Another Madoff Masquerade?: Questioning “Securities Fraud” in the Crime and its Cleanup

In December 2008, broker-dealer CEO Bernard Madoff confessed to a massive Ponzi scheme. Days later, he was charged by the Securities and Exchange Commission and the United States Attorney for, among other things, securities fraud. The theory of prosecution proceeded on the premise that Madoff’s illicit investment advisory activities (which stemmed from his reputation in the industry) operated wholly apart from his broker-dealer activities. Subsequently, both the SEC and FINRA (the industry’s largest selfregulator) concluded studies affirming that no securities transactions took place at the broker-dealer—for years, the man with the famous investment firm and his employees had simply spent the cash. Nonetheless, in remedy, the Securities Investor Protection Corporation commenced the process of marshalling all of Madoff’s broker-dealer assets for reimbursement of his Ponzi scheme victims. Accordingly, this Article examines two crucial, related determinations made in the aftermath of the Madoff scandal: 1) the decision to charge a Ponzi scheme as a violation of SEC Rule 10b-5, and 2) the decision to reimburse certain investors in the Ponzi scheme with SIPC funds. Those determinations are at best debatable given the “pooled fund” nature of the fraud, the complete absence of investment activity, and the near-complete absence of brokeragehouse custody of most of the fraud’s assets. Specifically, while case law from certain circuits supports the notion that, under certain circumstances, a non-purchase of a security can equate with a purchase/sale for purposes of Rule 10b-5, such an expansive reading of the * J. Scott Colesanti is an Associate Professor at the Hofstra University School of Law, where he has taught Securities Regulation every year since 2002. His articles have appeared in law reviews, The New York Law Journal, industry journals, and as expert commentaries before seminal securities law cases reported by LexisNexis. He is a former co-editor of the Business Law Professor Blog. He served as a securities regulator for over ten years and later as an industry arbitrator for a decade. Professor Colesanti wishes to thank Kristen A. Truver, Hofstra University School of Law Class of 2011, for her diligent research. SAINT LOUIS UNIVERSITY SCHOOL OF LAW 522 SAINT LOUIS UNIVERSITY LAW JOURNAL [Vol. 56:521 anti-fraud prohibition seems to greatly expand upon the Supreme Court’s reasoning whence last taking up the cause. And while SIPC reimbursement under the Securities Investor Protection Act is somewhat discretionary, the decision to reimburse Madoff investors and not those of a contemporaneous billion dollar fraud conducted by another brokerage house chief seems dangerously incongruent. In conclusion, this Article posits that future SEC rulemaking should remove all uncertainty surrounding the application of Rule 10b-5 to Ponzi schemes driven by the promoter’s reputation. In turn, such certainty (along with reforms to the investment advisory custodial process) should solidify both expectations and remedies when there is a lack of actual investment. In short, with some tweaking, the rules can better support the decision to reimburse those unfortunate investors who entrust funds with industry “players” who are later revealed to be to be merely market mascots. SAINT LOUIS UNIVERSITY SCHOOL OF LAW 2012] ANOTHER MADOFF MASQUERADE? 523