomberg.

Attorney Helen Davis Chaitman, who represents hundreds of victims, vowed to appeal to the U.S. Supreme Court, reports CNBC.

Many victims of the swindle, for which Madoff has been convicted and is expected to spend the rest of his life in prison, suffered “terrible detriment,” Jacobs said, because they relied on brokerage statements when making financial plans and filing income tax returns.

“The Second Circuit’s ruling will destroy investor confidence in the capital markets because the promise of SIPC insurance is illusory,” Chaitman told Bloomberg. “The message to every American who invests in the stock market is clear: Invest at your own risk and assume that SIPC insurance does not exist.”

Investors did win a round concerning the way their investments were characterized for the purpose of SIPC reimbursement. Although Madoff didn’t buy securities on their behalf, investors were considered to have lost securities, due to the brokerage statements they received falsely claiming that securities had been purchased. Had their losses instead been considered to involve cash, a lower reimbursement limit would have applied.

Additional and related material: “Repayment Plan for Madoff Victims Puts Total Ponzi Scheme Loss at $20B”

United States Courts: “SIPA. Securities Investor Protection Act”

SIPC (press release): “SIPC Statement on U.S. Court of Appeals Upholding of Madoff Trustee ‘Net Equity’ Calculation”

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