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Just how risky should it have been to invest with Bernard Madoff?

May 23, 2011 |  6:00 am

MadoffSuppose you put $10,000 into an account with an investment advisor who promises to double your money every year. Two years later your account statement says you've got $33,000, so you happily withdraw $5,000. It seems too good to be true, and that's what it turns out to be. When you try to withdraw  $10,000 more, your advisor sends you a check that bounces. The next thing you know, he's being led off in handcuffs by the feds for running a Ponzi scheme.

Under the Securities Investor Protection Act of 1970, you're protected for up to $500,000 in losses at the hands of unscrupulous investment professionals. The act creates a fund to reimburse investors, and fills it by taxing registered securities brokers and dealers. So, under our imaginary Ponzi scheme, how much should you be entitled to recover? Just the $10,000 you invested, or the full $28,000 shown on your account statement, even though it's a mythical number that your advisor concocted to conceal his fraud?

How about $5,000 -- the amount of cash you paid in minus the amount you withdrew?

That's the formula the Securities Investor Protection Corp., which administers the aforementioned fund, is using for investors in Bernard L. Madoff's epic sham. According to Ron Stein, president of Network for Investor Action and Protection, the SIPC's cash-in-minus-cash-out approach has led it to reduce or deny reimbursements to more than two-thirds of the Madoff investors who've filed claims. That's why Stein's group is backing HR 757, a bill by Rep. Scott Garrett (R-N.J.). HR 757 would force the SIPC to make reimbursements based on investors' account statements, not on their actual investments -- even if those statements aren't worth the paper they're printed on because the ostensible returns they reported never existed.

This strikes me as an overreach, but Stein offers several arguments in favor of the bill. His main assertion is that securities insurance should work the same way bank deposit insurance does. When a bank goes belly up, its customers are insured for up to $250,000 per account, including the interest the bank purported to pay even when it was insolvent.

Of course, bank deposits are supposed to be safe, and securities are inherently risky. Beyond that, the rationales for the two insurance programs are fundamentally different.

Congress started insuring bank deposits to guard against panic-fueled runs that would ruin otherwise healthy institutions. The rationale behind the investor insurance fund, Stein said, was to help Wall Street make the leap into electronic trading. The protection offered by the fund helped convince investors that they could trust the statements they received from their investment advisors and broker-dealers, rather than demanding physical copies of certificates. If investors were later denied the shares they thought they owned, the fund would reimburse them regardless of why it happened.

Garrett's bill would also stop trustees liquidating an investment company from trying to recover assets that the company had transferred to individual investors before its checks started bouncing. In the Madoff case, Stein said, "at least 1,000 claims have been filed against innocent victims" -- investors who withdrew money from their accounts with no knowledge of the sham.

It wasn't their fault that Madoff got away with so much for so long, Stein said; the blame belongs with the Securities and Exchange Commission and a securities industry self-regulatory body for repeatedly giving Madoff a pass. When they enacted the Securities Investor Protection Act, lawmakers knew that  Ponzi schemes could lead investors to seek reimbursement for exaggerated losses, Stein said. But such reimbursements were OK, he said, because they counted on "vigorous oversight" by regulators to minimize the impact.

I understand the argument, and can see why the SIPC's approach in the Madoff case might alarm some investors. Nevertheless, Garrett's bill would let people recover losses based on ginned-up results and fictitious account statements.

Regardless of what Madoff was telling them, the folks who put their cash in his hands lost money the minute he switched from investing to inventing. And the lucky ones who converted some of those fictitious gains into cash before Madoff's con was discovered didn't earn the money. They were just taking it from some other poor sap, albeit unwittingly. (The trustee liquidating Madoff's firm argues that a number of Madoff's customers weren't so innocent; Garrett's bill wouldn't provide any protection for those who knew their advisor or broker-dealer was "involved in fraudulent activity").

I'm not worried about investors being spooked by the SIPC. They should be spooked by regulators' failure to detect fraud even when it's done on a multibillion-dollar scale. One of the larger lessons of Wall Street's collapse in 2008-09 is that bad things happen when investors take an uncritical approach to the assets they buy. When risk assessment goes out the window, things don't end well.

SIPC should protect investors when they're suckered by a con man, but should it go so far as to guarantee them returns on their principal? If they bet on a fake horse, should they be able to collect winnings? I don't think so. Do you?

ALSO:

A warning to Wall Street

Raj Rajaratnam: The feeble defense of an insecure billionaire

-- Jon Healey

Photo: Bernard Madoff leaving court in 2009. Credit: David Karp / Associated Press

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