Substance and semblance in investor protection.

Author:Dombalagian, Onnig H.
  1. INTRODUCTION II. SIPC IN BRIEF A. SIPC and Member Liquidation Proceedings B. SIPC and the Exchange Act's Financial Responsibility Rules C. The SIPC Fund III. SIPC IN THE CRUCIBLE A. Lehman Brothers B. MF Global C. Bernard L. Madoff Investment Securities D. Stanford Financial Group IV. THE PARAMETERS OF INVESTOR PROTECTION A. Who Is Entitled to "Investor" Protection? 1. The SEC's Institutional Incentives 2. Institutional Design B. What is Investor "Protection"? 1. Evidentiary Considerations 2. Methodological Considerations 3. Relevance of Sophistication and Means V. BALANCING SUBSTANCE AND SEMBLANCE A. Substance, Without Semblance?: SIPC as Bidder Indemnification Fund B. Semblance, but How Much Substance?: SIPC as Public Restitution Fund VI. CONCLUSION I. INTRODUCTION

    The D.C. Circuit recently dealt a powerful blow to the Securities and Exchange Commission (SEC) in its unprecedented attempt to compel the Securities Investor Protection Corporation (SIPC) to liquidate--and thereby provide modest restitution for investors in--a multibillion dollar Ponzi scheme. Whether SEC v. SIPC is a blow for or against investor protection, however, depends on one's perspective. (1) On the one hand, victims of broker-dealer securities fraud (such as the Ponzi schemes perpetrated by Bernie Madoff and Allen Stanford) understandably resent efforts to limit claims to the SIPC Fund; their resentment is undoubtedly stoked by a "gantlet of legal technicalities" barring relief "that would challenge even those knowledgeable in securities law." (2) On the other hand, multibillion dollar claims on SIPC could impair its ability to facilitate the transfer and resolution of securities accounts in a time of crisis: a well-capitalized SIPC Fund arguably contributed to the efficient liquidation of Lehman Brothers and MF Global--and could play an even more constructive role as its purview is effectively extended to other types of instrument.

    These dueling perspectives reflect the dilemma SIPC poses for policymakers in the aftermath of the recent financial crisis. Congress created SIPC under the Securities Investor Protection Act of 1970 (SIPA) as part of its mission to remediate and prevent financial failures of stockbrokers nearly half a century ago. (3) By financing the prompt return of customer property in the event of a broker-dealer's insolvency, SIPC was intended "to reinforce the flagging confidence in the securities market by providing an extra margin of protection for the small investor." (4) That "extra margin," however, has grown wider over the years as SIPC has faced unrelenting pressure to cover an ever broader range of relationships, entities, and products far afield of its original mandate.

    As with any scheme of public insurance, the availability of SIPC advances to customers in the event of their broker's insolvency creates significant moral hazard for brokers and their customers. (5) Just as important, however, is the moral hazard created by separating SIPC's restitutionary function from the prophylactic regulation exercised by the SEC, the securities self-regulatory organizations (SROs) and other financial regulators. The SEC's decision to press the cause of the Stanford victims in spite of its longstanding interpretation of SIPA illustrates the danger. (6) In response to the multibillion dollar losses suffered by these investors, the public may view SIPC as a convenient industry-funded source of restitution when policymakers and regulators fail to protect investors against foreseeable fraud or misconduct by broker-dealers.

    The onslaught of SIPC proceedings and legislative, regulatory and judicial responses following the recent financial crisis presents a valuable opportunity to reflect on the strains SIPC endures in carrying out the dual role of resolving insolvent broker-dealers and promoting investor confidence in the brokerage industry. As the size and systemic import of major brokerage insolvencies grows, policymakers must ask whether SIPC's resources should be deployed with a focus on improving the efficiency of liquidation proceedings that could potentially result in a fair and orderly outcome (at the expense of customers trapped in proceedings too toxic to handle), or with a focus on treating investors as equitably as possible to remediate the losses they suffer due to outrageous misconduct or mismanagement. An emphasis on the former might better integrate SIPC with a variety of account regimes and industry mechanisms, while scaling back its role as a compensation fund for aggrieved investors. An emphasis on the latter might require better integration of SIPC with enforcement authorities to recover funds for defrauded customers and a better-developed claims process to manage public expectations.

    Part II of this Article provides an overview of SIPC and SIPA's relationship to the financial responsibility rules of the Securities Exchange Act of 1934 (Exchange Act) and the U.S. Bankruptcy Code. Part III considers four case studies--the collapse of Lehman Brothers and MF Global, and the Madoff and Stanford Ponzi schemes--and the questions they raise regarding the adequacy and legitimacy of the SIPC regime. Part IV considers the challenges policymakers face when defining the scope of investor protection under SIPA, both from the perspective of delimiting entitlement to protection and fashioning appropriate evidentiary, methodological, and eligibility rules to channel reasonable expectations. Finally, Part V considers two possible evolutionary paths to clarifying SIPC's role in our financial markets.


    SIPC was created as part of a series of financial responsibility reforms stemming from the "back-office" crisis in the 1960s securities market. The post-war boom fueled an era of heady speculation on Wall Street and with it, a perfect storm of highly leveraged trading, inadequate recordkeeping, and negligent or opportunistic management. (7) Upstart broker-dealers were able to support highly leveraged proprietary positions using customer funds and securities as collateral. (8) At the same time, the volume of increasingly automated trading on stock exchanges outpaced the largely manual process of comparing, clearing and settling transactions. (9) As the technological gap between "front office" trading and "back office" processing grew, brokerage firms became increasingly prone to fraud, theft, and loss of customer funds. (10) When the bubble burst in 1969, many firms were forced into liquidation (11) and, in the process, nearly exhausted industry guaranty funds maintained by exchanges. (12)

    The Congressional response was to revive investor confidence in the securities brokerage industry by providing immediate protection for their customers. In 1970, Congress created SIPC to administer SIPA's liquidation regime and to establish an industry-financed fund for the protection of customer funds and securities held by securities brokers. (13) In 1975, Congress acted on additional recommendations of Congressional hearings on unsafe and unsound practices in the brokerage industry (14) and amended the Exchange Act to grant the SEC greater authority to impose uniform financial responsibility rules on broker-dealers. (15)

    SIPC's organizational structure suggests a superficial similarity to the Federal Deposit Insurance Corporation (FDIC) and the variety of self-regulatory organizations registered under the Exchange Act, but the limitations on SIPC's governance structure and powers belie any real comparison. (16) SIPC is organized as a "membership corporation" whose membership includes by law all broker-dealers registered under the Exchange Act, excepting only certain niche and offshore broker-dealers. (17) Only a small fraction of its members hold customer funds and securities in a custodial capacity ("carrying brokers"); most of the remainder are "introducing brokers" that provide sales and execution services, but rely on carrying brokers to perform custodial services. (18) Introducing brokers are required to be SIPC members to the extent that customer securities may come to be "received, acquired, or held" by the broker as intermediary between customers and carrying brokers. (19) An understanding of SIPC's role requires a brief recitation of how SIPC liquidation proceedings provide for the distribution of customer funds and securities in a broker-dealer liquidation, how the Exchange Act's financial responsibility rules dovetail with SIPC's customer protection regime, and how the SIPC Fund bridges the gap between the two.

    1. SIPC and Member Liquidation Proceedings

      SIPC liquidation proceedings are designed to protect the claims of custodial customers of a SIPC member with respect to the distribution of customer property. The highly speculative nature of traditional investment banking and brokerage activities--such as underwriting, market making, and dealing--makes it impracticable to insure all of a broker-dealer's contractual obligations to its creditors and counterparties. (20) Instead, SIPC's narrow mandate is to streamline the return of customer funds and securities held in a broker-dealer's custody as the broker-dealer approaches insolvency. (21)

      SIPC may, upon notice to a member, file an application for a protective decree in federal district court, (22) if the broker-dealer "has failed or is in danger of failing to meet its obligations to customers," and triggers one or more additional conditions suggesting financial distress. (23) SIPC has the discretion not to intervene, or to delay intervention: (24) while the SEC may seek a judicial order "requiring SIPC to discharge its obligations," (25) customers of a broker-dealer have no private right of action to compel intervention. (26) If the statutory conditions are met or the member does not contest the matter, the district court must issue a protective decree, appoint a disinterested trustee for the liquidation of the broker-dealer's business as specified...

To continue reading