oversight

Securities Investor Protection Corporation: Interim Report on the Madoff Liquidation Proceeding

Published by the Government Accountability Office on 2012-03-07.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

             United States Government Accountability Office

GAO          Report to Congressional Requesters




March 2012
             SECURITIES
             INVESTOR
             PROTECTION
             CORPORATION
             Interim Report on the
             Madoff Liquidation
             Proceeding




GAO-12-414
                                              March 2012

                                              SECURITIES INVESTOR PROTECTION
                                              CORPORATION
                                              Interim Report on the Madoff Liquidation
Highlights of GAO-12-414, a report to
                                              Proceeding
congressional requesters




Why GAO Did This Study                        What GAO Found
With the collapse of Bernard L. Madoff        The Securities Investor Protection Corporation (SIPC) generally followed its past
Investment Securities, LLC—a broker-          practices in selecting the trustee for the Madoff liquidation. SIPC maintains a file
dealer and investment advisory firm           of trustee candidates from across the country, but given the anticipated
with thousands of clients—Bernard             complexities of the case, officials said the field of potential qualified trustees was
Madoff admitted to reporting $57.2            limited. SIPC has sole discretion to appoint trustees and, wanting to act quickly,
billion in fictitious customer holdings.      SIPC senior management considered four trustee candidates. After three of the
The Securities Investor Protection            four candidates were eliminated for reasons including having a conflict of interest
Corporation (SIPC), which oversees a          or ongoing work on a large financial firm failure, SIPC selected Irving H. Picard,
fund providing up to $500,000 of
                                              who has considerable securities and trustee experience. However, SIPC has not
protection to qualifying individual
                                              documented a formal outreach procedure for identifying candidates for trustee
customers of failed securities firms,
selected a trustee to liquidate the
                                              and trustee’s counsel, or documented its procedures and criteria for selecting
Madoff firm and recover assets for its        persons for particular cases, as internal control standards recommend. Having
investors. The method the Trustee is          such documented procedures could allow SIPC to better assess whether it has
using to determine how much a                 identified an optimal pool of candidates, and to enhance the transparency of its
customer filing a claim could be eligible     selection decisions.
to recover—an amount known as “net            A key goal of broker-dealer liquidations is to provide customers with the
equity”—has been the subject of               securities or cash they had in their accounts. However, because the Trustee
dispute and litigation. This report
                                              determined that amounts shown on Madoff customers’ statements reflected
discusses (1) how the Trustee and
                                              years of fictitious investments and profits, he chose to determine customers’ net
trustee’s counsel were selected, (2)
why the method for valuing customer           equity using the “net investment method” (NIM), which values customer claims
claims was chosen, (3) costs of the           based on amounts invested, less amounts withdrawn. SIPC senior management
liquidation, and (4) disclosures the          and officials of the Securities and Exchange Commission (SEC)—which
Trustee has made about its progress.          oversees SIPC—initially agreed on the appropriateness of NIM. Over the course
GAO examined the Securities Investor          of 2009, however, SEC officials continued to consider alternative approaches for
Protection Act; court filings and             reimbursing customers. Although some customers have challenged the
decisions; and SIPC, Securities and           Trustee’s use of NIM, two courts have held that the Trustee’s approach is
Exchange Commission (SEC), and                consistent with the law and with past cases, with both courts indicating that using
Trustee reports and records. GAO              the values shown on customers’ final statements would effectively sanction the
analyzed cost filings and interviewed         Madoff fraud and produce “absurd” results. In November 2009, SEC
SIPC, SEC, and SEC Inspector                  commissioners voted to support the use of NIM, but with an adjustment for
General officials, and the Trustee and        inflation, in an approach known as the “constant dollar” method. However, after
his counsel.                                  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
What GAO Recommends
                                              the constant dollar approach. The matter is currently pending.
SEC should advise SIPC to
(1) document its procedures for               As of October 2011, costs of the Madoff liquidation reached more than $450
identifying candidates for trustee or         million, and the Trustee estimates the total costs will exceed $1 billion by 2014.
trustee’s counsel, and in so doing, to        Legal costs, which include costs for the Trustee and the trustee’s counsel, are
assess whether additional outreach            the largest category. While the estimated total cost for the Madoff liquidation is
efforts should be incorporated, and           double the total for all completed SIPC cases to date, the Trustee, SIPC, and
(2) document a process and criteria for       SEC note that the costs reflect the unprecedented size, duration, and complexity
appointment of a trustee and trustee’s        of the Madoff fraud. SIPC senior management also said the liquidation costs are
counsel. SEC and SIPC concurred with          justified, as litigation the trustee has pursued has produced $8.7 billion in
our recommendations.                          recoveries for customers to date. Through various reports, court filings, and a
                                              website, the Trustee has disclosed information about the status of the liquidation.
View GAO-12-414. For more information,
contact A. Nicole Clowers at (202) 512-8678   SIPC senior management, SEC officials, and the U.S. Bankruptcy Court have
or clowersa@gao.gov.                          concluded that the Trustee’s disclosures sufficiently address the requirements for
                                              disclosure under the Bankruptcy Code and the Securities Investor Protection Act.
                                                                                        United States Government Accountability Office
Contents


Letter                                                                                 1
               Background                                                              3
               SIPC Says It Followed Its Normal Process in Selecting the Trustee,
                 but Lacks Documented Procedures and Formal Outreach                   9
               SIPC and SEC Have Supported, and Courts Have Affirmed, the
                 Trustee’s Use of the Net Investment Method                           16
               Cost of the Madoff Liquidation Will Be the Largest to Date, with
                 Efforts to Recover Assets Driving Costs                              31
               SIPC, SEC, and the Bankruptcy Court Have Been Satisfied That the
                 Trustee Has Made Sufficient Disclosures                              48
               Conclusions                                                            52
               Recommendations for Executive Action                                   53
               Agency and Third Party Comments and Our Evaluation                     53

Appendix I     Objectives, Scope, and Methodology                                     55



Appendix II    Securities Investor Protection Corporation Fund Assessments and
               Balances, 1990 to 2010                                                 57



Appendix III   Legal Appendix on Determination of Net Equity                          58



Appendix IV    Comments from the Securities and Exchange Commission                   68



Appendix V     Comments from the Securities Investor Protection Corporation           69



Appendix VI    GAO Contact and Staff Acknowledgments                                  72



Tables
               Table 1: The Trustee’s Experience in Previous SIPA Cases, from
                        1984 through 2005                                             14




               Page i                                                     GAO-12-414 SIPC
          Table 2: SIPA Liquidations Involving Ponzi Scheme Cases, from
                   1995 through 2012                                             19
          Table 3: Number of Accounts and Value of Claims under NIM and
                   FSM                                                           27
          Table 4: Approved Trustee-Related Legal Cost Requests, from
                   December 2008 through May 2011                                33
          Table 5: Total Hourly Billings for the Trustee and Trustee’s
                   Counsel, by Staff Category, from December 2008 through
                   May 2011                                                      34
          Table 6: Consultant Costs, May 2009 through September 2011             39
          Table 7: SIPC Fund Assessments and Balances, from 1990 to 2010         57


Figures
          Figure 1: SIPC Fund Balance, from 2000 through 2010                     5
          Figure 2: Key Events in the Madoff Liquidation, December 2008 to
                   January 2012                                                   9
          Figure 3: Total Costs of the Madoff Liquidation, by Type, as of
                   October 31, 2011                                              32
          Figure 4: Trustee’s Counsel Costs, by Category, from December
                   2008 through May 2011                                         35
          Figure 5: Partner Hours as a Percentage of Total Attorney Hours,
                   from December 2008 through May 2011                           36
          Figure 6: Distribution of Partner Work, by Hourly Billing Rate
                   Quintiles, from February 2011 through May 2011                38
          Figure 7: Total Costs as Percentage of Customer Recoveries for
                   Madoff and Completed SIPC Cases, for Selected Years
                   from 1979 to 2010, Ranked by Cost Percentage                  41




          Page ii                                                    GAO-12-414 SIPC
Abbreviations
ABA                      American Bar Association
Baker Hostetler          Baker & Hostetler LLP
FSM                      final statement method
NIM                      net investment method
SEC                      Securities and Exchange Commission
SEC IG                   Securities and Exchange Commission Office of
                         Inspector General
SIPA                     Securities Investor Protection Act of 1970
SIPC                     Securities Investor Protection Corporation
Treasury                 Department of the Treasury


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Page iii                                                                 GAO-12-414 SIPC
United States Government Accountability Office
Washington, DC 20548




                                   March 7, 2012

                                   The Honorable Scott Garrett
                                   Subcommittee on Capital Markets
                                     and Government Sponsored Enterprises
                                   Committee on Financial Services
                                   House of Representatives

                                   The Honorable Peter King
                                   House of Representatives

                                   The Honorable Carolyn McCarthy
                                   House of Representatives

                                   The Honorable Ileana Ros-Lehtinen
                                   House of Representatives

                                   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


                                   Page 1                                                        GAO-12-414 SIPC
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. 1 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. 2

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. 3 We analyzed
and summarized court decisions related to the Madoff liquidation and
selection of NIM. We also analyzed costs of the Madoff liquidation, as


1
 Avoidance, or clawback, actions enable a bankruptcy trustee to recover for the bankrupt
estate certain payments made by the debtor prior to the bankruptcy filing.
2
 We expect our future work will include, among other things, issues relating to customer
claims and the Trustee’s asset recovery actions.
3
 A Ponzi scheme is an investment fraud that involves the payment of purported returns to
existing investors from funds contributed by new investors.




Page 2                                                                   GAO-12-414 SIPC
             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.


             SIPC’s mission is to promote confidence in securities markets by seeking
Background   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. 4 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. 5 As of December 31, 2010,
             SIPC had 4,773 members.

             While SIPC is not a federal agency, it is subject to federal oversight.
             Under SIPA, SEC exercises what the U.S. Supreme Court has




             4
              The cash limitation amount is subject to potential adjustment for inflation every 5 years.
             According to SIPC, the $500,000 limit for securities, rather than the limit for cash, applied
             in the Madoff liquidation. At the start of the Madoff case, the cash protection limit was
             $100,000 per customer.
             5
              15 U.S.C. § 78ccc(a)(2)(A). This provision exempts certain categories of brokers and
             dealers, including those whose principal business is conducted outside of the United
             States.




             Page 3                                                                      GAO-12-414 SIPC
            recognized as “plenary,” or general, supervisory authority over SIPC. 6
            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. 7


SIPC Fund   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. 8

            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.



            6
                Securities Investor Protection Corporation v. Barbour, 421 U.S. 412, 417 (1975).
            7
             15 U.S.C. § 78ccc(c)(2). Three of the presidential appointees come from the securities
            industry. The other two are members of the general public not associated with the
            securities industry for at least 2 years preceding their appointment. The President
            designates the chair and vice chair from among the general public members.
            8
             In this report, we generally use “costs” to include fees, such as hourly billings for
            attorneys, as well as other expenses incurred.




            Page 4                                                                       GAO-12-414 SIPC
Figure 1: SIPC Fund Balance, from 2000 through 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
                                       flat $150 annual assessment per member firm. 9 Under the new levies, the
                                       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.




                                       9
                                        In March 2009, SIPC announced that it was increasing the assessment, effective April 1,
                                       2009, after determining, pursuant to SIPA and SIPC bylaws, that the fund balance was
                                       “reasonably likely” to remain less than $1 billion for at least 6 months.




                                       Page 5                                                                  GAO-12-414 SIPC
Liquidations under SIPA   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. 10 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,
                          SIPC itself, to liquidate the firm. 11 Under SIPA, SIPC has sole discretion
                          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




                          10
                             For SIPC to initiate a proceeding, at least one of the following other factors must exist:
                          (1) the firm must be insolvent under the Bankruptcy Code or unable to meet its obligations
                          as they become due; (2) the firm is subject to a court or agency proceeding in which a
                          receiver, liquidator, or trustee has been appointed; (3) the firm is not compliant with
                          applicable requirements under the Securities Exchange Act of 1934 or financial
                          responsibility rules of SEC or financial self-regulatory organizations; or (4) the firm is
                          unable to show compliance with such rules. In the smallest proceedings (in which, among
                          other factors, the claims of all customers are less than $250,000), SIPC may directly pay
                          customer claims without filing an application for a protective decree with a court and
                          without the appointment of a trustee.
                          11
                             Disinterested means, among other things, that the trustee has no outstanding financial
                          obligation with the failed firm or has not been employed or acted as attorney for the firm
                          within the last 2 years.




                          Page 6                                                                     GAO-12-414 SIPC
positions in liquidation proceedings. 12 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. 13

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



12
 See, for example, Securities Investor Protection Corp. v. Morgan, Kennedy & Co., Inc.,
533 F.2d 1314 (2d Cir. 1976); SEC v. Wick, 360 F. Supp. 312 (N.D. Ill. 1973); In re Bell
and Beckwith, 93 B.R. 569 (Bankr. N.D. Ohio 1988).
13
   15 U.S.C. § 78eee(b)(5)(A). In addition to the use of designated counsel, SIPA trustees
generally are authorized, with SIPC approval, to hire and fix the compensation of
personnel necessary to carry out liquidations, including officers and employees of the
debtor and its examining authority, as well as accountants, and to use the services of
SIPC employees. 15 U.S.C. § 78fff-1(a)(1), (2).




Page 7                                                                    GAO-12-414 SIPC
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.




Page 8                                                       GAO-12-414 SIPC
Figure 2: Key Events in the Madoff Liquidation, December 2008 to January 2012




                                        Note: Some amounts may be approximate.



                                        A SIPC liquidation of a member broker-dealer begins when either SEC or
SIPC Says It Followed                   a securities self-regulatory organization, such as the Financial Industry
Its Normal Process in                   Regulatory Authority, recommends that a firm’s failure may require SIPC
                                        assistance, usually because of theft or other misuse of customer assets
Selecting the Trustee,                  and insolvency. If SIPC’s president, general counsel, and vice president
but Lacks                               for operations agree that a case should be opened, the SIPC president
Documented                              requests authority from the SIPC board chair to begin the action.

Procedures and                          Upon receiving this authority, the SIPC president selects a trustee and
Formal Outreach                         trustee’s counsel after consultation within SIPC. According to SIPC senior
                                        management, the SIPC board does not vote on the selections. Instead,



                                        Page 9                                                      GAO-12-414 SIPC
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. 14 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. 15




14
   The statutory provision was adopted in 1978 amendments to SIPA, and SIPC supported
the change following inquiries from judges about whether the practice was permissible,
according to the SIPC President.
15
 According to SIPC senior management, it is important that SIPC attorneys be free to
express candid opinions on quality of services provided.




Page 10                                                                GAO-12-414 SIPC
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




Page 11                                                          GAO-12-414 SIPC
written manuals. 16 In the case of trustee selection, documented policies and
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.

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


16
   See GAO, Standards for Internal Control in the Federal Government, GAO/AIMD-00-
21.3.1 (Washington, D.C.: November 1999), and Committee of Sponsoring Organizations
of the Treadway Commission, Internal Control - Integrated Framework (1992).




Page 12                                                             GAO-12-414 SIPC
                          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. 17


The Trustee Has           The trustee that SIPC selected for the Madoff liquidation has considerable
Considerable Experience   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. 18 He has served as trustee’s counsel in two other cases. For his first
                          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.




                          17
                            SIPC senior management estimated that in SIPC’s 290 liquidations, 186 individuals
                          (excluding SIPC) have served as trustee or co-trustee, and at least 173 law firms have
                          served as trustee’s counsel. They also said that when the opportunity arises, SIPC
                          designates firms new to SIPA cases.
                          18
                             For example, according to SIPC senior management, the Madoff matter is SIPC’s
                          largest case as measured by missing assets and misstatement of customer assets, but is
                          not the largest by number of customers or size of bankruptcy filing.




                          Page 13                                                                 GAO-12-414 SIPC
Table 1: The Trustee’s Experience in Previous SIPA Cases, from 1984 through 2005

                                                                                                              Court-         Court-approved
                                        Number of            Customer     Cause of                   approved costs                 costs for
                                 Year   customers         distributions   firm’s failure                 for trustee       trustee’s counsel
Experience as SIPA trustee
Jay W. Kaufmann &                1984          1,019        $3,134,917    Financial distress                  $171,579                $128,903
Company
Norbay Securities, Inc.          1986          9,103        16,531,987    Financial distress                   256,555                      88,139
Investors Center Inc.            1989           700          2,462,389    Financial distress,                  516,586                 245,263
                                                                          failure to comply with
                                                                          regulatory standards
Faitos & Co., Inc.               1991            39          1,361,543    Misappropriation                     150,959                      39,000
U.S. Equity Management           1995            15            996,345    Diversion                            129,676                      37,039
Corp.
Hanover, Sterling & Co., Ltd.    1996           151          2,167,974    Unauthorized trading                 349,716                 300,627
Euro-Atlantic Securities, Inc.   1998            68          2,130,527    Unauthorized trading                 348,963                 212,877
Klein Maus & Shire, Inc.         2000            22          2,739,099    Unauthorized trading                 278,195                 275,460
Montrose Capital                 2001            10            917,146    Unauthorized trading                 239,716                 122,666
Management Ltd.
Park South Securities, LLC       2003            22          8,013,121    Conversion and                     1,077,996               2,843,040
                                                                          unauthorized trading
Experience as trustee’s counsel
John Franklin & Associates,      1986              3           980,568    Misappropriation                            —                     23,265
Inc.
Austin Securities, Inc.          2005            20          4,041,583    Unauthorized trading                        —                     98,855
                                          Source: SIPC.

                                          Notes: In each case, the trustee was a member of the trustee’s counsel firm. “Conversion” is
                                          generally the wrongful possession or disposition of another’s property as if it were one’s own.
                                          “Diversion” is generally the unauthorized use of funds.


                                          According to the Trustee, his involvement in the Madoff case began when
                                          he received a call from SIPC on December 11, 2008, the day Madoff was
                                          arrested, asking him to serve as trustee. On December 15, 2008, the U.S.
                                          District Court for the Southern District of New York appointed Mr. Picard
                                          as trustee, and his new law firm, Baker Hostetler, as trustee’s counsel. 19
                                          Selection of trustee’s counsel was not an independent decision; both
                                          SIPC and the Trustee understood that trustee’s counsel would be the



                                          19
                                            As part of the appointment order, the case was removed to the U.S. Bankruptcy Court
                                          for the Southern District of New York.




                                          Page 14                                                                             GAO-12-414 SIPC
Trustee’s law firm. SIPC designated the Trustee’s law firm as trustee’s
counsel, and the court issued an order to that effect.

Immediately before being formally appointed trustee, Mr. Picard changed
law firms, joining Baker Hostetler on December 15, 2008. The Trustee
told us that he had been on a year-to-year contract with his previous firm,
and in the fall of 2008, with the end of his contract approaching and
having received no indication it would be renewed, had begun to search
for new employment. He told us that he explored employment with
restructuring firms and other law firms, including Baker Hostetler, and
also considered short-term contract work. After SIPC asked him to
become the Madoff trustee on December 11, 2008, he said he felt he
needed to make a decision on joining a firm quickly, in advance of his
formal appointment, so that he would not be in the position of being at
one firm and then potentially departing only a short time later in
connection with the trustee work. Two firms with which he was in
discussions were not able to come up with offers, the Trustee told us, but
Baker Hostetler did so. In discussions with Baker Hostetler over the
weekend of December 13-14, the Trustee said he did not bring up the
subject of whether he was going to be appointed the trustee in the Madoff
case, although he said his pending selection was known. According to the
Trustee, Baker Hostetler representatives told him that the firm wanted him
to join regardless of whether he would become the Madoff trustee. The
Trustee noted that having Baker Hostetler as trustee’s counsel is helpful
because the firm has significantly more lawyers than his former firm,
which makes the case easier to manage. He also has been able to rely
on the in-house expertise of other partners who have assisted him in
areas including management of remaining Madoff employees when he
took on the case; real estate leases; intellectual property the Madoff firm
owned; sale of Madoff assets, such as the market-making and trading
side of the firm; and tax issues.

The Trustee also told us that a potential conflict at his former firm would
have had to be resolved for him to serve as Madoff trustee had he
remained there. He said that a partner at his former firm was going to
provide representation in a Madoff-related matter, which could have
presented a conflict. But the Trustee told us—and the SIPC President
concurred—that had he accepted the trusteeship while at his former firm,
arrangements would have been made to eliminate the conflict, so that the
firm would not represent the other client. As a result, the Trustee said that
any potential conflict was unrelated to his move between firms. The
Trustee said he never asked SIPC for advice on what firm to join, nor did
SIPC offer any guidance.


Page 15                                                       GAO-12-414 SIPC
                        According to the Trustee, his compensation at Baker Hostetler is based
                        on his overall contributions to the firm, as with other partners, and is not
                        directly related to activity of the Madoff liquidation. He also noted he
                        attracts other business to the firm in addition to the Madoff matter. The
                        Trustee said he pays all court-awarded compensation he receives from
                        the case as trustee to Baker Hostetler. He also noted that he is a contract
                        partner, not an equity partner, at Baker Hostetler, meaning he does not
                        have an ownership interest in the firm. The Trustee declined to provide us
                        with details of his employment contract, saying Baker Hostetler’s practice
                        is for “closed” compensation contracts, where details are not known
                        among members of the firm, but rather only by firm management. He
                        said, however, that with his compensation based on his overall
                        contributions, there are no provisions directly tied to the Madoff case, and
                        his compensation does not vary specifically based on the results of
                        Madoff case developments. He also noted that as trustee, his
                        compensation is not on a commission basis, as provided in the
                        Bankruptcy Code. 20


                        In valuing customer claims filed as part of the Madoff liquidation, the
SIPC and SEC Have       Trustee selected NIM, which determines the amounts that customers are
Supported, and          owed as the amounts they invested less amounts withdrawn. The
                        Trustee, supported at the outset of the case by SIPC and, after nearly a
Courts Have Affirmed,   year of analysis, by SEC as well, decided against valuing claims based
the Trustee’s Use of    on amounts shown on customers’ final statements. The parties said this
the Net Investment      was on the grounds that it met statutory requirements, and that using
                        statement amounts would effectively sanction the Madoff fraud by
Method                  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




                        20
                           Section 326(a) of the Bankruptcy Code provides that in a case under chapter 7 or
                        chapter 11, the court “may allow reasonable compensation…of the trustee for the trustee’s
                        services, payable after the trustee renders such services, not to exceed 25 percent on the
                        first $5,000 or less, 10 percent on any amount in excess of $5,000 but not in excess of
                        $50,000, 5 percent on any amount in excess of $50,000 but not in excess of $1,000,000,
                        and reasonable compensation not to exceed 3 percent of such moneys in excess of
                        $1,000,000, upon all moneys disbursed or turned over in the case by the trustee to parties
                        in interest, excluding the debtor, but including holders of secured claims.”




                        Page 16                                                                 GAO-12-414 SIPC
                            Circuit—have affirmed the Trustee’s decision on this method for
                            determining customer claims. 21


The Trustee Decided to      In a SIPA liquidation, it is the trustee that decides on the method for
Use Method Typically Used   determining customer claims. SIPA refers to this as calculating a
in Ponzi Scheme Cases       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. 22 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.” 23

                            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. 24 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



                            21
                                 Petitions seeking review of the case have been filed with the U.S. Supreme Court.
                            22
                                 15 U.S.C. § 78lll(11).
                            23
                                 15 U.S.C. § 78fff-2(b).
                            24
                               SEC officials told us that whenever feasible, customer accounts are quickly transferred
                            to another operating broker-dealer, to facilitate customers’ orderly receipt of cash and
                            securities, and to provide continuing access to brokerage services. In general, if the
                            accounts and records are in order, a trustee likely can transfer the accounts to another
                            broker-dealer in a process known as a bulk transfer. After such a transfer, customers have
                            full access to their accounts. If a bulk transfer is not possible, the trustee returns customer
                            securities and cash directly to customers on a pro rata basis through a claims process.




                            Page 17                                                                     GAO-12-414 SIPC
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.25 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




25
 According to the Trustee, as of February 2012, customer claims in the case break down
as follows:
  total claims received: 16,519;
  allowed claims: 2,426;
  denied claims: 2,703;
  other denied claims involving investors that held accounts at third parties: 10,976;
  withdrawn claims: 153; and
  other circumstances: 261.




Page 18                                                               GAO-12-414 SIPC
investors. 26 If the Trustee were less able to make such recoveries, less
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.

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.)

Table 2: SIPA Liquidations Involving Ponzi Scheme Cases, from 1995 through 2012

 Case                                                                                           Year
 Consolidated Investment Services, Inc.                                                         1995
 Old Naples Securities, Inc.                                                                    1996
 New Times Securities Services, Inc., and New Age Financial Services, Inc.                      2000
 Donahue Securities, Inc., and S.G. Donahue Company, Inc.                                       2001
 Northstar Securities, Inc.                                                                     2001
 Continental Capital Securities, Inc.                                                           2003
 Bernard L. Madoff Investment Securities, LLC                                                   2008
Source: SIPC.

Notes: SIPC told us that information on cases prior to 1995 was not readily available. The New Times
case, which involved the use of NIM for some accounts and FSM for others, has been central to legal
arguments on net equity determination in the Madoff case; see appendix III for details. Not included in
the table is the 1997 Ponzi scheme case of First Interregional Equity Corporation. According to SIPC
senior management, this was an atypical case that involved dual proceedings under SIPA and
chapter 11 bankruptcy. The net equity of customers who were victims of the Ponzi scheme was never
determined as part of the SIPC liquidation. Instead, customers were reimbursed from a settlement in
the non-SIPA portion of the case.


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



26
   SEC officials told us that clawbacks usually have not occurred in other Ponzi cases
because the duration of the frauds was generally shorter, which limits the amount of time
that customers had to make withdrawals that could be subject to recovery actions. SIPC
senior management told us SIPA and the Bankruptcy Code authorize clawbacks, and that
such actions have been brought where Ponzi schemes were involved.




Page 19                                                                            GAO-12-414 SIPC
                          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.


SIPC and SEC Both         Like the Trustee, SIPC quickly concluded that NIM was the appropriate
Supported Use of NIM,     method for determining customer claims, because of the fraud in the case
Although SEC Considered   and because using FSM would effectively sanction Madoff’s activities.
                          According to SIPC senior management, the focus in a net equity
Alternatives              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. 27 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. 28




                          27
                            SIPC senior management told us that with the exception of some transactions believed
                          to be executed on behalf of insiders to the scheme, all purported customer transactions
                          were fictional. SIPC senior management also stated that Madoff reviewed securities
                          trading data after the fact, selecting securities that had experienced good results. He then
                          issued purported purchase and sales confirmations based on the already known favorable
                          results. According to SIPC senior management, other than activity involving the insiders,
                          there has been no indication that any trades claimed on customers’ behalf were legitimate.
                          28
                               15 U.S.C. § 78fff-2(b).




                          Page 20                                                                   GAO-12-414 SIPC
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,


Page 21                                                     GAO-12-414 SIPC
and the Trustee or the bankruptcy court determined changes needed to
be made, claims payments would have to be adjusted as necessary. 29

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. 30

•      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. 31 These outside parties advanced arguments including that the
Trustee’s view of net equity was at odds with the statute and its legislative



29
  Within SEC, analysis of the net equity issue took place in three divisions: Trading and
Markets, which oversees SIPC; the Office of General Counsel (OGC), which is
responsible for SEC’s legal positions; and Risk, Strategy, and Financial Innovation, which
evaluated possible outcomes under different scenarios. The three divisions worked
collaboratively on the issue, SEC officials told us, but ultimately, OGC came to drive the
discussions, because it would be OGC that would present the agency’s legal position.
30
  SIPC rejected this approach, telling us that customer statements were equally as
fictitious whether they represented that holdings were in securities or other instruments
such as cash. Internal SEC correspondence we reviewed raised a similar concern.
31
     SEC officials told us they did not document the number of meetings and who attended.




Page 22                                                                    GAO-12-414 SIPC
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,




Page 23                                                      GAO-12-414 SIPC
                           should that be necessary to supplement fund balances to honor coverage
                           commitments. 32 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. 33

                           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.


Courts Have Affirmed the   After the Trustee chose NIM and began to settle claims based on the net
Trustee’s Use of NIM       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


                           32
                             An SEC Office of Inspector General report addressing portions of the Madoff case
                           included comments from SEC personnel suggesting impact on the SIPC fund was a
                           matter of concern to SIPC senior management in consideration of what net equity method
                           should be used. See SEC Office of Inspector General, Investigation of Conflict of Interest
                           Arising from Former General Counsel’s Participation in Madoff-Related Matters, OIG-560
                           (Washington, D.C.: Sept. 16, 2011). SIPC senior management noted to us that these
                           comments were second-hand, and reiterated that impact on the fund played no role in
                           their consideration.
                           33
                             SIPC senior management also told us that the burden customers might bear in pursuing
                           a claim, such as financial costs, time investment, or other hardship, did not enter into the
                           net equity decision. The main reason is that no matter what net equity method is used, it
                           remains necessary to investigate the facts and evidence supporting claims. In any case,
                           they said, trustee efforts to investigate claims can actually lessen the burden for
                           customers. SIPC senior management said the Trustee spends considerable time
                           reconstructing events and transactions on behalf of customers, and in the Madoff case,
                           the Trustee is better positioned to do so than customers.




                           Page 24                                                                    GAO-12-414 SIPC
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. 34 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.” 35 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.” 36 Instead, the court said the only verifiable
amounts evident from the Madoff firm’s books and records are customer


34
  In re Bernard L. Madoff Investment Securities LLC, 424 B.R. 122 (Bankr. S.D.N.Y.
2010).
35
     Id. at 135.
36
     424 B.R. at 129-130.




Page 25                                                                GAO-12-414 SIPC
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. 37 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. 38

In August 2011, the Court of Appeals for the Second Circuit affirmed use
of NIM as the appropriate method in the Madoff case. 39 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




37
     424 B.R. at 141.
38
     Id. at 136.
39
     In re Bernard L. Madoff Investment Securities LLC, 654 F.3d 229 (2d Cir. 2011).




Page 26                                                                    GAO-12-414 SIPC
                          Madoff’s fraud; rather, it said, SIPA does not clearly protect against all
                          fraud committed by brokers, or insure investors against all losses. 40


Customer Claims Would     According to information we reviewed, the differences in customer net
Increase Significantly    equity under the two approaches is significant, because during the
under FSM Compared with   decades of his fraud, Madoff reported considerable investment gains to
                          his investors. According to SIPC, customer claims allowed under NIM
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.

                          Table 3: Number of Accounts and Value of Claims under NIM and FSM

                                                          Under NIM                              Under FSM
                                                     (adopted by Trustee)              (advocated by some customers)
                           Account size            Accounts      Claims Value               Accounts      Claims value
                           Less than $1 million         1,204    $381.9 million                 1,485     $670.9 million
                           1-2.9 million                  626            1.1 billion            1,372         2.5 billion
                           3-4.9 million                  198         754.6 million              569          2.2 billion
                           5-9.9 million                  153              1 billion             529          3.7 billion
                           10 million or greater          138            14 billion              499         48.1 billion
                           Other                            —                    —                 5        76.9 million
                           Total                        2,319     $17.3 billion                 4,459      $57.2 billion
                          Source: SIPC.

                          Note: Totals may not sum due to rounding.


                          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



                          40
                               Id. at 239.




                          Page 27                                                                       GAO-12-414 SIPC
                              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.


Adjusting NIM for Inflation   Although SEC supported the Trustee’s decision to use NIM, SEC’s
Could Increase the Size of    position differed from the Trustee’s and SIPC’s in one respect: When
Customer Claims and           SEC commissioners voted to support NIM, they also said customer
                              deposits and withdrawals should be adjusted for inflation. According to
Remains an Outstanding        SEC staff, such adjustments would account for the length of time the
Issue                         Madoff firm held customer funds. This has become known as the
                              “constant dollar approach.” 41 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


                              41
                                   See 424 B.R. at 125, n. 8.




                              Page 28                                                        GAO-12-414 SIPC
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. 42 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




42
   In addition, according to SIPC senior management, recent amendments to SIPA show
Congress had no intent to allow inflation adjustment for net equity. Following changes
made by the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, there
is now an inflation-adjustment provision built into SIPC coverage—but not for net equity.
Rather, it involves determination of the amount of the standard maximum cash advance
amount in a SIPC case. SIPC advocated for this change, executives told us. However,
they said, the key point is that this provision does not apply to net equity. When adopting
the change, Congress had the ability to add provisions for inflation-adjustment of net
equity, but did not do so, they said.




Page 29                                                                   GAO-12-414 SIPC
losers. 43 We reviewed one sample of an inflation-adjusted Madoff account
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.

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. 44

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. 45 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


43
   One limited SEC study of about 2,100 accounts showed that adjusting for inflation
increased estimated payments for 1,033 accounts, or about half, while reducing estimated
payments for 438 accounts.
44
 SEC officials noted the 9 percent rate cited by the Trustee is a statutory judgment rate,
not a measure, such as the Consumer Price Index, contemplated as an inflation-
adjustment rate under a constant dollar approach.
45
   See OIG-560. The Inspector General told us he found no evidence that the former
General Counsel’s actions on the net equity matter were motivated by trying to serve his
own financial interests, or that he had become subject to a clawback action.




Page 30                                                                   GAO-12-414 SIPC
                             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.


                             Through October 31, 2011, the Trustee reported spending of $451.8
Cost of the Madoff           million for liquidation activities, with final costs expected to exceed $1
Liquidation Will Be          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
the Largest to Date,         consultants. Although the Madoff case is expected to be SIPC’s most
with Efforts to              costly case to date, the ratio of total costs to customer distributions is
Recover Assets               lower than for some other SIPC cases.

Driving Costs
Total Administrative Costs   Through October 31, 2011, the latest date for which information was
of the Liquidation Have      available, total administrative costs of the Madoff liquidation—ranging
Reached $452 Million and     from office expenses to professional services—reached approximately
                             $452 million. As shown in figure 3, the two major components have been
Are Expected to Exceed $1    legal costs, chiefly for time spent by the Trustee and his counsel, and
Billion                      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.




                             Page 31                                                       GAO-12-414 SIPC
Figure 3: Total Costs of the Madoff Liquidation, by Type, as of October 31, 2011




Note: General administrative category includes expenses such as computer, employee, insurance,
office rent, utilities, taxes, and supplies.


The Trustee told us that total administrative costs are estimated to reach
$1.094 billion through 2014.46 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
through 2010, the latest year for which information was available.47 Overall, a
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


46
   Further increases are possible, depending on how liquidation proceedings develop, the
Trustee said, and a new analysis will probably be done in the future.
47
  Costs in the bankruptcy of Lehman Brothers, Inc.—also a SIPC customer protection
proceeding—are substantial as well. They total $498.1 million, according to the most
recently available information. Unlike the Madoff case, the Lehman costs do not involve
any advances by SIPC, and instead are being paid from debtor assets. The case is not yet
complete.




Page 32                                                                       GAO-12-414 SIPC
                                duration of the fraud, its size, and the number of people involved, according
                                to the Trustee, SEC officials, and SIPC senior management.

Trustee and Trustee’s Counsel   Although the Trustee directs the liquidation, the bulk of the costs of the
Costs                           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). 48

                                Table 4: Approved Trustee-Related Legal Cost Requests, from December 2008
                                through May 2011

                                Dollars in millions
                                 Cost category                                                                            Total
                                 Trustee compensation                                                                      $4.9
                                 Trustee’s counsel compensation                                                           220.2
                                 Trustee’s counsel expenses                                                                  4.9
                                 Total                                                                                     $230
                                Source: GAO analysis of Trustee and trustee’s counsel cost applications.




                                48
                                   Because the interim reports and legal cost applications cover different periods, information
                                contained in them does not correspond. Because the legal cost applications submitted for court
                                consideration are more detailed, and because court approval is required for payment, our
                                review of Trustee and trustee’s counsel legal costs focused on the items submitted for court
                                approval. In addition to the legal costs submitted by the Trustee and trustee’s counsel, 19 other
                                parties, mostly special counsel, have also submitted, and won approval of, additional costs
                                totaling $25.3 million, or an amount equal to 11 percent of total Trustee and trustee’s counsel
                                costs approved. As of February 2012, the Trustee has retained, with the bankruptcy court’s
                                approval, 17 special counsel, consisting of 13 foreign law firms and 4 domestic law firms; this
                                number has changed over time. Because our review focuses on the Trustee and trustee’s
                                counsel, we omit the other parties’ costs from our discussion.




                                Page 33                                                                       GAO-12-414 SIPC
Notes: Totals may not sum due to rounding. The Trustee’s expenses are minimal—a total of $2,500—
and are not separately identified here. For the December 2008 to May 2011 period indicated, the
Trustee and trustee’s counsel have submitted seven cost applications, which the bankruptcy court
has approved. In February 2012, the Trustee and trustee’s counsel filed their eighth cost application,
covering the period June 2011 to September 2011. The eighth application seeks approval for a
combined total of approximately $48 million in compensation and $1.2 million in expenses, and as of
the date of our report, the request was pending with the court. References in this report to the “latest”
cost figures do not include amounts from the eighth application, and instead refer to court-approved
costs through May 2011.


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. 49

Table 5: Total Hourly Billings for the Trustee and Trustee’s Counsel, by Staff
Category, from December 2008 through May 2011

 Category                                                                                Hours billed
 Trustee                                                                                         6,704
 Trustee’s counsel partners                                                                   175,250
 Trustee’s counsel associate attorneys                                                        335,191
 Trustee’s counsel nonlegal professional staff                                                  79,907
 Total                                                                                        597,052
Source: GAO analysis of Trustee and trustee’s counsel cost applications.



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



49
 The partner figure includes “of counsel” attorneys, who are nonpartner lawyers also
participating in the case, such as on special assignment.




Page 34                                                                             GAO-12-414 SIPC
                                       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. 50

Figure 4: Trustee’s Counsel Costs, by Category, from December 2008 through May 2011




                                       50
                                        In addition, as noted earlier, the Trustee in November 2011 reached a $326 million
                                       settlement with the Internal Revenue Service, to recover certain foreign withholding taxes
                                       paid on behalf of Madoff account holders, allegedly to make the Ponzi scheme appear
                                       authentic.




                                       Page 35                                                                  GAO-12-414 SIPC
Partner hours have been declining. In general, billing rates for partners
at the trustee’s counsel firm are higher than rates for associate
attorneys. 51 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.

Figure 5: Partner Hours as a Percentage of Total Attorney Hours, from December
2008 through May 2011




51
  Comparing the billing rates of the trustees in the Madoff case and the Lehman Brothers,
Inc., liquidation shows them to be roughly the same—$850 per hour for Madoff, and $891
for Lehman. A rate comparison alone, however, does not take into account how a firm’s
attorney resources are deployed in handling a case, which in turn influences total cost.




Page 36                                                                 GAO-12-414 SIPC
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
staff such as paralegals, clerks, and librarians. 52 The Trustee attributed
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.




52
  We also examined whether individual attorneys’ billing rates corresponded with
experience levels but found considerable variance. As a result, we focused on billing
rates, not years of experience.




Page 37                                                                  GAO-12-414 SIPC
Figure 6: Distribution of Partner Work, by Hourly Billing Rate Quintiles, from
February 2011 through May 2011




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. 53 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


53
   ABA is a voluntary professional association for the legal field, and provides law school
accreditation, continuing legal education, information about the law, programs to assist
lawyers and judges in their work, and initiatives to improve the legal system.




Page 38                                                                     GAO-12-414 SIPC
                            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. 54

Costs for Consultants       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. 55 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).

                            Table 6: Consultant Costs, May 2009 through September 2011

                             Period ending                                                  Consultant costs (in millions)
                             May 31, 2009                                                                                $14.6
                             October 31, 2009                                                                             34.3
                             February 28, 2010                                                                            19.1
                             September 30, 2010                                                                           54.9
                             March 31, 2011                                                                               29.6
                             September 30, 2011                                                                           25.7
                             Total                                                                                     $178.2
                            Source: GAO analysis of Trustee’s interim reports.

                            Note: We also obtained information for the single month of October 2011, which totaled $661,671.




Total Costs of the Madoff   While the total costs of the Madoff liquidation are expected to be higher
Liquidation Have Been       than all other completed SIPC cases combined, we found that costs as
Within SIPC’s Range of      estimated thus far, as a percentage of current recoveries for customers,
                            have been within the range experienced in past SIPC cases. Specifically,
Experience                  we examined SIPC-reported total costs as a percentage of distributions to


                            54
                              Other factors from ABA’s nonexhaustive list are the likelihood, if apparent to the client,
                            that the acceptance of the particular employment will preclude other employment by the
                            lawyer; the fee customarily charged in the locality for similar legal services; the amount
                            involved and the results obtained; time limitations imposed by the client or by the
                            circumstances; and nature and length of the professional relationship with the client.
                            55
                                 Other types, for example, include investment banker fees and SEC receiver expenses.




                            Page 39                                                                         GAO-12-414 SIPC
customers in completed SIPC cases. 56 We grouped these cases on an
annual basis, focusing on years in which there were at least $50 million in
distributions. 57 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 58). 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.




56
   For our analysis, we defined total costs as administrative cost distributions from the
estate plus SIPC advances for administrative costs. We defined customer distributions as
those from the estate plus SIPC advances for securities and cash.
57
 We also excluded cases prior to and including 1978 because according to SIPC, the
method for covering administrative costs changed with SIPA amendments that year.
Before the amendments, administrative costs could be paid from customer funds.
58
  This 1990 case was the liquidation of Blinder, Robinson & Co., Inc., a Colorado “penny
stock,” or low price, firm. According to SIPC, no other brokerage firm would accept a
transfer of this firm’s customer accounts because they contained essentially worthless
securities that had been sold to dissatisfied customers, As a result, customer claims had
to be determined on a position-by-position basis, which was expensive.




Page 40                                                                  GAO-12-414 SIPC
Figure 7: Total Costs as Percentage of Customer Recoveries for Madoff and
Completed SIPC Cases, for Selected Years from 1979 to 2010, Ranked by Cost
Percentage




Notes: Total cost figures do not include the Madoff case. Customer distributions for the Madoff case
are not complete; figure is based on current recoveries by the Trustee, the IRS settlement, and
advances from SIPC.



The 13 years shown in figure 7 cover 104 cases that together account for
$15.5 billion in customer distributions. 59 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


59
 The $15.5 billion figure for the selected years is 99.1 percent of all distributions for the
entire 1979 to 2010 period, according to our analysis of SIPC information.




Page 41                                                                           GAO-12-414 SIPC
                             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. 60


Various Steps Are Being      In a SIPA liquidation, each of the main parties—the trustee, SIPC, the
Taken to Control Madoff      bankruptcy court, and SEC—has a role in examining costs. These roles
Liquidation Costs            vary by the party and the stage of the proceeding.

Trustee Efforts to Control   The Trustee noted that while he previously was at SEC and when serving
Costs                        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


                             60
                                The single large case was MJK Clearing, Inc., a Minneapolis, Minnesota, brokerage firm
                             with about 63,200 retail and 1,800 institutional customer accounts. MJK also cleared the
                             accounts of other broker-dealers, making it responsible for about 175,000 customers.
                             After the U.S. District Court ordered the firm’s liquidation, the SIPA trustee arranged
                             transfer of the customer accounts to another clearing firm, enabling customers to access
                             their funds. The cause of the firm’s failure involved defaults by a securities lending
                             counterparty. With settlement of the litigation, the trustee was able to pay all creditors and
                             return SIPC’s advances, with interest. Total customer distributions, according to SIPC,
                             were $11.8 billion, none of which were ultimately paid by SIPC.




                             Page 42                                                                     GAO-12-414 SIPC
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. 61

•   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. 62




61
   The firm has also built in-house tools for managing discovery that help manage costs,
but these are used for other clients as well, and not exclusively on the Madoff case. For
example, documents have been computerized, with the ability to search documents by
keyword.
62
   The Trustee and his counsel do not mark up costs submitted by vendors, consultants, or
others, according to the Trustee. The Trustee reviews invoices, after which they are sent
directly to SIPC for review and approval.




Page 43                                                                   GAO-12-414 SIPC
                                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.

SIPC Efforts to Control Costs   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. 63 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.



                                63
                                 See SEC Office of Inspector General, SEC’s Oversight of the Securities Investor
                                Protection Corporation’s Activities, report no. 495 (Washington, D.C.: Mar. 30, 2011).




                                Page 44                                                                   GAO-12-414 SIPC
In addition to the 10 percent discount, SIPC has also created guidelines
for review and approval of costs. 64 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. 65 SIPC senior management told us they followed the guidelines
in the Madoff case. 66 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. 67 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


64
  Securities Investor Protection Corporation Guidelines for Reviewing Applications and
Monthly Invoices For Compensation and Reimbursement of Expenses Under Section
5(b)(5) of the Securities Investor Protection Act, 15 U.S.C. § 78eee(b)(5). SIPC senior
management told us these guidelines were likely created in the 1990s, and updated in
2003, but could not specify dates.
65
   The SEC Inspector General confirmed to us SIPC’s close review of costs submitted in
the Madoff case, saying his office’s review showed all individual cost items were being
examined.
66
 In particular, SIPC senior management told us, each month, SIPC’s senior associate
general counsel for dispute resolution, who is the principal SIPC attorney assigned to the
Madoff case, closely reviews each cost record. The senior associate general counsel has
been reviewing fees for SIPC for many years, the SIPC President told us, and his
knowledge and experience are a key part of the process. To judge appropriateness of
costs claimed, SIPC senior management told us the first step is that the person with the
most knowledge of the case is the person who conducts the initial review. Issues
examined include whether it appears too senior a lawyer worked on a task, whether too
many hours were spent on a task, or whether too many people were involved with a task.
67
   According to SIPC senior management, litigation budgets have been used in some other
SIPA cases since the 1990s. The use of such budgets is especially important in the
Madoff case, they said, given the unprecedented scope of litigation stemming from it.




Page 45                                                                  GAO-12-414 SIPC
                                 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.

The Bankruptcy Court’s Role in   In the Madoff case, the bankruptcy court has a limited ability to oversee
Evaluating Legal Costs           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


                                 Page 46                                                       GAO-12-414 SIPC
                        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.

SEC Oversight of SIPC   Although SEC has oversight authority over SIPC, it does not have a direct
Liquidation Expenses    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



                        Page 47                                                      GAO-12-414 SIPC
                            recommendations, and SEC officials told us that formal responses are
                            being prepared.


                            Trustees for SIPA liquidations generally have the same duties as trustees
SIPC, SEC, and the          for liquidations under chapter 7 of the Bankruptcy Code. Under this
Bankruptcy Court            chapter, a trustee must make certain information disclosures, including:
Have Been Satisfied         •    furnishing information about the estate and the estate’s administration
That the Trustee Has             as requested by parties in interest, unless such disclosure is restricted
                                 by a court order;
Made Sufficient
Disclosures                 •    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.


The Trustee Has Disclosed   Through a variety of means, the Trustee has made disclosures that
Information in Variety of   address the statutory requirements. As of January 2012, the Trustee had
Ways                        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. 68 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


                            68
                              These interim reports were filed on July 9, 2009; November 23, 2009; April 9, 2010
                            (amended Apr. 14, 2010); October 29, 2010; May 16, 2011; and November 15, 2011.




                            Page 48                                                                 GAO-12-414 SIPC
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. 69 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.


69
  Declaration of Joseph Looby in support of Trustee’s Motion for an order upholding
trustee’s determination denying “customer” claims for amounts listed on last statement,
affirming trustee’s determination of net equity, and expunging those objections with
respect to the determinations relating to net equity (Oct. 16, 2009).




Page 49                                                                  GAO-12-414 SIPC
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. 70

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.




70
  Factors considered in making hardship program decisions include: advanced age;
inability to pay for necessary living expenses, such as housing (including loss of home to
foreclosure), food, utilities and transportation; inability to pay for necessary medical
expenses; need to return to work after having previously retired (special consideration
given to those who can no longer return to their former employment); declaring personal
bankruptcy; and inability to pay for the care of dependents.




Page 50                                                                   GAO-12-414 SIPC
Although Some Have          Although some parties have argued that the Trustee’s disclosures have
Sought Additional Trustee   not met statutory requirements, SIPC and SEC officials told us they view
Disclosures, SIPC, SEC,     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
and the Bankruptcy Court    avoid tipping off potential civil and criminal defendants that would become
Say Information Released    target of legal actions. More recently, according to SIPC, as that concern
Has Been Sufficient         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. 71 The officials said some may not like decisions the
                            Trustee has made, but there has been no lack of information about them.

                            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



                            71
                              Under SIPA, the trustee reports “shall be in such form and detail as (SEC) determines by
                            rule to present fairly the results of the liquidation proceeding as of the date of or for the
                            period covered by such reports….” 15 U.S.C. § 78fff-1(c). SEC has not issued any such
                            rules, but both SEC officials and SIPC senior management told us this has not been a
                            significant issue.




                            Page 51                                                                    GAO-12-414 SIPC
              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.


              When a broker-dealer firm fails, and large sums of customer assets could
Conclusions   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


              Page 52                                                       GAO-12-414 SIPC
                      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.


                      To help ensure that the pool of providers that could be employed in SIPC
Recommendations for   liquidations is as broad as reasonably possible, and to improve the
Executive Action      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.

                      We provided a draft of this report to SEC, SIPC, and the Trustee for their
Agency and Third      review and comment, and we received written comments from SEC and
Party Comments and    SIPC, which are reprinted in appendixes IV and V, respectively. In their
                      comments, SEC and SIPC concurred with our recommendations. The
Our Evaluation        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


                      Page 53                                                         GAO-12-414 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.




A. Nicole Clowers
Director
Financial Markets and
  Community Investment




Page 54                                                        GAO-12-414 SIPC
Appendix I: Objectives, Scope, and
              Appendix I: Objectives, Scope, and
              Methodology



Methodology

              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. 1

              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



              1
               The trustee in the Madoff liquidation is Irving H. Picard; the trustee’s counsel is the law
              firm of Baker & Hostetler LLP.




              Page 55                                                                      GAO-12-414 SIPC
Appendix I: Objectives, Scope, and
Methodology




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.




Page 56                                                     GAO-12-414 SIPC
Appendix II: Securities Investor Protection
                                       Appendix II: Securities Investor Protection
                                       Corporation Fund Assessments and Balances,
                                       1990 to 2010


Corporation Fund Assessments and
Balances, 1990 to 2010
                                       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.

Table 7: SIPC Fund Assessments and Balances, from 1990 to 2010

                SIPC member assessments
Year                    and contributions          Assessment rate   Assessment basis        SIPC fund at December 31
1990                           $73,029,832                0.001875   Gross revenue                       $568,587,250
1991                            38,851,496                 0.00065   Net operating revenue                678,769,209
1992                            27,217,374                 0.00057   Net operating revenue                720,214,522
1993                            32,612,767                 0.00054   Net operating revenue                791,366,865
1994                            37,115,454                 0.00073   Net operating revenue                867,152,034
1995                            57,831,365                 0.00095   Net operating revenue                965,932,279
1996                             2,639,822                   $150    Flat                               1,047,205,945
1997                             1,339,584                   $150    Flat                               1,109,450,764
1998                             1,186,279                   $150    Flat                               1,196,695,240
1999                             1,136,318                   $150    Flat                               1,129,653,262
2000                             1,108,632                   $150    Flat                               1,220,284,553
2001                             1,083,173                   $150    Flat                               1,184,157,015
2002                             1,050,096                   $150    Flat                               1,260,200,497
2003                             1,083,178                   $150    Flat                               1,249,116,852
2004                               972,817                   $150    Flat                               1,287,554,216
2005                               927,597                   $150    Flat                               1,286,092,231
2006                               894,941                   $150    Flat                               1,403,558,035
2007                               852,025                   $150    Flat                               1,522,257,439
2008                               816,322                   $150    Flat                               1,699,039,958
2009                           346,299,978                  0.0025   Net operating revenue              1,091,831,811
2010                           409,200,016                  0.0025   Net operating revenue              1,181,851,883
                                       Source: SIPC.




                                       Page 57                                                        GAO-12-414 SIPC
Appendix III: Legal Appendix on
                            Appendix III: Legal Appendix on Determination
                            of Net Equity



Determination of Net Equity

                            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. 1

                            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. 2 Later, the U.S.
                            Court of Appeals for the Second Circuit affirmed the bankruptcy court
                            decision. 3 In the following sections, we describe the Trustee’s position,
                            the positions of the other parties, and the two judicial decisions.


The Parties Advocated for   The issue of how to determine net equity in the Madoff case primarily
Two Different Net Equity    involved a choice between two methods with different impacts on the two
Methods, and the Trustee    main classes of customers. As is generally true of Ponzi scheme frauds,
                            the Madoff claimants were “net winners” or “net losers.” The net winners
Determined That NIM Was     were those customers who had withdrawn the full cash amount they had
Proper                      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. 4




                            1
                              SIPA authorizes an advance payment of up to $500,000 from SIPC to customers with
                            approved claims.
                            2
                             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).
                            3
                                In re Bernard L. Madoff Investment Securities LLC, 654 F.3d 229 (2d Cir. 2011).
                            4
                             The bankruptcy court noted that, in general, the net winners were concentrated among
                            early Madoff investors, while most net losers were later investors. 424 B.R. at 132.




                            Page 58                                                                    GAO-12-414 SIPC
                         Appendix III: Legal Appendix on Determination
                         of Net Equity




                         The two competing methods for calculating net equity were NIM and the
                         “final statement method” (FSM). 5 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. 6

                         SIPC and the Securities and Exchange Commission (SEC) both
                         supported the Trustee’s selection of NIM. 7 A number of claimants argued
                         for use of FSM. These claimants, most of whom were net winners, 8
                         challenged the Trustee’s choice of NIM.


Both Sides Claimed the   The legal arguments of the parties are reflected in the bankruptcy court
Law Supported Their      and Court of Appeals opinions. In addition, the bankruptcy court opinion
Position                 included an exhibit that outlined the competing arguments in detail. 9

                         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 [broker-dealer] 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). 10



                         5
                           NIM is also known as the “cash in/cash out” or “money in/money out” method, and FSM
                         as the “last statement method.”
                         6
                          As described earlier in this report, the Securities and Exchange Commission also
                         considered other methods. However, the two basic methods were NIM and FSM,
                         according to our review.
                         7
                          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.
                         8
                             424 B.R. at 132, n. 24.
                         9
                             Id. at 144-153.
                         10
                              15 U.S.C. § 78lll(16).




                         Page 59                                                                   GAO-12-414 SIPC
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of Net Equity




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.” 11

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. 12

The claimants advocating use of FSM argued that the plain language of
section 16(11) required use of this method, because the Madoff firm
statements reflected securities positions they had every reason to believe
were accurate and on which that they had relied. They emphasized
SIPA’s purpose to reinforce investor confidence in securities markets. In
particular, they cited the following passage from SIPA’s legislative history
as indicating that securities positions set forth in broker-dealer statements
need not be accurate in order to be relied upon under the act:




11
     15 U.S.C. § 78fff-2(b).
12
  Avoidance actions, sometimes referred to as “clawbacks,” enable a bankruptcy trustee
to recover for the bankrupt estate certain payments made by the debtor prior to the
bankruptcy filing.




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of Net Equity




     “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.” 13

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.




13
  H.R. Rep. No. 95-746, 21 (1977), the House report on the legislation enacted as the
1978 amendments to SIPA. The context for the quoted passage is a 1978 amendment,
now section 8(b)(2) of SIPA, 15 U.S.C. § 78fff-2(b)(2), authorizing trustees to satisfy
claims (in lieu of cash payments) by purchasing and delivering securities to replace those
ascertainable from a customer’s account.




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                         Appendix III: Legal Appendix on Determination
                         of Net Equity




The Bankruptcy Court     The bankruptcy court affirmed the Trustee’s determination of net equity
Affirmed the Trustee’s   method and essentially sided with the Trustee, SIPC, and SEC on each of
Selection of NIM         their key arguments. The court concluded:

                               “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.” 14

                         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. 15 The court added that legitimate customer expectations
                         based on false account statements “do not apply where they would give
                         rise to an absurd result.” 16

                         The bankruptcy court also found that fairness favored NIM. It concluded
                         that payments from the SIPC fund were inextricably connected to
                         payments from customer property, rejecting the argument by FSM
                         proponents to the contrary. Thus, use of FSM for purposes of SIPC fund
                         advance payments would in fact diminish the amount available for




                         14
                              424 B.R. at 125.
                         15
                              Id. at 135.
                         16
                              Id.




                         Page 62                                                                      GAO-12-414 SIPC
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of Net Equity




distribution from the customer property fund. Citing section 9(a)(1) of the
act, 17 the court observed:

      “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 [Final]
      Statement Method, and recovering customer property shares based on the Net
      Investment Method.” 18

Viewing fairness considerations from this perspective, the bankruptcy
court stated:

      “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 [Final] Statement Method were
      adopted, Net Winners would receive more favorable treatment by profiting from the
      principal investments of Net Losers, yielding an inequitable result.” 19




17
   15 U.S.C. § 78fff-3(a)(1): “In order to provide for prompt payment and satisfaction of net
equity claims of customers of the debtor, SIPC shall advance to the trustee such moneys,
not to exceed $500,000 for each customer, as may be required to pay or otherwise satisfy
claims for the amount by which the net equity of each customer exceeds his ratable share
of customer property . . .” (emphasis added by the court). 424 B.R. at 134.
18
     424 B.R. at 134.
19
     Id. at 140-141 (footnote and citation omitted).




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of Net Equity




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 [Final] 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.” 20

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. 21 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. 22



20
 Id. at 136 (footnote omitted). The bankruptcy court noted that no specific avoidance
actions were before it at the time and thus expressed no view on the merits of potential
defenses to them. Id. at 136-137.
21
   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”).
22
 The principal issue addressed in New Times I was whether the fake securities claimants
had claims for cash or claims for securities. This question has not been raised in the
Madoff litigation, and therefore we do not discuss that aspect of the New Times I decision.




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of Net Equity




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.” 23

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. 24 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). 25 Reliance on fraudulent promises in account statements, the
court stated, would create “the absurdity of ‘duped’ investors reaping



23
     371 F.3d at 88.
24
   The bankruptcy court also considered New Times II, 463 F.3d 125, as well as another
Ponzi scheme case, In re Old Naples Securities, Inc., 311 B.R. 607 (M.D. Fl. 2002), which
likewise rejected inclusion of fictitious interest earnings in SIPA net equity.
25
     424 B.R. at 139.




Page 65                                                                 GAO-12-414 SIPC
                          Appendix III: Legal Appendix on Determination
                          of Net Equity




                          windfalls as a result of fraudulent promises.” 26 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 . . . [as] account activity was manipulated with the benefit
                          of deliberately calibrated hindsight.” 27


The Court of Appeals      The Court of Appeals for the Second Circuit reviewed the bankruptcy
Affirmed the Bankruptcy   court’s ruling on net equity in the Madoff case on a de novo basis. 28 It
Court’s Decision          affirmed the bankruptcy court decision, holding that while SIPA does not
                          prescribe a single method for determining net equity in all situations—

                                “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 [Final] 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.” 29




                          26
                               Id. (citing New Times II, 463 F.3d at 130).
                          27
                               Id.
                          28
                               A de novo review gives no deference to the lower court’s rulings.
                          29
                               654 F.3d at 235.




                          Page 66                                                                      GAO-12-414 SIPC
                      Appendix III: Legal Appendix on Determination
                      of Net Equity




                      The Court of Appeals endorsed the reasoning of the bankruptcy court. At
                      the same time, it emphasized:

                            “In holding that it was proper for Mr. Picard to reject the [Final] 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 [Final]
                            Statement Method, for example, may be appropriate when securities were actually
                            purchased by the debtor, but then converted by the debtor.” 30

                      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.” 31
                      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.


Legal Issues Remain   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.




                      30
                           Id. at 238.
                      31
                           Id. at 239.




                      Page 67                                                                     GAO-12-414 SIPC
Appendix IV: Comments from the Securities
              Appendix IV: Comments from the Securities
              and Exchange Commission



and Exchange Commission




              Page 68                                     GAO-12-414 SIPC
Appendix V: Comments from the Securities
              Appendix V: Comments from the Securities
              Investor Protection Corporation



Investor Protection Corporation




              Page 69                                    GAO-12-414 SIPC
Appendix V: Comments from the Securities
Investor Protection Corporation




Page 70                                    GAO-12-414 SIPC
Appendix V: Comments from the Securities
Investor Protection Corporation




Page 71                                    GAO-12-414 SIPC
Appendix VI: GAO Contact and Staff
                  Appendix VI: GAO Contact and Staff
                  Acknowledgments



Acknowledgments

                  A. Nicole Clowers, (202) 512-8678 or clowersa@gao.gov
GAO Contact
                  In addition to the contact named above, Cody J. Goebel, Assistant
Staff             Director; Rachel DeMarcus; Dean P. Gudicello; Daniel S. Kaneshiro;
Acknowledgments   Jonathan M. Kucskar; Marc W. Molino, Barbara M. Roesmann; and
                  Christopher H. Schmitt made major contributions to this report.




(250636)
                  Page 72                                                  GAO-12-414 SIPC
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