The Congressional Bailout of Madoff's Investors

by: Matthew Rafat

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). It 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).

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' 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.