Interview: Stephen Harbeck and Irving Picard on the Lehman and Madoff Cases
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The SIPC® (Securities Investor Protection Corporation), the organization created by Congress and empowered to protect customers when a broker-dealer goes belly up, is facing two of the most challenging proceedings in its 39-year history. It was called in to protect the holdings of brokerage customers of both Lehman Brothers and Bernard L. Madoff Investment Securities LLC. Lehman Brothers filed for Chapter 11 in mid-September 2008, while Madoff’s multibillion-dollar house of cards began to tumble in December.
Stephen P. Harbeck is the president and CEO of the SIPC. Harbeck joined the SIPC in 1975 as a member of the organization’s legal staff. He was promoted to general counsel in 1995 and assumed his current joint role in December 2003.
Irving Picard, a partner with the New York law firm of Baker Hostetler, is the court-appointed trustee assigned to handle and liquidate all of Madoff’s brokerage business holdings.
PIZZANI: What lingering myths regarding the SIPC would you like to clear up?
HARBECK: First, the myth that the SIPC protects against all forms of fraud. We are not an insurance company. Your money is at risk.
The SIPC protects the custody function and only the custody protection related to your brokerage account. The SIPC owes you, the customer, the appropriate number of shares of whatever you bought with that brokerage firm. Our job is to complete the custody process. [The SIPC is charged with returning registered securities to their rightful owners after a broker-dealer fails. Securities registered in a broker-dealer’s “street name” are prorated to customers.]
If we owe you cash, it will be as of the date of the filing for claim or the shares of a security, and not necessarily what you originally paid for the securities.
Most, but not all, products are covered by the SIPC. Products not covered include fixed annuities, commodities, and unregistered limited partnerships. These products may loosely fit within the definition of “securities,” but they do not qualify as securities for the SIPC’s purposes.
PIZZANI: Prior to April 1, 2009, the level of assessments that broker-dealers were required to pay was very low—$150 annually. Why?
HARBECK: The SIPC was only required to have $150 million in its reserve fund. In 1990 the organization’s bylaws were changed to require it to have $1 billion in the reserve fund. That $1 billion level was reached by 1996, so the annual assessments were cut to $150 per member firm through 2008. The reserve fund by then had amassed $1.6 billion.
Post–Lehman Brothers, we are currently exploring another bylaw change to require the fund to have more than $1 billion in reserves. We need to rethink the size of the reserve. Our board of directors must first okay that, and the SEC [Securities and Exchange Commission] must approve an increase.
PIZZANI: Has the April increase in annual assessments—one-fourth of one percent of annual operating revenue—caused members to grumble?
HARBECK: While people have complained, they understand that it is necessary. They must pay the assessment in order to continue doing business.
PIZZANI: So everyone pays for the sins of others?
HARBECK: Yes, they do.
PIZZANI: How did the SIPC get involved in the Lehman Brothers bankruptcy case?
HARBECK: We are brought in by the SEC and FINRA® [Financial Industry Regulatory Authority] under statutory authority to intermediate when customers of failed brokerage firms need protection. We don’t have examiners or investigators. FINRA and the SEC told us that Lehman Brothers was in trouble.
PIZZANI: What about Bear Stearns?
HARBECK: On two occasions the SIPC stood ready to act on Bear Stearns but it was not necessary, and Bear Stearns was resolved on its own. [JPMorgan purchased Bear Stearns in March 2008.] But we were ready if the deal started to teeter.
PIZZANI: How has the Bernard Madoff case affected the SIPC?
HARBECK: It has had a large impact, as has Lehman Brothers. But Madoff in particular, because of the level of fraud involved. Some claimants disagree with the way we are handling this. Many Madoff clients were shown fictitious profits. But if you eliminate the fictitious profits, then the SIPC has to look at what each customer put in, what they took out, and then determine the net amount. When we use those net figures, the SIPC can use the $500,000 limit per customer to satisfy those claims.
PIZZANI: Is the Madoff case the SIPC’s largest-ever case?
HARBECK: To date it is our largest in terms of the amount the SIPC has had to expend.
In the case of Lehman Brothers, [$100 billion in] client accounts were cleanly transferred to Barclays Bank and to the spin-off unit of Neuberger Berman. Lehman Brothers was massive and has had truly profound global consequences. Lehman financed its daily operations with a $1 trillion purchase agreement, which was a pledge of securities. Unwinding that has proven to be time consuming and costly. It’s been like a gigantic dinosaur that moves slowly.
The Madoff case was assigned a bankruptcy trustee [to liquidate Madoff’s company and assets], and notices had to go out to Madoff’s clients. The case is taking more time to assess because there are lots of historical records. The problem is lots of those records are figments of Madoff’s imagination.
PIZZANI: Mr. Picard, you were appointed trustee of the Bernard Madoff case on December 15, 2008. What is the role of the court-appointed, SIPC trustee?
PICARD: The role and duties of the trustee are outlined in the statute [the Securities Investor Protection Act of 1970]. My job has lots of parts. I collect assets. I was running a business for awhile in the Madoff case.… We even kept the employees on for four or five months because we were trying to sell that business, and we felt there was more value to it with its people. In April we sold that business. [Madoff’s market-making business was auctioned off and sold to Castor Pollux for $1 million plus up to $24.5 million in deferred compensation.]
We conducted an investigation of the case. In July I filed a report with the bankruptcy court. There will be another report in November. We still have ERISA [Employee Retirement Income Security Act] problems, health care issues.… I’m also in charge of customer claims and what our decision is on each of those claims. We have gotten sixteen thousand claims that we are reviewing.
PIZZANI: Must everything you do be approved through the bankruptcy court?
PICARD: No. A lot of what we do doesn’t require bankruptcy court approval. However, a lot requires the approval of the SIPC.
PIZZANI: How is the Madoff case different from other, previous cases?
PICARD: Most liquidations under the Securities Investors Protection Act involve firms that ran into financial difficulty. This is not one of those. This is not a business reversal, not a company that made a bad bet in the market or made a trade for a customer who reneged.
There have been cases, such as A. R. Baron and Co. or Stratton Oakmont Inc., that involved market manipulation. In one case there were principals who stole $7.5 million from customers. But in those cases, unlike Mr. Madoff, they were introducing brokers, and they had a clearing firm that was responsible for the investments. In Mr. Madoff’s case, he was self-clearing. If another company would have cleared his firm’s trades, we would not have this problem.
PIZZANI: How is the Madoff liquidation different from other liquidations you’ve handled in the past?
PICARD: As I tell people, here every day is Groundhog Day. By that I mean every day is different. I’m not Bill Murray … but you can think of me that way. It’s never easy. It’s not every day we’re putting out fires, but every day is very different. That’s what makes this case very challenging.
PIZZANI: What have you learned from the Lehman Brothers and Madoff cases?
HARBECK: That these are anomalies. You know, in 2007 there were no new cases at all. And so far in 2009 there are no new cases. In the first nine months of 2008, there were only three small broker-dealer liquidations. Then, in the last quarter of 2008, Lehman and Madoff occurred. That makes me feel those cases were anomalies.
In the SIPC’s history there are only eleven cases prior to these two that cost the SIPC a net of $10 million or more. Of the total three hundred and twenty-two cases the SIPC has handled since inception, there were only twenty-eight cases that cost us $5 million or more.
Generally speaking, the regulatory system works to find these problems before they become problems. In the Madoff case, there was no excuse for not finding the fraud on an earlier basis. But, this was so unusual a case.
PICARD: It’s too early for me to comment.
PIZZANI: What changes will the SIPC face going forward?
HARBECK: The precursor to the SIPC needs to be examined. Are regulators aware of whether customer assets are properly segmented? Broker-dealers aren’t like banks. Banks take customers’ money, pool assets, and then use it and live on the difference—the spread. If the bank fails, the FDIC insurance kicks in.
But broker-dealers are different. If a client gives $1,000 to a broker-dealer, the firm may not use it, but they must segregate those shares so that custody is separate. That’s why the SIPC can survive with a smaller reserve.
PIZZANI: Who pays the SIPC claims of the customers, and who pays the administrative expenses for processing customer claims?
HARBECK: Generally the estate of the debtor pays, but there is generally not much there. The SIPC will pick up all of the administrative expenses of the Madoff case, with no customer money used. In this case, we’re not just talking about customer-related assets, but we are also talking about stolen money.
PIZZANI: Should the SIPC become more like the FDIC, the banking industry’s insurer?
HARBECK: You cannot establish a system to insure brokerage assets. It would be nearly impossible to determine who gets paid. In most broker-dealer failures it is extremely easy to know what customers owned, except for cases like Madoff where so much is fictitious.
You know, the US and Canada both have SIPC systems under their models. The UK, however, has a system of paying off losses where there is fraud. The elegance of our system is that there is risk in the system, but we will get you back what you invested in, what was in your account, whether those securities were stocks or bonds. That, however, excludes fictitious profits.
--Lori Pizzani is an independent journalist in Brewster, New York.