The securities industry is watching intently as the Securities and Exchange Commission and the Securities Investor Protection Corp. get set to do battle in court over SIPC's refusal to make good on some of the losses suffered by victims of R. Allen Stanford's alleged $7 billion Ponzi scheme.
A lawsuit filed by the SEC last week to force SIPC's hand is an unprecedented legal test of the limits of the commission's power over the government-created and industry-funded entity that protects investors in cases where brokerage firms fail, observers said.
But more than just a legal question is in dispute. Broker-dealers are worried about higher SIPC assessments if Stanford claims are paid out of the nonprofit organization's reserve fund.
“It's a scary thought,” David Sobel, general counsel of Abel/Noser Corp., said about higher assessments.
Mr. Sobel, who also is chairman of the National Association of Independent Broker/Dealers Inc., said representatives of small broker-dealers have been actively discussing the ramifications of the case and are looking for ways to aid SIPC's legal fight against the SEC.
SIPC president Steve Harbeck acknowledged that higher assessments might be necessary if SIPC has to cover Stanford victims. The added burden could put its $1.4 billion reserve fund at risk, he said.
That's of concern to the brokerage industry, which is still smarting from the costs of covering victims of the $65 billion Bernard Madoff Ponzi scheme. In 2009, SIPC increased assessments on broker-dealers to 0.25% of net operating revenue, from a flat $150 prior to the Madoff scandal.
The bump-up meant that even small firms faced SIPC bills of several thousand dollars a year.
“It's killing off the small firms,” Mr. Sobel said. “Why should we be paying off for fraud?”
Indeed, SIPC does not protect investors from fraud — only for missing cash and securities held in custody at a failed broker-dealer.
That's why many in the securities industry questioned SIPC's liquidation of the Madoff firm, where it is covering claims based on how much cash investors deposited.
Mr. Harbeck said investors at Bernard L. Madoff Investment Securities LLC were issued statements showing that securities were held at the Madoff brokerage firm, while Stanford investors knew they were buying CDs from an Antiguan bank.
“It's a bright-line rule — if you leave it with a brokerage firm, SIPC will give it back to you,” while in the Stanford case, customers actually held the CDs, he said.
SIFMA SUPPORT
The Securities Industry and Financial Markets Association has been urging SIPC to hang tough on Stanford.
“Crucially, unlike the situation [with Madoff], the purchasers of [Stanford] CDs actually purchased the very security they sought to acquire,” SIFMA said in an August letter to SIPC.
Covering Stanford would be “an unprecedented expansion of SIPC protection to investment fraud losses,” SIFMA added in a statement last week after the SEC filed suit.
In its court filing, the SEC argued that Stanford customers should be covered by SIPC because the fraudulent CDs were sold through the brokerage firm and because Allen Stanford controlled all of the firm's nonbrokerage entities.
Even for experts, the distinction between the Madoff and Stanford cases isn't an easy one to make.
“It isn't clear to me why SIPC isn't doing what they normally do,” Thomas Gorman, a former SEC lawyer and a partner at Dorsey & Whitney LLP, said about SIPC's refusal to liquidate the Stanford brokerage firm.
Legal observers were struck by the SEC's tone in essentially pulling rank on both SIPC and the court.
In its court filing, the agency claims that it has sole authority to determine if SIPC should get involved in a case — a determination the SEC says is not subject to judicial review.
The SEC said that disputes over what assets deserve SIPC protection should be handled via the claims process SIPC administers after taking over a failed firm.
SIPC countered that the SEC's move was an “extraordinary example of overreaching.” In its own filing last week, SIPC said the SEC “wants to avoid judicial scrutiny [because it] cannot prevail under any serious analysis of the facts and the law in this case.”
The legal action by the SEC is the first time the agency has invoked its authority to force action by SIPC.
If the court grants the SEC's request, Mr. Harbeck said SIPC would appeal. SEC spokesman John Nester declined to comment.
Legal observers were uncertain how the dispute might play out, given its unprecedented nature.
The legal fight is a marked contrast with what many have viewed as a hands-off policy the SEC historically has taken toward SIPC.SEC AT FAULT?
A March 2011 report from the SEC's inspector general faulted the agency for not having a formal SIPC oversight process.
But the Stanford case and other major frauds have given the SIPC liquidation process a high profile. The SEC's action in suing SIPC came amidst intense political pressure to cover Stanford victims.
Despite the fight, SIPC and the SEC are working more closely together than ever. In addition to the Lehman Brothers Holdings Inc. and Madoff cases, the SEC and SIPC are now dealing with the MF Global Holdings Ltd. failure.
“We work with those folks every day, and that will continue,” Mr. Harbeck said about the SEC. “We have to compartmentalize that” cooperation from the legal dispute.
djamieson@investmentnews.com
