Securities Investor Protection Corporation: Customer Outcomes in the Madoff Liquidation Proceeding
Published: 2012-09-13T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: After the collapse of Bernard L. Madoff Investment Securities, LLC--a brokerdealer and investment advisory firm with thousands of individual and institutional clients--the Securities Investor Protection Corporation (SIPC), which oversees a fund providing up to $500,000 of protection to qualifying individual customers of failed securities firms, selected a trustee to liquidate the Madoff firm and recover assets for its customers. In March 2012, GAO issued GAO-12-414 , which examined selection of the Trustee, his method for determining customer claims, and expenses of the liquidation, among other things. This report discusses (1) the extent to which account activity varied by type of Madoff customer, (2) the nature of claims filed, and rejected or approved, with the Trustee for reimbursement of losses, (3) litigation and settlement activity the Trustee has pursued in seeking to recover assets for distribution to customers, and (4) the effect of the fraud on customers' federal income tax liabilities. GAO reviewed transaction and claims data from the Trustee, lawsuits filed by the Trustee, IRS rules and guidance, and interviewed the Trustee, private sector tax experts, and officials from IRS, SIPC, and the Securities and Exchange Commission.
section_title: What GAO Found
paragraphs: GAO's analysis of Madoff account data shows that more than three-fourths of the firm's customers were individuals and families (individuals). The remaining accounts were held by institutions, such as pension funds and charities. A higher proportion of accounts held by an individual (60 percent) were "net winners" based on their net equity position--meaning they had withdrawn more from their accounts than they had deposited--compared to accounts held by institutions (50 percent). Correspondingly, 40 percent of institutional accounts were "net losers" that had deposited more into their accounts than they had withdrawn, compared to 29 percent of individuals' accounts that were net losers. However, individual and institutional accounts had similar deposit and withdrawal activity from 1981 through 2008, including increased withdrawals immediately before the firm's failure in December 2008.
GAO's analysis shows that the Trustee's decisions to accept or reject claims were similar for individual and institutional account holders. Of the more than 16,000 claims, about 66 percent were denied because the customers were not direct account holders of the Madoff firm, but instead had invested in funds or other vehicles that held accounts directly with the firm. For the remaining claimants who were directly invested, the Trustee generally used the customers' net investment positions--that is, whether they were net winners or net losers-- to determine claims. In examining claims decisions by customer type, GAO found the Trustee denied claims filed by individuals and institutions determined to be net winners in similar proportions. Similarly, most claims filed by individuals or institutions determined to be net losers were allowed.
The Trustee has been pursuing litigation to recover, or "claw back," assets from net winner customers and others that can be used to reimburse customers that did not withdraw all of their principal investments. For those customers that withdrew fictitious profits--net winners--the Trustee has been pursuing more than 1,000 lawsuits to recover funds, as allowed under federal bankruptcy law and state law. In about 60 suits, the Trustee has sought more than fictitious profits, to include principal or other funds received, arguing the parties knew or should have known of the fraud. Thus far, the Trustee said he has recovered about $9.1 billion of the $17.3 billion in principal investments lost by customers who filed claims, including $8.4 billion from settlement agreements.
Because the Madoff fraud affects customers' taxable income, it also affects tax collections by the Department of the Treasury. Under Internal Revenue Service (IRS) rules, Madoff customers can deduct lost principal and fictitious profits on which they paid taxes while holding their accounts. However, IRS does not maintain statistics on specific frauds or their impacts on tax collections, and the tax impact may be reduced because some taxpayers may not be able to fully use this tax relief, such as those that lack other income that can be offset by these deductions. Tax experts expressed concerns about the lack of clarity over how payments stemming from fraud-related avoidance actions filed by the Trustee will be treated for tax purposes. In response to a recommendation in a draft report that IRS provide guidance to help limit taxpayer errors resulting in over- or underpayment of taxes, the agency issued such guidance on September 5, 2012, in the form of "frequently asked questions" posted to its website.

section_title: Letter
paragraphs: After the collapse of Bernard L. Madoff Investment Securities, LLC—a  broker-dealer and investment advisory firm with thousands of clients—in  December 2008, thousands of customers found they had lost billions of  dollars to a Ponzi scheme Madoff had run for years. Within days of the  collapse, the Securities Investor Protection Corporation (SIPC), a  nonprofit, nongovernmental membership corporation responsible for  providing financial protection to customers of failed securities firms,  designated a trustee—attorney Irving H. Picard (referred to as the Trustee  throughout this report)—to oversee the liquidation of the Madoff firm and  recover assets for the benefit of former customers.
The Securities Investor Protection Act of 1970 (SIPA) established  procedures for liquidating failed broker-dealers. In a liquidation under  SIPA, the trustee establishes a fund of customer property consisting of  the cash and securities held by the broker-dealer on behalf of customers,  plus any assets recovered by the trustee, for distribution among  customers. The actions of the trustee in carrying out a liquidation have  direct effects for former customers who lost money, such as how much of  their losses the trustee can recover. There are also indirect effects—for  example, losses and potential recoveries can affect customers’ tax  liabilities, which in turn affect tax collections by the U.S. Treasury.
Because the Trustee’s activities affect thousands of customers, you  asked us to examine a series of questions about his efforts to resolve the  Madoff liquidation. We agreed to examine these issues in two reports.  The first, issued in March 2012, examined selection of the Trustee, his  method for determining customer claims, and expenses of the liquidation,  among other things. This second and final report discusses (1) the extent  to which account activity varied by type of Madoff customer; (2) the nature  of claims filed, and rejected or approved, with the Trustee for  reimbursement of losses; (3) litigation and settlement activity the Trustee  has pursued in seeking to recover assets for distribution to customers;  and (4) the effect of the fraud on customers’ federal income tax liabilities,  including the effect on amounts that would have been due if investor  losses had been based on customers’ reported final statement holdings.
For this report, we obtained and analyzed data from the Trustee,  including information on deposits to and withdrawals from Madoff  customer accounts from April 1981 to December 2008. We also analyzed  Trustee data on claims customers made for reimbursement from  proceeds of the firm’s liquidation and the determinations he reached on  these claims. We examined lawsuits the Trustee has been pursuing and  settlements he has reached with customers and others, including  reviewing a randomly selected sample of 50 of the more than 1,000 cases  filed seeking the return of fictitious profits, as allowed under federal and  state law. We reviewed 29 publicly available cases from among 30  actions in which the Trustee is arguing defendants knew or should have  known about the fraud, referred to as “bad faith” cases. In addition, we  reviewed the largest cases among 27 actions focusing on funds that  invested customer money in Madoff accounts. We interviewed the  Trustee and members of his law firm, as well as SIPC executives, and  officials of the Securities and Exchange Commission (SEC), which has  oversight authority for SIPC. We also interviewed four individuals with  income tax expertise, including a law professor and three tax advisors  who we selected based on their tax experience or publications related to  tax issues. We reviewed Internal Revenue Service (IRS) guidance and  interviewed IRS officials about tax treatment of fraudulent schemes like  the Madoff case. We conducted this performance audit from March to  September 2012 in accordance with generally accepted government  auditing standards. Those standards require that we plan and perform the  audit to obtain sufficient, appropriate evidence to provide a reasonable  basis for our findings and conclusions based on our audit objectives. We  believe that the evidence obtained provides a reasonable basis for our  findings and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: SIPC’s mission is to promote confidence in securities markets by seeking  to return customers’ cash and securities when a broker-dealer fails. SIPC  provides advances for these customers up to the SIPA protection limits— $500,000 per customer, except that claims for cash are limited to  $250,000 per customer. SIPA established a fund (SIPC fund) to pay for  SIPC’s operations and activities. SIPC uses the fund to make advances  to satisfy customer claims for missing cash and securities, including  notes, stocks, bonds, and certificates of deposit. The SIPC fund also  covers the administrative expenses of a liquidation proceeding (including  costs incurred by a trustee, trustee’s counsel, and other advisors) when  the general estate of the failed firm is insufficient.
SIPC finances the fund through annual assessments it sets for member  firms, plus interest generated from its investments in Treasury notes. If  the SIPC fund becomes, or appears to be, insufficient to carry out the  purposes of SIPA, SIPC can borrow up to $2.5 billion from Treasury  through SEC. That is, SEC would borrow the funds from Treasury and  relend them to SIPC. According to SIPC senior management, recent  demands on the fund, including from the Madoff case, together with a  change in SIPC bylaws that increased the target size of the fund from $1  billion to $2.5 billion, led SIPC to impose new industry assessments  totaling about $400 million annually. The assessments, equal to one- quarter of 1 percent of net operating revenue, will continue until the $2.5  billion target is reached, according to SIPC senior management. The new  assessments replaced a flat annual assessment of $150 per member  firm.$91,755 per firm, with a median of $2,095, according to SIPC.
subsections: section_title: Liquidations under SIPA
paragraphs: SIPA authorizes SIPC to begin a liquidation action by applying for a  protective order from an appropriate federal district court if it determines  that one of SIPC’s member broker-dealers has failed or is in danger of  failing to meet its obligations to customers and one or more additional  statutory conditions are met.protective order application. If the court issues the order, the court  appoints a trustee selected by SIPC, or, in certain cases, SIPC itself, to  liquidate the firm. While SIPC designates the trustee, that person, once  judicially appointed, becomes an officer of the court. As such, the trustee  exercises independent judgment and does not serve as an agent of SIPC.
The broker-dealer can contest the  Under SIPA, the trustee must investigate facts and circumstances relating  to the liquidation; report to the court facts indicating fraud, misconduct,  mismanagement, or irregularities; and submit a final report to SIPC and  others designated by the court. Also, the trustee is to periodically report to  the court and SIPC on his or her progress in distributing cash and  securities to customers. To the extent that it is consistent with SIPA, the  proceeding is conducted pursuant to provisions of the Bankruptcy Code.
Promptly after being appointed, the trustee must publish a notice of the  proceeding in one or more major newspapers, in a form and manner  determined by the court. The trustee also must see that a copy of the  notice is mailed to existing and recent customers listed on the broker- dealer’s books and records, and provide notice to creditors in the manner  SIPA prescribes. Customers must file written statements of claims. The  trustee’s notice includes a claim form, and also informs customers how to  file claims and explains deadlines.
section_title: Determination of Madoff Customer Claims
paragraphs: Once filed, the claims undergo various reviews, according to the Trustee.  First, the Trustee’s claims agent reviews claims for completeness; if  information is found to be missing, the claims agent sends a request for  additional information. Second, the Trustee’s forensic accountants review  each claim form, information from the Madoff firm’s records about the  account at issue, and information submitted directly by the claimant. The  Trustee uses the results of this review in assessing his determination of  the claim. Finally, claims move to SIPC, where a claims review specialist  provides a recommendation to the Trustee on how each claim should be  determined. Once that recommendation has been made, the Trustee and  trustee’s counsel review it, as well as legal or other issues raised  previously. When the Trustee has decided on resolution of a claim, he  issues a determination letter to the claimant.
As of the start of 2012, the Trustee had received 16,519 customer claims  in the Madoff proceeding, and reached determinations on all but two of  them. According to SIPC, many Madoff customers were older. For  example, according to Trustee information we reviewed on his hardship  program (described later in this report), more than half of applicants were  age 71 or older.
In a liquidation under SIPA, amounts in the customer property fund  generally are distributed to the failed firm’s customers according to the  value of their account holdings, or “net equity.” SIPA generally provides  the net equity amount is what would have been owed to the customer if  the broker-dealer had liquidated all their “securities positions,” less any  obligations of the customer to the firm. In the Madoff case, if the Trustee recovers less than the total amount of allowed claims, some claimants  likely will receive only a portion of their allowed claims. The Trustee told  us his goal is to recover the full amount, but that is not likely, given  developments in litigation and decisions to settle cases.
In SIPA liquidations not involving fraud, trustees typically determine that  the amounts owed to customers match the amounts shown on their final  statements, in what is known as the “final statement method” (FSM).  However, in cases involving fraud, amounts in customer accounts may  not correspond to statement amounts. In the Madoff case, the Trustee  determined that the securities positions shown on customer statements  were fictitious. As a result, supported by SIPC and SEC, he decided to  value each customer’s net equity according to the amount of cash  deposited less any amounts withdrawn—a method known as the “net  investment method” (NIM). Under NIM, Madoff claimants generally divide  into two categories: “net winners,” who have withdrawn more than the  amount they invested with the Madoff firm, and “net losers,” who have  withdrawn less than they invested.
Some customers challenged the Trustee’s decision on valuing customer  net equity, but two courts have considered the issue—the U.S.  Bankruptcy Court for the Southern District of New York and the U.S.  Court of Appeals for the Second Circuit—and each has affirmed the  Trustee’s decision to use NIM. In June 2012, the U.S. Supreme Court  declined to hear an appeal on the issue, thus concluding legal challenges  to the Trustee’s decision.
section_title: Efforts by the Trustee to Recover Assets for the Benefit of Customers
paragraphs: The Trustee has taken various steps to recover assets for distribution to  former Madoff customers, including recovery of bank account balances and  sale of the firm’s assets. In addition, the Trustee has filed hundreds of  lawsuits known as “avoidance actions” or “clawbacks.” Avoidance powers  enable a trustee to “avoid,” or set aside, certain transfers made by a  debtor—here, the Madoff firm—prior to the bankruptcy filing, in order to  recover transferred funds for the benefit of the estate. In pursuing these  actions, a trustee can generally seek return of fictitious profits paid to  investors, and in some cases, principal amounts withdrawn, for specified  periods of time—90 days, 2 years, and 6 years preceding the filing. In  doing so, the Trustee has available state statutes, common law claims, and  federal bankruptcy law upon which to build his cases. Actions also can vary  according to whether the Trustee alleges a customer acted in good or bad  faith. Under the Bankruptcy Code, a recipient’s good faith or bad faith is not  relevant to whether the transfer is avoidable but does affect the extent of  the recipient’s liability. Table 1 summarizes the legal avenues available. A  fuller discussion of legal remedies available can be found in appendix II.
Generally, transfers are avoidable as actually fraudulent if the debtor- transferor had intent to defraud; or, as constructively fraudulent if they  were made without fraudulent intent but for less than equivalent or fair  value, while the debtor was insolvent. Courts generally presume Ponzi  scheme payouts to be actually fraudulent. As for constructive fraud, Ponzi  scheme transfers in excess of principal are not made for value—meaning  they are not paid to satisfy any legitimate obligation the debtor owed to  the recipient—and thus fall within the constructive fraud provisions.
section_title: Individual Customers Tended to Be Net Winners, While Transaction Patterns for Individuals and Institutions Were Generally Similar
paragraphs: In our analysis of information obtained from the Trustee, we identified  7,994 accounts with at least one transaction. We examined names on  each of these accounts, to determine whether individuals and families (to  which we refer jointly as individuals) or institutions held the accounts.  We found that individuals held more than three-fourths (77 percent) of  accounts, while almost one-quarter (23 percent) of accounts were held by  institutions, such as charities, pension funds, and feeder funds. Using  these groupings, we further examined the account holders’ claims  outcomes—whether they were net winners or net losers—and the pattern  of their transactions leading up to the Madoff firm’s collapse. The  Trustee, however, noted that accounts held by institutions generally  represented funds from individuals as well, because with the exception of  funds from nonprofit organizations, the institutions were investing money  on behalf of individuals. The Trustee said that based on his examination,  he was not aware of any direct corporate investment in the Madoff firm.
subsections: section_title: Accounts Held by Individuals Tended to Be Net Winners
paragraphs: As shown in table 2, our analysis indicates that a higher proportion of  accounts held by individuals (60 percent) were net winners that had  withdrawn more than they had deposited over the lifetime of their  accounts, compared to accounts held by institutions (50 percent). We  also found that more institutional accounts (40 percent) were net losers  than were individual accounts (29 percent). Among individual accounts,  net winners outnumbered net losers by 2-to-1, with outcomes split more  evenly for institutional accounts. Overall, for both categories combined,  we found that 57 percent of account holders were net winners. About  one-third (32 percent) were net losers, whose total withdrawals were less  than their total investment deposits. The remaining 11 percent of  accounts had zero balances from a net investment perspective, with  account holders having withdrawn exactly what they had invested.
Table 2 also shows that as a group, institutional accounts lost principal  amounts they invested in the fraud, while accounts owned by individuals in  the aggregate withdrew more than they invested. For individuals, the total  net investment position at the time of the Madoff firm’s failure was ($767  million), meaning they had withdrawn more money than they originally  invested. As a result, individual account holders as a group were net  winners. By contrast, the total net investment position for institutional  accounts as a group showed that they were net losers, having made nearly  $3.0 billion more in deposits than withdrawals. We note that while we  divided the population into account types for analytical purposes, the  Trustee and SIPC executives stressed that each customer claim was  determined on a case-by-case basis without regard to whether the account  holder was an individual or institution. In addition, SIPC executives noted  that notwithstanding the overall totals for the two customer categories,  there were nevertheless both net winners and net losers in each grouping.
section_title: Individual and Institutional Accounts Had Similar Patterns of Deposits and Withdrawals
paragraphs: Our analysis found that individual and institutional accounts had similar  deposit and withdrawal activity throughout the 27-year period we  examined, including during the period immediately before the failure in  2008. For both groups, total annual deposits and total annual withdrawals  increased steadily since 1981, growing by greater amounts in more recent  years. Overall, deposit volume more than doubled between 2005 and  2007, rising from $4.5 billion to $9.4 billion annually. Withdrawal volume  grew more slowly from 2005 to 2007, rising only about 14 percent, from  $5.7 billion to $6.4 billion. However, withdrawal volume in 2008, at $12.6  billion, was almost double the volume in 2007. Figure 1 breaks out total  deposit and withdrawal activity by individual and institutional accounts. As  noted, the pattern of activity is similar for each group, except that deposit  volume for individual accounts was about the same in 2007 and 2008, at  $3.4 billion annually, while deposit volume from institutional accounts fell  between 2007 and 2008, from $6.0 billion to $5.1 billion.
Our analysis also showed that in the final year of the Madoff firm’s  existence (2008), both individuals and institutional account holders  withdrew large amounts of principal they had invested. Figure 2 shows  such principal withdrawals, excluding any fictitious profits, during quarterly  periods leading up to the failure. Withdrawals of principal began to  increase three quarters before the failure, with most of the increase in  withdrawals occurring in the 90 days before the Madoff firm’s failure.  Under his clawback authority, described earlier, the Trustee can, among  other things, seek to recover principal withdrawals during this period.
Accounts that had large withdrawals, particularly those made just before  the Madoff firm’s collapse, could suggest that such customers knew of the  fraudulent scheme and were attempting to avoid suffering losses when  the firm failed. Although the increase in withdrawals we identified during  the period preceding collapse could suggest some customers anticipated  the firm’s failure, this activity may also have been due to investor  reactions to the financial crisis, which was peaking at the time, or to other  factors affecting where investors place their money. As we describe later,  the Trustee has filed extensive litigation to recover withdrawals that many  customers made. In appendix III, we show other results of our analysis,  listing the largest Madoff accounts by transaction volume, total  withdrawals, and net winnings.
section_title: Trustee Denied Feeder Fund Investor Claims, and Decided Individual and Institutional Claims Similarly
paragraphs: As required by SIPA, the Trustee solicited claims from Madoff customers  for reimbursement of their losses, with approved claimants eligible to  receive a share of any cash or securities Madoff held on behalf of his  customers, plus assets recovered by the Trustee during the liquidation  proceeding. According to claims data provided by the Trustee, a total of  16,519 claims were filed. As shown in figure 3, most of the claims were  denied. Sixty-six percent of the claims were denied because the filers had  not invested directly with the Madoff firm themselves (referred to as “third  party” denials). Instead, they had invested in feeder funds or other  vehicles that owned the accounts at the firm. The Trustee determined that  under SIPA, only those who had invested directly with the Madoff firm  were customers for claims purposes.
Among 5,543 claims from direct investors remaining after denial of the  third party claims, the Trustee denied 2,703 claims (16 percent of all  claims). Almost all of the denied claims were from net winners, meaning  that they had withdrawn more money than they invested. The Trustee  allowed 2,425 claims (15 percent of all claims), totaling $7.3 billion. Of  the allowed claims, the majority were filed by net losers, meaning they  had withdrawn less from their account than they had invested. Figure 4  details the Trustee’s disposition of claims, by net winner and loser status.  However, there were exceptions to the general pattern of approvals and  denials by net investment status. For example, 10 (less than 1 percent of  all claims) net winner claims were allowed. According to the Trustee, in  some cases, these claims were allowed because the account holders  repaid certain withdrawals made from their accounts, and when they  returned those funds, they became eligible for an allowed claim.instances, net winner claims were allowed when combined with net loser  account(s) held by the same party. The Trustee also denied seven net  loser claims, most often because the account was combined with net  winner account(s) held by the same party.
section_title: Trustee Has Been Pursuing Hundreds of Lawsuits to Recover Assets
paragraphs: The Madoff Trustee is pursuing various litigation to recover assets from  customers and others that can be used to reimburse those customers that  have allowable claims under SIPA. For those customers that withdrew  fictitious profits in excess of their investments—net winners—the Trustee  is pursuing more than a thousand lawsuits to recover these funds as  allowed under federal bankruptcy law and state law. The Trustee is also  suing some individuals and entities that he argues knew or should have  known about the fraud and from whom he is seeking to recover more than  just fictitious profits. In addition, the Trustee has filed other actions  involving feeder funds. Through such efforts, the Trustee has obtained  billions of dollars in settlement agreements with customers that either  faced the possibility of litigation or had been sued already. However, the  Trustee established a hardship program, in which he expedited claims  processing or declined to pursue litigation for individuals who could  demonstrate financial distress.
subsections: section_title: Trustee’s Authority and Approach to Litigation
paragraphs: As discussed earlier, various laws grant authority to the Trustee to seek  return of funds paid out by the Madoff firm. This includes federal  bankruptcy and state laws, which allow actions to return transfers from the  failed entity—the debtor—made in different periods of time, including within  90 days, 2 years, or 6 years prior to the bankruptcy filing. In deciding  whether to bring an action, the Trustee told us that he has generally  considered the same factors as would apply in a typical bankruptcy case or  those that a private plaintiff would also likely consider. In particular, the  Trustee said he has considered the costs and benefits of taking the  action—that is, how much could be recovered and at what cost—as well as  prospects for success and potential legal barriers, such as the statute of  limitations.
While the overall goal of an action is to recover a reasonable amount for  the customer property fund, the Trustee also told us that when filing an  action, he might not seek all possible assets. Many former account  holders were older and renting their homes, he said. At the same time,  some customers have assets that are protected against judgments, such  as homes or pension assets, which reduces the amount of assets he can  pursue. The Trustee told us that while the amount of potential recoveries  is important, he has not established any minimum amount in deciding  whether to sue. The underlying decision on whether to sue, he said, is the  acknowledgment that each time he declines to pursue an action, he  allows a customer who withdrew more than their principal invested to  keep money taken from others who had not recovered as much as they  had invested.
According to information the Trustee provided, his litigation has targeted a  high portion of amounts withdrawn from the firm during the periods  preceding failure for which he is legally authorized to pursue recoveries.  For example, the total amount withdrawn from the Madoff firm during the  90-day period under which federal bankruptcy law allows recoveries was  $5.5 billion, he said. Of that, his lawsuits have sought $5.2 billion, or 95  percent. The total amount withdrawn under the 2- and 6-year recovery  periods allowed by federal and state law was $9.7 billion. Of that, the  Trustee has sought $8.4 billion, or 87 percent, he said. According to the  Trustee, the differences between amounts withdrawn and sought are  based on consideration of the factors whether to sue as noted earlier, as  well as having reached settlements to return funds prior to filing of an  action.
section_title: The Trustee Has Filed Hundreds of Actions to Recover Excess Withdrawals from Customers Not Claimed to Have Known of the Fraud
paragraphs: According to our review, the Trustee has filed 1,002 actions seeking to  recover $3.5 billion from Madoff customers that were net winners but that  are not alleged to have had knowledge of the fraud or been in a position  to know about it—referred to by the Trustee as “good faith” defendants.  According to the Trustee, the good faith designation indicates that while  defendants profited from the fraud, he did not have evidence they had  knowledge of the scheme or were in a position to know about it. When  bad faith is not alleged, the laws providing the Trustee with the ability to  recover funds allow him to seek principal withdrawn during the 90 days  preceding the Madoff firm’s failure—the preference period—plus fictitious  profits withdrawn in the 6 years prior to the failure. The Trustee told us  that although he anticipated negative publicity from filing suits against  customers who did not know about the fraud, the $3.5 billion at issue in  the good faith cases was an amount too large to ignore.faith cases, the amounts sought by the Trustee range from a low of  $33,000 to a high of $152 million. The average amount sought was $3.5  million, with the median at $1.4 million.
Some of the good faith cases have settled, but about 88 percent of  complaints remained in litigation or were on appeal as of May 2012,  according to information we obtained from the Trustee. Table 3 summarizes the status of the good faith cases. In general, most good  faith cases are proceeding slowly, with the Trustee seeking to mediate  and settle them, he told us.
We examined a random sample of 50 good faith cases and found them to  be similarly structured and generally citing the same federal and state  laws as grounds for recovery. The good faith actions generally include the  name of the defendants, their account numbers, the amounts sought, and  the legal basis on which the Trustee relied to seek recovery. In several  filings, the Trustee also included an accounting of deposits and  withdrawals. In contrast to a bad faith action, the good faith complaints we  reviewed generally do not include narrative details of the defendant’s  history or relation to the Madoff firm. Table 4 summarizes the 10 largest  actions in our sample, by amount sought.
The Trustee has pursued a variety of legal approaches in the cases we  sampled. Thirty-eight cases cited the 2-year period provided in the federal  bankruptcy statute, while 48 cases cited the 6-year period. In six of the  cases, the Trustee sought to recover transfers from the 90-day  preference period. In 20 of the 50 cases, the Trustee also sued to recover  funds he alleged were transferred from defendants to third parties, known  as “subsequent transferees.” For instance, in one case, the Trustee  alleged that an individual account holder transferred to a relative some or  all of $1.2 million in fictitious profits withdrawn. Additionally, in five cases,  the Trustee has also sought to temporarily disallow customer claims filed  by defendants. For example, one limited liability company filed a claim for  SIPC coverage in May 2009, and the Trustee filed suit to recover funds in  December 2010. As part of the action, the Trustee sought to disallow the  SIPC claim until $4 million was recovered for the Madoff estate.
In one good faith case in our sample, the defendant was Madoff’s  nephew, considered an insider, and had received fraudulent transfers, but  was not deemed to have acted in bad faith. Specifically, according to the  Trustee, the nephew worked full-time at the Madoff firm beginning in  1980, most recently as director of administration. The Trustee alleged he  received preference transfers, fictitious profits, and improperly used  Madoff firm funds to pay for personal expenses. However, the Trustee  told us his investigation indicated the relative was not likely aware of the  fraud.
section_title: In Some Asset Recovery Actions, the Trustee Has Alleged That Defendants Knew or Should Have Known of the Fraud
paragraphs: In addition to the good faith lawsuits, the trustee has also filed 30 actions  against individuals or entities in which he has alleged the defendants  acted in bad faith because they either knew, or should have known, of  Madoff’s fraudulent investment scheme. According to the Trustee,  asserting that a defendant acted in bad faith allows him to potentially  recover greater amounts than in other actions. For example, in a bad faith  action, a trustee can seek to recover not only fictitious profits, but also  seek principal amounts invested as well. Additionally, while New York  debtor and creditor law generally limits to 6 years the period for which a  trustee can seek recovery from parties that received funds from a  bankrupt entity, a trustee can sue a customer that acted in bad faith in  earlier years, if it can be shown the defendant knew or should have  known of the fraud and certain other conditions are met. The trustee can  also pursue common law claims such as conversion and unjust  enrichment against bad faith defendants that received other funds from  the bankrupt entity, such as receiving cash or purchases of goods on their  behalf.damages to recover sums allegedly received improperly by the  defendant. However, although the Trustee has the authority and standing  to enforce common law claims, two recent judicial decisions dealing   Common law claims allow the Trustee to seek compensatory  specifically with the Madoff liquidation limited his ability to pursue  common law claims.
Our review of the 30 bad faith actions showed that the complaints list  several hundred defendants and seek $11 billion overall, with demand  amounts ranging from more than $500,000 to approximately $6.7 billion. Defendants include Madoff family members, employees of the Madoff  firm, individuals who identified investors for Madoff, and other business  associates of Madoff. In addition to suing defendants as individuals, the  complaints also seek to recover funds from vehicles these individuals  used to invest in the Madoff scheme, including corporations, limited  partnerships, trusts, estates, partnerships, foundations, and profit-sharing  plans. Additionally, the Trustee is suing individual retirement accounts, to  recover funds allegedly received from another defendant. According to  the Trustee, his objective in alleging bad faith, even for some net loser  defendants, is to maximize recoveries for distribution to other harmed  customers.
Twenty-nine of the 30 bad faith complaints are available publicly, either through the U.S.  Courts’ Public Access to Court Electronic Records (PACER) system or the trustee’s  website, http://www.madofftrustee.com. One bad faith complaint is under seal and  unavailable. According to the trustee, this complaint involves a husband and wife as  defendants and is sealed because it includes allegations about the defendants’ federal  income taxes. that could have revealed the Ponzi scheme. In some instances, the  Trustee alleges that defendants were also sophisticated investors with  sufficient education or specialized work experience in securities law,  accounting, or finance that they should have known their returns were  unusual. Table 5 shows the most frequently cited bases on which the  Trustee alleged bad faith, according to our analysis of available cases.
The Trustee told us that initially, he believed that anyone working in  Madoff’s investment advisory unit would be a bad faith participant.  However, through additional investigation, including document  examination, taking of depositions, and reconstruction of computer  records, the Trustee said he determined not all such employees may  have been aware of the fraud. For example, the Trustee initially believed  Madoff’s secretary was involved in the fraud, given her position close to  Madoff, but later determined she did not have knowledge of the fraudulent  activities.
In several cases, the Trustee is alleging bad faith against Madoff relatives  who worked at the firm, or other, nonemployee relatives who received  funds. For example, the Trustee sued Madoff’s wife to recover funds  transferred from the firm that were used to buy a yacht for approximately  $2.8 million, to pay off a $1.1 million credit card balance, or to fund other  investments. The Trustee sued the wife of Madoff’s brother, who worked  at the firm, for receiving $1.5 million in purported salary from 1996 to  2008, after the Trustee’s investigation concluded she never performed  any work for the position. Among defendants who were not employees or  relatives are individuals who allegedly identified and recruited investors  for the Madoff firm. For example, the Trustee alleges an accounting firm  pooled hundreds of millions of dollars for investment while keeping tens of  millions of dollars itself.
Although many Madoff customers typically experienced outsized returns  based on market developments, some bad faith defendants received  exceptionally high returns, the Trustee alleges. In one case, for example,  the Trustee cites returns as high as 175 percent. Moreover, in some  cases, the bad faith defendants include large investors for whom the  trustee alleges their financial or business sophistication provided them  with the ability to realize that they were benefiting from a fraud. For  example, the Trustee alleges one set of defendants is a closely held  family business that was also an investor in another investment fraud that  was so similar to the Madoff firm it should have been clear Madoff was  also running a fraud. In his complaint, the Trustee quotes an employee of  the business as saying shortly after Madoff’s arrest, “Our CIO [chief  information officer] always said it was a scam, ‘too good to be true’”  Another bad faith defendant, according to the Trustee, had been closely  associated with Madoff professionally and socially for decades, investing  in the firm through more than 60 entity and personal accounts. According  to the Trustee, some of the accounts reported consistently high annual  returns between 20 percent and 24 percent, with only 3 months of  negative returns over 12 years. Other accounts of the defendant  sometimes experienced returns greater than 100 percent or even 300  percent, he alleges. According to the Trustee, the defendant acted as an  investment advisor, and thus should have known such returns were not  likely possible without fraud.
As shown in table 6, the 10 largest bad faith complaints, measured by  amount sought, have sought a total of $10.7 billion, or more than 97  percent of the $11.0 billion the Trustee is seeking in all 30 bad faith  litigations. As of April 2012, the Trustee had obtained settlements, or a  partial settlement, in four of these cases.
As noted, feeder funds are investment vehicles that collected funds from  investors and then channeled the money to the Madoff firm. The Trustee  has filed 27 bad faith actions against feeder fund defendants, seeking  nearly $100 billion. The amounts sought range from a low of $10.4 million  to a high of $58.5 billion. The average amount sought is $3.7 billion, with  a median of $182.4 million. The amounts the Trustee is seeking include  fictitious profits, principal amounts invested, fees, interest, and in some  cases, punitive damages. Typically, the Madoff feeder funds raised  money from high-net-worth individuals in operations that spanned the  globe. In addition to the feeder funds themselves, banks and other  financial institutions are among the defendants in these cases. For  example, some were custodians of the feeder funds, some were  administrative agents, and some were involved in marketing the funds to  prospective investors. Some banks and financial institutions had more  than one role in their involvement with feeder funds.
According to the Trustee, feeder funds account for about $14.2 billion of  the approximately $19.6 billion in total principal lost by all customers. In  suing for bad faith, the Trustee has alleged these defendants either knew  or should have known of the Madoff fraud. In some of the feeder fund  cases, the Trustee is also alleging participation in, and concealment of,  the fraud. With the bad faith allegations, as with bad faith cases filed  against individuals, the Trustee can sue to recover funds beyond principal  withdrawn in the preference period and fictitious profits withdrawn in the  6-year period. In addition, he can use common law grounds to seek  additional damages based on alleged harm caused by parties aiding the  fraud. As a result, the total he is seeking in the six largest feeder fund  actions is $94 billion, which greatly exceeds the amount of principal these  entities invested into the scheme. Table 7 summarizes these cases,  which represent nearly 95 percent of the total amount sought in feeder  fund cases.
The Trustee told us that compared to other litigation he is pursuing,  feeder fund actions require different types of evidence, due to the nature  of their operations. For example, feeder fund managers benefited through  investment and management fees charged by the funds, which were  subsequently paid to individuals as salaries and bonuses. The Trustee  considers these payments to be fraudulent. In the Tremont case, for  instance, the firm managed five funds that invested directly with the  Madoff firm, as well as more than a dozen other funds that were indirect  Madoff investors, via investments in the directly invested funds. The  Trustee alleged that in the 6 years before the Madoff firm failed, Tremont  defendants received more than $180 million in management,  administration, and other fees; bonuses; profits; compensation; dividends;  and partnership distributions. Additionally, a number of the feeder fund  defendants were net losers. In such cases, the Trustee also sought to  defer SIPA claims they filed pending resolution of the Trustee’s actions  against them. In general, given the complexities of feeder fund  relationships, the Trustee determined amounts sought by looking at  principal, not fictitious profits, he told us.
As shown in table 7, the Trustee has alleged that banks, financial  services entities, and related individuals facilitated the Madoff fraud. For  example, HSBC served as marketer, custodian, and administrator for  numerous feeder funds. The Trustee alleged that HSBC surrendered all  custodial duties to the Madoff firm, while continuing to collect fees, and  without any disclosure to investors. The Trustee stated that this surrender  removed a system of checks and balances and allowed the Madoff firm to  assert the existence of assets and trades that never existed. As for  marketing feeder funds, the Trustee maintains that HSBC acquiesced to  Madoff’s demands to keep his name out of offering documents, despite  the bank’s own concerns about its inability to conduct proper due  diligence on Greenwich Sentry, a Madoff feeder fund. Feeder funds also  worked with banks to create derivative products based on feeder fund  returns, according to the Trustee. For example, investors in these  “leveraged notes” would be entitled to receive returns based on a feeder  fund’s returns, while a financial institution, usually a bank, would receive  fees for structuring the notes and interest for lending funds used as part  of the investment. Concurrently, the bank would purchase shares in the  feeder fund in order to hedge its exposure in the leveraged notes. The  end result, according to the Trustee, was that hundreds of millions of  additional dollars were invested into the Madoff operation.
In bringing the feeder fund actions, the Trustee has made a number of  specific allegations to support bad faith and complaints of illicit funds  received. While particular allegations vary across cases, we found the six  cases we examined shared three major elements. First, defendants are  alleged to have profited from the fraud primarily through fees received.  For example, UBS is alleged to have received fees for purportedly serving  in custodial and asset management functions for the feeder funds,  Luxalpha and Groupement Financier. UBS sponsored the formation of  Luxalpha and served as prime banker for Groupement Financier. The  Trustee considers the fees UBS derived to be customer property that  should be recovered. Second, the Trustee alleges defendants breached  their duty of due diligence to their customers. For example, the Trustee  alleged that Fairfield Greenwich Group, Madoff’s largest feeder fund  group, did not “properly, independently, and reasonably perform due  diligence into the many red flags strongly indicating Madoff was a fraud.”  Third, the defendants are alleged to have either aided and abetted or  actively participated in the fraud. In the JP Morgan Chase case, the  Trustee alleged that through its interactions in different capacities—as  banker, lender, and investor—with the Madoff firm over 20 years, the  bank was uniquely positioned to see the fraud and put a stop to it.  Instead, the trustee alleges that this institution continued to conduct  business as usual, which allowed the firm to profit and the fraud to  continue unabated.
As with other actions, the Trustee has sought feeder fund recoveries  based on the 90-day preference period and the 2- and 6-year periods,  relying on both the federal bankruptcy statute and New York state law. In  instances where the defendant was considered an insider, the Trustee  sought to extend the preference period to 1 year. The Trustee has also  sought to recover transfers to subsequent transferees. In a number of  cases, for example, the Trustee has pursued this course against  individuals paid a salary or a bonus by the banks or feeder funds  involved.
section_title: Trustee Settlements to Date Have Recovered Nearly Half of Customer Investment Losses
paragraphs: In hundreds of cases, the Madoff Trustee has reached settlements with  former customers and others, either before or after filing clawback  actions, and these agreements have produced recovery of a significant  amount of assets. As of April 2012, the Trustee had entered into 441  settlement agreements in which the opposing parties agreed to return  about $8.4 billion—an amount equal to about 49 percent of the  approximately $17.3 billion in principal investments lost by customers who  filed claims. According to our review, the settlement amounts range from  a low of $36 to a high of $5 billion, with an average of $19 million and a  median of $66,000. Through July 2012, the Trustee had collected 85  percent of total settlement amounts, or about $7.1 billion. Many  settlement terms are complex. For example, settlements with feeder  funds that were net losers require these entities to return certain funds  they received before the Trustee will consider accepting their loss claims.
The Trustee groups settlements into three major categories:
Prelitigation: Settlements reached before the Trustee filed a  clawback action.
Litigation: Settlements reached in cases where the Trustee had  already filed a clawback action.
Customer avoidances: Recoveries based on the 90-day preference  period, but where no clawback action was filed.
A fourth category, “Funds not yet received,” is a temporary accounting of  amounts that will be allocated to the three main categories upon receipt of  the first settlement payment. Table 8 shows a summary of the Trustee’s  settlement agreements by category as of July 2012. As the table shows,  for example, the customer avoidance category represents 85 percent of  all settlement agreements reached, although these cases have the  smallest total dollar value among the categories. Although, as the table  shows, the settlements total $8.4 billion, the Trustee through July 2012  had yet to receive $1.2 billion in settlement funds, due to pending appeals  and specific provisions in settlement agreements.
The Trustee told us he and his counsel consider a number of factors  when deciding to enter into a settlement agreement. There are no formal  criteria, he said, but factors such as location of the defendants, litigation  risk, and timing of the clawback can influence the settlement decision.  Two of the most important factors, the Trustee told us, are the  defendant’s ability to pay and whether the settlement will produce  proceeds that enhance the customer fund he is building during the  liquidation. The bankruptcy court must approve settlement agreements  worth $20 million or more. In addition to whether a settlement is in the  best interest of the estate, the court also considers whether a proposed  settlement is fair and equitable, and above “the lowest point in the range  of reasonableness,” the Trustee told us. In deciding whether a particular  agreement falls within that range, the court considers: probability of success in litigation; difficulties of collection;  litigation complexity, and expense, inconvenience, and potential for  delay; and   creditor interests.
On the key issue of ability to pay, the Trustee said his approach is that he  would rather agree to a settlement for less money and be able to collect  it, than win a judgment for a greater sum that he is ultimately unable to  collect. He cited the Katz-Wilpon settlement as an example. Originally,  the Trustee sued for more than $1 billion, but reached a settlement in  April 2012 for $162 million, based on his conclusion of what the  defendants could pay. In other areas, the Trustee also told us he is  sensitive about clawing back funds from charitable institutions, saying that  although they have received other investors’ funds, he did not want to put  them in the position of raising money in order to pay a settlement. We  examined all but one settlement agreement among those worth at least  $20 million.
Appendix IV provides details of these settlements, including  amounts sought and obtained, the extent to which settlements have been  paid, strategies behind settlements, and key provisions.
A number of factors motivate counterparties to settle with him, the  Trustee told us. One is that defendants have fiduciary duties to clients or  customers, and amounts at issue in a case might be so significant that,  for example, feeder fund managers might conclude their duty is to settle  in order to recover assets for customers. Some parties, to protect client  confidentiality, may settle in order to prevent disclosure of client  information that could become public in litigation. Other parties might  seek closure. Overall, the Trustee told us he thinks he has built a solid  record in his settlements. The market itself has validated his efforts, he  said, which can be seen in increases in the price of Madoff claims being  traded following announcement of recent settlement agreements.
As part of our review of records provided by the Trustee, we noted some  customer accounts having a negative balance. For example, in the  Picower case, the records showed a negative balance of $6.3 billion. In  theory, this reflected some kind of margin account or debit account, the  Trustee told us, even though such an amount would not have been in  keeping with standard industry practices. Such negative balances raised  questions whether the reported amounts represented debt owed by  customers to the Madoff firm, and if so, whether the presence of such  debt diminished the value of settlements obtained from such customers.  To obtain the $7.2 billion Picower settlement, for example, the Trustee  told us that he agreed to characterize the amount being returned as a  loan repayment. However, both the Trustee and SIPC executives told us  that the use of this terminology, or presence of negative balances, does  not change the effect of underlying actions, which was to extract fictitious  profits from the Madoff firm. In particular, the Trustee told us, he  determined claims for all accounts based on the money invested less  money withdrawn method. Purported indebtedness or negative balances  did not affect those calculations, he said, and had no effect on settlement  efforts.
section_title: Under a Hardship Program, the Trustee Expedited Claims and Avoided Lawsuits for Individuals in Financial Distress
paragraphs: The Trustee created a hardship program in which he considered the  degree of financial distress of Madoff customers in processing claims and  deciding whether to pursue clawback litigation. He told us that the  program was to recognize harm the Madoff fraud caused to former  customers. No other SIPC liquidation has had such an option, the Trustee  told us. This program, which was not open to institutional customers, had  two elements for individuals who could demonstrate financial hardship:
Claims. The Trustee provided expedited consideration of claim  applications. This did not provide applicants with any more favorable  treatment, as claims were still determined on the NIM basis. But it  accelerated consideration of claim applications, which, if approved,  could result in customers receiving any SIPC advances due them  more quickly. According to the Trustee, if complete account  information was available, a determination on qualification for  expedited claim review was made in about 20 to 30 days, with another  20 to 30 days to determine the actual claim. This compares to a  typical claim taking 3 months or more.
Clawbacks. The Trustee would not sue for clawbacks, or would drop  suits already filed.
The Trustee told us he invited applications to the hardship program, but  also included some claimants in the program on his own initiative. Figure  7 shows a breakdown of the Trustee’s consideration of hardship cases.
According to the Trustee, he assessed general factors in considering  hardship applications, but there were no formal criteria or decision rules.  Instead, the Trustee told us, he applied his judgment after applications  were reviewed at the Trustee’s counsel law firm. The general factors,  applicable to both the claims and clawback elements of the program,  included whether, due to lost investments or the possibility that funds  withdrawn must be returned, the customer: needed to return to work, had declared bankruptcy, was unable to pay for living expenses, was unable to pay for dependents, or  suffered from health problems.
Additionally, the Trustee said he took into account whether former  customers used any fictitious profits to pay taxes. If so, the Trustee told  us he considered such payments in his decisions.
The process for considering hardship applications was similar for both the  claims and clawback elements, the Trustee told us. For claims, an  attorney reviewed an application and made a recommendation to the  Trustee, who then decided the matter. For clawbacks, the Trustee’s  counsel team responsible for the litigation reviewed the application, and, if  necessary, would seek additional information. The team would make a  recommendation to a review committee, comprised of five lawyers, for its  evaluation. The committee would make a recommendation to the Trustee,  who then decided the matter.
According to information we reviewed, hardship program applicants were  predominantly older, and the most commonly cited reasons for financial  distress, for either element, were the inability to pay living expenses and  health problems. The Trustee said most cases were not difficult to decide,  based on the evidence presented. He told us that while he and others  reviewed applications carefully, requesting additional information when  necessary, they attempted to not be overly intrusive into private affairs.  We reviewed a number of applications provided by the Trustee,  illustrating acceptance or rejection of customers’ hardship applications.  Table 9 summarizes some of the cases we reviewed.
As noted, the claims hardship part of the program did not alter outcomes,  as it provided only expedited review. For the clawback portion, results  varied by type of action, according to information the Trustee supplied in  response to our queries. Figure 8 summarizes results.
Within weeks of the Madoff firm’s failure, SEC officials were studying  whether clawback actions were permissible, and concluded they were.  SEC officials told us the issue was a difficult one, because innocent  investors would become the target of lawsuits; at the same time, if the  Trustee did not pursue the recovery actions, others would be hurt. From  the beginning of the case, SEC thought that clawbacks would produce the  bulk of assets available for distribution to customers, because billions of  dollars had been withdrawn from the firm shortly before its failure.
SEC officials told us they have had discussions with the Trustee (and  SIPC) on his clawback litigation, on such issues as legal theories being  employed, risks presented, legal costs, and expected future  developments. But they have not had day-to-day involvement in the  litigation, nor been involved in developing the legal strategies employed,  the officials told us. SEC officials told us an examination will come later,  but based on their experience, the Trustee appears to be conducting the  litigation in an acceptable manner and has applied the law properly and  fairly. They said they were not aware of any particular problems or issues  with the litigation, although courts have not always adopted the Trustee’s  positions. SEC officials told us they were not concerned about runaway or  needless litigation, and the main outcome of the litigation is that the  Trustee has recovered large sums that are considerably more than  initially expected.
SIPC executives likewise told us they always thought clawbacks would be  a critical part of recovering assets for customers. SIPC did not have any  discussions with the Trustee about clawbacks prior to his appointment,  they said, other than to discuss whether there were adequate resources  available at his law firm to bring the expected cases. The officials  characterized their involvement with the Trustee as providing institutional  knowledge and high-level advice and strategy, albeit with the  understanding that the independent Trustee need not accept it. SIPC’s  most significant contribution is payment of litigation expenses, SIPC  executives told us, because otherwise, the Trustee could not finance his  litigation. The SIPC executives told us they consider the Trustee’s  litigation a success, but that his efforts are thus far incomplete, as many  cases remain outstanding. Although total settlement amounts to date  reflect mostly one case ($5 billion for Picower), other settlements still  have produced significant sums. The cases the Trustee is pursuing are  complex, involving difficult and time-consuming legal work to resolve, the  executives said. Costs of the litigation are favorable when compared to  what attorneys would collect in contingent lawsuits, they said.
section_title: Effects of the Fraud on Income Tax Revenues Cannot Be Determined, and New Guidance on Clawbacks Could Reduce Taxpayer Errors
paragraphs: Because the Madoff fraud affects customers’ taxable income, it also  affects federal tax collections by the U.S. Treasury. Madoff customers can  seek tax relief for fraud-related losses in several ways, including one  special procedure announced by IRS in the wake of the firm’s failure.  However, IRS officials were unable to quantify the overall impact of the  fraud on tax collections, and the impact may be reduced by various  factors that could limit taxpayers’ ability to take full advantage of the tax  relief available. In addition, while the use of either NIM or FSM to  determine customer net equity could lead to different outcomes for  account holders, either method likely reduces tax revenues. Tax experts  expressed concerns about the lack of clarity over how payments  stemming from fraud-related avoidance actions, or clawbacks, filed by the  Trustee will be treated for tax purposes. After we identified concerns to  IRS that lack of guidance could lead to taxpayer errors resulting in over-  or underpayment of taxes, the agency issued such guidance.
subsections: section_title: Madoff Customers Can Seek Tax Relief Several Ways
paragraphs: The Madoff fraud affected the federal income tax liabilities of former  customers in two primary ways, according to our review. First,  customers likely paid federal income taxes on fictitious profits reported to  them in each year they held their account.theft of funds invested, which under tax law would be considered an  investment theft loss.
Second, they likely suffered  Typically, there are two ways to address these effects upon discovery of  such fraud, according to IRS officials. Taxpayers can file amended returns, in which they remove fictitious profits from previously reported  income. In addition, they can claim a theft loss deduction against income,  to reflect principal amounts stolen and fictitious profits reflected on  account statements that were not removed on any amended returns.  Under the Internal Revenue Code, an investment theft occurs when a  taxpayer loses property to theft in connection with a transaction entered  into for profit. Taxpayers can use amended returns or claim theft loss  deductions, singly or in tandem, depending on their situation, according to  IRS officials. But each of these approaches has limitations, according to  the officials. For instance, taxpayers can generally file an amended return  to claim a refund of taxes paid within 3 years of the original filing date, or  2 years from the date the tax was paid, whichever is later. In the case of  the theft loss deduction, taxpayers cannot take the deduction to the extent  they have been reimbursed for the loss, and if they have a claim for  reimbursement, they cannot deduct their loss until the amount of recovery  to be received can be “ascertained with reasonable certainty.” In the  Madoff case, the Trustee is working to recover assets to benefit former  customers, but how much he will ultimately recover, and by when,  remains unknown.
In addition to these typical remedies, IRS has also provided another  option, referred to as a “safe harbor” approach. This allows taxpayers to  deduct a percentage of lost principal including all previously reported  profits in a single year—the year of a criminal charge against the  perpetrator, or 2008 for the Madoff case. According to IRS, the purpose of the safe harbor is to ease the compliance burden for both the agency  and taxpayers, avoiding what can be complicated questions on size and  timing of a theft loss deduction. Under the safe harbor approach,  taxpayers can deduct 95 percent of their losses in the year of discovery  (when the lead figure is criminally charged). The loss is calculated by  adding principal invested plus profits (whether fictitious or real), less cash  withdrawals and recoveries from SIPC or other sources. For taxpayers  seeking recovery from third parties, such as through lawsuits, the figure is  reduced to 75 percent. If the taxpayer follows the safe harbor  requirements, IRS agrees not to challenge the taxpayer’s treatment of a  qualified loss as a theft loss, and taxpayers waive their right to other  remedies that might have been available. The safe harbor approach  deems the reasonable prospect of recovery condition of the standard theft  loss deduction to be satisfied in the year of discovery. Thus, Madoff  customers electing to use the safe harbor approach may be able to  recognize their losses earlier than under the normal method for deducting  a theft loss. However, if customers using the safe harbor approach later  receive distributions of recovered assets from the Trustee that cause their  claimed deduction to exceed their actual losses, they must report the  excess amounts as income in the year received.
IRS officials told us they could not say which method of claiming tax relief  is best for taxpayers, because individual tax situations can vary widely.
Tax practitioners to whom we spoke said the safe harbor is attractive for  its certainty and ease of use, but some taxpayers may be better off using  the traditional methods. However, one practitioner told us that anyone  who can use the safe harbor should do so.
section_title: The Fraud’s Impact on Tax Collections Cannot Be Determined, but It May Be Reduced by Limits on Taxpayers’ Ability to Fully Realize Tax Relief
paragraphs: According to IRS officials, the agency cannot determine the tax revenue  loss to the U.S. Treasury that will result from Madoff customers seeking  relief for their fraud-related losses. IRS cannot identify Madoff taxpayers,  and even if it could, it does not collect necessary information to conduct a  post-Madoff analysis of the fraud’s impact on tax revenues. IRS officials  told us they generally do not maintain statistics on any particular Ponzi  scheme or identified investment fraud. They also told us they cannot  identify which Madoff customers are using which tax relief method, further  complicating any effort to assess the impact of the fraud on tax revenues.
In any case, although IRS cannot determine the amount of any revenue  loss, the Madoff fraud’s effect on tax collections could be reduced by  various factors that can limit taxpayers’ ability to take full advantage of  their losses. These factors generally affect the ability of taxpayers to claim  an investment theft loss deduction, rather than limit the ability to file  amended returns. According to IRS officials, SIPC executives, and tax  practitioners, factors affecting the ability to make use of the theft loss  deduction include:
Deductions need income. The theft loss deduction is a deduction  against income, not a tax credit. Therefore, to use the deduction,  taxpayers must have income to apply it against. If they do not have  sufficient income, they cannot use all or part of the deduction. This  could be a common situation, because many Madoff customers are  older and without income. If taxpayers have insufficient income to  make use of the deduction in a particular year, IRS rules allow theft  loss deductions to be carried over to other years—generally,  backwards for 3 years, and forward for 20. But taxpayers must still  have income, and even if they do, it could take a number of years to  fully apply their deductions on that income, meaning that benefits  could be delayed. One tax practitioner told us that even with extended  carryback and carryforward periods, he would expect many people— especially smaller investors—will not be able to use their deductions,  for lack of income against which to apply it.  “Leakage.” There can be considerable “leakage” when using the  carryforward and carryback options for the theft loss deduction—that  is, loss of other deductions when taking the theft loss deduction.  Individuals claiming the theft loss deduction might also have other  personal deductions, such as interest, taxes, or charitable  contributions. With application of the theft loss carryback or  carryforward amounts, income is reduced, with the result being that  income against which to claim the personal deductions can be lost.
With insufficient income against which to claim the personal  deductions, they are lost as well, offsetting benefits of the theft loss  deduction. This is because the personal deductions are not  themselves subject to carryback or carryforward. Generalizing about  the effects of leakage is difficult because such calculations are  taxpayer-specific, but the effect can be substantial, according to one  tax practitioner.
Rate differences. A taxpayer may have initially paid taxes on  fictitious profits at a relatively high marginal rate, but later realize a  theft loss deduction at a lower rate. This can mean the actual value of  fraud-related tax relief received is less than initial amounts of tax paid.  For example, someone may have paid taxes at a 35 percent rate, but  be subject to a 15 percent rate when claiming deductions, because,  for example, they lost investment income or retired and their income  has fallen. As a result, their deduction reduces their income by a  smaller amount than the amount of taxes that they paid in the past  when their income tax bracket was higher. Such a rate difference  could be significant if a taxpayer uses the IRS safe harbor approach.A taxpayer may have received reported profits for a number of years,  but be required, under the safe harbor approach, to deduct all losses  in a single year. Such a large deduction in one year could reduce the  taxpayer’s marginal tax rate from a high rate to a low rate. For  example, a taxpayer may have paid taxes at the 35 percent rate, but  by taking a deduction for all losses in a single year, find their tax rate  averages out significantly lower. Further, the manner in which the  Alternative Minimum Tax is calculated could also cause customers to  realize the benefit of their theft loss deductions at a rate lower than  when they initially paid taxes.
Death. Should Madoff customers have died, estate and trust taxation  issues could prevent full utilization of tax relief arising from the Madoff  losses. For example, losses can offset estate income, but any losses  remaining may not transfer with the property in subsequent tax  considerations, according to one tax practitioner.
In addition, other factors also stand to affect tax collections, either  providing additional revenues or increasing revenue loss, according to our  review. These factors include:
Future tax liability. Taxpayers using the safe harbor approach may  owe additional taxes in the future. By allowing taxpayers to claim 95  percent (or 75 percent) of their losses, the approach assumes a 5  percent (or 25 percent) recovery of assets by the Trustee or in other  recovery proceedings. According to IRS officials, if actual recoveries  exceed those amounts, taxpayers must declare the excess as income  and pay taxes on that income. Currently, the Trustee expects  recoveries to be at least 50 percent, meaning losses taxpayers have  claimed under the safe harbor could be overstated, triggering the  future tax liability.
Other deductions. Investors can generally deduct expenses incurred  in the production of income, IRS officials noted. That means that over  the course of the Madoff fraud, customers would have been able to  reduce taxable income based on any expenses the Madoff firm  charged them.
Madoff insiders. The Trustee told us that payments received by  Madoff insiders raise tax issues. In some cases, Madoff made loans  to immediate family, other relatives, and close associates. He often  forgave such loans later, but the forgiven amounts were not reported  to IRS as income, the Trustee said. In other cases, some people  received large cash payments from Madoff that were not reported as  income. Additionally, according to the Trustee, some insiders  periodically asked Madoff to produce gains or losses on their  accounts, presumably in order to offset income from non-Madoff  sources for tax purposes.
Timing. Even if the government surrenders tax revenue as Madoff  customers realize tax relief, the U.S. government collected and had  use of tax receipts for multiple years. Meanwhile, as discussed earlier,  taxpayers may have difficulty making full use of available benefits  today. Given time value of money, and difficulty in capitalizing on  benefits, this is advantageous to the government, tax practitioners and  others told us.
section_title: Either Claims Valuation Method Is Likely to Reduce Tax Collections
paragraphs: While the use of NIM or FSM to determine net equity produce different  outcomes for customers, both would likely reduce tax collections for the  U.S. Treasury. Under NIM, net winners generally have their claims denied  and are not eligible for reimbursement from the SIPC fund. Because SIPC  payments reduce the amount that a taxpayer would claim as a loss, these  customers would then likely have correspondingly larger theft loss  deductions. In turn, those higher deductions could cause revenue losses  for the Treasury that would not have been experienced if the Trustee had  used FSM, which would have provided higher SIPC reimbursements.  This can be seen in SIPC estimates for coverage under the two methods.  Under NIM, SIPC estimates an outlay of $889 million for payment of SIPC  advances to Madoff customers. If FSM had been used to value claims,  SIPC executives estimate that SIPC reimbursements would have  increased by an additional $1.2 billion to about $2.1 billion. According to  IRS officials, an increase in SIPC coverage amounts—or any other  coverage of losses—will correspondingly lower theft loss deductions.
Ultimately, though, the choice of either claims determination method  creates the potential for loss in tax revenues, because both NIM and FSM  would create deductions against income by parties affected by the Madoff  liquidation. While using FSM might have lowered theft loss deductions,  owing to the greater SIPC reimbursements, it also would have caused  greater demand on the SIPC fund, according to SIPC executives. As a  result, SIPC’s broker-dealer members would have had to pay additional  amounts to keep the fund at the level targeted by the SIPC board, the  executives said. These greater amounts would have been either in the  form of higher member annual assessments, or maintaining SIPC’s  recently increased assessment for a longer period, they said. At this new  assessment rate, SIPC members are currently paying about $400 million  into the fund annually.
Under SIPA, the assessments are an ordinary business expense, SIPC  executives told us. Thus, they are deductible as business expenses for  tax purposes by member broker-dealers, which would have the effect of  lowering members’ taxable income (or increasing losses). As a result,  rather than the U.S. Treasury facing lower tax collections from Madoff  customers due to use of NIM, it would experience lower revenues from  broker-dealers under FSM. Although this tax trade-off effect is  straightforward to describe, estimating how, if at all, tax revenues would  change under one method compared to the other is not possible, due to  taxpayer-specific reasons described earlier.
The Trustee told us that the effect on Madoff customers’ tax liabilities was  not a consideration in his determination of how to calculate investor net  equity. There is no statutory support for any such consideration, he said,  and even if there was, considering tax implications would have created a  substantial burden. To consider any tax implications, the Trustee said it  would have been necessary to examine details of each account, which  would have significantly increased the cost and amount of time to  consider claims. Further, the Trustee told us he did not research or  compile data on tax implications. However, he said he did provide  information to IRS and the U.S. Department of Labor.
section_title: Tax Treatment of Avoidance Actions Could Affect Accuracy of Income Tax Filings
paragraphs: As described earlier, a significant part of the Trustee’s efforts to recover  assets for distribution to Madoff customers is his avoidance action, or  clawback, litigation, in which he seeks to recover funds paid to certain  customers. In general, if taxpayers, due to a clawback, return money  previously paid to them, they are entitled to some reduction in tax liability  as a result, IRS officials told us. However, application of relevant law,  which deals with issues such as timing and nature of income, can be very  taxpayer-specific, they said. IRS officials also told us initially that the  agency did not have generally applicable guidance on the treatment of  those payments. They said the agency had been seeking to formulate the  right answer for dealing with clawbacks, but that it has otherwise provided  only “factually specific guidance” on a case-by-case basis. In cases in  which IRS has not issued such specific guidance, taxpayers must rely on  the Internal Revenue Code, regulations, court cases, and relevant  revenue rulings by the agency. Tax practitioners to whom we spoke noted  uncertainties in determining how clawbacks should be treated for tax  purposes, and that this makes completing income tax returns challenging  and could contribute to errors.
IRS officials to whom we spoke said they had not issued guidance on this  topic because their general approach was to initially focus on issuing  guidance in areas with more widespread effect, such as the safe harbor  procedures. A part of IRS’s mission is to help taxpayers understand and  meet their tax responsibilities, and more than a thousand Madoff account  holders and others face the possibility of having to return funds to the  Trustee as a result of clawbacks. Future financial fraud cases could  involve clawbacks in their resolutions as well. Without additional guidance  to taxpayers for such situations, the potential for taxpayer error is  increased, which could lead to either over- or underpayment of taxes to  the U.S. Treasury. A recent audit by the Department of the Treasury  Inspector General for Tax Administration illustrated tax compliance issues  surrounding investment theft losses. After reviewing what it said was a  statistically valid sample of 140 returns claiming investment theft loss  deductions for 2008, the inspector general’s audit estimated that 82  percent of 2,177 tax returns may have erroneously claimed deductions  totaling more than $697 million and resulting in revenue losses of  approximately $41 million. Three percent of the tax returns the inspector  general sampled included taxpayers who claimed more than $215,000 in  investment theft losses resulting from the Madoff scheme. This audit did  not specifically investigate treatment of clawbacks.
Given the number of taxpayers that could be affected by clawbacks, in  the Madoff case or others, the lack of guidance could affect the accuracy  of many tax returns and potentially involve billions of dollars in returned  funds. We identified this concern to IRS and recommended in a draft  report that the Commissioner of Internal Revenue ensure that the agency  provide taxpayer guidance on a timely basis on the proper tax treatment  of funds returned through avoidance actions or settlements arising from  cases of investment fraud. Subsequently, IRS on September 5, 2012,  issued such guidance, in the form of “frequently asked questions” on how  to treat clawbacks, which were posted to the agency’s website.
section_title: Agency and Third Party Comments and Our Evaluation
paragraphs: We provided a draft of this report to SEC, SIPC, IRS, and the Trustee for  their review and comment, and each provided technical comments, which  we have incorporated as appropriate.
We are sending copies of this report to the appropriate congressional  committees, the SEC Chairman, the SIPC President, the Commissioner  of Internal Revenue, and the Trustee for the Madoff liquidation. In  addition, this report is available at no charge on the GAO website at  http://www.gao.gov. If you or your staff have any questions regarding this  report, please contact me at (202)-512-8678 or clowersa@gao.gov.  Contact points for our Offices of Congressional Relations and Public  Affairs may be found on the last page of this report. GAO staff who made  major contributions to this report are listed in appendix V.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: This report discusses (1) the extent to which account activity varied by  type of customer of the failed Bernard L. Madoff Investment Securities,  LLC firm; (2) the nature of claims filed, and rejected or approved, with the  Trustee for reimbursement of losses following the firm’s failure due to  fraud; (3) litigation and settlement activity the Trustee has pursued during  the subsequent liquidation of the firm, in seeking to recover assets for  distribution to customers; and (4) the effect of the Madoff fraud on  customers’ federal income tax liabilities, including the effect on amounts  that would have been due if investor losses had been based on  customers’ reported final statement holdings.
We excluded from our analysis transactions we identified as instances of the Madoff firm  debiting foreign account holders for purported U.S. federal income tax withholding and  paying those amounts to the Internal Revenue Service (IRS). These amounts, totaling  about $330 million, were later credited to the accounts through a December 2011  settlement between the Trustee and IRS. identified with at least one transaction.because the account holder names did not provide sufficient information  to make a determination. These 30 accounts had a total of $82 million in  deposits and $117 million in withdrawals, each of which is less than 0.1  percent of all deposits and withdrawals. Using the account classifications  and net investment status, we analyzed subgroups of the overall  customer population, to examine potential differences in account activity.  Specifically, we reviewed deposits, withdrawals, and timing of these  transactions. In reviewing withdrawals, we also focused specifically on  withdrawal of principal amounts, as distinct from fictitious profits. This is  because under his authority to sue for return of assets, the Trustee can,  among other things, presumptively seek to recover principal withdrawals  during the 90-day period immediately before the Madoff firm failed. In our  analysis, we relied on our own examination of data provided by the  Trustee. The Trustee reviewed our results, noting some small differences  between our review and his work, but generally confirming our findings.  Upon further review of our work, we determined that the variances arose  from differing methodologies and particular algorithms used to conduct  the analysis. For example, we excluded from our analysis accounts that  had no transactions, and we counted multiple allowed claims for one  account as a single allowed claim. Further, in determining whether  accounts were net winners or net losers, we summed all applicable  deposits and withdrawals to determine net positions. In a small number of  cases, this produced very small negative or positive account balances,  which we considered to be different than zero. We also interviewed the  Trustee and members of his law firm on customer-type and transaction- related issues. To assess the reliability of the account and transaction  data provided by the Trustee, we interviewed members of the trustee’s  counsel law firm and a contractor that manages the data, reviewed  reports of the forensic accountants that assembled the data from records  of the Madoff firm, and examined the data for invalid or missing data  points. We concluded the data were sufficiently reliable for our purposes.
We could not classify 30 accounts  To examine the nature of claims filed and then rejected or approved  following the Madoff firm’s failure, we obtained claims data from the  Trustee. We tallied claims received and claims dispositions, while also  examining the total claims population, and claims outcomes. We matched  claims information with account information as described above to  examine claim information by customer type and net investment status.  As described above, we relied on our own examination of data provided  by the Trustee. We also interviewed the Trustee and members of his law  firm on claims-related issues. To assess the reliability of claims data  provided by the Trustee, we interviewed members of the trustee’s counsel  law firm and a contractor that manages the data and examined the data  for invalid or missing data points. We concluded the data were sufficiently  reliable for our purposes.
To examine litigation and settlement activity the Trustee has pursued  during liquidation of the Madoff firm, we obtained and analyzed court  documents covering a range of legal activity. These included: lawsuits  against net winners that are not alleged to have had knowledge of the  fraud or been in a position to know about it—referred to by the Trustee as  “good faith” defendants; lawsuits against individuals and entities the  Trustee argues knew or should have known about the fraud—referred to  by the Trustee as “bad faith” defendants; lawsuits against investment  vehicles that collected funds from investors and invested them with the  Madoff firm; and agreements the Trustee has reached to settle a number  of the actions he has filed as part of his asset recovery efforts. We  selected a random sample of 50 good faith actions for examination, from  among more than 1,000 cases filed; we reviewed 29 publicly available  bad faith complaints from among 30 such actions filed, analyzing the  most frequently cited bases for the Trustee’s allegations of bad faith; we  examined the largest complaints among 27 actions filed against feeder  funds; and we reviewed the largest settlements the Trustee had reached  during his litigation efforts. In addition, we examined Trustee records  associated with the “hardship program,” in which the Trustee expedited  claims processing or declined to pursue litigation for customers that could  demonstrate financial distress. We interviewed the Trustee and members  of the trustee’s counsel law firm on litigation and settlement issues, and  we conducted legal research on the Trustee’s legal basis for pursuing  asset recovery actions. We also interviewed Securities and Exchange  Commission (SEC) officials and executives of the Securities Investor  Protection Corp. (SIPC) for their views on conduct of Madoff-related  litigation.
To examine the effect of the Madoff fraud on customers’ federal income  tax liabilities, including potential differences based on how investor losses  were calculated, we examined relevant portions of the Internal Revenue  Code and Internal Revenue Service (IRS) revenue rulings and revenue  procedures. In addition, we reviewed a September 2011 audit by the  Department of the Treasury Inspector General for Tax Administration. We  also interviewed SEC and IRS officials, SIPC executives, and four  individuals with income tax expertise, including a law professor and three  tax advisors who we selected based on their tax experience or  publications related to tax issues.
We conducted this performance audit from March to September 2012 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform our audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
section_title: Appendix II: Trustee Avoidance Actions and Other Claims
paragraphs: Avoidance actions, often called “clawbacks,” enable a bankruptcy trustee  to set aside certain transfers of property made by the debtor within  specified periods preceding a bankruptcy filing, in order to recover the  property for the benefit of the estate and its creditors. These actions are  authorized by the federal Bankruptcy Code (title 11, United States Code)  as well as state laws, which section 544(b) of the Bankruptcy Code  makes available to bankruptcy trustees. Avoidance powers apply fully to  trustees conducting liquidations under the Securities Investor Protection  Act (SIPA).
As discussed below, two types of avoidance actions authorized by the  Bankruptcy Code are preferential transfers (or preferences) and  fraudulent transfers. Fraudulent transfers are further subdivided into two  types: actual fraud and constructive fraud. Individual lawsuits brought by  trustees can (and in the Madoff liquidation, often do) include preference  avoidance counts, avoidance counts alleging both constructive and actual  fraud under the Bankruptcy Code, and avoidance counts arising under  state law. Indeed, the bankruptcy court has affirmed the Madoff Trustee’s  right to bring a wide range of avoidance claims under both the Bankruptcy  Code and New York law.
A trustee’s avoidance powers are especially strong when the liquidation  involves a Ponzi scheme. This is because courts have developed a series  of specific interpretive rules, including the “Ponzi scheme presumption,”  which work to the advantage of the trustee and to the disadvantage of the  recipients of money paid out by Ponzi schemers—particularly when it  comes to recovering payments that represent fictitious profits.
subsections: section_title: Preferential Transfers
paragraphs: Avoidance actions based on preferential transfers, which are governed by  section 547 of the Bankruptcy Code, enable the trustee to avoid and  recover payments the debtor made to creditors within 90 days preceding  the bankruptcy filing, or up to 1 year prior to filing in the case of transfers  to “insiders.” Under section 547(b) of the Code, a trustee may avoid any  transfer of a property interest of the debtor to or for the benefit of a  creditor made within the preference period “for or on account of an  antecedent debt” while the debtor was insolvent, if the transfer enabled  the creditor to receive more than the creditor would have received without  it under the bankruptcy distribution. The U.S. Supreme Court has  observed that preference avoidance is a “mechanism  prevents the  debtor from favoring one creditor over others by transferring property  shortly before filing for bankruptcy.”
There are several statutory exceptions to avoidance under section 547(c).  For example, preference avoidance does not extend to payments of a  debt incurred by the debtor “in the ordinary course of business.” However,  the courts consistently hold that the concept of “ordinary course of  business” has no application in a Ponzi scheme setting and, therefore,  cannot provide a defense to preference avoidance. Furthermore,  preference avoidance does not take account of the conduct of the  recipient. Thus, it applies to all “transferees,” or recipients of transfers,  including innocent victims of Ponzi schemes.
For the above reasons, a trustee usually has no difficulty avoiding as  preferential transfers Ponzi scheme payments made during the  preference period. At the same time, the prevailing view is that  preferential transfer actions can only reach payments that represent  customer investments of principal in a Ponzi scheme—not fictitious  profits. In the leading precedent on this subject, the court reasoned that  since a Ponzi investor does not have a valid claim to fictitious profits,  payouts based on them are not made on account of an “antecedent debt”  as required for preference avoidance. This limitation has little if any  practical effect, however, since fictitious profits paid during the preference  period are recoverable through the fraudulent transfer avoidance actions  described below.
section_title: Fraudulent Transfers
paragraphs: Avoidance actions based on fraudulent transfers are governed by section  548 of the Bankruptcy Code. Section 548(a)(1) provides that a trustee  may avoid any transfer of an interest of the debtor in property made within  2 years before the filing date—  A.  if the debtor made the transfer “with actual intent to hinder, delay, or  defraud any entity” to which the debtor was or became indebted; or  B.  if the debtor received “less than equivalent value in exchange for” the  transfer and was insolvent at the time of the transfer, became  insolvent as a result of the transfer, was engaged in business for  which the debtor’s remaining property provided unreasonably small  capital, or met one of several other conditions specified in section  548(a)(1)(B).
Section 548 thus provides for two types of avoidance actions. An action  based on section 548(a)(1)(A) is one for actual fraud. As the language  indicates, it applies to transfers made by a debtor with actual intent to  defraud. By contrast, an action based on section 548(a)(1)(B) is one for  constructive fraud and does not require fraudulent intent on the part of the  debtor. Instead, the key consideration is whether the transfer was made  for less than equivalent value while the debtor was insolvent.
As a practical matter, the distinction between actual and constructive  fraud under section 548 has little significance in the unique context of a  Ponzi scheme, where the trustee is seeking to recover fictitious profits. By  virtue of the Ponzi scheme presumption, Ponzi scheme payouts are  generally considered to be actually fraudulent. Case law has held that  transfers beyond the principal investment lack value, making those  transfers recoverable under the constructive fraud provisions. Thus,  transfers of fictitious profits are subject to avoidance as both actual and  constructive fraudulent transfers.
The concept of fraud under section 548(a) focuses on the debtor- transferor rather than the transferees. Thus, all recipients of Ponzi  scheme payouts, innocent or otherwise, are potentially subject to  avoidance actions based on both actual and constructive fraud. However,  the recipients’ status is important in determining the nature and extent of  their liability. Section 548(c) of the Bankruptcy Code provides that the  transferee in a fraudulent transfer avoidance action may retain any  interest transferred upon showing that the interest was taken “for value  and in good faith.” Principal invested in a Ponzi scheme is considered  value with respect to a good faith transferee in this context, while fictitious  profits are not. In general, therefore, the liability of good faith recipients in  a Ponzi scheme-related fraudulent transfer action will be limited to  fictitious profits paid to “net winners”—that is, investors who withdrew  more than they invested in the scheme. Recipients who cannot establish  their good faith are liable for the return of their principal investment as  well as any fictitious profits paid out during the 2-year avoidance period. “ . . . If the investor knew or should have known that the debtor’s investment scheme was  too good to be true, then the investor fails to carry his burden of proving that he accepted  sums from the debtor in good faith, and the trustee is entitled to recover all amounts the  investor received from the debtor.”
McDermott, note 3, 176-177 (footnotes omitted). investor suspicious. Under this approach, an investor who fails to inquire  into suspicious circumstances, or even one who inquires but conducts an  inadequate inquiry, cannot establish a good faith defense. By contrast,  other courts have applied a so-called “subjective” test, whereby investors  are found to have acted in good faith so long as they lacked actual  knowledge of the fraud or did not “turn a blind eye” in the face of obvious  signs of fraud. One recent U.S. District Court opinion in a Madoff-related  case endorsed the subjective test of good faith.
section_title: Avoidance Actions under New York Law
paragraphs: As noted, a trustee, including a SIPA liquidator, can bring avoidance  actions under state law as well as the federal Bankruptcy Code. Since the  Madoff firm was formed as a New York limited liability company with its  principal place of business there, the Madoff Trustee’s avoidance actions  include claims under New York’s fraudulent conveyance law, codified in  sections 270 through 281 of the New York Debtor and Creditor Law  (DCL) (McKinney 2012). “Every conveyance made and every obligation incurred with actual intent, as distinguished  from intent presumed in law, to hinder, delay, or defraud either present or future creditors,  is fraudulent as to both present and future creditors.”
Additionally, DCL section 276-a provides for the award of attorney fees in  a successful avoidance action based on actual fraud where fraud on the  part of the transferee is demonstrated.
The main difference between avoidance actions under the federal  Bankruptcy Code and the DCL relates to the reach-back period. In  contrast to the 2-year Bankruptcy Code reach-back, DCL constructive  fraud avoidance actions are subject to the general 6-year statute of  limitations in section 213(1) of the New York Civil Practice Law and Rules  (CPLR) (McKinney 2012). Thus, these actions can reach transfers  made up to 6 years before the filing date.
Under CPLR sections 203(g) and 213(8), the reach-back period for  actions based on actual fraud is 6 years before the filing date or 2 years  from the time the fraud was discovered or could have been discovered  with reasonable diligence, whichever date is earlier. The Madoff Trustee  has used this authority to seek avoidance and recovery of fraudulent  transfers occurring more than 6 years before the filing date where the  recipients received the transfers in bad faith.
section_title: Other Considerations
paragraphs: Claims by recipients of avoidable payments. Section 502(d) of the  Bankruptcy Code generally requires disallowance of any claim against the  bankruptcy estate by the recipient of an avoidable transfer, unless the  recipient has paid over the avoidable amount. The Madoff Trustee has  invoked this authority in seeking to temporarily disallow SIPA claims and  other claims brought by some defendants in avoidance actions.
Subsequent transferees. Under section 550 of the Bankruptcy Code,  the trustee can seek recovery of the proceeds of an avoided transaction  from not just the initial transferee but also from “subsequent  transferees”—third parties who obtained funds from those receiving funds  directly from the bankrupt entity. Thus, for example, the Madoff trustee  can maintain avoidance actions against Madoff investors who received  payouts through feeder funds or other intermediaries. However, there are  limits to this authority. For example, a trustee cannot recover from a  subsequent transferee who can show receipt of the proceeds for value, in  good faith, and without knowledge that the transfer was avoidable. Also,  an action under section 550 generally must be commenced within 1 year  after the avoidance of the transfer for which recovery is sought against.
Like the Bankruptcy Code provisions, sections 278 and 279 of the DCL  authorize avoidance and recovery against subsequent transferees,  except purchasers for fair consideration without knowledge of the fraud.
Stockbroker safe harbor. One important area of uncertainty concerning  securities-related Ponzi scheme avoidance actions is the applicability of  the so-called “stockbroker safe harbor” or “stockbroker defense” provided  in section 546(e) of the Bankruptcy Code. This provision exempts certain  securities transactions from avoidance actions except those alleging  actual fraud. Thus far, Madoff-related judicial decisions have reached  different conclusions regarding the applicability of section 546(e). The  bankruptcy court held that section 546(e) did not apply to the Madoff  Ponzi scheme, while a district court held that it did.
section_title: Other Claims
paragraphs: A number of lawsuits the Madoff trustee has filed against bad faith  transferees contain common law claims in addition to avoidance counts  under the Bankruptcy Code and the New York DCL. These claims  include, for example, counts for conversion, unjust enrichment, and  money had and received.
A trustee has the authority and standing to sue to enforce claims that the  debtor had prior to bankruptcy that represent property of the estate,  including common law claims.decisions dealing with the Madoff liquidation emphasized limits on the   However, two recent U.S. District Court  Madoff Trustee’s ability to pursue common law claims. In both cases,  the courts concluded that the Trustee could not pursue certain common  law claims that, in the courts’ view, more appropriately belonged to  creditors rather than the debtor and the estate. Furthermore, with respect  to debtor claims, the courts noted that Madoff and his firm were  wrongdoers, and that the Trustee stands in their shoes for purposes of  pursuing common law claims. Therefore, the courts concluded, such  claims would be subject to the legal principle that bars resolution of  disputes between one wrongdoer and another.
section_title: Appendix III: Largest Madoff Accounts by Transaction Volume, Total Withdrawals, and Net Winnings
paragraphs: We obtained and analyzed transaction data for customers of the failed  Bernard L. Madoff Investment Securities, LLC firm. Table 10 shows  account information and status for the 10 largest Madoff accounts by  transaction volume.
Table 11 shows account information and status for the 10 largest Madoff  accounts by total withdrawals.
Table 12 shows account information and status for the 10 largest Madoff  accounts by “net winnings,” that is, the amount by which an account  holder withdrew more than they invested in the Madoff firm.
section_title: Appendix IV: Details of Settlements by the Madoff Trustee
paragraphs: In hundreds of cases, the Madoff Trustee has reached settlements with  former customers and others, either before or after filing clawback  actions, and these agreements have produced recovery of a significant  amount of assets. This appendix provides details of these settlements,  including amounts sought and obtained, the extent to which settlements  have been paid, strategies behind settlements, and key provisions.
As of April 2012, the Trustee had entered into 441 settlement agreements  in which the opposing parties agreed to return about $8.4 billion—an  amount equal to about 49 percent of the approximately $17.3 billion in  principal investments lost by customers who filed claims. Based on a  bankruptcy court review threshold, we examined all but one settlement  agreement worth at least $20 million. Table 13 provides a summary of  the 13 settlements we identified. These settlements account for more  than 97 percent of all settlement amounts. They include settlements from  family estates, such as Picower, Shapiro, and Levy, as well as feeder  funds, in the case of UBP, Optimal, Fairfield, Mount Capital, and Trotanoy  Investment. The group also includes settlements with charitable  foundations and the federal government. As the table shows, the amounts  collected by individual case vary widely.
Among these settlements, the Optimal case has played an influential role,  the Trustee told us. Optimal was the sponsor of two feeder funds, and it  was an early case with potentially risky legal issues present, such as  jurisdiction and foreign entities—it was not clear the U.S. Bankruptcy  Code or SIPA apply outside the United States, the Trustee told us. The  Trustee secured an agreement requiring Optimal to return 85 percent of  amounts received during the 90-day preference period. Included was a  term providing that if the Trustee settled with another party on more  advantageous terms, Optimal would also receive those terms.
The 85 percent figure effectively became the benchmark for settlements  of similar claims, the Trustee told us. In turn, the Trustee also set a  complementary benchmark for good faith claims at 95 percent, in  consideration of the comparative ease in making such cases compared to  bad faith actions. The Trustee told us that in the Optimal settlement, he  considered it important to secure the agreement in order to build the  customer fund. However, looking back, he said the “most favored nation”  provision has been an issue. Optimal recently attempted to invoke the  clause following the Trustee’s recent settlement with Hadassah. Due to  the complexity of these cases, it is difficult to discern what constitutes a  settlement to which the clause would apply, the Trustee said.
Based on our examination of the largest settlement agreements, table 14  provides a summary of key settlement provisions.
The Trustee’s settlement agreements also go beyond simply obtaining  cash agreements, we found, as allowance of customer claims and SIPC  advances have also been key components of settlements of feeder fund  cases. For example, the Tremont settlement, in addition to its $1.025  billion settlement amount, also included allowing more than $3 billion in  customer claims and granting SIPC advances for eligible accounts. With  the exception of the Katz-Wilpon case, all seven settlements that included  allowed customer claims as part of the agreement were feeder fund  cases. Because these feeder funds were net losers, the settlement  agreements granted SIPC advances to each of the funds that directly  held Madoff accounts. In the Katz-Wilpon agreement, the allowed  customer claim was assigned to the Trustee, so that customer  distributions will fund the $160 million settlement payment.
For both the Picower and Levy settlements, the Trustee told us he  believed he obtained the largest sums possible. The $5 billion settlement  in the Picower case represents 100 percent repayment of funds received  by the Picower estate and related investors named in the complaint.  Similarly, the Levy settlement, reached before litigation was filed,  represents nearly 100 percent of the amounts the Levy account holders  withdrew during the 6 years prior to the Madoff firm’s collapse.  Additionally, both Picower and Levy withdrew their customer claims as  part of the settlements, the Trustee said.
section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Cody J. Goebel, Assistant  Director; Donald W. Brown; Daniel S. Kaneshiro; Jonathan M. Kucskar;  David J. Lin; Marc W. Molino, Barbara M. Roesmann; Christopher H.  Schmitt; Andrew J. Stephens; Ethan S. Wozniak; and Henry R. Wray  made major contributions to this report.