Tuesday, September 28, 2010

How Should Madoff's Victims Be Compensated?

The government has an insurance fund that covers broker-dealer accounts known as the Securites Investors Protection Corp. (SIPC). The SIPC generally covers victims' losses up to $500k. As such, victims who had more than $500k invested with Bernie Madoff, will receive $500k from the SIPC plus the law allows for recovered assets to be divided among the victims based on a weighted average of their actual funds over $500k that they had deposited with Madoff.

There are two groups of victims in a Ponzi scheme such as that run by Madoff: net winners and net losers. The net winners took out more money than they put in. Under the current rules, this group gets nothing when a Ponzi scheme collapses and they may be asked to give some of their assets back to the net losers in what is known as a "clawback."As for the net losers, they are covered by SIPC and get a share of the recovered assets.

Some victims of Madoff are saying that they should be entitled to recoup what Bernie's statements showed they had in their account. In other words, suppose they put in $500k and never took any out. If they had the money with Bernie for, say, a dozen years or so, it would have supposedly grown to about $2 million. Now, these victims would love to get the SIPC to give them $500k and then to get some share of the recovered assets based on the additional $1.5 million that Bernie said was in their account. Under the current rules, they will get $500k and nothing else.

The question some lawmakers are asking is whether this is fair? Apparently, a few of our esteemed representatives in Washington don't think so. The WSJ reported recently that Rep. Paulk Kanjorski (D., Pa.) "would pursue changes to require the SIPC to fulfill claims of customers based on the account statements they received from failed broker-dealers." Well, I'm afraid the good Senator is confused about where money comes from. He must think the government can just print some up and give it to these victims without it hurting anyone else. Let's consider the options.

First, if everyone is given a share of the recovered assets based on their statement balance, this means less money for those who didn't have the money with Madoff very long. Thus, two people may have a statement balance showing $2 million. One from the example above invested $500k for about 12 years (let's call him Investor12), the other gave Madoff $2 million the day before Madoff's sons turned Bernie in to the authorities (let's call him Investor0). Under currrent rules, both will get $500k from SIPC but Investor0 will get some share of the recovered assets based on the additional $1.5 million he invested.

From what I've read, it sounds like the recovered assets will be around 10% of what Madoff received. Thus, Investor12 gets $500k which is exactly what he invested while Investor0 gets $500k plus 10% of $1.5 million or $150k. Investor0 ends up with $650k or 32.5% of his one-day investment and Investor12 gets 100% of his initial investment after 12 years.

If they were each given equal status under Rep. Kanjorski's proposal then each investor's share of the pool of recovered assets would go down. Instead of 10% it may be 5%. If so, both investors would end up with $575k. One would get a 15% return on his original investment and the other would end up losing over 60% from an overnight investment.

To me, this is a no-brainer. However, to make the point, let's assume that Kanjorski's proposal was made law and Madoff knew of this provision. He probably had some investors that were his friends and others who were strangers. As such, he decides to show a higher return for his friends in case the scheme collapses. He puts them in the elite fund paying 30% return and leaves the strangers in the other fund paying 10% a year. If Investor12 is a friend, his balance now shows about $12 million and Investor0 shows $2 million and some change. In that case, assuming the 5% recovery rate, Investor12 gets over $1 million and Investor0 gets his $575k.

Another absurdity in the proposal can be illustrated by considering that the proposal is meant to cover the amount of the SIPC insurance based on the statement balance. Let's assume someone puts in $50k and leaves it with a Ponzi schemer for a little over three years when the balance grows to $500k. Under the proposal, it sounds like Kanjorski would have the SIPC give that investor the $500k!

I personally think this is a ridiculous proposal. It makes me wonder how many of Madoff's victims live in the congressman's district. Either he is trying to look responsive to his constituents or Kanjorski went into law because he wasn't very good at math...


  1. The SEC was supposed to be auditing Madoff for over 20 years. They detected no fraud. People had their hard earned money in those accounts, expecting that money was growing annually with interest using their statements as proof of what is held in their accounts. If we cannot believe statements, especially when brokerage houses are supposed to be audited by government run agencies. Then what do we count on? That would mean that we should not count on our bank statement either, or our 401K statements. Should we all start putting our money back under our mattresses then since banking and broker statements are not valid proof of assets? This affects everyone, not just the Madoff victims. And YES, the government failed to expose this ponzi scheme after yearly audits, so I think they ARE responsible to make these people whole. SIPC does owe ALL investors 500K regardless of net winner/loser status. They are protecting their own bank accounts, not those of the investors.

  2. I don't think you understand the role of the SEC. The SEC doesn't audit any particular fund or company. Instead, the SEC primarily provides regulatory oversight. The SEC was not responsible for auditing Madoff, nor did they provide any kind of guarantee to Madoff investors.

    You also seem to be misunderstanding the fundamental relationship between risk and reward. Higher returns come with greater risk. If you want guaranteed returns, the closest thing you can get is through the purchase of government debt or traditional savings accounts/CDs with an FDIC guarantee. In exchange for the potential for greater returns, Madoff's investors took on greater risk and invested in an a fund that did not have any kind of government assurance that fraud would not be present. If those investors aren't comfortable taking on that kind of risk, they should have invested elsewhere (note that the risk of losing money by investing in a fraud can be reduced significantly by an informed investor asking the right questions and steering clear of shady investments).