SIPC has huge holes. Gretchen's best article of the year IMO. Should be required reading for all US investors...
INVESTOR BEWARE: A Special Report
September 25, 2000
Many Holes Weaken Safety Net for Victims of
Failed Brokerages
By GRETCHEN MORGENSON
Kevin Heebner, owner of a building supply store in
Temple, Pa., got a call four years ago from his longtime
stockbroker recommending an investment in short-term bonds.
Assured the bonds were safe, Mr. Heebner invested $100,000.
Three months later, Mr. Heebner received a stunning phone call.
The broker told him the money he had put into the bonds was
gone. The president of the broker's firm, Old Naples
Securities, had stolen it.
With his wife about to deliver their third child, Mr. Heebner, 36,
reeled at the thought of a $100,000 loss. Then he
remembered with relief that his account was insured by the
Securities Investor Protection Corporation, created by
Congress in 1970 to protect investors' brokerage accounts
from just the sort of theft he had been a victim of. "I knew that if
they didn't find the money from
Old Naples Securities, I was insured through S.I.P.C.," Mr. Heebner
recalled. The broker's "business card and letterhead all had S.I.P.C.
logos on them; I figured S.I.P.C. would cover it."
Mr. Heebner figured wrong. For more than four years, the corporation
maintained he was entitled to nothing - even though three federal
courts ruled that S.I.P.C. should pay him $87,000. Only last week,
days after a reporter interviewed the lawyer representing the
corporation about Mr. Heebner, did the investor receive a check in
the amount of $87,000.
"I never got the sense that S.I.P.C. was in any way trying to help my
client," said William P. Thornton Jr., a lawyer at Stevens & Lee in
Reading Pa., representing Mr. Heebner against the corporation.
"They are very aggressive in attempting to prove that investors'
claims do not come within certain legal definitions within the S.I.P.C.
statute. And the loser is the investor."
At a time when millions of United States citizens have taken their
money out of federally insured banks and put it into brokerage firms,
the Securities Investor Protection Corporation's charge of protecting
the investing public has never been more important.
Officials of the S.I.P.C. defend the corporation's record and say they
must be vigilant in protecting against invalid claims by investors.
But a close look at this little-understood organization shows that the
safety net that investors believe the corporation offers is in fact full of
holes.
Industry-financed but not government-backed, the corporation is a
far cry from the agency on which it was loosely modeled, the Federal
Deposit Insurance Corporation, which protects bank customers
against losses.
Created three decades ago after a number of brokerage firm failures
and securities thefts, the corporation is chartered to protect each
investor with securities held at a member brokerage firm for up to
$500,000; claims for cash are limited to $100,000 a customer.
But convincing the corporation to pay can be extremely difficult. The
organization, requires investors to run a gantlet of legal technicalities
that would challenge even those knowledgeable about securities law.
Some securities lawyers say this is because trustees overseeing
the cases are chosen by, and paid by, the corporation. This differs
from the independent trustees who are appointed by the court to
handle corporate bankruptcy cases, and who are working for the
people owed money.
Indeed, the trustees working for the investor protection corporation -
many of them from a coterie of lawyers who have made a lucrative
specialty of such cases - have received far more from representing
the corporation than the corporation itself has paid to investors.
Their critics say that trustees wanting repeat business from the
corporation have an incentive to minimize payouts to investors. One
trustee is the former president of the corporation.
In Mr. Heebner's case, the corporation made several arguments.
First, because the investor had sent his money not to Old Naples but
to a subsidiary, his investment was not covered. In addition,
because the corporation could find no proof that bonds had ever
been bought with the $100,000, the organization assumed Mr.
Heebner had given the money to the brokerage firm as a loan.
Lenders are not covered by the corporation.
"Although these legal arguments may follow the letter of the investor
protection act, S.I.P.C.'s reliance on them is reminiscent of a private
insurance company trying to use every conceivable esoteric legal
stratagem to avoid customer claims," said Lewis D. Lowenfels, a
lawyer at Tolins & Lowenfels in New York and a leading authority in
securities law.
The list of what the corporation does not cover is long. For one thing,
while $100,000 placed in a bank account insured by the Federal
Deposit Insurance Corporation is covered regardless of why the
bank failed, assets lost in a failed brokerage firm are not covered if
the loss is a result of most kinds of securities fraud, including a
failure to execute a purchase or sale of securities or
misrepresentation in the sale of a stock or bond. Losses from
unauthorized trading, a large problem among small brokerage firms in
the 1990's, are covered only if an investor can prove to the
satisfaction of corporation representatives that he complained
promptly to the firm.
In addition, because the act that created the corporation covers only
securities held by a failed brokerage firm, customers whose firms
handle their trades through other brokerage firms may not have a
claim for coverage by the corporation.
Additionally, cash held in a brokerage account that is not earmarked
for a securities purchase is not covered by the organization. Nor is
an investment in gold, other commodities or a limited partnership.
"The bottom line is S.I.P.C. is outdated and needs to be reviewed,"
said Joseph P. Borg, securities commissioner for Alabama. "It's
been around since 1970, when one in 10 Americans were in the
markets. Now everyone is in the markets. And everyone thinks that
S.I.P.C. logo reads F.D.I.C., but the protection is very limited."
The corporation's president, Michael E. Don, disagrees with
accusations that his organization does not put investors first.
"It simply is not true that protecting our fund is our interest," he said.
"Our interest is to see to it that customers get paid." Mr. Don added
that when the corporation considered an investor's claim invalid, it
had no choice but to fight the investor in court, as it did Mr. Heebner.
The Beginning
Create an Equivalent of the F.D.I.C.
The corporation started as an idea of Edmund S. Muskie, the former
Democratic senator from Maine. He introduced a bill in 1969 to
create a Federal Broker-Dealer Insurance Corporation that would
insure brokerage firm customers against losses, as the F.D.I.C. does
with bank depositors. A group representing the securities industry
countered with a proposal that its chairman said would maintain
public confidence in the securities markets without creating "a vast
new governmental agency." The S.E.C. joined the group and drafted a
proposal that was largely accepted by lawmakers.
The investor protection corporation and the F.D.I.C. are vastly
different. While the F.D.I.C. is an agency of the federal government
and its insurance fund is backed by the full faith and credit of the
government, the corporation is financed by the securities industry
and can borrow from the government, with special approval, only in
emergencies. It also maintains a $1 billion line of credit with a
consortium of banks.
And while bank examiners employed by the F.D.I.C. routinely monitor
risks at banks, the corporation steps in only when a brokerage firm
has collapsed or is close to failure.
Another difference is that a brokerage firm, no matter how large or
troubled, pays just $150 a year to be a S.I.P.C. member, while
payments into the F.D.I.C. insurance fund are based on a bank's size
and financial health: the riskier the bank, the larger the fee. Although
the healthiest banks have not had to pay into the fund for several
years because it has grown so large and bank failures have been
few, a financially vulnerable bank with $100 million in insured deposits
would have had to pay $270,000 a year to the F.D.I.C. fund this year.
Not long ago, brokerage firms paid much more to be members of the
corporation. Between 1991 and 1995, firms were levied an amount
based on their net operating revenues. In 1995, for instance,
members were required to pay 0.095 percent of such revenues and
the organization received $43.9 million. But when the S.I.P.C. fund
reached $1 billion, the corporation cut the levy to $150 a member.
Last year, the corporation received $1.14 million in fees.
When a bank fails, the F.D.I.C. steps in to keep it operating or close it
and return assets - up to $100,000 per depositor - to their rightful
owners. The F.D.I.C., created in 1934, typically resolves bank failures
by arranging for another institution to assume the crippled bank's
deposits and other assets. This has the effect of keeping most failed
banks open and operating, if under a new name.
When a brokerage firm fails, the wheels grind much more slowly.
First, the corporation applies to the appropriate court to issue a
protective order. If it does, the corporation chooses a trustee to
oversee the liquidation of the brokerage firm.
The corporation has presided over the liquidation of 282 brokerage
firms. In the 247 cases completed through the end of last year, the
corporation had returned $3.38 billion to customers in cash and
securities. More than 90 percent of this money - $3.15 billion -
came straight from the accounts of customers of the failed firms.
The corporation itself has paid investors $233 million over almost 30
years. But that amount is far less than the money received by the
lawyers that act as trustees and the firms that help them shepherd
the cases through the bankruptcy courts, trying to recover additional
assets from the failed brokerage firms and assessing customer
claims for validity. Since 1971, trustees have received $320 million,
37 percent more than has been paid to wronged investors.
The money the trustee receives comes from two sources: the assets
of the failed brokerage firm and the corporation itself. As is typical in
most bankruptcy cases, the corporation's trustees are paid first,
customers second.
The corporation made its biggest payout to investors last June when
it paid $31 million to about 10,000 customers of Sunpoint Securities,
a Texas brokerage firm that failed last November when some of its
officials stole $25 million, according to prosecutors.
The corporation's move to repay Sunpoint customers was swift
indeed. But according to people close to the case, the failure was
unusual in its simplicity. Unlike most brokerage failures, which involve
accounts that hold a variety of stocks and bonds, in the Sunpoint
case the missing funds had been placed in a money market fund at
the firm. As a result, all the customers' claims were identical and a
result of the same theft, making it comparatively easy for the
corporation's trustee to resolve.
Most brokerage firm liquidations drag on for years. For instance, the
trustee was recently still billing for litigation in the 1985 failure of
Donald Sheldon & Company, a New York brokerage firm. The
corporation said that all the customers' claims it considered valid
were paid early on, but that the trustee has been trying to recover
assets from principals of the firm to defray the costs of administering
the liquidations. Indeed, the trustee recently won $11 million from an
insurance company that had underwritten officer and director
insurance for the firm.
A Nasty Example
A Look at the Case of Stratton Oakmont
The case of Stratton Oakmont, a small but notorious brokerage firm
based in Lake Success, N.Y., has been particularly protracted and
acrimonious. The firm was expelled from the industry by securities
regulators four years ago, and the corporation stepped in after the
firm was closed. Last fall, Stratton's two owners pleaded guilty to
federal charges of securities fraud and money laundering; investors
lost hundreds of millions of dollars during the 10 years the firm
operated.
Nevertheless, of the 3,368 customers who submitted claims for
S.I.P.C. coverage in the failure, as of last May only 34 had been
deemed entitled, to a total of $2.1 million, according to the trustee
overseeing the case. The corporation's executives and Weil
Gotshal & Manges, the law firm representing the trustee in the case,
argue that only 1 percent of the Stratton customers seeking
remuneration from the corporation are entitled to payments.
Adam Rogoff, a partner at Weil Gotshal & Manges who is the lawyer
for the trustee, Harvey R. Miller, also a partner at the firm, said: "We
look for credible evidence that there was a contemporaneous
reaction; we look for a letter to the company; for a complaint; for a
lawsuit or an arbitration. Otherwise people take advantage of an
opportunity to revisit trades and say they were unauthorized when
they weren't."
Mr. Don, the corporation's president, said: "The Securities Investor
Protection Corporation was not chartered by Congress to combat
fraud."
While 34 investors had received $2.1 million, the professionals
overseeing the case had received $7 million as of the end of May.
Most of that amount - $4.3 million in fees and expenses - has been
paid to Weil, Gotshal. The payments do not yet include the fees
charged by the trustee, Mr. Miller.
Mr. Miller and his colleagues have spent a lot of time trying to
recover assets of Stratton Oakmont principals. So far, success has
been limited. According to bankruptcy court documents through
May, Weil Gotshal, which has spent $8.8 million, has recovered $3.6
million in assets.
Mr. Rogoff, the lawyer for Mr. Miller, said: "You can't analyze it from a
balance-sheet perspective. There are costs attendant to
administering the case. We have a staff; we have office space -
these are all costs relating to the process."
Asked whether the corporation is concerned about Mr. Miller's
spending, Mr. Don said: "We have reason to believe that Harvey
Miller has a reasonable shot at collecting substantial sums of money
in this case. We take very seriously our responsibility to make sure
that the trustees don't overspend the general estate's money and
our money."
Indeed, Mr. Don argued that the fees charged by trustees are
necessary to fend off false claims filed by investors and to locate
hidden assets held by principals of failed firms.
Stephen Harbeck, general counsel at the corporation, said that
trustees' bills were typically paid as submitted. "I don't believe we
have made any substantial requests for adjustments because we
believe the fees they have charged are appropriate to the task
involved," he said.
A key problem with S.I.P.C. liquidations, some securities lawyers say,
is that trustees overseeing the cases have allegiance to the
corporation that appointed them, rather than to wronged investors.
To be truly in the corner of investors, these people say, trustees in
brokerage firm liquidations should be completely independent of the
corporation, which naturally wants to protect its assets. Trustees are
indeed independent in corporate or personal bankruptcy cases
because they are appointed by the bankruptcy court.
Mr. Don denied that trustees work to deny claims on the
corporation's behalf. "It is a false argument," he said. "Since 1970,
S.I.P.C. has advanced $354 million in order to make possible the
recovery of $3.3 billion in assets for an estimated 440,000 investors.
S.I.P.C. estimates that more than 99 percent of eligible investors
have been made whole in the failed brokerage firm cases that it has
handled."
But it is impossible to say how many investors the corporation has
considered ineligible over the years might have prevailed if they had
had the money or tenacity to battle the corporation in multiple courts,
as Mr. Heebner did.
A coterie of bankruptcy lawyers does get repeat business from the
corporation. Irving H. Picard, a partner at Gibbons, Del Deo, Dolan,
Griffinger & Vecchione in New York, has been appointed trustee in
four brokerage firm failures the last nine years, and J. William Holland
of Holland & Holland in Chicago has overseen three liquidations
since 1990. Five other lawyers have overseen two or more
liquidations for the corporation the last decade.
No surprise, Mr. Don said. "We look for trustees who have
developed expertise in liquidating stockbrokers and satisfying
customer claims," he said. "That's why we've gone back to Harvey
Miller, Irving Picard and we went to Ted Focht, because there's
probably no one in the country who knows more about liquidating a
stockbroker than he does."
Theodore H. Focht is the trustee in the Old Naples case who kept
Mr. Heebner at bay until this month. Retired and living in Florida, Mr.
Focht was general counsel at the corporation when it was created
and remained its chief lawyer for 24 years. According to Mr. Don, Mr.
Focht wrote the 1970 statute that gives the corporation its charges.
He was the corporation's president for a decade until he retired in
1995. The next year, he was appointed by the corporation to oversee
the Old Naples liquidation. Mr. Focht hired the law firm of Foley &
Lardner to help him litigate the case.
Mr. Focht denied Mr. Heebner's $100,000 claim for S.I.P.C. coverage
from the outset. First, he said, Mr. Heebner erred by sending his
investment money not to the brokerage firm but to a related entity,
Old Naples Financial Inc. S.I.P.C. protection is afforded only to
investors whose assets are held by the brokerage firm that fails.
In addition, Mr. Focht argued that the $100,000 Mr. Heebner had
sent to his broker represented a loan to Old Naples and was not for
the purchase of bonds, as the investor said. Loans are not covered
by the corporation.
Mr. Heebner's lawyer objected to the trustee's ruling, and at a
hearing in February 1998 in federal bankruptcy court in Florida, the
investor told his story. The next month a judge ruled that Mr.
Heebner was entitled to S.I.P.C. insurance in the amount of $87,000,
reflecting a reduction of $13,000 in interest the investor had earned
on the investment before the failure of Old Naples.
Mr. Focht appealed to a Florida district court, which ruled for Mr.
Heebner in February 1999. Mr. Focht then appealed the district court
decision to the Federal Court of Appeals for the 11th Circuit, which
heard arguments on the matter last May.
On Aug. 23, the appellate court ruled in favor of Mr. Heebner and two
other customers with similar cases - the other two lost a total of
$610,000. Because the president of Old Naples had misappropriated
clients' funds, the firm's failure was just the situation the corporation
was supposed to protect against, the appellate court opinion stated.
Reached on Sept. 6, Mr. Focht said he was still deciding whether to
appeal the ruling. Less than a week later, Mr. Heebner received a
letter stating that he would be paid the $87,000.
Not counting Mr. Heebner and the two other investors that are now
receiving remuneration on their claims, 21 of the 156 Old Naples
customers seeking remuneration from the corporation had received
$2 million since the firm failed.
As of last May, the most recent filing made in the case, Mr. Focht
and Foley & Lardner had billed approximately $660,000 for their
services.
The Catch
A Key Argument in Denying Claims
Some securities lawyers and regulators say that the arguments used
by the corporation to justify the denial of Mr. Heebner's claim for
more than four years are characteristic of the corporation's
approach to investor protection. "It's part of the gantlet to make it as
difficult as possible for an investor to make a recovery," said Mark
Maddox, a former Indiana securities commissioner who is now a
lawyer representing victims in the Stratton Oakmont case.
Indeed, one argument used to deny many investors' claims in the
Stratton Oakmont case, if applied to all brokerage firm failures, would
disqualify millions of investors from S.I.P.C. coverage even though
their brokerage firms are members of the organization.
Mr. Miller, the trustee at Weil Gotshal, has argued successfully to
the bankruptcy court that Stratton customers do not qualify for
S.I.P.C. coverage because their assets were not held physically at
Stratton, they were held at the firm that cleared Stratton's trades. The
act of Congress that created the corporation states that the
coverage extends only to customers of firms that hold their assets.
Customers of a failed broker that used another firm to clear its trades
and conduct administrative duties do not qualify.
This delineation may have made sense in 1970, when most
brokerage firms cleared their own trades. But today, most of the
nation's brokerage houses use clearing firms to carry out their
customers' transactions and administer accounts. Using Mr. Miller's
argument, customers of these firms, were they to fail, could get no
satisfaction from the corporation.
"The argument may be technically correct under the law," said Mr.
Borg, the Alabama securities commissioner, "but it insulates a lot of
people who sell stocks. It indicates even more reason why S.I.P.C.
has to be re-examined."
The corporation is overseen by a board of seven, five of whom are
appointed by the president. Three of the five represent the securities
industry and two, including the chairman and vice chairman, are
appointed to represent the general public. The two other directors
are appointed by the secretary of the Treasury and the Federal
Reserve Board.
The chairman, Clifford Hudson, is chief executive of the Sonic
Corporation, an Oklahoma City operator of fast-food restaurants. Mr.
Hudson, who has been chairman six years, declined to discuss
specific cases. "My belief is that as the statute was originally
intended, S.I.P.C. management does a good job of implementing it,"
he said. "There are people today who would like to see the nature of
that coverage expanded. That could happen, but Congress would
have to change the statute."
How the corporation compensates investors and whether it does so
fairly is the subject of a study being done by the General Accounting
Office that was requested by Representative John Dingell, Democrat
of Michigan. The report is due next March.
Robert M. Morgenthau, the Manhattan district attorney, who has
aggressively pursued fraudulent brokerage firms to help wronged
investors recoup some of their losses, said: "The investor protection
act has to be revisited for two reasons. It doesn't cover a majority of
investors' losses, such as those incurred by fraud or malfeasance,
and the red tape that is involved for investors trying to recover is
incredible."
The corporation has been relatively free of scrutiny since it was
created. In that period, the Securities and Exchange Commission
has inspected the organization twice, once in 1985 and again in
1994. Three months ago, the S.E.C. began another regular
inspection.
"We're telling people to go into the market; it's safe; it's transparent
and that we're going to watch out for their interests," Mr. Borg said.
"But S.I.P.C. does not provide for a lot of protection, and I think that's
a defect of the law." |
