Editor’s Note: In a column last week, Making Sen$e’s Social Security columnist Larry Kotlikoff urged readers to close their brokerage accounts and argued that the Securities Investor Protection Corporation, which was created to protect investors, actually penalizes them. He published a similar column in Forbes and the The Huffington Post. President and CEO of the SIPC Steve Harbeck offered the following statement. In a follow-up column, Kotlikoff responds to the SIPC. Neither the views of Kotlikoff nor Harbeck and the SIPC represent the views of PBS NewsHour or Making Sen$e.
— Simone Pathe, Making Sen$e Editor
The article by Laurence Kotlikoff entitled “Why No One Should Use Brokerage Accounts” is misleading in the extreme. The author omits facts which are very important to understanding the reality here.
First, the author fails to mention that the brokerage firm he describes was Bernard Madoff’s firm and that the fraud in question was a Ponzi scheme. The account statements the victims received in that case were complete fictions. No investments were ever made for them. Under the law, what each investor was entitled to receive was the return of the net amount deposited with Madoff. The court overseeing Madoff’s fraud agreed, and stated that using the phony account statements to determine what each victim should receive was “absurd.” Using those statements would have allowed the thief, Madoff, to decide who wins and who loses. The Court of Appeals also agreed, and stated that using those statements “would have the absurd effect of treating fictitious and arbitrarily assigned paper profits as real and would give legal effect to Madoff’s machinations.”
Second, the author fails to note that any money a participant receives in such a case, over and above the amount deposited, is money stolen from other innocent investors. To enable other victims to recover the amounts they invested, a trustee has a duty under the law to those other victims to recover funds where possible. A Ponzi scheme is a zero-sum game. A dollar of fictional “profit” given to one person who has received more than he or she contributed is a dollar that can’t be given to a victim that was unlucky enough to have lost principal.
Third, the trustee in the Madoff case didn’t sue people like Frank and Sally, the hypothetical victims mentioned by the author. To deal with situations exactly like the one described in the article, the trustee instituted a hardship program. The trustee exercised discretion in instances where suing to recover assets would not be appropriate. Mr. Kotlikoff asserts that his hypothetical victims “are treated as if they are criminals” and “forced to pay back money to SIPC.” No one has ever asserted that people in this situation are criminals or wrongdoers. Indeed, sadly, they too are victims of Madoff. But if a trustee has sued Frank and Sally, it is because they withdrew more than they deposited, and in doing so, received other people’s money. The assets returned by Frank and Sally would go back to other victims who had not yet been made whole.
Fourth, the author’s proposed solution was not thought through. He proposes a boycott of brokerage accounts in favor of investing directly in mutual funds. There is certainly nothing wrong with investing directly in mutual funds. But if Madoff, or someone like him, establishes a mutual fund, and runs a Ponzi scheme of the same magnitude and duration, avoiding regulatory scrutiny and making no actual purchases of securities for that mutual fund, the investors would receive nothing. This is precisely what has happened, on a smaller scale, in a number of hedge fund frauds.
Fifth, the legislation the author champions has the unintended effect of legitimizing Ponzi schemes. Indeed, under that legislation, taxpayer money could be used to pay fictional Ponzi scheme profits. The legislation would make the outcome the Court of Appeals called “absurd” the law of the land — and an obligation of the taxpayers.
Finally, the author’s disparagement of the SIPC program in the article is without foundation. SIPC has advanced approximately $700 million to the trustee to satisfy Madoff’s customers and spent $1 billion in administrative expenses in that case. This has resulted in the trustee’s recovery, through litigation and settlements, of $9.8 billion. Over $5.2 billion of that has already been distributed. Any investor who gave Madoff $925,000, net, has already received all of his or her original investment back, with more distributions to come. The legislation championed by the author would rob future trustees of the tools that made those recoveries possible, and rob future victims of potential compensation. Further, the trustee’s investigation of the Madoff fraud, financed by SIPC, has been instrumental to the convictions in the Madoff criminal cases and to the recovery of assets forfeited to the government. Not one cent of those administrative costs has been taken from the funds recovered for customers or paid out of taxpayer monies.
Mr. Kotlikoff initially published his article in Forbes. After I wrote a response, Mr. Kotlikoff disclosed in a reply, also published in Forbes, that his relatives were victims of the Madoff fraud. Presumably, they have been sued by the Madoff trustee. SIPC is sympathetic to all of the victims of the Madoff fraud. But the legislative proposals proffered by Mr. Kotlikoff are replete with unintended results. To be sure, under the proposed legislation, Mr. Kotlikoff’s relatives would be allowed to keep any fictitious profits, but it would be at the expense of even more unfortunate victims of the fraud who have not yet recovered all of their principal. In that sense, even greater unfairness is perpetuated, and the statutory program SIPC administers makes market reality out of the thief’s fraud.