Securities Investor Protection Corporation: Interim Report on the Madoff Liquidation Proceeding
Published: 2012-03-07T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: With the collapse of Bernard L. Madoff Investment Securities, LLCa broker-dealer and investment advisory firm with thousands of clientsBernard Madoff admitted to reporting $57.2 billion in fictitious customer holdings. 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 investors. The method the Trustee is using to determine how much a customer filing a claim could be eligible to recoveran amount known as net equityhas been the subject of dispute and litigation. This report discusses (1) how the Trustee and trustees counsel were selected, (2) why the method for valuing customer claims was chosen, (3) costs of the liquidation, and (4) disclosures the Trustee has made about its progress. GAO examined the Securities Investor Protection Act; court filings and decisions; and SIPC, Securities and Exchange Commission (SEC), and Trustee reports and records. GAO analyzed cost filings and interviewed SIPC, SEC, and SEC Inspector General officials, and the Trustee and his counsel.
section_title: What GAO Found
paragraphs: The Securities Investor Protection Corporation (SIPC) generally followed its past practices in selecting the trustee for the Madoff liquidation. SIPC maintains a file of trustee candidates from across the country, but given the anticipated complexities of the case, officials said the field of potential qualified trustees was limited. SIPC has sole discretion to appoint trustees and, wanting to act quickly, SIPC senior management considered four trustee candidates. After three of the four candidates were eliminated for reasons including having a conflict of interest or ongoing work on a large financial firm failure, SIPC selected Irving H. Picard, who has considerable securities and trustee experience. However, SIPC has not documented a formal outreach procedure for identifying candidates for trustee and trustees counsel, or documented its procedures and criteria for selecting persons for particular cases, as internal control standards recommend. Having such documented procedures could allow SIPC to better assess whether it has identified an optimal pool of candidates, and to enhance the transparency of its selection decisions.
A key goal of broker-dealer liquidations is to provide customers with the securities or cash they had in their accounts. However, because the Trustee determined that amounts shown on Madoff customers statements reflected years of fictitious investments and profits, he chose to determine customers net equity using the net investment method (NIM), which values customer claims based on amounts invested, less amounts withdrawn. SIPC senior management and officials of the Securities and Exchange Commission (SEC)which oversees SIPCinitially agreed on the appropriateness of NIM. Over the course of 2009, however, SEC officials continued to consider alternative approaches for reimbursing customers. Although some customers have challenged the Trustees use of NIM, two courts have held that the Trustees approach is consistent with the law and with past cases, with both courts indicating that using the values shown on customers final statements would effectively sanction the Madoff fraud and produce absurd results. In November 2009, SEC commissioners voted to support the use of NIM, but with an adjustment for inflation, in an approach known as the constant dollar method. However, after an SEC officials conflict of interest was made public in February 2011, the SEC Chairman directed SEC staff to review whether the commission should revote on the constant dollar approach. The matter is currently pending.
As of October 2011, costs of the Madoff liquidation reached more than $450 million, and the Trustee estimates the total costs will exceed $1 billion by 2014. Legal costs, which include costs for the Trustee and the trustees counsel, are the largest category. While the estimated total cost for the Madoff liquidation is double the total for all completed SIPC cases to date, the Trustee, SIPC, and SEC note that the costs reflect the unprecedented size, duration, and complexity of the Madoff fraud. SIPC senior management also said the liquidation costs are justified, as litigation the trustee has pursued has produced $8.7 billion in recoveries for customers to date. Through various reports, court filings, and a website, the Trustee has disclosed information about the status of the liquidation. SIPC senior management, SEC officials, and the U.S. Bankruptcy Court have concluded that the Trustees disclosures sufficiently address the requirements for disclosure under the Bankruptcy Code and the Securities Investor Protection Act.
section_title: What GAO Recommends
paragraphs: SEC should advise SIPC to (1) document its procedures for identifying candidates for trustee or trustees counsel, and in so doing, to assess whether additional outreach efforts should be incorporated, and (2) document a process and criteria for appointment of a trustee and trustees counsel. SEC and SIPC concurred with our recommendations.

section_title: Letter
paragraphs: With the collapse of Bernard L. Madoff Investment Securities, LLC—a  broker-dealer and investment advisory firm with thousands of clients—in  December 2008, Bernard Madoff admitted to crafting fictitious trades and  account statements that showed customer investments totaling $57.2  billion. After the fraud was disclosed, investigators found no securities  were ever purchased for customers. Within days of Madoff’s arrest, the  Securities Investor Protection Corporation (SIPC), a nonprofit,  nongovernmental membership corporation responsible for providing  financial protection to customers of failed securities firms, put the Madoff  firm into liquidation. As part of this process, SIPC designated a trustee,  attorney Irving H. Picard (referred to as the Trustee throughout this  report), to oversee the liquidation of the firm and recover assets for the  benefit of investors.
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. Amounts in this customer property fund generally are  distributed to the firm’s customers according to the value of their account  holdings, known as “net equity.” Determination of net equity is a crucial  step in settling customer claims for reimbursement from the SIPC fund  and distributing any assets recovered from a firm’s liquidation. According  to SIPC, in a typical case, net equity is based on amounts reflected on  statements from the broker-dealer firm to the customer, in what is known  as the “final statement method” (FSM). In the Madoff case, however, the  Trustee said he determined that securities positions shown on customer  statements were fictitious. Thus, 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). As a  result, not all customers are eligible to receive funds from the liquidation.  Further, the Trustee has also been pursuing lawsuits, known as  “avoidance” or “clawback” actions, to recover funds from customers who  withdrew more from their accounts than they had invested. SIPC senior  management and officials of the Securities and Exchange Commission  (SEC), which has oversight responsibilities for SIPC, told us they  supported the Trustee’s decision to use NIM.
Because of the importance of the decision to use NIM in determining  customer claims, you asked us to examine a series of questions about  the actions of SIPC, the Trustee, and SEC as they relate to this decision.  This report discusses (1) how the Trustee and trustee’s legal counsel  were selected for the Madoff liquidation, (2) the process and reasoning for  the selection of NIM in determining customer claims, (3) the costs of the  Madoff liquidation, and (4) the information that the Trustee has disclosed  about his investigation and activities. You also asked us to examine  additional issues related to the Madoff liquidation, which we will address  in a future report, as agreed with your offices.
For this report, we reviewed SIPA’s requirements, analyzed SIPC  procedures for trustee selection, and compared the process for selecting  the trustee for the Madoff liquidation with past cases. We also examined  how and why the Trustee selected NIM as the method for determining  customer net equity, including comparing the selection of NIM in this case  to the methods used in other SIPC Ponzi scheme cases. We analyzed and summarized court decisions related to the Madoff liquidation and  selection of NIM. We also analyzed costs of the Madoff liquidation, as  reported by the Trustee, and examined SIPC and Trustee procedures for  reviewing and controlling liquidation costs. We assessed the cost data to  the extent necessary and deemed it sufficiently reliable for our purposes  of identifying total costs, cost components, and trends. We examined  SIPA requirements for information disclosures that trustees must make,  and reviewed disclosures the Trustee has made to date. Finally, we  interviewed officials from SIPC, SEC, and the SEC Office of Inspector  General, plus the Trustee and his counsel. See appendix I for additional  information on our scope and methodology.
We conducted this performance audit from October 2011 to March 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. SIPC is governed by a seven-member board of  directors. Its membership is, generally, brokers or dealers registered  under section 15(b) of the Securities and Exchange Act of 1934.  Membership is mandatory for all registered broker-dealers that do not  meet one of the limited statutory exemptions.SIPC had 4,773 members.
As of December 31, 2010,  While SIPC is not a federal agency, it is subject to federal oversight.  Under SIPA, SEC exercises what the U.S. Supreme Court has  recognized as “plenary,” or general, supervisory authority over SIPC.  Specifically, SIPC bylaws and rules are subject to SEC review. SEC also  may require SIPC to adopt, amend, or repeal any bylaw or rule. In  addition, SEC can participate as a party in any judicial proceeding under  SIPA and can file an application in the U.S. District Court for the District of  Columbia for an order compelling SIPC to carry out its statutory  obligations. Further, SIPA authorizes SEC to conduct inspections and  examinations of SIPC, and requires SIPC to furnish SEC with reports and  records that it believes are necessary or appropriate in the public interest  or to fulfill the purposes of SIPA. All seven members of SIPC’s board of  directors are appointed by federal officials: one is appointed by the  Secretary of the Treasury and one by the Federal Reserve Board, from  among the officers and employees of those agencies, and five are  appointed by the President, subject to Senate confirmation.
subsections: section_title: SIPC Fund
paragraphs: 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 when the general estate of the failed  firm is insufficient; these include costs incurred by a trustee, trustee’s  counsel, and other advisors.
SIPC finances the fund through annual assessments, set by SIPC, on all  member firms, plus interest generated from its investments in Department  of the Treasury (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 the Treasury through SEC, whereby SEC would  borrow the funds from the Treasury and relend them to SIPC. Figure 1  shows the SIPC fund’s balance over the past decade, with the balance  falling after the 2008 financial crisis and beginning to recover in 2010.
According to SIPC senior management, recent demands on the fund,  including from the Madoff case, coupled with a change in SIPC bylaws  increasing the target size of the fund from $1 billion to $2.5 billion, led  SIPC to impose new industry assessments that total 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   Under the new levies, the  flat $150 annual assessment per member firm.average assessment for 2010 was $91,755 per firm, with a median of  $2,095, according to SIPC. See appendix II for a history of assessments  and assessment rates for the SIPC fund.
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 its 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. The broker-dealer has an opportunity to contest the  protective order application. If the court issues the order, the court  appoints a “disinterested” trustee selected by SIPC, or, in certain cases,   Under SIPA, SIPC has sole discretion  SIPC itself, to liquidate the firm.to select a trustee and trustee’s counsel for the liquidation of a member  broker-dealer firm. SEC has no statutory role in the selection of the  trustee or trustee’s counsel. SIPC attempts to match the size of the  engagement with the capabilities of service providers. If SIPC were not to  act immediately, SEC could opt to seek court appointment of an SEC  receiver, pending SIPC action, according to SIPC senior management.  After SIPC makes its selection and the trustee is appointed, the  bankruptcy court holds a disinterestedness hearing, at which interested  parties can object to the selected individual and firm named as counsel.  The district court also orders removal of the liquidation proceeding to the  federal bankruptcy court for that district. To the extent that it is consistent  with SIPA, the proceeding is conducted pursuant to provisions of the  Bankruptcy Code.
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. Indeed, SIPC- designated trustees and SIPC have occasionally taken opposing legal  positions in liquidation proceedings. 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. The bankruptcy  court is to grant the trustee and trustee’s counsel “reasonable  compensation” for services rendered and reimbursement for proper costs  and expenses incurred in connection with the liquidation proceeding.
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  the Bankruptcy Code prescribes. Customers must file written statements  of claims. The notice typically informs customers how to file claims and  explains deadlines. Two deadlines apply. One is set by the bankruptcy  court supervising the proceeding, and the other by SIPA. The bankruptcy  court deadline for filing customer claims applies to customer claims for  net equity and may not exceed 60 days after the date that notice of the  proceeding is published. Failure to meet the deadline can affect whether  a customer claim is satisfied with securities or cash in lieu of securities.  The SIPA deadline occurs 6 months after the publication date. SIPA  mandates that the trustee cannot allow any customer or general creditor  claim received after the 6-month deadline, except claims filed by the  United States, any state or local government, or certain infants and  incompetent persons (although a request for an extension must be filed  before the 6-month period has lapsed).
Once filed, claims undergo various review, 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. Next, the Trustee’s forensic accountants review each claim  form, information gathered from the Madoff firm’s records regarding 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. The letter also informs  claimants of their right to object to the determination and how to do so.  The bankruptcy court judge overseeing the liquidation rules on a  customer’s objections after holding a hearing on the matter. Decisions of  the bankruptcy court may be appealed to the appropriate federal district  court, and then upward through the federal appellate process. As of  January 27, 2012, the Trustee had received 16,519 customer claims in  the Madoff proceeding, and reached determinations on all but two of  them.
Figure 2 shows a timeline of key events in the Madoff liquidation.
section_title: SIPC Says It Followed Its Normal Process in Selecting the Trustee, but Lacks Documented Procedures and Formal Outreach
paragraphs: A SIPC liquidation of a member broker-dealer begins when either SEC or  a securities self-regulatory organization, such as the Financial Industry  Regulatory Authority, recommends that a firm’s failure may require SIPC  assistance, usually because of theft or other misuse of customer assets  and insolvency. If SIPC’s president, general counsel, and vice president  for operations agree that a case should be opened, the SIPC president  requests authority from the SIPC board chair to begin the action.
Upon receiving this authority, the SIPC president selects a trustee and  trustee’s counsel after consultation within SIPC. According to SIPC senior  management, the SIPC board does not vote on the selections. Instead,  the selection relies on the judgment of SIPC senior management in what  they describe as a relatively narrow field of specialty. SIPC senior  management told us they attempt to match the size of the liquidation  proceeding with the capabilities of the individuals and firms that will  perform the liquidation. Typically in SIPC cases, the firm selected to act  as the trustee’s counsel is the same law firm of which the trustee is a  member, and the statute explicitly permits this. According to SIPC  senior management, having a trustee from the same law firm increases  efficiency and cuts costs, as it provides better communication and allows  the trustee to make better use of legal resources.
To assist in selection of a trustee or trustee’s counsel, SIPC maintains a  file of candidates from across the country, which contains information  such as professional experience and billing rates, and it subscribes to an  information service that provides background information and ratings on  lawyers and law firms, and identifies areas of specialization. SIPC  informally assembles its roster from multiple sources, including inquiries  from firms interested in SIPC business and SIPC’s experience with firms  it encounters in legal proceedings. Where SIPC is unfamiliar with local  practitioners, it will seek recommendations from SEC staff and local  judges. Among firms new to its roster, SIPC seeks to build their  experience by using them as trustee’s counsel in relatively small cases in  which SIPC itself acts as trustee, or by having them serve as counsel in  matters in which the SIPA trustee or trustee’s counsel discover during an  investigation a previously unknown conflict of interest, according to SIPC  senior management. At the conclusion of a case, SIPC senior  management prepares a legal and accounting evaluation of service  providers used. Included in this evaluation is a recommendation whether  to use the service provider again. If SIPC staff recommends against a  provider, SIPC senior management told us, the provider is less likely to  be selected in the future. We sought to review such evaluations, but SIPC  senior management declined to provide them to us on the grounds they  cover privileged attorney work-product information.
According to SIPC senior management, the selection of the Madoff trustee  followed these past practices. Specifically, according to senior management,  the SIPC President received a call from SEC on December 11, 2008,  advising him that Madoff had just turned himself in to law enforcement and  had admitted to a massive fraud at his firm. Because of the likely size and  complexity of this case, SIPC senior management told us that selecting an  experienced attorney to act as trustee would be important, which limited the  field of potential trustees. Upon learning of the failure of the Madoff firm,  SIPC senior management used their experience and judgment to initially  identify four potential trustees from their pool of candidates, including Mr.  Picard. The three others were a former New York municipal finance official,  who was a lawyer and accountant but had not done a SIPC case and was  not a member of a law firm; an experienced liquidation attorney who was  already busy with another large financial firm failure; and another candidate  from a large New York law firm with extensive bankruptcy experience, but  that law firm had a disqualifying conflict of interest. Because of the situations  of the other candidates, SIPC contacted Mr. Picard on the morning of  December 11, 2008, and asked him to serve as trustee for the Madoff  liquidation. As described later, the law firm Mr. Picard would soon join, Baker  & Hostetler LLP (Baker Hostetler), was named as the trustee’s counsel.  Similarly, SIPC senior management told us that SIPC followed a similar  process in the recent large failure of MF Global, Inc., in which they contacted  5 candidates, drawn from an initial field of about 10, before the selection was  made.
Although SIPC senior management said the process in selecting the  Madoff trustee followed past selection practices, such practices are not  documented. According to SIPC senior management, current SIPC  policies do not document the decision process and any criteria applied in  making selections because senior managers rely on their judgment and  familiarity with individuals with appropriate experience. Further, they  noted they must act quickly to get a trustee in place for a failed firm as  soon as possible, because broker-dealer firms often fail with little advance  warning. Moreover, they said that getting a trustee in place quickly to take  over operations of the firm is essential to preserving assets and  maximizing returns to customers.
However, federal and private sector standards for internal control  recommend that an entity document its system of internal controls, by such  means as management directives, policies, operating instructions, and  written manuals.criteria would allow SIPC’s oversight agency, SEC, to more effectively  assess whether SIPC follows consistent practices in selecting trustees, as  well as increase the transparency of SIPC’s decisionmaking. SEC officials  told us that having SIPC better document its selection process would  improve SEC’s ability to oversee SIPC activities, in such areas as  determining the extent to which SIPC considered the fees charged by  trustees or how it addressed potential conflict-of-interest situations. SEC  officials told us they plan to discuss better documenting the trustee selection  process and criteria with SIPC.
In the case of trustee selection, documented policies and  SIPC also has not documented its outreach process for identifying  potential candidates to serve as trustees. SIPC senior management told  us they do not make formal efforts to expand the trustee candidate roster,  such as by regularly or systematically identifying or approaching other  parties. They said they view such efforts as unnecessary or impractical  because the number of attorneys who conduct work relevant to broker- dealer bankruptcies is small enough that SIPC is already is aware of most  of them, or the attorneys already are familiar with SIPC. Moreover,  according to SIPC senior management, actively soliciting candidates  could be burdensome for SIPC, by producing too much information about  too many firms that can quickly become outdated. They told us such an  undertaking would duplicate information already available through its  information service subscription, and that because SIPA liquidations can  be infrequent and in more remote areas of the country, it is more efficient  to obtain current information on qualified firms through the information  service and the firms’ websites.
However, undertaking additional efforts to more systematically identify  other candidates, and to document this process, could help ensure that  the range of choices, which SIPC senior management acknowledges is  currently limited to a small group with the requisite skills, reflects the  widest capabilities available. Access to a potentially wider pool of  candidates could help ensure that SIPC is better equipped to meet its  responsibilities. SEC officials told us that SIPC’s goal is to use individuals  and law firms capable of high-quality work, to avoid potentially damaging  legal decisions that could hinder SIPC in future liquidations. Having a  documented, formal outreach process would allow SEC to better assess  whether SIPC’s outreach efforts are sufficient for ensuring that SIPC is  identifying the optimal pool of candidates. SEC officials told us they likely  would discuss with SIPC senior management whether its roster of  candidates is sufficiently broad, as a wider pool could preserve quality  while offering the opportunity for lowering costs.
subsections: section_title: The Trustee Has Considerable Experience
paragraphs: The trustee that SIPC selected for the Madoff liquidation has considerable  industry and broker-dealer liquidation experience. He served as the first  U.S. Trustee for the Southern District of New York, where his duties  included appointing and supervising trustees who administer consumer  debtors’ bankruptcy estates and corporate reorganization cases, and who  litigate bankruptcy related matters. He appointed the trustee for  reorganization of O.P.M. Leasing Services, Inc., a several-hundred- million-dollar Ponzi scheme case involving nonexistent computer  equipment leases. He was on the staff of the SEC for about 8 years,  where he was involved with corporate reorganization cases and also  served as an assistant general counsel. In private practice, he was  appointed the receiver in connection with an SEC injunction action  against David Peter Bloom, a Ponzi scheme case involving investor cash  losses of about $13 million. Additionally, he has been a trustee in 10 other  SIPC cases beginning in 1984, although these cases were much smaller  than the Madoff case, which is, by some measures, SIPC’s largest case  ever.case as trustee, Mr. Picard said SIPC contacted him and asked whether  he would take the position. Subsequently, Mr. Picard said he has  indicated to SIPC his continuing interest over the years in serving as a  trustee, but did not solicit particular cases. Table 1 summarizes the  Trustee’s previous SIPC cases.
section_title: SIPC and SEC Have Supported, and Courts Have Affirmed, the Trustee’s Use of the Net Investment Method
paragraphs: In valuing customer claims filed as part of the Madoff liquidation, the  Trustee selected NIM, which determines the amounts that customers are  owed as the amounts they invested less amounts withdrawn. The  Trustee, supported at the outset of the case by SIPC and, after nearly a  year of analysis, by SEC as well, decided against valuing claims based  on amounts shown on customers’ final statements. The parties said this  was on the grounds that it met statutory requirements, and that using  statement amounts would effectively sanction the Madoff fraud by  establishing claims according to the fictitious profits Madoff reported. NIM  has consistently been used in SIPC liquidations involving Ponzi schemes,  and the two courts that have considered the net equity issue in the Madoff  case—the bankruptcy court and the U.S. Court of Appeals for the Second  Circuit—have affirmed the Trustee’s decision on this method for  determining customer claims.
subsections: section_title: The Trustee Decided to Use Method Typically Used in Ponzi Scheme Cases
paragraphs: In a SIPA liquidation, it is the trustee that decides on the method for  determining customer claims. SIPA refers to this as calculating a  customer’s “net equity,” and the statute generally provides that this  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. The statute also provides that the trustee shall  make payments to customers “insofar as such obligations are  ascertainable from the books and records of the debtor or are otherwise  established to the satisfaction of the trustee.”
In SIPA liquidations not involving fraud, trustees typically determine that  the amounts owed to customers match the amounts shown on their final  statements—that is, the “final statement method” (FSM). In particular,  according to SEC officials, in most SIPA liquidations, the books and  records of the broker-dealer match the amounts shown on customers’  final statements. In many cases in which a broker-dealer fails, customer  accounts are transferred to another broker-dealer firm. However, in cases involving fraud, amounts in customer accounts may not correspond  to statement amounts—as in the Madoff case—and SIPA does not have  any particular provisions for fraud cases beyond its general terms.
The Trustee told us that soon after the case began, and once he realized  the investment advisory unit of the Madoff firm was a Ponzi scheme, he  concluded that NIM—also known as “money-in/money-out”—was  appropriate. As noted earlier, this method determines customer net equity  as customer deposits less customer withdrawals; it does not rely upon  holdings reported on customers’ final statements. Under NIM, Madoff  claimants are divided 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. Following the  firm’s closure, the Trustee received 16,519 claims and denied most of  them, chiefly because customers did not have accounts with the Madoff  firm. The Trustee said the firm had 4,905 active accounts at the time of  closure. Determination of claim amounts under NIM resulted in 2,356 net  loser accounts and 2,459 net winner accounts.
According to the Trustee, the chief reason for rejecting FSM in favor of  NIM was that adopting customer statement amounts as the basis for  account values would legitimize Madoff’s fraud and cause account values  to hinge on the fictitious trading and returns that Madoff reported to  investors. The Trustee took the position that customer statements did not  show “securities positions” that could be used for the net equity  determination, because the statements were fictitious. Instead, the only  Madoff records that reflected reality were those detailing the cash  deposits and withdrawals of customers. Thus, the Trustee asserted that  he was required to determine net equity based on these records, because  they provided the only obligations that could be ascertained and  established from the firm’s books and records.
The Trustee also said that NIM was the most equitable method for Madoff  customers. According to the Trustee, using FSM would allow some  customers to retain fictitious “profits” they had withdrawn that actually  were misappropriated investments of other customers. Moreover, FSM  would divert the limited customer assets available from the liquidation by  paying these fictitious profits at the expense of reimbursing real losses.  The Trustee also said FSM could conflict with his obligation to recover  through clawback actions fictitious profits that Madoff paid to some   investors.money would be available to return to customers. The Trustee told us that  he is not aware of any Ponzi case in which FSM was used to value  customer claims.
If the Trustee were less able to make such recoveries, less  We also found that the Trustee’s selection of NIM was consistent with use  of NIM in previous SIPA liquidations involving Ponzi schemes. According  to SIPC data, among seven Ponzi scheme cases since 1995, including  the Madoff case, all used NIM, in whole or in part, depending on facts and  circumstances of individual accounts. (See table 2.)
Although the Trustee decided to use NIM to value Madoff customer  claims, he also chose to recognize a portion of customer statement  amounts—specifically, those dated before April 1, 1981. The Trustee told  us this decision was due to gaps in available Madoff or third party records  prior to that date, and that beginning with April 1, 1981, more complete  and reliable records became available. The Trustee said he chose to  recognize these older customer statement amounts in an attempt to favor  customer interests, even though the amounts likely reflect some fictitious  profits. The impact of this decision, however, is relatively minor, according  to the Trustee—recognizing about $165 million in 371 accounts, equal to  about 1 percent of total claims allowed and about 15 percent of total  accounts with approved claims.
Questions have been raised whether the effect on the SIPC fund  influenced selection of the net equity method, as acceptance of higher  customer claims under FSM could have affected SIPC’s liability under the  coverage it provides to investors. However, the Trustee told us that effect  on the SIPC fund did not enter into his selection, and that he did not  discuss how the use of NIM would affect the fund with either SIPC or SEC.
section_title: SIPC and SEC Both Supported Use of NIM, Although SEC Considered Alternatives
paragraphs: Like the Trustee, SIPC quickly concluded that NIM was the appropriate  method for determining customer claims, because of the fraud in the case  and because using FSM would effectively sanction Madoff’s activities.  According to SIPC senior management, the focus in a net equity  determination is on individual customer transactions—that is, officials do  not consider at the case level which method might be best. In the Madoff  case, the transactions were alike—fictitious. As a result, applying a single  method of determining net equity to the entire Madoff case was  appropriate. Furthermore, while trading and reported investment profits  were fictitious, records were available on individual customer deposits  and withdrawals. Such records make NIM calculations possible,  according to SIPC. SIPC senior management emphasized that final  customer account statements are not the only “books and records” of the  failed firm, as cited in the statute.
SIPC senior management told us that when the Madoff case began, they  quickly began discussions aimed at producing agreement among SIPC,  the Trustee, and SEC on the method for determining net equity.  According to SIPC, such agreement was important in order to avoid a  situation that had arisen in a previous case in which SEC took a position  in court at odds with SIPC. Further, SIPC senior management said they  wanted to reach consensus early in the liquidation out of concern that  SEC would come under pressure to change its position as the extent of  customer losses became clearer.
By February 2009, SIPC senior management believed that based on their  discussions, they had achieved consensus with SEC on use of NIM.  These discussions included a meeting with the SEC Chairman, who,  according to SIPC, reported that a majority of commissioners supported  NIM. SIPC senior management noted that NIM has unpleasant  consequences in some cases, but that honoring final statements would  mean others would receive less than the amount of their own  contributions. Further, adopting FSM would have put at risk a large  majority of asset recoveries the Trustee has secured, SIPC senior  management told us, because some funds withdrawn by customers that  otherwise could be subject to recovery actions under NIM would instead  be recognized as legitimate under FSM and thus not subject to recovery.
Although initially agreeing on use of NIM, SEC staff continued to research  other options in a process that would extend until November 2009. SEC  officials told us their preliminary view in the early days of the case was  that NIM appeared to be the only feasible alternative, because it was the  most consistent with the statute and fraud law related to Ponzi schemes.  However, they said there was no official SEC position at the time. SEC’s  continued examination was of great concern to SIPC, according to SIPC  senior management, who told us they saw the continuing analysis as a  reversal of the earlier support for NIM. SIPC also said that SEC’s  continuing analysis raised concerns because SIPC needed certainty on  method for valuing claims in order to begin processing and paying them.
SEC officials told us they agreed it was important to settle on a method as  quickly as possible, but that early in the case, a considerable amount of  research remained necessary to formulate a recommendation for the  commission’s consideration. They said SEC’s task was not to simply  review SIPC’s determination, but rather to examine the issue  independently. With SIPC under considerable pressure to start making  payments to Madoff customers, SEC’s position was that the Trustee had  to do what he thought was correct. If SEC came to a different view later,  and the Trustee or the bankruptcy court determined changes needed to  be made, claims payments would have to be adjusted as necessary.
In a SIPA liquidation, SEC seeks to provide the maximum recovery  possible under the law for former customers, according to SEC officials.  Toward that end, in addition to NIM and FSM, SEC staff considered  several net equity methods as part of their review:
NIM plus an adjustment based on Treasury notes. The adjustment  would apply an interest rate based on the yield of 13-week Treasury  notes for periods in which Madoff customer statements indicated  customer holdings were not in securities.
NIM plus an alternative adjustment based on Treasury notes. Under  this alternative, the adjustment would be made on the assumption  customers had been fully invested in 13-week Treasury notes for the  life of their account. This revision was in recognition that positions  reported on Madoff statements were fabricated.
A combination of FSM and NIM, under which FSM would be used to  pay claims against the SIPC fund up to the maximum protection of  $500,000, and NIM would be used for claims against assets  recovered by the trustee.
NIM plus an adjustment for inflation (described more fully later in this  report).
During their review, SEC officials met with outside parties who advocated  for FSM. These outside parties advanced arguments including that the  Trustee’s view of net equity was at odds with the statute and its legislative  history and purpose. In a letter to SEC, several law firms noted that the  typical Madoff customer received written trade confirmations and monthly  statements, which they said are the basis for determining net equity under  the statute. Further, they said the legislative history shows that Congress  intended customers to have valid net equity claims even when securities  reflected on their confirmations and account statements were never  purchased. The outside parties also argued that the Trustee’s position  would erode investor confidence at a time—during the financial crisis— when markets and the securities industry could least afford it. They asked  that SEC attempt to persuade the Trustee to reverse course, or if that  was unsuccessful, seek a court order to that effect.
SEC officials characterized the meetings as an opportunity to listen and  ask questions. They said they did not make any decisions based solely  on information presented in these meetings, and that in general, the  outside interests did not advance any new arguments. The clients of the  law firms were undisclosed, but according to SIPC senior management,  the parties represented were Madoff customers subject to large clawback  actions. The SEC Inspector General told us that he does not believe there  were any improper motivations in the lobbying by the outside groups, but  that such meetings can create appearance problems because other  parties, perhaps those with fewer resources and which SEC did not hear,  might have had a different position. SEC officials told us they were open  to meeting with any parties and did not turn down any requests to meet  during this time.
Over the course of 2009, SEC staff conducted various analyses of past  cases and alternative approaches for valuing customer claims. After  receiving various memorandums and briefings, SEC commissioners  voted in November 2009 to approve the staff’s request to submit a brief to  the bankruptcy court supporting the Trustee’s use of NIM. As one  commissioner said at the time, given the difficult situation it faced, the  commission did all that it could do legally and equitably in opting for NIM.
Both SIPC senior management and SEC officials agreed with the Trustee  that the effect on the SIPC fund played no role in the selection of NIM.  Both said their approach was to make their best determination under the  statute, without regard to cost. They told us they considered any impact  on the fund only to identify what actions would be necessary for SEC to  extend a loan to SIPC, to be funded by SEC borrowing from Treasury,  should that be necessary to supplement fund balances to honor coverage  commitments. Further, even if FSM had been selected, the SIPC fund  would not have become insolvent, SIPC senior management told us.  Under FSM, based on the SIPC coverage limit of $500,000 per customer,  the SIPC fund’s maximum exposure would have been $2.1 billion,  compared to an expected $889 million outlay under NIM.
The use of NIM, rather than relying on final statement amounts, makes  determination of customer net equity a more expensive process, SIPC  senior management and SEC officials told us. But as with impact on the  SIPC fund, they said that cost does not factor into selection of method.  Instead, SIPC senior management told us, the higher expenses are  necessary, because of the investigation required after Madoff’s  statements to customers were found to be fabricated. In any case, use of  FSM would not have avoided substantial administrative costs, according  to SIPC senior management. Such costs would still have totaled several  hundred million dollars, they said, to conduct the liquidation, pursue  recovery actions, and process claims.
section_title: Courts Have Affirmed the Trustee’s Use of NIM
paragraphs: After the Trustee chose NIM and began to settle claims based on the net  investments that Madoff customers had made to their accounts, a number  of customers objected to this approach. As a result, the Trustee petitioned  the bankruptcy court in August 2009 for proceedings to affirm his choice of  NIM. Opposing claimants argued that the Trustee must use FSM because  Madoff statements reflected securities positions that they had every reason  to believe were accurate and upon which they had relied. They  emphasized SIPA’s purpose of reinforcing investor confidence and cited  the act’s legislative history as indicating that securities positions set forth in  broker-dealer statements need not be accurate to be covered under SIPA.
The opposing claimants further argued that Madoff’s profits, while  fictitious, may have been received and spent years ago, that customers  paid taxes on them, and may have foregone other investment  opportunities in reliance on investment results shown in their statements.  They further maintained that, at least in the case of advances from the  SIPC fund, use of FSM would not limit payments to reimburse net losers  for their losses. This was because they viewed the SIPC fund as a source  for paying customer claims that operated independently of any customer  assets recovered by the Trustee. Thus, they claimed all customers, both  net winners and losers, could receive up to $500,000 from the SIPC fund  without affecting customer assets recovered during the liquidation.
Both sides contended that precedent dealing with SIPA liquidations  involving Ponzi schemes supported their calculation method. In March  2010, the bankruptcy court affirmed the Trustee’s determination, agreeing  with the Trustee, SIPC, and SEC on their key arguments. The court  agreed with the Trustee that net equity can be based on “securities  positions” only to the extent that such positions are “ascertainable from the  books and records of the debtor” or “otherwise established to the  satisfaction of the trustee.” The court further agreed that in a Ponzi scheme  like Madoff’s—in which no securities were ever ordered or acquired—that  “securities positions” do not exist, and the trustee cannot pay claims based  on the false premise that customer positions are what the account  statements purported them to be. The court added that legitimate customer  expectations based on false account statements “do not apply where they  would give rise to an absurd result.” It said the Madoff customer  statements “were bogus and reflected Madoff’s fantasy world of trading  activity, replete with fraud and devoid of any connection to market prices,  volumes, or other realities.”amounts evident from the Madoff firm’s books and records are customer   Instead, the court said the only verifiable  cash deposits and withdrawals. (For a fuller discussion of legal issues  involving determination of net equity in the Madoff case, see appendix III.)
The court also found that fairness and “the need for practicality” favored  NIM. It concluded that payments from the SIPC fund were inextricably  connected to payments from customer assets, rejecting the argument by  FSM proponents to the contrary. Thus, use of FSM for SIPC advance  payments would diminish the amount available for distribution from the  customer asset fund. Because there are limited customer funds, any  funds paid to reimburse fictitious profits would no longer be available to  pay other claims.
The court also agreed with the Trustee that NIM was more compatible  with efforts to recover assets. The court said that customer withdrawals  made in furtherance of a Ponzi scheme, and specifically, withdrawals  based on fictitious profits, can be subject to recovery actions. NIM  harmonizes the definition of net equity with clawback actions, by similarly  discrediting withdrawals based on fictitious profits, and unwinding, rather  than legitimizing, the fraud. The court noted that FSM, by contrast, would  base compensation to customers on the same withdrawals the trustee  has the power to seek to recover.
In August 2011, the Court of Appeals for the Second Circuit affirmed use  of NIM as the appropriate method in the Madoff case. The appeals court  found that while SIPA does not prescribe a single method for determining  net equity in all situations, the Trustee’s use of NIM was the best  proposed method given the statutory definition of net equity. The court  noted that use of FSM would have the absurd effect of legitimizing the  arbitrarily assigned paper profits that Madoff’s fraud produced. The court  emphasized that while FSM may be appropriate in typical situations, the  nature of the Madoff Ponzi scheme, including “extraordinary facts” of the  Madoff fraud, point toward use of NIM. The court rejected the claimants’  characterization of SIPA as providing an “insurance guarantee” against  Madoff’s fraud; rather, it said, SIPA does not clearly protect against all  fraud committed by brokers, or insure investors against all losses.
section_title: Customer Claims Would Increase Significantly under FSM Compared with NIM
paragraphs: According to information we reviewed, the differences in customer net  equity under the two approaches is significant, because during the  decades of his fraud, Madoff reported considerable investment gains to  his investors. According to SIPC, customer claims allowed under NIM  total about $17.3 billion, while under FSM, the total would be  approximately $57.2 billion. Table 3 shows a comparison of claims,  broken down by account size, under the as-adopted NIM and the as- proposed FSM.
As table 3 shows, the number of accounts that potentially would have  allowable claims under FSM nearly doubles from the corresponding  number under NIM. This is because FSM generally accepts customer  statements as accurate representations of holdings, and thus even those  customers that withdrew more than they invested—net winners—would  also be entitled to have their claims approved. Total account value would  more than triple. However, this does not necessarily mean that customers  would recover their statement amounts under FSM. Rather, the amounts  distributed to customers will depend on how much the Trustee can  recover during the liquidation. If the amount recovered is less than the  amount of allowed claims—as is currently expected—then customers  receive payments based on their relative share of total claims. Thus, the  significance of using different methods for calculating net equity is that the  different methods can affect customers’ relative shares of total claims. In  turn, that affects the amount of money they ultimately receive.
section_title: Adjusting NIM for Inflation Could Increase the Size of Customer Claims and Remains an Outstanding Issue
paragraphs: Although SEC supported the Trustee’s decision to use NIM, SEC’s  position differed from the Trustee’s and SIPC’s in one respect: When  SEC commissioners voted to support NIM, they also said customer  deposits and withdrawals should be adjusted for inflation. According to  SEC staff, such adjustments would account for the length of time the  Madoff firm held customer funds. This has become known as the  “constant dollar approach.” To date, neither the bankruptcy court nor the  appeals court has addressed the merits of the SEC position. SEC officials  told us they see the constant dollar approach as a way to treat customers  more fairly and equally.
SEC’s consideration of the constant dollar approach arose from the  agency review, as described earlier, of potential methods for calculating  customer claims. SEC officials told us that after they rejected FSM and  adjustments based on Treasury notes, study continued on whether  another method consistent with SIPA would allow customers to recover  more money. However, the focus of their efforts shifted from investments  that Madoff claimed to have made but did not, and toward the time value  of money, pegged to when customers made their investments, so that  customers would be treated equivalently in real dollar terms. The concept  was that this would recognize the long duration of the Madoff fraud.
Under the constant dollar approach, a customer’s series of deposits and  withdrawals over time would be adjusted for inflation and converted into  dollar amounts that reflect current price levels. The simplest instance would  be a single customer deposit made years ago that would be converted into  current dollars based on price changes over the specified period. For  example, according to the Consumer Price Index, the value of a $10,000  deposit made 20 years ago would be $16,156 in 2012 dollars. Calculations  would become more involved with multiple deposits and withdrawals over  time, but the basic reasoning of converting past transaction amounts into  current dollars would be the same, according to SEC officials.
SEC officials told us their analysis indicated this approach could be  consistent with case law. Although case law has not specifically  recognized inflation adjustments, they said, it does provide support for the  general notion of seeking to treat investors equally. Translating that  concept to the Madoff case, SEC viewed inflation-adjustment as a way to  treat customers equally over time, during which price inflation would  occur. In a memorandum to commissioners, SEC’s Office of General  Counsel said that failing to do so would ignore the effects of inflation on  innocent investors and treat early victims of the fraud inequitably  compared with later investors.
SIPC senior management disagrees with SEC’s analysis and conclusion,  saying the statute provides no authority for inflation adjustment and that  no such authority can be inferred or implied. According to SIPC,  determination of net equity is a specified mathematical function, and the  notion of adjusting net equity determinations for inflation is an SEC- created approach that the statute does not support. SIPC senior  management also noted that adjusting customer claims for inflation has  never come up before in any other SIPC case, because the fraud in the  Madoff case is atypical in having such a lengthy duration. While inflation  calculations likely could be done, there would be large costs in doing so,  given the scope of the case and the number of transactions. SIPC senior  management further noted that if inflation-adjustment were permitted, the  size of some claims would increase. Because the pool of funds to satisfy  customer claims is fixed, larger payouts to some could depress payments  to others, according to SIPC senior management. This could lead to  litigation among customers because some net winners could become net  losers.that illustrated how claims could change significantly. It showed a  beginning balance of $130,000 in 1992, followed by a series of 23  withdrawals totaling $145,900 made through 2008. Thus, the customer  had withdrawn $15,900 more than initially invested, and under NIM, is a  net winner whose claim would be denied. But after adjusting the  sequence of transactions for inflation, based on specific timing and  amounts, the customer would become a net loser—having withdrawn  $29,829 less, in inflation-adjusted dollars, than originally contributed.
We reviewed one sample of an inflation-adjusted Madoff account  The Trustee told us he did not consider a constant dollar approach, as it  is not in the statute or supported by case law. He concurred with SIPC  that claim amounts could increase considerably. As an example, he said,  if a 9 percent annual interest rate, as allowed under New York fraud law,  were applied, claims could grow by tens of billions of dollars, from their  currently approved $17.3 billion.
Following disclosure of a conflict of interest by a former SEC official in  February 2011, SEC has plans to reconsider its position on supporting  adjusting customer accounts for inflation. With the filing of a clawback suit  by the Trustee against SEC’s former General Counsel, it became public  that the former official and his brothers had inherited a Madoff account  from their mother. In a report on the matter, the SEC Inspector General recommended—and the SEC Chairman agreed—that the commission  should reconsider the inflation-adjustment issue because of concerns  about the former General Counsel’s participation in SEC’s decision- making process.
The involvement of the SEC general counsel’s office in the net equity  issue began in January 2009, before the former General Counsel took his  position on February 23, 2009. Thus, while the former general counsel  became involved in the review, he did not initiate it. The Inspector  General recommended that commissioners revote to avoid any possible  bias or taint. The SEC Chairman has directed commission staff to review  whether commissioners should readopt the constant dollar approach.
section_title: Cost of the Madoff Liquidation Will Be the Largest to Date, with Efforts to Recover Assets Driving Costs
paragraphs: Through October 31, 2011, the Trustee reported spending of $451.8  million for liquidation activities, with final costs expected to exceed $1  billion through 2014. To date, the two largest components of these costs  have been legal costs of the Trustee and trustee’s counsel, and costs for  consultants. Although the Madoff case is expected to be SIPC’s most  costly case to date, the ratio of total costs to customer distributions is  lower than for some other SIPC cases.
subsections: section_title: Total Administrative Costs of the Liquidation Have Reached $452 Million and Are Expected to Exceed $1 Billion
paragraphs: Through October 31, 2011, the latest date for which information was  available, total administrative costs of the Madoff liquidation—ranging  from office expenses to professional services—reached approximately  $452 million. As shown in figure 3, the two major components have been  legal costs, chiefly for time spent by the Trustee and his counsel, and  consultant costs, for work such as investigating fraudulent activities of the  Madoff firm and analyzing customer accounts. Legal costs represent the  largest expense, according to a series of interim reports the Trustee has  filed with the bankruptcy court, plus other information we reviewed.
The Trustee told us that total administrative costs are estimated to reach  $1.094 billion through 2014. The $1.094 billion for the Madoff case is  approximately double the combined costs of $512.6 million for all 315  previously completed SIPC customer protection proceedings from 1971   Overall, a  through 2010, the latest year for which information was available.Ponzi scheme fraud is not necessarily intrinsically more expensive to handle,  according to the Trustee. For instance, in the Madoff case, forensic analysis  to determine what occurred at the firm has been similar to investigations in  other Ponzi scheme cases. However, the Madoff case stands out for the  duration of the fraud, its size, and the number of people involved, according  to the Trustee, SEC officials, and SIPC senior management.
Although the Trustee directs the liquidation, the bulk of the costs of the  liquidation are those associated with the legal work performed by attorneys  of the law firm acting as the trustee’s counsel. That firm, Baker Hostetler,  performs work that includes assisting the Trustee’s investigation; asset  search and recovery, including related litigation; case administration; and  document review. In addition to the Trustee’s interim reports, periodic cost  applications filed with the bankruptcy court for approval contain more  detailed information on costs incurred by the Trustee and trustee’s counsel.  Our review of these cost applications, which cover from December 2008  through May 2011, found that costs for the Trustee and trustee’s counsel  were $230 million for this period (see table 4).
These costs reflect a substantial number of hours—597,052—that the  Trustee and trustee’s counsel have billed (see table 5). For the most  recent reporting period, covering February to May 2011, about 100  partners, who are the most senior staff in the law firm, and 200 associate  attorneys, worked on the case.
Our review of costs for the Trustee and trustee’s counsel also identified  several trends within the overall amounts.
Attempts to recover assets are driving costs. As shown earlier in table  4, the Trustee’s costs alone are relatively small compared to the trustee’s  counsel costs. Within this larger category, costs for litigation to recover  assets have risen sharply to account for a large majority of the trustee’s  counsel costs. As of December 2011, the Trustee told us about 1,050  lawsuits have been filed as part of efforts to recover assets on behalf of  customers. These recovery actions are international in scope, with the  Trustee reporting more than 70 actions involving foreign defendants. For  example, actions have been filed in the United Kingdom, Bermuda, the  British Virgin Islands, Gibraltar, and the Cayman Islands. According to the  Trustee, international investigations have involved identifying the location  and movement of assets abroad, becoming involved in litigation brought  by third parties in foreign courts, bringing actions before U.S. and foreign  courts and government agencies, and hiring international counsel for  assistance. As figure 4 shows, asset recovery actions—that is, avoidance  or clawback actions—have outpaced all other trustee counsel costs as  the case has progressed. According to SIPC senior management, the  considerable expenses of the actions have been worthwhile, as the  Trustee has produced $8.7 billion in recoveries for customers thus far.
Partner hours have been declining. In general, billing rates for partners  at the trustee’s counsel firm are higher than rates for associate  attorneys. Thus, the more work partners handle, the higher the costs;  while the more work that associates perform, the lower the costs. Our  review showed that partner hours as a fraction of total hours claimed by  the trustee’s counsel have been declining steadily, from about 42 percent  near the beginning of the case to about 28 percent in the most recent  period (see fig. 5). The Trustee told us the partner hours have been  declining as case activity has shifted. Through the end of 2010, as the  Trustee and trustee’s counsel were busy preparing to file the many  complaints brought as part of the liquidation, partners were heavily  involved in case preparation and policy decisions. Later, as cases moved  into litigation, associate attorneys handled more of the load.
Higher-cost people have performed more work. Although the  proportion of hours attributable to partners has been declining, we also  found that within each category of professional work at the trustee’s  counsel—partners, associates, and nonlegal staff—higher-cost people  have been performing a larger share of work. We examined the  distribution of costs at two points during the Madoff liquidation: the  second cost application following start-up of the case (covering May to  September 2009), and the most recent cost application (covering  February to May 2011). Figure 6 illustrates our findings, showing results  for the partner category as an example. Partners whose billing rates are  in the top 20 percent (the top quintile) of all billing rates for partners  working on the Madoff case accounted for a greater share—about a  third—of all partner hours compiled, and more than 40 percent of all  partner billings in dollars. By contrast, partners whose billing rates are in  the bottom 20 percent (the bottom quintile) accounted for a smaller share  of activity—about 12 percent of hours compiled, and about 7 percent of all  partner billings in dollars. Middle quintiles followed the same trend. We  found that similar patterns applied for associate attorneys, and nonlegal   The Trustee attributed  staff such as paralegals, clerks, and librarians.this trend to differences in billing rates among Baker Hostetler offices.  Most case activity takes place in New York, where rates are higher than  elsewhere. Attorneys in other offices, where rates are lower, provide  assistance to New York-based lawyers, the Trustee said.
Limited guidance is available to assess the reasonableness of legal costs,  such as those incurred in the Madoff case. The American Bar Association  (ABA) publishes “model rules,” or recommended professional standards,  including a model rule on professional conduct, which includes legal  costs. The rules are only advisory, but according to ABA, nearly every  state patterns its professional conduct rules on the ABA model rule.  According to ABA, there is no formula for determining whether costs  charged in specific situations—or, in the case of the Madoff case, to  hundreds of individual instances of litigation—are reasonable. Rather  than provide a formula, the ABA model rule focuses on reasonability of  legal costs and provides a number of qualitative factors that can be  considered in evaluating reasonableness of attorney costs. Among the  factors are the time and labor required; the novelty and difficulty of the  questions involved; the skill needed to perform the legal service properly;  and the experience, reputation, and ability of the lawyer(s) performing the  services.
In addition to the costs for the Trustee and his counsel, there have been a  number of other professional costs in the Madoff case. Largest among  them, according to the Trustee, have been $178.2 million in consultant  costs.  These costs include, for example, forensic accounting services  performed as part of the fraud investigation. While legal costs have been  increasing, consultant costs have been decreasing, reflecting their  prominence earlier in the case (table 6).
Other types, for example, include investment banker fees and SEC receiver expenses. customers in completed SIPC cases. We grouped these cases on an  annual basis, focusing on years in which there were at least $50 million in  distributions. As shown in figure 7, the currently estimated total costs of  the Madoff liquidation, as a percentage of current recoveries, are within  the range of costs incurred in previous SIPC cases. For individual years,  the cost percentages have ranged from a low of 0.3 percent (2001) to a  high of nearly 40 percent (1990, when there were considerable expenses  in one relatively large case). For the Madoff case—which is not yet  complete, and as discussed earlier, is atypical—the cost percentage is  currently 11 percent, based on the latest estimate of total cost ($1.094  billion), and $8.7 billion in current recoveries from the Trustee’s efforts,  the $326 million Internal Revenue Service (IRS) settlement, plus an  expected $888.5 million in SIPC customer advances. The ratio for the  Madoff case could change, depending on future costs incurred and if the  Trustee secures additional recoveries.
The 13 years shown in figure 7 cover 104 cases that together account for  $15.5 billion in customer distributions. Total costs for all these cases  equal 2.5 percent of customer distributions. We note, however, that  results for one year—2001—reflect almost entirely the outcome of a  single large case, in which a firm failed but recoveries were sufficient to  reimburse all valid customer claims fully. Excluding 2001, total costs for  all cases as a percentage of customer distributions are equal to 9.5  percent.
section_title: Various Steps Are Being Taken to Control Madoff Liquidation Costs
paragraphs: In a SIPA liquidation, each of the main parties—the trustee, SIPC, the  bankruptcy court, and SEC—has a role in examining costs. These roles  vary by the party and the stage of the proceeding.
The Trustee noted that while he previously was at SEC and when serving  as U.S. trustee, he had experience reviewing fee applications. He  described a variety of ways by which he seeks to hold down expenses of  the Madoff liquidation. The general process for approval of costs begins  with the Trustee, who reviews them before submitting them to SIPC for its  review, prior to submission to the bankruptcy court. For billings, the  Trustee conducts a two-level review of Madoff-related time entries.  Following completion of work, a mid-level attorney reviews the billings,  and then a partner conducts another review. This second review is in  tandem with SIPC, the Trustee told us. The purpose of these reviews is to  determine whether too much time has been billed for a particular task. If  so, it is written off, the Trustee said. Information the trustee’s counsel  produced for us, covering from inception through January 2011, showed  about 1 percent of hours worked not being billed, with about another 1.5  percent of hours being written off after review. The Trustee also said that  he does not bill for 5 percent to 10 percent of the time he spends on the  case.
The Trustee said a similar review of billings takes place for costs  submitted by other law firms and consultants that the Trustee and  trustee’s counsel use in their work. The Trustee said that in some cases,  amounts claimed are reduced. However, the Trustee did not have specific  amounts for any such reductions. The outside entities also discount their  billings at least 10 percent, as the Trustee and trustee’s counsel do, with  some providing 11 or 12 percent discounts.
In addition to billing reviews, the Trustee also described other approaches  intended to help ensure that costs incurred are necessary and  reasonable.
Teams. Using teams, in which the same people work on similar  matters, to help achieve greater consistency and efficiency. For  example, the Trustee uses teams for different tasks, such as motions,  discovery, and litigation. For litigation, for example, the trustee’s  counsel has set up about 16 teams, which work on similar topics,  such as employee-related, review of charities, or family-related  matters. The teams follow cases from beginning to end, taking  advantage of experience gained through the process and limiting  additional costs that could occur if staff were assigned work in  unfamiliar areas, according to the Trustee.
Digitizing information. Computerizing information as much as possible  allows for faster, more efficient retrieval of information. This has  involved significant up-front costs, but the Trustee noted that it  reduces costs over time by avoiding the need to undertake time- consuming, expensive manual searches through thousands of boxes  of paper material.
Budgeting work in advance. The Trustee said he uses a process in  which consultants must fill out project forms and provide budgets,  which are submitted and must be approved by trustee’s counsel.  SIPC also receives some of these budgets. When bills are received  later, the trustee’s counsel compares the amount claimed with the  budget, and there have been instances in which costs exceeding  budgeted amounts have been refused, according to the trustee.
When the Trustee has completed in-house review of costs, he presents  them to SIPC for review. The Trustee may hold informal discussions with  SIPC before submitting actual costs for formal consideration. SIPC also  may contact outside vendors directly to inquire about charges. SIPC does  not pay for some charges, and following discussions with SIPC, the  Trustee may decide to write off some costs, according to the Trustee.
As SIPC senior management said is typical, at the outset of the case,  they sought and obtained a 10 percent reduction in the hourly rates of the  Trustee and trustee’s counsel. According to our review, this 10 percent  reduction has produced savings of $25 million through May 2011. In  addition, the Trustee and trustee’s counsel have provided additional  reductions of $5.4 million over costs they said would customarily be billed.
Some have suggested that SIPC should have sought a discount greater  than 10 percent. For example, the SEC Office of Inspector General has  reported that an SEC bankruptcy attorney raised questions whether a 10  percent discount for SIPC cases is sufficient. Similarly, the Inspector  General noted to us that the Madoff case began during the recent  financial crisis, when law firms’ business was suffering, and suggested  that as a result, SIPC would have had strong leverage to negotiate lower  compensation for firms.
SIPC senior management, however, told us that a 10 percent reduction is  appropriate for several reasons. Above that amount, service providers  object, and a 15 percent discount is not economical for sophisticated work  like that required in the Madoff case, according to SIPC senior  management. Also, SIPC senior management noted that liquidation  cases such as the Madoff matter draw highly qualified talent in opposing  counsel, so that as a result, SIPC also must draw upon highly qualified  providers. Furthermore, the 10 percent discount, coupled with  “holdbacks”—in which payment of approved amounts is not released until  later—amount to a significant burden on the service provider, according  to SIPC. Finally, SIPC senior management said that the results the  Trustee has produced to date support the costs incurred. For these  reasons, SIPC has not sought a reduction greater than 10 percent in the  Madoff case.
In addition to the 10 percent discount, SIPC has also created guidelines  for review and approval of costs. The guidelines cover matters including  obtaining a fee discount; submitting costs; reviewing costs submitted; and  documenting questions and discussions relating to the review of costs,  including items flagged for attention or reduced or written off. Under these  guidelines, a SIPC attorney reviews each time entry and expense item  submitted, after which they prepare a memorandum to the SIPC general  counsel, summarizing findings and making recommendations for  approval. The general counsel is to review the memo and  recommendations, before approving, modifying, or rejecting the cost  request. SIPC senior management told us they followed the guidelines  in the Madoff case. Also as part of this portion of the review process,  SIPC’s general counsel makes a line-by-line review of Trustee and  trustee’s counsel invoices, according to SIPC senior management.
Because costs in the Madoff case are so much greater than in previous  SIPC cases, the Trustee, working with SIPC, has established “litigation  budgets” for the many lawsuits resulting from the case. These budgets detail expected costs of specific litigation, and for each case, divide tasks  into specific categories, including research, drafting, motions, discovery,  trial, appeal, and collection. According to SIPC senior management, this  budgeting process is aimed at managing costs in advance or as they are  being incurred, rather than after-the-fact. In addition, several SIPC  personnel are in daily contact with the Trustee or trustee’s counsel. As a  result, they are aware what activities are planned, and will discuss them  ahead of time. They also discuss possible future actions. SIPC senior  management told us the Trustee has revised certain planned actions or  changed direction as a result of such discussions during the case.
We sought details on the extent to which SIPC has reduced or disallowed  expenses submitted by the Trustee. SIPC senior management declined to  provide documentation of its cost reviews, citing attorney work-product  privilege. According to SIPC, releasing such information could provide an  unfair advantage to litigation opponents and undermine attempts to  recover assets on behalf of customers. Similarly, SIPC noted that  releasing the litigation budgets could allow an opposing party to see how  much has been allocated for an activity in litigation, which can provide a  tactical advantage to opposing parties. However, the trustee’s counsel  provided us information on amounts written off at SIPC’s request.  According to this information, the trustee’s counsel has written off, at  SIPC’s request, less than 1 percent of hours submitted. For the Trustee,  SIPC-requested reductions to billings have been about 0.02 percent,  according to the information provided by the trustee’s counsel. SIPC  senior management also declined to provide other cost review-related  information we requested, again citing attorney work-product privilege.
In the Madoff case, the bankruptcy court has a limited ability to oversee  costs. As noted earlier, the Trustee and trustee’s counsel submit legal  costs to SIPC, which reviews them, before filing with the bankruptcy court a  recommendation on what the court should approve. SIPC files the  recommendation after the trustee and trustee’s counsel file their detailed  cost applications with the court. Under SIPA, the court must approve cost  applications if two conditions are met: (1) if there is no reasonable  expectation of SIPC recouping its advances, and (2) if SIPC recommends  to the court that it approve the costs requested by the trustee and trustee’s  counsel. In the Madoff case, both conditions have been met.
For the first condition, SIPC does not anticipate recouping its  administrative advances because it expects that recoveries by the  Trustee will be insufficient to cover all approved customer claims. SIPC  senior management told us that they have opted to devote all asset  recoveries—of both investor funds and sale of assets of the Madoff firm  itself—to repaying approved customer claims. If a trustee can recover  assets that exceed the amount of allowed customer claims, SIPC has a  priority claim on the excess assets, in order to recoup its advances to  cover liquidation costs. However, based on expected recoveries in the  Madoff case, SIPC senior management does not expect there will be any  excess assets. The current Trustee estimate of allowed claims is $17.3  billion, compared with $9.1 billion in Trustee recoveries and settlements.  Thus, about $8.3 billion in additional recoveries would be needed, and  based on current Trustee assets, lawsuits filed, and the estimated  possibilities for recoveries arising from that litigation, SIPC senior  management does not now expect this level of recoveries to occur.
For the second condition, SIPC has recommended that the bankruptcy  court approve the legal costs requested in the applications submitted to the  bankruptcy court. SIPC senior management told us that the statute  requires the court to defer to SIPC’s judgment on the appropriateness of  expenses because it is SIPC that faces the economic risk of covering the  costs in situations where SIPC does not expect recoveries to be sufficient  to recoup its advances. For the first seven rounds of approved cost  applications to date, the bankruptcy court has approved all of the legal  compensation and expense requests submitted by SIPC for the Trustee  and trustee’s counsel. Although the court has been obliged to approve the  cost applications because the two conditions have been met, the judge has  said in hearings on the applications that notwithstanding the statutory  requirement, he would nevertheless approve the costs on the basis of the  work performed.
Although SEC has oversight authority over SIPC, it does not have a direct  role in approving costs incurred in any particular SIPC liquidation.  Instead, fee exams typically take place as part of its general examinations  of SIPC, and SEC officials told us they plan a review of Trustee and  trustee’s counsel costs in coming months. In a March 2011 report, the  SEC Inspector General noted that the Madoff and Lehman Brothers  cases—the two largest liquidations in SIPC history—had focused new  attention on concerns about the amount of trustee fees. The report made  recommendations to improve SEC’s oversight of SIPC liquidation costs.  For example, the report recommended that SEC encourage SIPC to  negotiate more vigorously with court-appointed trustees to obtain fee  reductions greater than 10 percent and to develop a more regular process  for monitoring SIPC’s oversight of costs, rather than relying on  examinations that do not occur regularly. The report also asked SEC to  assess whether SIPA should be modified to allow bankruptcy judges  presiding over SIPA liquidations to assess the reasonableness of  administrative costs in cases in which SIPC pays the costs. The  respective units of SEC indicated they concurred with these  recommendations, and SEC officials told us that formal responses are  being prepared.
section_title: SIPC, SEC, and the Bankruptcy Court Have Been Satisfied That the Trustee Has Made Sufficient Disclosures
paragraphs: Trustees for SIPA liquidations generally have the same duties as trustees  for liquidations under chapter 7 of the Bankruptcy Code. Under this  chapter, a trustee must make certain information disclosures, including:  furnishing information about the estate and the estate’s administration  as requested by parties in interest, unless such disclosure is restricted  by a court order; providing periodic reports and summaries of the operation of the  bankrupt firm if it continues operating; and making a final report and filing a final account of the administration of  the estate with the court and with the U.S. trustee.
SIPA directs a trustee to make the disclosures required under chapter 7  but also directs a trustee to include in such reports information on  progress made in distributing cash and securities to customers. In  addition, SIPA directs the trustee to promptly investigate the acts,  conduct, property, liabilities, and financial condition of the firm being  liquidated and report this information to the court. The trustee must also  report to the court any facts learned by the trustee regarding fraud,  misconduct, mismanagement, and irregularities, and any causes of action  available to the estate as a result; and, as soon as practical, submit a  statement of the investigation.
subsections: section_title: The Trustee Has Disclosed Information in Variety of Ways
paragraphs: Through a variety of means, the Trustee has made disclosures that  address the statutory requirements. As of January 2012, the Trustee had  issued six interim reports to the bankruptcy court that outline progress  made in liquidating the Madoff firm. These interim reports have been filed  approximately every 6 months. The first report, filed in July 2009, gave  the status of the Trustee’s activities in administering the estate, his  progress in addressing customer claims, and results to date from his  investigation of the Madoff firm’s activities. The report also included a  discussion of Madoff’s fraudulent scheme, including his admitting to  soliciting billions of dollars under false pretenses and failing to invest  customer funds as promised. The Trustee said that extensive  investigation of the firm’s financial affairs inside and outside the United  States revealed “a labyrinth of interrelated international funds, institutions,  and entities of almost unparalleled complexity and (breadth).” The  Trustee also noted that he was providing information to, and coordinating  efforts with, other parties investigating the firm, including SEC, the  Federal Bureau of Investigation, the U.S. Attorney’s Office, and other  regulators. The Trustee’s other five interim reports provide information on  similar issues, including the status of the investigations.
The Trustee has also provided various records to the court, as part of  litigation involving his activities, which provide disclosures of the type  required under the Bankruptcy Code and SIPA. For example, in a motion  filed in October 2009 asking the bankruptcy court to affirm the use of NIM  in determining customer claims, he included the report of a consultant  hired to review the Madoff firm’s activities in detail. This report  described, among other things, how little trading was done as part of the  investment advisory business, and it also included statements from a  Madoff firm employee who admitted to creating fake investment positions  that were reported to customers on their statements.
The Trustee also has provided information to individual Madoff  customers. To address customer claims, the Trustee told us that he  provided determination letters to Madoff customers, showing individual  account transactions and how net equity for their accounts was  determined. For customers with questions about their claims  determinations, the trustee’s counsel was available to provide additional  information, which in some cases, involved sharing information contained  in the records maintained by the Madoff firm. The Trustee has also  provided information to former Madoff account holders seeking  information necessary for tax returns or for filing fraud claims under  homeowner’s insurance coverage. The Trustee told us he has not  provided information about the fraud in general because individual  customers do not need such information to have their claims processed.
To facilitate access to customer records, the Trustee has created an  “electronic data room.” Initially, access was limited to customers sued by  the Trustee that were determined to be net winners—those who withdrew  more than they invested—and who were deemed to have acted in good  faith without knowledge of the fraudulent nature of the firm’s activities. In  January 2012, the bankruptcy court judge granted a motion by the  Trustee to expand access to the data room to attorneys for nongood faith  defendants with whom the Trustee is in litigation.
In addition, the Trustee maintains a public website that contains a large  volume of information about the case. It includes a timeline of the  liquidation and provides data on the amount of customer assets  recovered, amounts distributed to customers, and amounts committed by  SIPC to date. The website also includes more than 600 selected court  filings, which are provided in a searchable database with the original  documents available for download. These documents date to the start of  the Madoff liquidation in December 2008. All six interim reports filed by  the Trustee, plus amendments, are included. In addition, the website  provides information on the claims process, including links to SIPA, SIPC,  and orders of the bankruptcy court. The website also has a page for the  Trustee’s hardship program, under which the Trustee does not seek to  recover assets from customers suffering from particular financial or other  hardships.
Recently, expert reports produced as part of the Trustee’s investigation  have been made public, which the Trustee said contain extensive details  on proof of fraud at the Madoff firm and its subsequent insolvency.
section_title: Although Some Have Sought Additional Trustee Disclosures, SIPC, SEC, and the Bankruptcy Court Say Information Released Has Been Sufficient
paragraphs: Although some parties have argued that the Trustee’s disclosures have  not met statutory requirements, SIPC and SEC officials told us they view  the Trustee’s disclosures to date as sufficient. SIPC senior management  told us that early in the case, the Trustee did not release many details, to  avoid tipping off potential civil and criminal defendants that would become  target of legal actions. More recently, according to SIPC, as that concern  eased, the Trustee has been doing an exemplary job in releasing  information relevant to account holders and the public. SIPC senior  management told us they expect the Trustee will file a complete report of  his investigative activities after officials are satisfied that legal actions and  investigations will not be endangered. While the Trustee has not yet  issued such a report, complaints filed in the case provide a considerable  amount of information that will eventually be released, they said. SEC  officials also told us that while the statute provides no standards for the  extent of disclosures that must be made, the Trustee has made  considerable information available, which appears to be complete for the  relevant topics.Trustee has made, but there has been no lack of information about them.
The officials said some may not like decisions the  An attorney representing former Madoff customers offered a different  view to us, saying the Trustee has not provided information critically  important for account holders making claims and those who are the  subject of clawback actions by the Trustee. In particular, according to the  attorney, while the Trustee has asserted that all reported trading activity  was fictitious, and that the Madoff investment advisory arm operated  independently from the rest of the Madoff firm, that cannot be established  from information released thus far. The attorney told us he believed that  more complete disclosure would show at least some legitimate trading  activity on behalf of customers, which is important because investment  returns from that activity would affect claims determination and what  amounts the Trustee could seek to claw back.
In April 2010, attorneys representing various Madoff customers filed a  motion with the bankruptcy court to compel additional disclosures by the  Trustee, arguing that reports filed “discuss the nature of his investigation  in sweeping terms, with a bare minimum of detail and only conclusory  statements about what has actually been uncovered.” However, the  Trustee told us he believes he has made great efforts to respond to the  public, noting his interim reports, a recent redesign of the website, and his  attempts to update case statistics at least every couple of weeks. By  contrast, he said in a typical chapter 7 bankruptcy case, the only  information available would be documents filed with the court. According  to the Trustee, there is no information, other than litigation-related, that  individual account holders might want but have not been able to get.
In his brief opposing the customers’ motion to compel additional reporting,  the Trustee said that in his many filings seeking recovery of customer  assets, he has detailed the Madoff fraud and identified those he alleges  were involved or knew of the fraud. He argued that the customers seeking  additional disclosure were seeking to sidestep the Federal Rules of Civil  Procedure and Bankruptcy Procedure that govern disclosure in litigation.  These rules, covering what is known as the “discovery process,” address  matters such as parties making inquiries of each other and requests for  the production of documents. As litigation proceeds, customers seeking  greater disclosure will receive information through the discovery process  and will have opportunity to access and challenge the Trustee’s evidence,  according to the Trustee. The attorney representing former Madoff  customers, however, told us that while the discovery process will provide  an opportunity for disclosure of some information, that process will be  prohibitively expensive for many customers, and in any case, is not likely  to develop case-wide information of value to all customers.
The bankruptcy judge denied the customers’ motion to compel additional  disclosures from the Trustee, calling the action a discovery dispute, rather  than a failure by the Trustee to follow the statute. He said the Trustee has  satisfied his disclosure obligations under SIPA and the Bankruptcy Code  “by creating a thorough and specific record regarding Madoff’s fraud.”  Affirming the Trustee’s position, the judge said the demands will be  satisfied during court-regulated discovery as litigation proceeds. The  customers filed a motion for leave to appeal the bankruptcy court ruling,  which the district court denied.
section_title: Conclusions
paragraphs: When a broker-dealer firm fails, and large sums of customer assets could  be at risk, SIPC must move quickly to appoint a trustee and trustee’s  counsel in order to safeguard those assets and to maximize the possibility  of any recoveries for customers. Toward that end, SIPC maintains an  informally assembled roster of candidates, and its senior management  confers before the SIPC president uses his professional judgment to  select a trustee. In the Madoff fraud, SIPC moved to appoint a trustee and  trustee’s counsel within hours after Madoff was taken into custody.
Notwithstanding the need to move quickly, however, our review identified  two areas in which SIPC’s selection process could be improved. First,  while SIPC seeks to identify potential trustees for its liquidations, it lacks a  formal, documented outreach procedure for identifying those candidates.  Although SIPC believes the field of broker-dealer bankruptcy is  sufficiently small that the relevant parties are known, undertaking  additional efforts to more systematically identify candidates would help  ensure that the range of choices reflects the widest capabilities available  in the most cost-effective fashion. Such outreach efforts could be tailored  for SIPC’s purposes, so that they are not excessively time-consuming or  resource-intensive. Second, while SIPC draws on the experience and  expertise of its senior management in selecting trustees, that process,  including criteria for selection, is not documented or transparent. This lack  of transparency can contribute to questions and concerns about SIPC’s  decisions. Better documentation of the selection process and criteria  could help address some of these concerns.
section_title: Recommendations for Executive Action
paragraphs: To help ensure that the pool of providers that could be employed in SIPC  liquidations is as broad as reasonably possible, and to improve the  transparency of SIPC’s selection of trustee and trustee’s counsel for  liquidations, the SEC Chairman should take the following two actions:  1.  Advise SIPC to document its procedures for identifying candidates for  trustee or trustee’s counsel, and in so doing, to assess whether  additional outreach efforts should be adopted and incorporated.  2.  Advise SIPC to document its procedures and criteria for appointment  of a trustee and trustee’s counsel for its cases.
section_title: Agency and Third Party Comments and Our Evaluation
paragraphs: We provided a draft of this report to SEC, SIPC, and the Trustee for their  review and comment, and we received written comments from SEC and  SIPC, which are reprinted in appendixes IV and V, respectively. In their  comments, SEC and SIPC concurred with our recommendations. The  director of SEC’s Division of Trading and Markets said the division will  recommend that the SEC Chairman implement our recommendations.  The SIPC President said SIPC will make plans to implement them  immediately. Regarding documenting and assessing its outreach efforts  for identifying trustee and trustee’s counsel candidates, the SIPC  President said such efforts may lead to expansion of its file of potential  service providers and thus allow SIPC to choose from a broader base. To  achieve this, he indicated SIPC will explore expanding SIPC’s contacts  with relevant professional organizations, to locate qualified people and  firms that SIPC has not previously encountered. Regarding documenting  the process by which SIPC designates a trustee and trustee’s counsel,  the SIPC President’s letter indicated that there is nothing in our  recommendation that would delay or slow SIPC’s progress, and that the  need for transparency can be achieved as well. The SIPC President also  said that in implementing both recommendations, SIPC will consult with  SEC. SIPC, SEC, and the Trustee also 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, 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 VI.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: This report discusses (1) how the Trustee and trustee’s counsel were  selected for the Bernard L. Madoff Investment Securities, LLC liquidation;  (2) the process and reasoning for the selection of “net investment  method” (NIM) in determining customer claims arising from the Madoff  fraud; (3) the costs of the subsequent liquidation of the Madoff firm; and  (4) the information that the Trustee has disclosed about his investigation  and activities.
To examine how the Trustee and trustee’s counsel were selected for the  Madoff liquidation, we reviewed the requirements of the Securities  Investor Protection Act (SIPA) for the selection of a trustee, plus court  filings, correspondence and records of the Securities Investor Protection  Corporation (SIPC), Standards for Internal Control in the Federal  Government, the Internal Control – Integrated Framework of the  Committee of Sponsoring Organizations of the Treadway Commission,  biographical information for the Trustee, and relevant portions of the  Bankruptcy Code. We also interviewed SIPC senior management,  officials of the Securities and Exchange Commission (SEC) and the SEC  Office of Inspector General (SEC IG), and the Trustee and members of  the trustee’s counsel law firm.
To examine the process and reasoning for the selection of NIM, we  reviewed court filings, in particular those related to the Madoff fraud; and  the Trustee’s determination to use NIM, as well as a subsequent challenge  to that decision. We examined SIPC correspondence and records,  including information on open and closed SIPC cases (Ponzi scheme  cases in particular), and customer claims under NIM and the final  statement method (FSM). We also reviewed SIPC rules, annual reports,  and board meeting minutes. We reviewed SEC correspondence and  records, including consideration of net equity methods, arguments  presented to the agency in support of FSM, and commission meeting  minutes. We reviewed findings of the SEC IG. Additionally, we interviewed  SIPC senior management, SEC officials, the SEC Inspector General, and  the Trustee and members of the trustee’s counsel law firm.
To examine the costs of the Madoff liquidation, we analyzed cost  information from interim reports submitted by the Trustee to the  bankruptcy court, covering the period from December 2008 to September  2011; cost requests submitted by the Trustee and trustee’s counsel for  approval by the bankruptcy court, covering the period from December  2008 through May 2011; and other records. We discussed with the  Trustee, trustee’s counsel, and SIPC their process for verifying costs  submitted. Because this cost information is prepared for or approved by  the bankruptcy court, we determined that no additional steps were  necessary to assess its reliability and that this data was sufficiently  reliable for our purposes of identifying total costs, cost components, and  trends. We also reviewed SIPA provisions related to review and approval  of legal costs, and SIPC guidance on trustee compensation and review of  liquidation costs. We reviewed an American Bar Association model rule  on the reasonability of legal fees, and an SEC IG report on SEC’s  oversight of SIPC costs. In addition, we interviewed SIPC senior  management, SEC officials, the SEC IG, and the Trustee and members  of the trustee’s counsel law firm generally on the topic of Madoff  liquidation costs.
To examine what information the Trustee has disclosed about his  investigation and activities, we reviewed SIPA’s disclosure requirements  and the duties of trustees under chapter 7 of the Bankruptcy Code. We  also reviewed court filings related to the Trustee’s disclosures of  information and his interim reports. We examined information the Trustee  has made public about the investigation, including material on his  website. In addition, we interviewed SIPC senior management, SEC  officials, and the Trustee and members of the trustee’s counsel law firm.
We conducted this performance audit from October 2011 to March 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: Securities Investor Protection Corporation Fund Assessments and Balances, 1990 to 2010
paragraphs: Since 1990, the Securities Investor Protection Corporation (SIPC) has  assessed its member broker-dealers varying rates to support the fund  used to protect customers of failed securities firms. Over this period,  members have paid assessments to the fund based on different  percentages of either their gross revenues or net operating revenues, or  have paid a flat-rate amount.
section_title: Appendix III: Legal Appendix on Determination of Net Equity
paragraphs: Customer claims in a Securities Investor Protection Act (SIPA) liquidation  are based on customers’ “net equity” as of the filing date (Dec. 11, 2008,  in the Madoff case). The statute generally provides that net equity is what  would have been owed to the customer if the broker-dealer had liquidated  the customer’s “securities positions,” less any obligations of the customer  to the firm. Overall, each customer’s net equity determines the value of  each claim. In particular, it determines their pro rata share from the  customer property portion of the insolvent broker-dealer’s estate, as well  as the amount of any advance payment from the Securities Investor  Protection Corporation (SIPC) fund to which the customer may be  entitled.
The Trustee chose the “net investment method” (NIM), which focuses on  investments made and not profits reported, to determine net equity.  Claimants challenged the method, and it was upheld first by the U.S.  Bankruptcy Court for the Southern District of New York. Court of Appeals for the Second Circuit affirmed the bankruptcy court  decision.the positions of the other parties, and the two judicial decisions.
Later, the U.S.
subsections: section_title: The Parties Advocated for Two Different Net Equity Methods, and the Trustee Determined That NIM Was Proper
paragraphs: The issue of how to determine net equity in the Madoff case primarily  involved a choice between two methods with different impacts on the two  main classes of customers. As is generally true of Ponzi scheme frauds,  the Madoff claimants were “net winners” or “net losers.” The net winners  were those customers who had withdrawn the full cash amount they had  invested in the Madoff firm before its collapse, plus some “profit” (that is,  fictitious gains that actually came from funds provided for investment by  others). The net losers were customers who had paid in more than they  had withdrawn at the time the Madoff firm collapsed.
Securities Investor Protection Corp. v. Bernard L. Madoff Investment Securities LLC (In re  Bernard L. Madoff Investment Securities LLC), 424 B.R. 122 (Bankr. S.D.N.Y. 2010).
The two competing methods for calculating net equity were NIM and the  “final statement method” (FSM). NIM calculates what customers are  owed as the amounts they invested, less amounts withdrawn. FSM  calculates net equity based on the amounts shown as customers’  securities positions on the last statements received from the broker- dealer firm; in the Madoff case, as of November 30, 2008.
SIPC and the Securities and Exchange Commission (SEC) both  supported the Trustee’s selection of NIM. for use of FSM. These claimants, most of whom were net winners,challenged the Trustee’s choice of NIM.
section_title: Both Sides Claimed the Law Supported Their Position
paragraphs: The legal arguments of the parties are reflected in the bankruptcy court  and Court of Appeals opinions. In addition, the bankruptcy court opinion  included an exhibit that outlined the competing arguments in detail.
The issue of how to determine net equity in the Madoff case turned on  two key SIPA provisions: One is the definition of “net equity” in section  16(11) of the act, which generally requires the trustee to determine a  customer’s net equity by “calculating the sum which would have been  owed by the  debtor to such customer if the debtor had  liquidated, by sale or purchase on the filing date . . . all securities  positions of such customer . . . minus . . . any indebtedness of such  customer to the debtor on the filing date . . .” (emphasis added).
SEC’s position differed from the Trustee’s in one respect. SEC advocated adding an  inflation adjustment to customers’ NIM claims, to compensate them for the time value of  their money. It referred to this as the “constant dollar approach.” See 424 B.R. at 125, n.  8. Neither the bankruptcy court nor the Court of Appeals have addressed the merits of the  SEC position thus far.
The other is section 8(b) of the act, which requires the Trustee to  determine net equity claims “insofar as such obligations are ascertainable  from the books and records of the debtor or are otherwise established to  the satisfaction of the trustee.”
The Trustee, supported by SIPC and SEC, took the position that because  the statements customers received from the Madoff firm were fictitious,  they did not show “securities positions” that could be relied upon for  purposes of the net equity determination. Instead, the only Madoff firm  records that reflected reality were those recording the cash deposits and  withdrawals of customers. Thus, the Trustee argued, the plain language  of section 8(b) required the trustee to determine net equity based on  these records, since they provided the only obligations that could be  established from the Madoff firm’s books and records. Accordingly, in his  view, NIM was the only legally permissible option.
The Trustee also contended that fairness considerations strongly  supported use of NIM. Using FSM would exacerbate Madoff’s fraud and  enable some Madoff customers to retain “profits” that were in reality the  misappropriated investments of other customers. Moreover, FSM would  divert the limited customer assets available in the bankrupt estate by  paying imaginary “profits” at the expense of reimbursing real losses. The  Trustee also argued that using FSM could conflict with his obligation to  recover the fictitious profits paid out by the Madoff firm through avoidance  actions. “What The Customer Gets. A customer generally expects to receive what he believes  is in his account at the time the stockbroker ceases business. But because securities  may have been lost, improperly hypothecated, misappropriated, never purchased or  even stolen, this is not always possible. Accordingly, when the customer claims for a  particular stock exceed the supply available to the trustee in the debtor’s estate, then  customers generally receive pro rata portions of the securities claims, and as to any  remainder, they will receive cash based on the market value as of the filing date.”
FSM advocates also argued that the profits Madoff reported, while  fictitious, may have been withdrawn and spent years ago; that customers  paid taxes on them; and they may have foregone other investment  opportunities in reliance on investment results shown in their statements.
Furthermore, they maintained that, at least in the case of advances from  the SIPC fund, use of FSM would not limit payments to reimburse net  losers for their losses. They viewed the SIPC fund as a payment source  for customer claims that operated separately and independently from any  customer assets in the bankrupt estate. Thus, all claimants, both net  winners and losers, could potentially receive up to $500,000 from the  SIPC fund without any decrease in customer property.
Finally, both sides contended that judicial precedent dealing with SIPA  liquidations involving Ponzi scheme cases (discussed in the following  section) supported their calculation method.
section_title: The Bankruptcy Court Affirmed the Trustee’s Selection of NIM
paragraphs: “The Court recognizes that the application of the Net Equity definition to the complex  and unique facts of Madoff’s massive Ponzi scheme is not plainly ascertainable in law.  Indeed, the parties have advanced compelling arguments in support of both positions.  Ultimately, however, upon a thorough and comprehensive analysis of the plain  meaning and legislative history of the statute, controlling Second Circuit precedent, and  considerations of equity and practicality, the Court endorses the Trustee’s Net  Investment Method.”
Specifically, the court agreed with the Trustee that sections 16(11) and  8(b) of the act must be read together, so that net equity can be based on  “securities positions” only to the extent that securities positions are  “ascertainable from the books and records of the debtor” or “otherwise  established to the satisfaction of the trustee.” The court further agreed  that in a Ponzi scheme case like the Madoff fraud, where no securities  were ever ordered or acquired, securities positions did not exist, and the  Trustee cannot satisfy claims by relying upon fictitious account  statements that provided fictitious securities positions. Instead, only cash  deposits and withdrawals were verifiable from the books and records of  the Madoff firm. based on false account statements “do not apply where they would give  rise to an absurd result.”
Id. at 135. “SIPC payments therefore serve only to replace missing customer property and cannot  be ascertained independently of the determination of the customer’s pro rata share of  customer property. Accordingly, the SIPA statute does not allow bifurcation of the  claims process, with customers recovering SIPC payments based on the   Statement Method, and recovering customer property shares based on the Net  Investment Method.” “While the Court recognizes that the outcome of this dispute will inevitably be  unpalatable to one party or another, notions of fairness and the need for practicality  also support the Net Investment Method.”  “As distribution of customer property to the ‘equally innocent victims’ of Madoff’s fraud  is a zero-sum game, equity dictates that the Court implement the Net Investment  Method. Customer property consists of a limited amount of funds that are available for  distribution. Any dollar paid to reimburse a fictitious profit is a dollar no longer available  to pay claims for money actually invested. If the  Statement Method were  adopted, Net Winners would receive more favorable treatment by profiting from the  principal investments of Net Losers, yielding an inequitable result.”424 B.R. at 134.
The bankruptcy court also agreed with the Trustee that NIM was more  compatible with trustee avoidance powers under the Bankruptcy Code. “The Trustee relies on numerous cases, all holding that transfers made in furtherance  of a Ponzi scheme, and specifically transfers of fictitious profits, are avoidable. The Net  Investment Method harmonizes the definition of Net Equity with these avoidance  provisions by similarly discrediting transfers of purely fictitious amounts and unwinding,  rather than legitimizing, the fraudulent scheme. The  Statement Method, by  contrast, would create tension within the statute by centering distribution to customers  on the very fictitious transfers the Trustee has the power to avoid.”
Finally, the bankruptcy court concluded that judicial precedent involving  Ponzi scheme cases, including In re New Times Securities Services, Inc.,  supported use of NIM in the Madoff liquidation.  New Times also  concerned a SIPA liquidation arising out of a Ponzi scheme fraud.
In New Times, some investors (known as “real securities claimants”) had  been offered shares in real mutual funds, which the Ponzi schemer- debtor never purchased. Other investors (known as “fake securities  claimants”) purchased shares in fictitious money market funds with  fictitious names. The debtor generated monthly statements for both sets  of investors that showed fictitious securities positions as well as interest  and dividend earnings. The SIPA trustee in New Times treated the two  sets of investors differently. He determined that for those investors whose  fictitious statements reflected the purchase of real securities, their net  equity for purposes of the act should be based on the positions shown in  their statements—that is, he applied FSM. (This treatment was not before  the court in New Times.) However, the trustee determined that for  investors whose statements reflected earnings from the entirely fictitious  funds, their net equity was limited to their initial investments—that is, he  applied NIM to them.
371 F.3d 68 (2d Cir. 2004). This decision is often referred to as “New Times I” because  of a somewhat related subsequent decision, In re New Times Securities Services, Inc.,  463 F.3d 125 (2d Cir. 2006) (“New Times II”).
The fake securities claimants appealed the trustee’s determinations to the  federal district court. The district court sided with the investors, holding  that their net equity should be calculated using FSM, recognizing the  fictitious interest and dividend reinvestment earnings shown on their  statements. The SIPA trustee then appealed the district court’s decision.  SEC joined SIPC in maintaining that NIM should be used to determine the  fictitious fund investors’ net equity.
On appeal, the Court of Appeals for the Second Circuit endorsed the joint  position of SIPC and SEC that net equity of the fake securities claimants  should be based solely on their initial investments, excluding imaginary  interest and dividends shown on the statements. The appeals court  agreed that basing recoveries on fictitious interest and dividend amounts  would be “irrational and unworkable.”
In the Madoff litigation, both parties argued that New Times supported  their position. The Madoff net winners argued they should be compared to  the first group of New Times customers, who were supposedly invested in  real mutual funds, because Madoff’s account statements showed  positions in real securities. Because the real securities claimants in New  Times had their net equity calculated by FSM, Madoff net winners argued  they should likewise have their net equity calculated by FSM.
Instead, the bankruptcy court endorsed the position of the Trustee, SIPC,  and SEC by analogizing Madoff net winners to the fake securities  claimants in New Times with their fictitious holdings, which led to NIM as  the appropriate method by which to calculate their net equity. The court  explained that the key precedent set by New Times regarding net equity  analysis is that customer recovery cannot be based on account  statements that contain numbers with no relation to reality, whether the  securities are identifiable by name (as in Madoff) or not (as in New  Times).court stated, would create “the absurdity of ‘duped’ investors reaping   Reliance on fraudulent promises in account statements, the  windfalls as a result of fraudulent promises.” The court also noted that  the initial investments of real securities claimants in New Times were  sufficient to acquire their initial securities, and subsequent statements  listing earnings reflected actual market events. By contrast, initial  investments by Madoff investors were “insufficient to acquire their  purported securities positions, which were made possible only by virtue of  fictitious profits . . .  account activity was manipulated with the benefit  of deliberately calibrated hindsight.”
section_title: The Court of Appeals Affirmed the Bankruptcy Court’s Decision
paragraphs: “Mr. Picard’s selection of the Net Investment Method was more consistent with the  statutory definition of ‘net equity’ than any other method advocated by the parties or  perceived by this Court. There was therefore no error. . . . The statutory definition of  ‘net equity’ does not require the Trustee to aggravate the injuries caused by Madoff’s  fraud. Use of the  Statement Method in this case would have the absurd effect of  treating fictitious and arbitrarily assigned paper profits as real and would give legal  effect to Madoff’s machinations.”  654 F.3d at 235. “In holding that it was proper for Mr. Picard to reject the  Statement Method, we  expressly do not hold that such a method of calculating ‘net equity’ is inherently  impermissible. To the contrary, a customer’s last account statement will likely be the  most appropriate means of calculating ‘net equity’ in more conventional cases. We  would expect that resort to the Net Investment Method would be rare because this  method wipes out all events of a customer’s investment history except for cash  deposits and withdrawals. The extraordinary facts of this case make the Net  Investment Method appropriate whereas in many instances, it would not be. The   Statement Method, for example, may be appropriate when securities were actually  purchased by the debtor, but then converted by the debtor.”
The Court of Appeals also rejected the FSM advocates’ characterization  of SIPA as providing “an insurance guarantee of the securities positions  set out in their account statements” which should “operate to make them  whole from the losses they incurred as a result of Madoff’s dishonesty.”
On the contrary, the Court of Appeals observed that SIPA did not  necessarily protect against all forms of fraud committed by brokers or  insure investors against all losses.
section_title: Legal Issues Remain
paragraphs: The U.S. Court of Appeals for the Second Circuit has affirmed the  Trustee’s use of NIM, but several legal issues remain. Courts have yet to  rule on whether calculations of net equity under NIM should include an  adjustment for inflation. A ruling supporting this “constant dollar” approach  would stand to affect liquidation payouts for a significant number of  Madoff customers. In addition, the Trustee is pursuing a large number of  actions against Madoff net winners—known as clawbacks or avoidance  actions—seeking to recover assets they received that exceeded their  investments. The outcome of these actions likewise will affect liquidation  payouts to Madoff customers. Finally, petitions seeking review of the  appeals court’s net equity ruling have been filed with the U.S. Supreme  Court.
Id. at 239.
section_title: Appendix IV: Comments from the Securities and Exchange Commission
section_title: Appendix V: Comments from the Securities Investor Protection Corporation
section_title: Appendix VI: 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; Rachel DeMarcus; Dean P. Gudicello; Daniel S. Kaneshiro;  Jonathan M. Kucskar; Marc W. Molino, Barbara M. Roesmann; and  Christopher H. Schmitt made major contributions to this report.