House Financial Services Committee
Subcommittee on Capital Markets
Assessing the Limitations of the Securities Investor Protection Act
September 23, 2010
Members Present:
Paul Kanjorski (D-PA), Gary Ackerman (D-NY), Ed Perlmutter (D-CO), Travis Childers (D-MS), Ron Klein (D-FL), Scott Garrett (R-NJ), Peter King (R-NY)
Witnesses:
Mr. Joseph Borg, Director, Alabama Securities Commission
The Honorable Orlan Johnson, Chairman of the Board, Securities Investor Protection Corporation
Mr. John Coffee, Adolf A. Berle Professor of Law, Columbia Law School
Mr. Ira Hammerman, Senior Managing Director and General Counsel, Securities Industry and Financial Markets Association
Mr. Steven Caruso, Partner, Maddox, Hargett, & Caruso
Opening Statements:
Kanjorski:The Dodd-Frank Act makes important changes to this law. Much more remains to be done, however, to protect investors. There were many victims of the Madoff and Stanford schemes who invested their hard-earned money and were cheated by fraud. They believe that SIPC has fallen short in meeting its responsibilities and therefore it should be changed. We must explore the expansion of its coverage. There are inconsistencies that are unacceptable. SIPC, which was designed to restore investor trust, has failed to do so. We must consider how to change the tone of SIPC and promote investor protection. We ought to explore how SIPC could learn from the success of the FDIC in maintaining the public’s trust. We can further improve SIPA by building on the reforms of the Dodd-Frank Act. The recommendations of these experts will undoubtedly help us in our work in updating SIPA.
Garrett: We’re here to assess the limitations of SIPA and SIPC and to identify if there are reforms that would better protect investors. There’s one piece of legislation that might make this right. Rep. Bill Pascrell (D-NJ)has introduced H.R. 5058, the Ponzi Scheme Victims’ Tax Relief Act, that would accomplish this. I’m concerned that the SIPC trustee has denied access to Madoff’s records. Inequitable access to these records results in an imbalance of justice and determines whether there will be a fair trial at the end of the day. SIPC is supposed to mean protection. Now it seems as though SIPC is blaming the victims instead of protecting them. It has clearly lost the trust of investors. This hearing is timely. SIPC clearly needs the modernization task force.
Perlmutter: We have to look at who’s in office to see if the system works, and it did not work at that time under Bush. This really does add insult to injury because of the unfairness of the system. The victims were not active participants in the fraud. There should be an opportunity for them to recover through their taxes, claims, SIPC, or something else, and the law needs to be changed to make this fair.
Childers: These investors purchased securities that they didn’t get. These investors are ordinary Americans that planned and saved for retirement that they may now never enjoy. As we examine ideas to improve SIPA, I urge all participants to keep these victims and their families in mind.
Highlights from Witness Testimony:
Borg: I believe the level of protection should be increased from $500,000 to $1 million. It would match SIPC’s Canadian counterpart which is currently at $1 million. I also believe it should be indexed to inflation. A major issue is the treatment of claims on securities that never existed. I believe that part of the problem stems from SIPA’s distinction between cash and securities. This should be eliminated. I would note that the Canadian counterpart eliminated this distinction in 1998. It would not alter the risk models used by SIPC. If we expect continued growth in the securities market, it may require an increase in the line of credit from the Treasury. There should be a minimum assessment of some amount for members. I believe that since all investors benefit from protection, revenues on mutual funds should be included for assessment levels as well. The current arrangement with the Treasury should be a revolving loan to ensure continuity and flexibility. On investor education, the general public has the misconception that SIPC is an insurance fund. I think this misconception is exacerbated by references to FDIC. We need to include in brokerage statements a section on SIPC protections about what it is but most importantly what it is not.
Johnson:We anticipate that some of our recommendations are not going to make some people happy, but we believe that everything needs to be put on the table. We’ve undertaken a major public outreach effort to make sure that as many investors as possible are aware of our efforts and have an opportunity to participate. We’re hoping to organize a live event so the public can present their views directly to the task force. It’s our goal to have a full set of recommendations by the end of the first quarter of 2011. The Dodd-Frank Act gives SIPC a new role. I would hope that the task force would present additional recommendations that would lead to additional legislation that would improve SIPC’s role even more.
Coffee:There are things that Congress should and should not do in reforming SIPC. I think there is harm in some of the potential reforms. Congress should extend the definition of customer to reach beneficial and indirect owners. The highest priority should be to cover the smaller pension funds where typically the legal owner has failed to inform the covered broker of all of the funds in that account. SIPA is behind in not having adopted an approach to reach indirect owners. I understand that this would be costly for SIPC, so that’s why we should prioritize it. The smaller funds would be my priority to cover first, and I realize that this would increase the level of assessment. I think we should abolish the distinction between cash and securities, and it’s an arbitrary distinction. I don’t think Congress should limit the power of the net losers. If you want to do something for the net winners, it would be better to create an exception or an imputed interest factor. I do think that trying to cover all of the losses of the Stanford scheme are beyond what SIPC can do.
Hammerman:SIPA’s fundamental purpose is to promote investor confidence. It is not intended to protect investors on losses of their investments. Investors who lose money due to a decline in the value of the securities are not entitled to SIPC’s protection. SIPA’s customer protection framework has been challenged by the Madoff Ponzi scheme and the failure of Lehman Brothers. The basis on which members contribute to the fund might be outdated and may need revision. We are committed to working with you to improve reforms to better protect investors and restore investor confidence.
Caruso: We need to look at what can we do to make sure that what we have experienced in the past few years does not happen again. There is a lot of blame to go around. What do we do to keep anything tragic from happening as we move forward? What do we do to remedy what has happened to investors in Madoff and Stanford and other situations? These are the questions we need to consider. You need to eliminate the distinction between cash and securities. Everyone should get at least a million dollars of coverage. Madoff will happen again. There are people out there who are greedy. So what do we do? We build in protections going forward, but it begs the question about what we do about all of these people who have been hurt in the past. I’m not aware of any legislation that would provide financial restitution to those people. I call on Congress to introduce legislation that would do this. That’s the most equitable and the fairest thing to do.
Questions and Answers:
Ackerman: We have created classes of victims. I don’t understand net winners and net losers. People who put their money in banks have been victimized. If you’re telling people their whole lifestyle not only in the future but in the past has to be reversed, these people are victims. It’s traumatic. I have a question about claw backs. If we’re trying to move forward, how do we move backward? Caruso: Anytime you get into the issue of claw backs, you implicate SIPA and SIPC and also the bankruptcy code. I think Congress should say that this isn’t fair. There should be no limitation on the ability to get the money back. Coffee: I would suggest that we look at all of the participants who fall into the category of net winners. You could protect them with a diminimus test. You could protect them with an imputed interest test.
Garrett: How do people know which categories they fall in if they miscalculated or didn’t read all of the disclaimers? Are we going to create different classifications of people? Hammerman: The solution is better investor education about what SIPC is all about. From the industry standpoint, we’d be willing to work with all experts to do a better job of investor education. Johnson: We’ll continue to look at the statements that come in and look at the global aspect of the circumstances, and if we need to, we’ll take it to a court for a third party interpretation. Once we are told from a third party that we should be operating differently, we will move in that direction. Caruso: Clearly there are going to be different opinions from different courts. The problem is that there is no well-defined standard.
King: I don’t think we’re getting the full impact of the fact that even though SIPC was set up to help investors, the trustee is acting as a prosecutor of the victims. There’s no evidence that any of these people are co-conspirators. How is the trustee appointed? Johnson: He’s appointed by the bankruptcy court. We make a recommendation about who would be a good trustee. King: So we have the court selecting a trustee based on a recommendation that you made. He’s now acting to protect the SIPC fund rather than protecting the investors. It seems to me that we should find a way to have a much more independent person as the trustee so SIPC wouldn’t be involved at all. Johnson: I’ve tried to make sure that we set the proper tone for how we’re going to move forward. The one thing we have made clear is that everyone has the opportunity to come in and speak with the trustee. Our goal is to make sure that we’re going after the correct individuals. King: I think someone should tell him that he has an arrogant attitude and that he needs to stop treating these victims like criminals.
Ackerman: Don’t we have a moral responsibility to these victims? Johnson: We absolutely do. We just have to make sure that we don’t just benefit those who got out in time and didn’t get hurt.
Garrett: Do you know what the trustee has billed SIPC so far? Where do those funds come from? Johnson: $39 million. They come from fees that are paid by SIPC members. Garrett: Is it just the norm that SIPC makes the recommendation for the trustee and the judge would just approve that? Johnson: It is the norm for us to make the recommendation, but it’s completely up to the judge to make the decision. Caruso: I don’t think investors would have the right to recommend their own trustee. Johnson: This is what we’re looking at in the task force. We’ve got everything on the table. Garrett: I have questions about access to the records and how net equity is calculated. Johnson: I don’t see a reason why they shouldn’t have access to those documents, and that’s a recommendation we’ll make in the task force. We’re trying to figure out how to get the statute to be more flexible. Borg: Most of the cases my office prosecutes are Ponzi schemes, so there is no SIPC coverage. Historically, it’s because the securities are not held by a broker-dealer. Private placements are an example. The sales are through a broker-dealer. They have not gone through SIPC. The Ponzi schemes that we oversee end up having a very limited pool of funds. I suggest that if we are looking at things like covering the Stanford matter or outside of the broker-dealer custody area, you’re looking at a several billion dollar fund that would need to be established. I don’t think it’s practical, but if we expand coverage, we need to expand coverage for investors in all frauds, not justStanford and Madoff.
King: After all of this, if another Madoff scheme occurs, is there any reason to believe that investors would receive any more equity than they are now? It seems like we could be back in the same place in the future unless we have a fund of billions of dollars. Borg: If you have an unlimited fund, then you can cover everyone’s expectations, but I don’t think it’s practical to cover everyone’s full amount without some limitations. The important thing is that we have a finite number to start with. Coffee: I do not want to totally disarm the trustee. The better way to deal with the victims is to create a diminimus test or another technique that would reach most of those people. You have to be careful so the trustee doesn’t lose any power to do anything when there is fraud going on.
Ackerman:What if you discovered that you had more money than you thought? Borg: On that rare occasion, you just make the pro rata distributions go up. I do not personally favor claw backs.
Garrett: In 2003, the GAO and Members of Congress warned that the size of the fund wasn’t big enough. Is there an actual analysis to determine what the right size is? Johnson: That’s one of the concerns we have. It boils down to ultimately what the responsibilities we would have to investors would be. We’re trying to find people to do this analysis and figure out what the right size is.