Madoff Ruling: A Question

Chidem Kurdas

An appeals court upheld the Madoff trustee’s decision that the former clients of the defunct firm have a claim only to the capital they originally invested, not the profits Madoff fraudulently reported on their accounts.  This has precedent from past Ponzi schemes, where investors who took out more than their capital had to return the difference. It’s a reasonable principle not to allow fake profits, though a hardship on people who relied on them, like New York Mets owners Fred Wilpon and Saul Katz. The supposed gains, after all, came from other investors’ money.

But there’s something else going on.

Besides litigation to force people who redeemed more than their capital to return the difference – called claw backs –  Madoff trustee Irving Picard and allied lawyers have undertaken various other litigation.  Thus Messrs. Wilpon and  Katz are being sued for $1 billion, which is mostly not a claw back but rather money demanded on the basis of a separate argument by the trustee that these investors knew or should have known that Madoff was conducting a fraud.

The lawsuits that are not about the claw backs have a surprising implication. If the government-appointed trustee had not initiated the many lawsuits and instead the fraud victims had hired their own lawyers and sued some of the same parties, in particular the feeder fund operators against whom there is a strong case, their claims would not be restricted to the principal they lost. They would get whatever settlement they could negotiate.

With Mr. Picard controlling the litigation, if the proceeds are more than the $17.3 billion principal lost, the rest will go not to the victims but to reimburse the Securities Investor Protection Corp., which is paying the legal and administrative expenses. What it means is that SIPC pays Mr. Picard and associated lawyers along the way, then gets the money back. But the bankruptcy judge has opined that there is no reasonable expectation that SIPC will recoup the legal expenditures.  As I wrote before, the estate lawyers get paid for litigation whether or not they succeed.  

As of May the trustee had recovered more than $7.6 billion, about 44% of the $17.3 billion lost capital. Some of the trustee’s pending lawsuits are unlikely to succeed, such as the $19 billion case against JP Morgan for being Madoff’s bank. But the feeder funds that fed the Madoff scheme are vulnerable.

Suppose the victims were free to pursue lawsuits of their choice and hire lawyers for this purpose, paying them according to agreed-upon terms. Could they have recouped their capital loss and legal expenses and had something left over?  Then they would be better off than they are currently, even though SIPC pays the mounting legal bills.

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