Regulators Create Madoff Investor Underclass

Chidem Kurdas

A few days ago a district court affirmed that indirect investors – that is, those whose money went to Madoff via feeder funds – were not customers of the fraudster’s brokerage. Hence they can’t get assistance from the fund for brokerage customers – under a law known as SIPA – and are not allowed to make any claims on the estate, except through the feeder funds.

By contrast, the direct investors received about $807 million from brokerage fund, up to $500,000 per investor. But because each feeder fund counts as a single investor, all the customers of a feeder fund have to share a single payment.

For these investors, all payments and legal actions have to go through the feeder fund. This is a particularly bad situation because the feeder funds are almost all defunct and in liquidation. Tough luck, isn’t it? The two groups of investors lost money in the one and same con game but some are treated much better than others.

Yes, the law is the law. But this outcome was engineered by regulators.

The legal point turns on whether an investor gave cash or securities to the Madoff brokerage. Indirect investors gave their money to feeder funds. The district court says on the basis of the facts, it has to “conclude that appellants do not qualify as BLMIS ‘customers’ under SIPA.”

The last word there is key. Funny that this bankruptcy was put under SIPA, a law meant to protect brokerage customers from the misplacement or theft of the assets in their account. It is not usually applied to investment fraud. In fact the agency that runs the program, SIPC, refused to get involved in the aftermath of the Allen Stanford swindle, even though a brokerage was part of the Stanford operation —see my book Political Sticky Wicket: The Untouchable Ponzi Scheme of Allen Stanford

During the decades that Madoff ran his fraud, the Securities and Exchange Commission regarded his brokerage and his asset management business as separate entities. So much so that the SEC never even told the brokerage regulator FINRA that Madoff was managing money.

The SEC itself examined the money management operation and FINRA repeatedly examined the brokerage, but FINRA had no idea there were investor assets at the brokerage. Had regulators looked at the two businesses together, they would have had a better chance of stopping the fraud. So it would have been useful.

But they did not, until Madoff confessed in December 2008. At that point, for reasons of its own, the SEC decided that the brokerage was involved in the fraud and therefore the bankruptcy estate would go under SIPA. This had the effect of helping one group of investors while victimizing another group of investors. Behind the legalities of the court decision is the deliberate SEC choice to invoke SIPA.

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