Thursday, July 2, 2009

H.R. 2798: Madoff's Investors Ask for a Congressional Bailout

On's comments board, I've written that investors who invested directly with Madoff ought to get their original investment back from the SIPC, but nothing more. Feeder fund investors who invested indirectly with Madoff should look to their investment fund for recourse, not the SIPC or taxpayer. The SIPC fund was clearly not intended to reimburse mutual fund or feeder fund investors for bad investment decisions or advice. In any case, I assumed that only member banks and brokerages, not the taxpayer, fund the SIPC. I was wrong.

Most writers praised my earlier article, but a few detractors kept focusing on the SIPC coverage. I got curious about the SIPC and did a little bit of research. Guess what? At the end of the day, the SIPC is funded by American taxpayers. In fact, Congress is about to change the law, increasing the SIPC's borrowing limits and enabling the government to print money to give to the SIPC. No wonder the pro-Madoff-investor camp kept focusing on the SIPC--as long as the SIPC received taxpayer-backed funding, Madoff's direct investors would get paid. I naively thought that only private sector financial institutions were contributing to the SIPC fund. Again, I was wrong.

Some of what you will read below is technical. I did not spend more than half an hour researching the law, but I was able to ascertain a lot of information. It is shocking to me that the NY Times or some other major newspaper did not blow the cover off this scheme in early June 2009, when the House of Representatives drafted a special bill--H. R. 2798--for Madoff's investors.

Also, I cannot find anything online about what interest rate the Secretary of the Treasury is charging SIPC members. That number is key. If the interest rate is reasonably high, American taxpayers may eventually make money from SIPC loans; however, if the interest rate is low, then American taxpayers are basically giving Madoff's investors free money. In short, a low-interest-rate SIPC note is tantamount to American taxpayers acting as financial guarantors for Madoff's unconventional investment strategies and investors who voluntarily chose to invest in non-mainstream products.

First, let's cast aside the idea that most of Madoff's investors are going to be destitute. From the WSJ (Jay Miller, 07/02/09):

A total of $2.97 billion in claims has been allowed, including $2.74 billion that exceed the statutory limit of protection.

$231 million has been set aside for claims from victims of the Ponzi scheme, with another $2.74 billion authorized for potential recoveries.

Yes, Madoff's direct investors will divvy up almost $3 billion. If anyone starts talking about how Madoff's investors were poor widows, give them a three word response--three billion dollars--and a link to this article.

On top of the $3 billion, some of Madoff's investors--including the ones who invested through feeder funds--may come out ahead, courtesy of the American taxpayer. After the CPAs and tax lawyers are done exploiting new tax breaks, many Madoff investors will get credits for much more than their original investments. These changes may result in windfalls for Madoff investors. For example, let's assume you invested $5,000 with Madoff in 1975 (we're using smaller numbers for simplicity's sake). By 1995, your $5,000 investment has become $25,000. Then, from 1995 to 2008, your account balance increases to $50,000, which allows you to withdraw an average of $5,000 each year for thirteen years. Thus, even if you lose your entire investment in 2009, you've still gained much more than your original investment of $5,000. In addition, you will submit an SIPC claim for the full $50,000, even though your original investment was only $5,000.

Now, let's discuss the SIPC. The SIPC is basically a government-backed institution similar to the FDIC. Like Fannie Mae and Freddie Mac, the SIPC is not technically a government entity, but operates in a murky zone that's not quite "private entity" and not quite "government agency." (For the lawyers out there, the SIPC is codified in Title 15 USC Sections 78aaa. The SIPC fund is codified in Title 15 USC 78ddd.)

Below is a good summary of the SIPC, from SEC v. GUARANTY BOND AND SECURITIES CORP, 496 F.2d 145 (1974):

The Securities Investor Protection Act was enacted in response to the need to protect the customers of securities brokers and dealers which might fail, thereby jeopardizing the cash and securities that customers had left on deposit with the firm. S.I.P.A. accordingly created the Securities Investor Protection Corporation as a 'non-profit corporation,' not designed to 'be an agency or establishment of the United States Government,' but rather to be 'a membership corporation,' consistent with the self-regulatory nature of the securities industry. 15 U.S.C. 78ccc(a). The S.I.P.C.'s role is primarily one of consultation and cooperation with the self-regulatory organizations which remain subject to the federal securities laws and the rules of the S.E.C. By mandating membership in the S.I.P.C. for certain members of the securities industry and by granting the S.I.P.C. general assessment authority over the members in order to establish an S.I.P.C. fund, Congress accomplished its intention that the cost of providing protection to customers under S.I.P.C. was to be borne by the securities industry itself.

But look at footnote 3:

S.I.P.C.’s first responsibility under the Act was to establish a fund which would consist of all amounts received by S.I.P.C. and from which all expenditures would be paid. 15 U.S.C. Sec. 78ddd(c). If the fund should become insufficient for the purposes of the Act, the S.E.C. is authorized, if necessary for the protection of the customers of brokers and dealers and for the maintenance of confidence in the United States securities markets, to issue notes under certain conditions to the Secretary of the Treasury in an amount up to one billion dollars, which then may be lent to S.I.P.C. 15 U.S.C. 78ddd(g). [emphasis added]

Take a look at this bill, H. R. 2798, referred to the Committee on Financial Services in June 2009:

(b) Increasing SIPC line of credit with the Department of Treasury.—Section 4(h) of the Securities Investor Protection Act (15 U.S.C. 78ddd(h)) is amended by striking out “$1,000,000,000” and inserting “the lesser of $2,500,000,000 or the target amount of the SIPC Fund specified in the bylaws of SIPC”.

Congress wants to more than double the one billion dollars limit to make sure Madoff's investors will be paid in full. But that's not all. Congress also wants to increase the amount of money that the SIPC can directly pay Madoff's investors, from $250,000 to a whopping $850,000. See section (d) of the proposed bill:

(d) Eligibility for direct payment procedure.—Section 10(a)(4) of the Securities Investor Protection Act (15 U.S.C. 78fff–4(a)(4)) is amended by striking out “$250,000” and inserting “$850,000”.

Another section of the proposed bill increases the amount of cash payable to investors:

Standard maximum cash advance amount. For purposes of this Act, the term ‘standard maximum cash advance amount’ means [an increase from $100,000 to] $250,000, adjusted as provided under subsection (e) after March 31, 2010.

Don't let the March 31, 2010 date fool you--this proposed law will help investors prior to March 31, 2010, i.e. Madoff's investors. The language in subsection (e) refers to an "inflation adjustment" provision that gives the SIPC the discretion to increase the direct payment amount more than $250,000 after March 31, 2010.

It gets even better if you're a rich investor. There's practically no legal limit to the SIPC's power to increase the $250,000 cash advance amount. Two of the three factors allowing the SIPC to increase the amount are unconscionably vague. One talks about "economic conditions" and another refers to "potential problems affecting members of SIPC."

You'd think Congress would help non-rich Americans, who hold most of their money in bank accounts. The FDIC, not the SIPC, insures these bank accounts. Congress did pass similar insurance coverage for normal bank account deposits, but the coverage reverts to the old $100,000 limit in 2014. Here is a paragraph from the FDIC's website:

The standard insurance amount of $250,000 per depositor is in effect through December 31, 2013. On January 1, 2014, the standard insurance amount will return to $100,000 per depositor for all account categories except IRAs and other certain retirement accounts, which will remain at $250,000 per depositor.

In contrast, the proposed SIPC changes have no sunset provision. Rich investors and Madoff's investors should thank House member Michael Arcuri, who represents New York's 24th congressional district, and House member Dan Maffei, who represents New York's 25th congressional district--these two men are the sponsors of HR 2798. They sure have their priorities right, don't they? After all, isn't it Congress's job to pay rich investors for their losses after they voluntarily invest their money with a reclusive financial advisor?

The best part? Although Arcuri's and Maffei's bill is basically a gift to Madoff's investors, it's called "Support Investment Protection for Customers Reform Act of 2009." The second best part? Both Arcuri and Maffei are Democrats. Next time you think there's much difference between Republicans and Democrats, or that Republicans are the party of the rich, just remember these words: "Support Investment Protection for Customers Reform Act of 2009."

Now, who is going to fund all this protection? Well, that’s where it gets confusing. A federal court's website states:

The fund is supported by assessments upon its members. If the fund should become inadequate, the SIPA authorizes borrowing against the U.S. Treasury. An analogy could be made to the role of the Federal Deposit Insurance Corporation in the banking industry.

Then look at 15 USC §78ddd(g) and (h):

In the event that the fund is or may reasonably appear to be insufficient for the purposes of this chapter, the Commission is authorized to make loans to SIPC...The Secretary of the Treasury may reduce the interest rate if he determines such reduction to be in the national interest.

See those words? Secretary of the Treasury? That means the U.S. Treasury, which manages government revenue--otherwise known as the taxes we pay. Have you figured it out yet? Yup, it’s the taxpayers who are going to pay off Madoff's direct investors, because the SIPC doesn't have enough money in the till to make the investors whole. The Treasury may just end up printing money--at a low interest rate--to save Madoff’s direct investors.

I really, really want to know what the interest rate is on these taxpayer-backed SIPC loans. (Where’s the NY Times when you need them?) What’s really funny/tragic is that the SIPC’s members include banks, which are already receiving billions of dollars of taxpayer money. Our government has printed money--to be paid by our children and their children--to give to banks, the SIPC, and Madoff’s investors. You might argue it’s not a giveaway, it’s a loan, but I’m not budging until I see the interest rate charged.

I can’t believe I didn’t see this before. I’m not a securities attorney, so I hadn’t looked at the specific code sections to see how SIPC was funded. (Where are all the articles from securities and tax lawyers? Perhaps they’re too busy figuring out how to make money for Madoff’s investors to do anything for the public interest.)

The way I see it, the American taxpayer has gotten screwed (again), and the rich seem to have a direct line to Congressional lawmakers. Rather than draft legislation that allows the orderly winding down of institutions when complex financial transactions cause multi-party failure, Congress is thinking about how to bail out Madoff's investors. No wonder China unofficially wants a modified reserve currency–our government keeps printing money without rhyme or reason. America’s financial credibility is eroding. Mark my words: unless fiscal discipline makes a comeback, this will end badly.

Update on July 10, 2009: Here is the letter I sent today to the House Financial Committee:

Dear House members:

I am asking that you vote against H.R. 2798 or decline to submit the bill for a full House vote. The proposed bill bails out Madoff's investors under the guise of shoring up the SIPC. In reality, SIPC members will only be expected to pay $1000 annually (up from $150 annually). This amount is stunningly low, given that credit unions have had to pay millions of dollars to shore up their own version of SIPC, the National Credit Union Share Insurance Fund (NCUSIF). Star One Credit Union, for example, will be assessed a $44.2 million charge to maintain adequate member protection. Thus, a revised annual SIPC fee of $1000 is laughable if consumer protection is the goal.

H.R. 2798 would be even more comedic if the money to expand SIPC protection wasn't coming from taxpayers. Unfortunately, because the SIPC has been woefully underfunded, if H.R. 2798 passes, the U.S. Treasury must issue loans to raise the SIPC fund's available credit from one billion dollars to 2.5 billion dollars. As you know, the U.S. Treasury is basically the American taxpayer, so ordinary Americans and their children will be on the hook for this proposed bailout.

Most tragically, H.R. 2798's proposed penalties for white collar crime are too low at five years' jail time and a $250K fine. Such minimal deterrence will not protect the public against a future Madoff. Approving such low penalties post-Madoff will make voters wonder if white collar criminals have lobbyists. I would not want my name associated with H.R. 2798 in its current form.


Richard said...

You have taken the focus off the guilty parties here, Madoff for committing the crime, and the SEC for enabling it for decades, and instead focused in on the victims and have vilified them instead. You have thrown out large numbers implying that Madoff investors are going to make out like bandits, rather than researching the facts that thousands of Madoff investors will not receive a dime under the way Trustee Picard has calculated compensation. Most of the others who receive anything at all, will receive far less than the amounts that they were due under existing legislation that Picard is not following. You should be blaming SIPC for collecting for at least a dozen years a mere $150 per company to be able to tell each and everyone of their customers that their investements were safe, up to the maximum limit should their broker fail or if there was theft. SIPC gave the securities industry a virtual free deal for all those years, leaving the investor to think they were protected against the above mentioned items, when in fact they were not. Now SIPC has to turn to a credit line. You seem to turn down the fact that this will be a loan not a "grant" from the U.S. Treasury, and are already complainig about the interest rate before one is even determined. SIPC will pay this money back, with interest, from the increased fees they have been charging since April 1. (.0025 of net operating revenue). Sadly, you have chosen to take a position, and then distorted the facts with fuzzy math and other innuendos in order to support your position. I strongly suggest you start by getting the facts straight first, then come to your own conclusion.

If you really cared you would direct your attention to the SEC and SIPC going forward, for it is just a matter of time until the next scandal is uncovered and more Americans are deprived of their life savings.

Matt Rafat said...

Richard, I appreciate your comment. I agree the SIPC needs to have better funding, but from its members, not general taxpayers. It shocked me when I saw that the law only requires the SIPC fund to have 75 million dollars (see 15 USC § 78ddd(b)).

Even so, American taxpayers should not be held responsible for the SIPC's failure to have sufficient member contributions. Remember: Madoff's investors and the feeder funds voluntarily went "off-the-grid" to gain access to an exclusive investing club and a unique strategy unavailable to most investors.

Madoff's investors could have invested in funds available to everyone else--Vanguard, T. Rowe Price, and so on. Instead, they wanted a sure thing backed by the Madoff mystique. Now that the "sure thing" has turned out to be a scam, Madoff's investors want the Treasury to print money to reward their poor investment choice. This demand--that American taxpayers provide money to a relatively small group of formerly wealthy investors--is particularly galling because Madoff's investors deliberately shunned mainstream investments and basic investing rules, such as diversification.

We are left with two questions:

1. Why should the American taxpayers be forced to guarantee any investor's choice of financial advisor, especially someone who was unavailable to the average investor and who openly told investors he was using unique investing strategies?

Stated another way, if I give all my money to an advisor who then invests it in exotic animals, should the U.S. Treasury give me money if it turns out that all profits from the exotic animal trade were illegal and/or non-existent?

2. Why should American taxpayers suffer because banks and other major financial institutions failed to adequately contribute to the SIPC fund? If major financial institutions are responsible for the SIPC fund's insufficient assets, why should innocent taxpayers be held responsible?

Richard said...

K Yew - we are on the same page for most of your comments. I do not support taxpayer funding for SIPC. Never have. You seem to think that I support it, but I don't. You can't exactly say that Madoff investors went "off the grid" since Madoff was a SIPC member and it is only with benefit of hindsight we learned that his operation was phony. SEC claimed to investigate him 7 times and found nothing out of the ordinary. Now we learned that we cannot trust the SEC, and we all suffer as a result.

Madoff's investments were never touted as a sure thing, even though his track record seemed to indicate that. There were plenty of funds around that did significantly better than Madoff purported to, plus in the 1990's the Dow Industrials and S&P beat Madoff almost every year.

There is a problem with misinformation out there. You have said several times that Madoff investors want the taxpayers to rescue them or the Treasury. There is nothing further from the truth. We want SIPC to follow its own statutory regulations under the SIPA Act of 1970 and just do what it has done before under similar, if not identical circumstances. SIPC itself, as you correctly recognized, was negligent in not collecting sufficient funds from its member brokers.
As to your points:
1) American taxpayers are not forced to guarantee to pay anything to any investor. SIPC is funded by the member brokers. Taxpayers do not pay a dime. Just like the FDIC is funded by member banks. If the SEC did its job and did not ignore all the warning signs and have 7 examinations of Madoff that failed to come up with anything, we would not be having this conversation.
2) American taxpayers are not going to suffer because SIPC did not adequately fund itself. That is the contention of the blogmaster. The securities industry has to make up the difference, and because they only paid in $150 per comany so that every one of their accounts were insured to the maximum, SIPC is to blame, not the taxpayer, not the investor.

You cannot find one Madoff investor who will support a taxpayer bailout. Bailouts in this country are only for the companies who are "too large to fail," the ones who were so greedy that everything they did had no economic benefit to anyone but themselves, and who, in this case knew, they were going to get bailed out.

Matt Rafat said...

I agree the SEC should have done a better job, but American taxpayers shouldn't be forced to reimburse any investor because of the SEC's negligence. The big banks and financial institutions lobbied hard for deregulation, got what they wanted, and then took advantage of the situation. After the Gramm-Leach-Bliley Act, financial institutions had a responsibility to self-regulate. They--not the American taxpayer--failed.

You said, "You cannot find one Madoff investor who will support a taxpayer bailout." You are incorrect. Madoff's investors have already asked for a taxpayer bailout:

"[S]ome government aid is a very logical request," said Robert Schachter, [who] is representing several Madoff victims. "If we're bailing out Wall Street and the auto industry, maybe these individuals should be bailed out too.",4670,MadoffScandalInsurance,00.html

You also say, "SIPC is funded by the member brokers. Taxpayers do not pay a dime." This is also incorrect. The SIPC does not have enough money in its fund to pay all the claims. It must tap the U.S. Treasury for money. Where does the U.S. Treasury get its money? From the American taxpayer.

The issue is whether the Treasury is charging the member banks a sufficient interest rate or an insufficient interest rate on SIPC loans. If the interest rate is low, the Treasury is basically printing free money for Madoff's investors. Even if the interest rate is reasonable, the U.S. Treasury has to borrow money from American taxpayers to make the SIPC loans. Thus, all roads lead to the American taxpayer.

Why should the American taxpayer become the insurer of last resort for wealthy investors?