A federal appeals court affirmed that victims of Allen Stanford's massive $7 billion Ponzi scheme - the second largest scheme in history behind only Bernard Madoff's scheme - are not "customers" of Stanford's American-based bank and thus not eligible to seek compensation from the industry-funded pool administered by the Securities Investor Protection Corp. ("SIPC"). Judge Sri Srinivasan of the U.S. Court of Appeals for the District of Colombia ruled that, despite professed sympathy for Stanford's victims, the fact that Stanford's investors purchased certificates of deposit from an Antiguan bank precluded any finding that investors were "customers" of Stanford Group Company ("SGC"). The ruling is a blow to the Securities and Exchange Commission, which brought the suit in December 2011 to force SIPC to commence a liquidation and compensate victims - the first time it had brought such a suit.
Stanford, who is currently serving a 110-year prison term after being convicted by a federal jury, built a banking conglomerate that touted its certificates of deposit that promised above-market returns to investors. However, prosecutors argued that Stanford actually used CD proceeds to prop up his empire of businesses and support a lavish lifestyle that included private jets, cricket teams, and a once-sterling reputation on the Caribbean island of Antigua. Stanford was convicted on 13 of 14 fraud counts, and ordered to pay nearly $6 billion in restitution to victims. Victims face a bleak prospect of recovery; the receiver appointed to recover assets for Stanford victims have to date has made one distribution to date representing 1% of victims losses. The recovery process has been hampered by overseas liquidations and competing claims to hundreds of millions of dollars in overseas assets and bank accounts.
After initially deciding that Stanford victims were not entitled to SIPC protection, the SEC reversed course in June 2011 and concluded that a liquidation under the Securities Investor Protection Act (the "Act") was required to compensate investors who had purchased certificates of deposit at the heart of Stanford's scheme. Following unsuccessful attempts by Congress to put pressure on SIPC, the SEC filed suit against SIPC contending that a SIPA liquidation was warranted by virtue of the Stanford Group Company's SIPC membership. In response, SIPC countered that the fraudulent certificates of deposit sold to Stanford's victims originated not from SGC, but were instead issued by Stanford International Bank, an Antiguan entity that was not a SIPC member.
Thus, the issue presented, according to Judge Srinivasan, was whether SIPC could be ordered to proceed against SGC - rather than the Antiguan bank - to protect the CD investors' property. The Commission claimed that victims were "customers" because they had purchased CDs from the Antiguan bank at the urging of SGC employees, and urged the court to disregard the corporate separateness of the two entities and rather treat the two entities as a combined entity. SIPC disagreed, arguing that the CD investors failed to qualify as "customers" because the investors never deposited the funds directly with SGC. Judge Srinivasan agreed with SIPC, stating that:
Here, insofar as the analysis focuses on the entity that in fact held custody over the property of the SIBL CD investors, the investors fail to qualify as “customers” of SGC under the statutory definition. That is because SGC never “received, acquired, or held” the investors’ cash or securities. 15 U.S.C. § 78lll(2)(A); see 15 U.S.C. § 78lll(2)(B)(i). With regard to the investors’ cash, it is undisputed that investors at no time deposited funds with SGC to purchase the SIBL CDs. The funds instead went to SIBL....Because SGC had no custody over the investors’ cash or securities, the investors do not qualify as SGC “customers” under the ordinary operation of the statutory definition
According to Judge Srinivasas, even if it were to accept the Commission's substantive consolidation argument, the result would remain unchanged due to a provision of the Act excluding from “customer” status “any person, to the extent that . . . such person has a claim for cash or securities which by contract, agreement, or understanding, or by operation of law, is part of the capital of the debtor.” Because victims who purchased CDs were lenders by virtue of loaning money to - and not through - the Antiguan entity, the substantive consolidation of the two entities would result in investors assuming a creditor-debtor relationship with that entity - a result specifically excluded under the Act.
Financial Ramifications For SIPC Coverage
Shortly after the suit was filed, SIPC raised the potential of financial shortfalls associated with being forced to compensate victims, saying that an adverse decision
would vastly exceed SIPC's Fund, and would jeopardize the availability of the Fund for the legitimate purposes for which it was created."
SIPC's 2010 financial statements adds some veracity to such a claim. The fund received $400 million in member assessments in 2010 and listed net assets of approximately $100 million (having listed $1.38 billion in assets and $1.28 billion in liabilities). Not surprisingly, the majority of its listed liabilities were allocated to "estimated costs to complete customer protection proceedings in progress" - the largest of which, Bernard Madoff's Ponzi scheme, was and remains pending. Those financial statements also indicated that the weight of the Madoff proceeding caused SIPC to operate at a loss in 2010 and reduced net assets from $344 million at the beginning of 2010 to $100 million at the end of the year. The then-recent bankruptcy of MF Global, a SIPC member, threatened to further strain resources depending on the severity of investor losses.
SIPC's finances have since rebounded, with the 2013 financial report listing $1.162 billion in net assets due in part to average member assessments of $400 million in the past few years. While today's SIPC is in a much better financial position to respond to a massive fraud at one of its members, today's decision no doubt alleviates the potential of having to compensate Stanford victims.
The appellate decision is below: