Contributed by Rahul Sharma
There are many reasons why an investor might choose to make investments through an intermediary. Perhaps the investment opportunity requires a certain minimum level of investment, which the investor might not be able to meet (but the intermediary would). Perhaps the investor has enough to invest directly, but wants to limit his exposure or diversify. Perhaps there are tax reasons.
In any case, the idea of investing indirectly is not a new one and is common for many types of securities. In publicly traded stock markets, there are mutual funds, as well as hedge funds and even “funds of hedge funds.” Private equity also has “funds of funds.” And, in the Ponzi scheme perpetrated by Bernard L. Madoff Investment Securities LLC, many investors did not open accounts at Madoff directly, but rather invested in “feeder funds” which themselves opened accounts with Madoff. Such investors had many reasons for investing through the feeder funds, but, as discussed below, doing so drastically reduced the protection they would have enjoyed under the Securities Investor Protection Act (“SIPA”).
On February 22, 2013, in In re Bernard L. Madoff Investment Securities LLC, Judge Reena Raggi, of the United States Court of Appeals for the Second Circuit, issued an opinion affirming the decisions of the district court and bankruptcy court, which had granted the motion of the SIPA trustee for a determination that certain investors – who had lost money by investing in feeder funds which themselves opened accounts with Madoff – were not “customers” of that broker-dealer entitled to SIPA protection.
The appellants included 19 individual investors as well as nearly 30 different pension, health-care and benefit funds for bricklayers, construction workers, electrical workers, and others. All had invested in two funds managed by Select Spectrum Partners LLC. The marketing materials for one of these funds, Spectrum Select LP, stated, “Spectrum Select LP is a feeder fund that provides access to 3 underlying funds managed by an underlying manager that has executed the same trade for over 20 years. The mentioned manager has never had a losing year and only a handful of negative months, which is attributed to the hedged nature of the strategy. The underlying funds differ only in terms of the leverage they employ to exploit the same strategy.” Who wouldn’t want to invest in this fund that was delivering steady double-digit returns for 20 years? Madoff was a popular fund, was difficult to get into, and required a $1 million minimum investment. As noted in its marketing materials, Spectrum provided access to Madoff with a lower minimum investment size, in exchange for a 1% management fee and a 10% performance fee.
Spectrum would take the money it received and invest it directly in two hedge funds called Rye Select Board Market Fund, L.P. and Rye Select Broad Market Prime Fund, L.P. The Rye Funds were managed by Tremont Partners, owned by Oppenheimer Funds, itself a subsidiary of Mass Mutual. The Rye Funds invested their capital with Madoff through securities accounts maintained only in the names of the Rye Funds, not in the names of any of the appellants.
This was not an uncommon situation. As it turned out, thousands of investors worldwide lost money in the Madoff Ponzi scheme, but most did not have an account with Madoff. Rather they invested directly or, as the appellants did, indirectly in feeder funds, which then invested with Madoff.
When a broker-dealer is liquidated, to the extent that the broker-dealer’s assets are not enough to compensate customers for their losses, each customer can have its remaining losses covered by the Securities Investor Protection Corporation (“SIPC”), up to a cap of $500,000 per customer – in essence, a sort of deposit insurance for brokerage accounts. 15 U.S.C. § 78fff-3
SIPA defines “customer” as “any person (including any person with whom the debtor deals as principal or agent) who has a claim on account of securities received, acquired, or held by the debtor in the ordinary course of its business as a broker or dealer from or for the securities accounts of such person for safekeeping, with a view to sale, to cover consummated sales, pursuant to purchases, as collateral, security, or for purposes of effecting transfer.” 15 U.S.C. § 78lll(2)(A). This definition includes “(i) any person who has deposited cash with the debtor for the purpose of purchasing securities; (ii) any person who has a claim against the debtor for cash, securities, futures contracts, or options on futures contracts received, acquired, or held in a portfolio margining account carried as a securities account pursuant to a portfolio margining program approved by the Commission; and (iii) any person who has a claim against the debtor arising out of sales or conversions of such securities.” 15 U.S.C. § 78lll(2)(B).
Many of the indirect investors in Madoff filed claims in Madoff’s SIPA liquidation, seeking up to $500,000 each. In fact, such claims comprised the majority of claims in the Madoff SIPA liquidation. The trustee denied all of the claims of indirect investors, but, because there were so many such claims, the trustee asked the bankruptcy court for a determination that such indirect investors were not in fact “customers” eligible for protection under SIPA. Under such a determination, in the instant case, the nearly 50 appellants would not be considered customers. Neither would Spectrum or its sibling fund. Only the Rye Funds would be considered customers of Madoff, eligible for up to $500,000 in uncompensated losses. Spectrum and the appellants only would be eligible to recover a fraction of that amount, indirectly through the Rye Funds.
In June 2011, bankruptcy judge Burton R. Lifland granted the determination sought by the trustee. The appellants appealed, and in January 2012, the District Court for the Southern District of New York affirmed. The appellants then appealed again, to the Second Circuit Court of Appeals.
The Second Circuit Court of Appeals also affirmed, finding that the appellants did not qualify as Madoff “customers” under SIPA. Specifically, it said that previous rulings in the Second Circuit had identified the “critical aspect of the ‘customer’ definition” to be “the entrustment of cash or securities to the broker-dealer for the purposes of trading securities” and that the appellants failed to satisfy this requirement. Specifically, they had no direct financial dealings with or securities accounts at Madoff, no control of the Rye Funds’ investments with Madoff, and were not identified as Madoff investors in Madoff’s books and records.
The appellants argued that they exercised a degree of control over the Rye Funds’ investments with Madoff, but the bankruptcy court had found exactly the opposite. Just as with many other indirect investments, or funds of funds, the offering memoranda for the Rye Funds stated that the limited partners had no authority to make investment decisions. The court said that, even if the appellants had been able to show a degree of control over the Rye Funds, that by itself would have been insufficient to confer customer status on the appellants, because, individually, they still had no direct financial dealings with Madoff.
The appellants also argued that they were Madoff customers because they always intended the money they invested in Spectrum to be invested in Madoff. The Second Circuit found, however, that the LP interests sold by the Rye Funds to Spectrum did not confer any ownership interest in money that the Rye Funds ultimately would invest in Madoff because a partnership interest is an interest in the partnership itself, not in its property. Regardless of intent, the appellants’ cash was never entrusted to Madoff, only to Spectrum, and so the appellants failed to satisfy that “critical aspect of the ‘customer’ definition.”
Finally, the appellants argued that the Rye Funds were Madoff agents and cited cases in which money entrusted to a broker-dealer’s agent (who then misappropriated the funds) entitled the investor to be considered a customer of the broker-dealer. In this case, the Rye Funds’ offering materials made clear they were offering only LP interests in the Rye Funds, not a direct investment with Madoff. Additionally, the appellants provided no evidence that Madoff controlled the Rye Funds or authorized them to act on Madoff’s behalf.
The court did not address the appellants’ last argument — that they were not required by the statute to have had accounts with Madoff to be considered customers — stating that even if it decided that question in the appellants’ favor, they would still not be “customers” under SIPA. While that question remains open, the decision in this case has re-affirmed that the definition of “customer” under SIPA is a narrow one.
As mentioned above, there are many pros and cons to making investments through an intermediary. To the extent that investors were not aware of the specific risk discussed in this case, they should now be on notice.