If General Motors is going to receive more financial aid from the federal government, it is apparently going to have to achieve new concessions from creditors, unions and retirees. Former GM CEO Rick Wagoner and other directors have reportedly lost their jobs as a condition for the White House to provide any more funding to the U.S. auto industry giant.
All this raises questions about what the government's role in private industry should be, and how to apply that power across different industries. For example, although the executives at some banks have been replaced and certain FDIC members placed under government control, there are also financial firms which have received bailouts but have not been forced to restructure. Meanwhile, President Obama and Treasury Secretary Geithner have been calling for a plan under which the taxpayers would assume control of the banking industry's toxic assets - a far cry from forcing a restructuring deal.
To begin with, does President Obama or "the government" actually have the authority to force GM into bankruptcy, even if it is a short-lived "prepackaged bankruptcy"? Actually, yes - prepackaged bankruptcies are allowed under Chapter 11 restructuring bankruptcies, and certain creditors can force a company into an involuntary bankruptcy under Section 303 of the bankruptcy code. So because the government is a creditor to GM, and not simply an investor owning common or preferred stock, it would be permissible under certain circumstances for the government to force GM into bankruptcy.
But another question also looms: what is the definition of "the government"? When it is said that "the government" is a GM creditor, does that refer to the President, Congress, or the Treasury? Or is there even a written definition for this particular circumstance? Certainly the government should not be interfering with private industry except as authorized by law, but all these bailouts and questions as to which firms are "too big to fail" has left us in a situation not seen in over 70 years, so there is little experimental evidence to go on as to how we should proceed. And since there are economic and social differences between modern times and the Great Depression, from the loss of the manufacturing industry to the social safety net programs such as unemployment benefits, what would have been effective int the 1930s will not necessarily work now.
When any company, from a bank to GM to AIG, requests government assistance, that firm should expect to have changes imposed on it. After all, if the company had been healthy and prosperous to begin with, there would have been no need for any bailout. Furthermore, the possibility of government intervention following a bailout would hopefully provide incentive for companies to NOT seek government assistance, but rather would convince both the company and its creditors that a mutually acceptable restructuring with no government interference would be in their best interests.
Alas, there have already been billions of dollars spent in assisting U.S. firms, with the possibility of much more on the way. So while we should strive to minimize or eliminate all government funding to private businesses, there should also be a system in place in case such action is deemed necessary by both the public and private sectors in order to minimize abuses to the system. For example, when the government becomes a creditor to a private company, perhaps there should be a clause in the bankruptcy code in which only a joint congressional resolution would place that company into involuntary bankruptcy, or perhaps that power should reside with the President or the Treasury Secretary. Point is, there is no such legal provision, so while the President's actions may be with the best intent and for the protection of the taxpayers, the fact that there is currently no legal framework for what is happening could very well be setting a dangerous precedent. Of course, any mere legal framework in and of itself cannot prevent abuses from either private industry or the government, nor could such framework even guarantee positive results. But at least a legal framework would have to be agreed upon by both Congress and the President in the typical legislative process, and hopefully that would ensure greater accountability in the hopefully rare instance that bailouts are deemed necessary.
Monday, March 30, 2009
Friday, March 27, 2009
President Obama needs more decisiveness in dealing with bank execs
Today, President Obama met with the CEOs of 15 major banks at the White House to encourage cooperation with the administration’s new plan to free up the credit and lending markets. The bank executives appear optimistic about the initial proposal but would also like further details.
Apparently, the plan to partner with private investors, the Federal Reserve and the FDIC to buy as much as $1 trillion in toxic assets from the banks to encourage lending is still on the table. As mentioned before, can we really trust the same banks whose dealings led to those toxic assets with that amount of capital, while simply HOPING the plan will free up lending but not actually require it? Or will even $1 trillion not be enough to cover all of the toxic assets, in which case the lending crisis will remain as it is now, only with more accumulation to the national debt?
Although the President should definitely make overtures to bank executives to encourage their cooperation in an economic recovery plan, the President also has considerable leverage in the matter and should not be afraid to use it if absolutely necessary – but hopefully the mere possibility of such action would convince banks to accept an alternative solution. Since most, if not all, of the major banks are members of the FDIC, the Federal Deposit Insurance Act allows the FDIC to step in and assume control of those institutions under certain conditions, including “unsafe or unsound condition” and “losses”. If the FDIC were to assume control of the banks, those toxic assets could be renegotiated, with a corresponding loss of economic income and prestige to both the banks and their counterparties in the toxic assets.
However, it is not in the best interest of the economy at large or the banks for the FDIC to take such initiative. But it should be sufficient incentive for the banks to accept an alternative plan to the outright purchase of the toxic assets by the government and private investors: no-interest loans provided by the Treasury and Federal Reserve to the banks UNDER THE WRITTEN CONDITION THAT THOSE FUNDS BE USED IN EXTENDING LOANS TO PRIVATE BUSINESSES. A written agreement will prevent another AIG scandal, as the bank executives would be criminally liable if the conditions of the agreement were broken. And even though the banks would still hold the toxic assets, they would benefit from the interest earned on the business loans, while the counterparties in the toxic assets wouldn’t be paid immediately but also would not see the assets diminish in value as a result of FDIC action. Finally, the government would benefit not only from the economic stimulation of loans to businesses, but also by not holding onto those toxic assets and eventually being repaid by the banks to minimize the impact on the national debt.
President Obama is taking the correct approach in being diplomatic with the bank executives and soliciting their cooperation in the economic recovery plan. But he also needs to keep in mind the leverage he has in this particular situation, and use that to his advantage in putting forth a plan which will first and foremost stimulate the economy while also allowing the banks to gradually eliminate their toxic assets. This plan will also allow the Congress time to debate and establish the new regulatory measures before all the toxic assets are removed and the wheeling and dealing begins with renewed vigor.
After all, if the President is willing to spend upwards of $1 trillion in the HOPE that banks will begin lending again, why not spend less than that amount in a plan which ENSURES that the money go towards stimulating the economy?
Apparently, the plan to partner with private investors, the Federal Reserve and the FDIC to buy as much as $1 trillion in toxic assets from the banks to encourage lending is still on the table. As mentioned before, can we really trust the same banks whose dealings led to those toxic assets with that amount of capital, while simply HOPING the plan will free up lending but not actually require it? Or will even $1 trillion not be enough to cover all of the toxic assets, in which case the lending crisis will remain as it is now, only with more accumulation to the national debt?
Although the President should definitely make overtures to bank executives to encourage their cooperation in an economic recovery plan, the President also has considerable leverage in the matter and should not be afraid to use it if absolutely necessary – but hopefully the mere possibility of such action would convince banks to accept an alternative solution. Since most, if not all, of the major banks are members of the FDIC, the Federal Deposit Insurance Act allows the FDIC to step in and assume control of those institutions under certain conditions, including “unsafe or unsound condition” and “losses”. If the FDIC were to assume control of the banks, those toxic assets could be renegotiated, with a corresponding loss of economic income and prestige to both the banks and their counterparties in the toxic assets.
However, it is not in the best interest of the economy at large or the banks for the FDIC to take such initiative. But it should be sufficient incentive for the banks to accept an alternative plan to the outright purchase of the toxic assets by the government and private investors: no-interest loans provided by the Treasury and Federal Reserve to the banks UNDER THE WRITTEN CONDITION THAT THOSE FUNDS BE USED IN EXTENDING LOANS TO PRIVATE BUSINESSES. A written agreement will prevent another AIG scandal, as the bank executives would be criminally liable if the conditions of the agreement were broken. And even though the banks would still hold the toxic assets, they would benefit from the interest earned on the business loans, while the counterparties in the toxic assets wouldn’t be paid immediately but also would not see the assets diminish in value as a result of FDIC action. Finally, the government would benefit not only from the economic stimulation of loans to businesses, but also by not holding onto those toxic assets and eventually being repaid by the banks to minimize the impact on the national debt.
President Obama is taking the correct approach in being diplomatic with the bank executives and soliciting their cooperation in the economic recovery plan. But he also needs to keep in mind the leverage he has in this particular situation, and use that to his advantage in putting forth a plan which will first and foremost stimulate the economy while also allowing the banks to gradually eliminate their toxic assets. This plan will also allow the Congress time to debate and establish the new regulatory measures before all the toxic assets are removed and the wheeling and dealing begins with renewed vigor.
After all, if the President is willing to spend upwards of $1 trillion in the HOPE that banks will begin lending again, why not spend less than that amount in a plan which ENSURES that the money go towards stimulating the economy?
Wednesday, March 25, 2009
New regulatory framework for financial institutions
Treasury Secretary Timothy Geithner is petitioning Congress for a set of new regulatory powers which would enable the federal government to seize certain financial companies which are near insolvency, similar to powers the FDIC has in taking control of troubled banks. The idea is to prevent another bailout disaster similar to AIG, but is such drastic new legislation really necessary, or could a more moderate increase in federal regulatory powers serve to fulfill the same purpose?
Let’s review the bank situation Mr. Geithner is attempting to draw a parallel with. The Federal Deposit Insurance Act, which created the FDIC, contains provisions under which that entity can take over certain troubled banks, including conditions of “assets insufficient for obligations”, “unsafe or unsound condition”, “cease and desist orders”, “violations of law”, and “losses”. This Act was passed soon after FDR took office in the early 1930s, when bank failures were commonplace, and provided a mechanism for the government to take early action to prevent catastrophic failure of a critical component of the economy. Since bank failures can suppress economic growth and lead directly to both short and long-term distress for bank account holders, there is a good basis for this law even today.
But even with the public outrage over the AIG situation, is there a more moderate approach to handling new regulatory measures for non-banks? First off, both President Bush and a Democratic Congress failed to expressly write conditions under which AIG should use the bailout funds, so public outrage should first and foremost be directed at the federal government. If you give a bunch of crooks some money without police escort, what would you expect?
Alas, we could play the political blame game to infinity without achieving any significant progress, so here is a solution to the regulatory problem which will allow some level of government intervention when appropriate while allowing non-banks to function in a manner deemed appropriate by their directors: amend the Investment Company Act of 1940. An “investment company” is one whose primary business is in investment, i.e. trading stocks and bonds and other securities and derivatives to achieve profit. AIG currently does not qualify as an investment company because its primary business is insurance, not investing. And yet, poor investing is what put this insurance giant into distress. So why not amend the Investment Act of 1940 to require certain publicly-traded companies, i.e. firms required to register under the Securities Act of 1933 or Securities Exchange Act of 1934, as investment companies? There could be an exception for companies who only invest extra cash into savings accounts or other publicly-traded companies, but otherwise if a publicly traded company (1) engages primarily in investing, (2) has a subsidiary engaged primarily in investing (i.e., AIG Financial Products) or (3) invest cash in anything other than demand deposits or other publicly-traded securities, that company would also have to register as an investment company.
What intervention authority should the federal government have over investment companies? For starters, companies classified as “investment companies” under provision (2) or (3) above should have more stringent and frequent reporting requirements so both investors and federal authorities would be more likely to catch any particular trouble spots. This would exclude firms such as hedge funds and other companies engaged primarily in investing activities from these reporting requirements. And federal authorities should then be allowed to file for a cease and desist order in federal bankruptcy court to prevent dangerous activities by those companies, but not for the government to simply take over those companies. The companies could then either play ball and cooperate with the government, or appeal the order first in bankruptcy court then in district court. In this manner, more consumer and overall economic protection would be provided without allowing the government too much control over the daily operations of non-banking private companies.
Let’s review the bank situation Mr. Geithner is attempting to draw a parallel with. The Federal Deposit Insurance Act, which created the FDIC, contains provisions under which that entity can take over certain troubled banks, including conditions of “assets insufficient for obligations”, “unsafe or unsound condition”, “cease and desist orders”, “violations of law”, and “losses”. This Act was passed soon after FDR took office in the early 1930s, when bank failures were commonplace, and provided a mechanism for the government to take early action to prevent catastrophic failure of a critical component of the economy. Since bank failures can suppress economic growth and lead directly to both short and long-term distress for bank account holders, there is a good basis for this law even today.
But even with the public outrage over the AIG situation, is there a more moderate approach to handling new regulatory measures for non-banks? First off, both President Bush and a Democratic Congress failed to expressly write conditions under which AIG should use the bailout funds, so public outrage should first and foremost be directed at the federal government. If you give a bunch of crooks some money without police escort, what would you expect?
Alas, we could play the political blame game to infinity without achieving any significant progress, so here is a solution to the regulatory problem which will allow some level of government intervention when appropriate while allowing non-banks to function in a manner deemed appropriate by their directors: amend the Investment Company Act of 1940. An “investment company” is one whose primary business is in investment, i.e. trading stocks and bonds and other securities and derivatives to achieve profit. AIG currently does not qualify as an investment company because its primary business is insurance, not investing. And yet, poor investing is what put this insurance giant into distress. So why not amend the Investment Act of 1940 to require certain publicly-traded companies, i.e. firms required to register under the Securities Act of 1933 or Securities Exchange Act of 1934, as investment companies? There could be an exception for companies who only invest extra cash into savings accounts or other publicly-traded companies, but otherwise if a publicly traded company (1) engages primarily in investing, (2) has a subsidiary engaged primarily in investing (i.e., AIG Financial Products) or (3) invest cash in anything other than demand deposits or other publicly-traded securities, that company would also have to register as an investment company.
What intervention authority should the federal government have over investment companies? For starters, companies classified as “investment companies” under provision (2) or (3) above should have more stringent and frequent reporting requirements so both investors and federal authorities would be more likely to catch any particular trouble spots. This would exclude firms such as hedge funds and other companies engaged primarily in investing activities from these reporting requirements. And federal authorities should then be allowed to file for a cease and desist order in federal bankruptcy court to prevent dangerous activities by those companies, but not for the government to simply take over those companies. The companies could then either play ball and cooperate with the government, or appeal the order first in bankruptcy court then in district court. In this manner, more consumer and overall economic protection would be provided without allowing the government too much control over the daily operations of non-banking private companies.
Monday, March 23, 2009
New Obama plan similar to AIG bailouts?
While final details are still a little sketchy, the Obama administration has proposed a plan to provide both public and private investment in removing toxic assets from bank balance sheets in an attempt to improve the credit markets. Although improving unemployment should remain the priority at this stage of the economic recovery, there is little or no doubt that the financial markets need to be strengthened so that viable companies which actually have a demand for their products can obtain credit in order to obtain more inventory and increase payrolls. So, will this plan actually strengthen the financial system?
The proposed plan will involve the purchase, by both the government and private investors, of both troubled securities and loans currently on bank balance sheets. While purchasing the loans may prevent some foreclosures and therefore steady the housing markets, there should be more than a little skepticism about purchasing troubled securities – most of which are tied into the housing market. Under the current plan, the government (including the Federal Reserve) will hold upwards of 93% of the toxic securities. It is important to note that this plan will NOT improve the market for such securities - that will only occur when and if the housing market returns to its pre-2007 high water mark. The plan simply assumes that, by removing these toxic assets from the banks, the banks will have incentive to once again provide loans and hopefully raise the GDP.
One problem (amongst many potential issues): what is the total amount of “toxic” assets that we are talking about? The initial plan seems to call for a grand total of anywhere between one half and one trillion dollars in total relief. But what if the total amount of the assets in question exceeds the amount provided by the federal government? In that case this would resemble the AIG bailout, with government (and a little private) funds going to banks to purchase the securities, the government left with the toxic assets and hoping their value rises over time, the banks paying off the investment banks or other parties they are currently indebted to, and not enough capital left over to provide for credit consumers. If any estimate of the total amount of toxic assets is available, I have yet to see one in any of the press releases.
Instead of simply paying off the investment bankers in the hopes that credit will start flowing again, why not provide the relief to banks in the form of zero-interest loans with a five-year maturity under the condition that the funds be used in extending credit? That is the surest way to get loans out to businesses which are willing to expand and provide more jobs. It doesn’t solve the toxic asset problem anytime soon, but it does get credit flowing, and by improving the unemployment rate and stimulating the economy the impact of those toxic assets can eventually be either be lessened or completely negated, and there will be a stronger base for the U.S. economy going forward. Besides, by making economically sound loans and earning interest, the banks can gradually fulfill their prior obligations and thereby remove the toxic assets.
The proposed plan will involve the purchase, by both the government and private investors, of both troubled securities and loans currently on bank balance sheets. While purchasing the loans may prevent some foreclosures and therefore steady the housing markets, there should be more than a little skepticism about purchasing troubled securities – most of which are tied into the housing market. Under the current plan, the government (including the Federal Reserve) will hold upwards of 93% of the toxic securities. It is important to note that this plan will NOT improve the market for such securities - that will only occur when and if the housing market returns to its pre-2007 high water mark. The plan simply assumes that, by removing these toxic assets from the banks, the banks will have incentive to once again provide loans and hopefully raise the GDP.
One problem (amongst many potential issues): what is the total amount of “toxic” assets that we are talking about? The initial plan seems to call for a grand total of anywhere between one half and one trillion dollars in total relief. But what if the total amount of the assets in question exceeds the amount provided by the federal government? In that case this would resemble the AIG bailout, with government (and a little private) funds going to banks to purchase the securities, the government left with the toxic assets and hoping their value rises over time, the banks paying off the investment banks or other parties they are currently indebted to, and not enough capital left over to provide for credit consumers. If any estimate of the total amount of toxic assets is available, I have yet to see one in any of the press releases.
Instead of simply paying off the investment bankers in the hopes that credit will start flowing again, why not provide the relief to banks in the form of zero-interest loans with a five-year maturity under the condition that the funds be used in extending credit? That is the surest way to get loans out to businesses which are willing to expand and provide more jobs. It doesn’t solve the toxic asset problem anytime soon, but it does get credit flowing, and by improving the unemployment rate and stimulating the economy the impact of those toxic assets can eventually be either be lessened or completely negated, and there will be a stronger base for the U.S. economy going forward. Besides, by making economically sound loans and earning interest, the banks can gradually fulfill their prior obligations and thereby remove the toxic assets.
Saturday, March 21, 2009
AIG executives to blame for "liquidity events"?
With the recent public outcry over bonuses paid to AIG derivatives traders, another issue has been raised: is it possible that those bonuses, representing about 0.1% of the total federal amount poured into the troubled giant, are actually veiling a larger problem? And do the derivatives traders deserve sole blame for the financial meltdown, or were AIG executives aware of what was happening some time ago?
Let’s begin with an overview of AIG, whose primary businesses include general insurance, life insurance & retirement services, financial services and asset management. For insurance operations, AIG charges premiums and deductibles to customers and in exchange provides payments for certain health-related costs based on the individual insurance policies, which are contracts between AIG and its customers. As with any business, AIG must bring in enough revenue to cover expenses and hopefully generate an acceptable profit margin. So when AIG receives premiums, it doesn’t just have extra cash sitting idly around somewhere – it can either place the proceeds into an interest-bearing bank account, or invest in securities or other financial instruments, in order to obtain a return from available cash while it pays out insurance-related expenses.
Why would AIG, or any other business, invest cash into securities instead of simply keeping it in a bank account? Shouldn’t the company focus on achieving profits from its core operations, and not on financial instruments? This could be the subject for an interesting philosophical or regulatory debate, but in truth this kind of investment happens with all manners of companies, from aircraft manufacturers to commercial banks. Such companies shouldn’t receive a large portion of their profits from investing cash into securities (lest equity research analysts become alarmed), but it is commonplace for many business to participate in such investments – and by investing in securities the companies hope to attain a greater return than from simple bank deposits.
Of course, whenever a company invests cash into securities, liquidity (the ability to convert an asset into cash) becomes an issue. It’s all well and fine that firms are trying to realize a larger profit, just so long as they can continue to fulfill their contractual obligations to customers. And because those obligations require cash, investment in securities could become problematic the value of those securities declines. To further complicate matters, AIG had “loaned” its securities to other parties in exchange for cash collateral, and then invested that cash into residential mortgage-backed securities (i.e., AIG owned the rights the payments from certain pools of mortgages). When the market for those mortgage-backed securities evaporated, AIG was left devalued assets and an inability to repay the investors under the securities lease program.
Enter the derivatives traders. AIG had taken a short position with respect to its credit default swaps (CDS), meaning that AIG received regular payments from the CDS, but in return would have to make payments if defaults occurred. So if the housing market had remained strong, AIG would have profited both from the rising value of the residential mortgage-backed securities and from not having to pay under the terms of the CDS – but this is the exact opposite of a hedging position. So the derivatives traders in AIG Financial Products were not hedging to safeguard against risk in the AIG investment portfolio; rather, they were speculating and hoping for the best.
Why would the derivatives traders place AIG in such a precarious position, one which had little to do with the company’s core operations and in fact posed a threat to ongoing operations? The answer may very well be that AIG had already been facing liquidity problems, and the executives engaged in a gambling scheme in an attempt to avoid difficulties and cover the liquidity issues from a probing media. According to its 2008 Annual Report, AIG had raised $20 billion by issuing common stock and subordinated debt in May 2008, and raised another $3.25 billion from more debt issued in August 2008. Why would a healthy, prosperous company need to issue additional stock and debt in order to raise capital, unless it was not nearly as prosperous as we were led to believe? One cannot blame derivatives traders for registering stock and debt with the SEC and then issuing the securities in the market to obtain cash, and it is entirely possible that AIG executives either knew about or instructed the derivatives traders to engage in their speculating activities in order to raise short-term cash to cover liquidity difficulties.
Let’s begin with an overview of AIG, whose primary businesses include general insurance, life insurance & retirement services, financial services and asset management. For insurance operations, AIG charges premiums and deductibles to customers and in exchange provides payments for certain health-related costs based on the individual insurance policies, which are contracts between AIG and its customers. As with any business, AIG must bring in enough revenue to cover expenses and hopefully generate an acceptable profit margin. So when AIG receives premiums, it doesn’t just have extra cash sitting idly around somewhere – it can either place the proceeds into an interest-bearing bank account, or invest in securities or other financial instruments, in order to obtain a return from available cash while it pays out insurance-related expenses.
Why would AIG, or any other business, invest cash into securities instead of simply keeping it in a bank account? Shouldn’t the company focus on achieving profits from its core operations, and not on financial instruments? This could be the subject for an interesting philosophical or regulatory debate, but in truth this kind of investment happens with all manners of companies, from aircraft manufacturers to commercial banks. Such companies shouldn’t receive a large portion of their profits from investing cash into securities (lest equity research analysts become alarmed), but it is commonplace for many business to participate in such investments – and by investing in securities the companies hope to attain a greater return than from simple bank deposits.
Of course, whenever a company invests cash into securities, liquidity (the ability to convert an asset into cash) becomes an issue. It’s all well and fine that firms are trying to realize a larger profit, just so long as they can continue to fulfill their contractual obligations to customers. And because those obligations require cash, investment in securities could become problematic the value of those securities declines. To further complicate matters, AIG had “loaned” its securities to other parties in exchange for cash collateral, and then invested that cash into residential mortgage-backed securities (i.e., AIG owned the rights the payments from certain pools of mortgages). When the market for those mortgage-backed securities evaporated, AIG was left devalued assets and an inability to repay the investors under the securities lease program.
Enter the derivatives traders. AIG had taken a short position with respect to its credit default swaps (CDS), meaning that AIG received regular payments from the CDS, but in return would have to make payments if defaults occurred. So if the housing market had remained strong, AIG would have profited both from the rising value of the residential mortgage-backed securities and from not having to pay under the terms of the CDS – but this is the exact opposite of a hedging position. So the derivatives traders in AIG Financial Products were not hedging to safeguard against risk in the AIG investment portfolio; rather, they were speculating and hoping for the best.
Why would the derivatives traders place AIG in such a precarious position, one which had little to do with the company’s core operations and in fact posed a threat to ongoing operations? The answer may very well be that AIG had already been facing liquidity problems, and the executives engaged in a gambling scheme in an attempt to avoid difficulties and cover the liquidity issues from a probing media. According to its 2008 Annual Report, AIG had raised $20 billion by issuing common stock and subordinated debt in May 2008, and raised another $3.25 billion from more debt issued in August 2008. Why would a healthy, prosperous company need to issue additional stock and debt in order to raise capital, unless it was not nearly as prosperous as we were led to believe? One cannot blame derivatives traders for registering stock and debt with the SEC and then issuing the securities in the market to obtain cash, and it is entirely possible that AIG executives either knew about or instructed the derivatives traders to engage in their speculating activities in order to raise short-term cash to cover liquidity difficulties.
Saturday, March 14, 2009
Some Protection for Madoff Victims
When Bernard Madoff plead guilty to eleven criminal counts in federal court on Thursday, many of the victims of his Ponzi scheme were present in the courtroom. And although there was applause and satisfaction from the investors present, it does not necessarily improve there future prospects. While estimates of the exact amount of total losses vary from a few billion to $65 billion, depending on how one accounts for the fraud, there is no doubt that many individuals have been emotionally scarred and left in a precarious financial situation.
With so many government dollars invested in bailing out the financial and automotive sectors, and additional federal assistance approved for the unemployed, is there any recourse for not only the Madoff victims but also other sophisticated or high net worth individuals? Federal securities laws, namely the Securities Act of 1933, Securities Exchange Act of 1934 and Investment Advisers Act of 1940, were passed with the goal of protecting investors from fraud. But there are also exceptions to these laws, designed to allow certain individuals to make investments without having to register their securities and fully disclose the nature of their operations in order to hopefully achieve a greater return on a particular investment. The investors in the Bernard L. Maddof Investment Securities LLC would have (or should have) fallen into this category, so what federal protection is available for these individuals?
Enter the Securities Investor Protection Corporation (SIPC, http://www.sipc.org). Created in 1970 under the Securities Investor Protection Act, this is actually a non-profit corporation, somewhat akin to the FDIC, who charges member investment firms a certain fee to maintain a small security blanket for investors. Unlike the FDIC, which guarantees deposits up to a certain amount regardless of how a bank loses the money, the SIPC does NOT grant relief for normal investment losses. But the SIPC does provide relief in the event that a brokerage firm fails and the cash/shares are missing from an investor’s account, which is what happened for the Madoff victims whose investments were not used to purchase stocks or other legitimate investment instruments but went instead to pay other investors.
For the Madoff victims, the SIPC has granted a waiver to allow for the maximum $500,000 claim. In combination with the fraudulent transfer laws incorporated into bankruptcy law, it might be possible for the victims to receive a more equitable portion of their original investment, but undoubtedly the measures will not provide full compensation. Investors looking into any brokerage or investment firm would be well advised to ensure that the firm is in fact a member of the SIPC, and to consider the maximum amount of coverage available when deciding how much to invest in any one financial institution.
Concerning the SEC, was it negligent of not pursuing the matter further, considering the reports of tips of possible fraud it had received about Mr. Madoff’s operations? While it is true that securities laws in general allow for sophisticated or high net worth individuals to invest in firms which do not have to fully comply with all aspects of securities laws, the intent being to allow for such individuals to invest without having to deal with the costs of reporting and to prevent others from duplicating their methods of attaining high returns, it is also true that the securities laws contain anti-fraud provisions which can never be waived. In fact, on the same day federal agents arrested Mr. Madoff, the SEC filed a civil suit against him accusing him of violating the anti-fraud provisions of the securities acts and seeking an injunction to cease Mr. Madoff’s operations (http://www.sec.gov/litigation/litreleases/2008/lr20834.htm). So there were in fact provisions in the regulatory framework which the SEC could have invoked to initiate an investigation against Bernard Madoff years ago, meaning that there does not necessarily have to be any change in the regulations, but there does have to be enforcement of the existing laws to ensure protection for all classes of investors.
With so many government dollars invested in bailing out the financial and automotive sectors, and additional federal assistance approved for the unemployed, is there any recourse for not only the Madoff victims but also other sophisticated or high net worth individuals? Federal securities laws, namely the Securities Act of 1933, Securities Exchange Act of 1934 and Investment Advisers Act of 1940, were passed with the goal of protecting investors from fraud. But there are also exceptions to these laws, designed to allow certain individuals to make investments without having to register their securities and fully disclose the nature of their operations in order to hopefully achieve a greater return on a particular investment. The investors in the Bernard L. Maddof Investment Securities LLC would have (or should have) fallen into this category, so what federal protection is available for these individuals?
Enter the Securities Investor Protection Corporation (SIPC, http://www.sipc.org). Created in 1970 under the Securities Investor Protection Act, this is actually a non-profit corporation, somewhat akin to the FDIC, who charges member investment firms a certain fee to maintain a small security blanket for investors. Unlike the FDIC, which guarantees deposits up to a certain amount regardless of how a bank loses the money, the SIPC does NOT grant relief for normal investment losses. But the SIPC does provide relief in the event that a brokerage firm fails and the cash/shares are missing from an investor’s account, which is what happened for the Madoff victims whose investments were not used to purchase stocks or other legitimate investment instruments but went instead to pay other investors.
For the Madoff victims, the SIPC has granted a waiver to allow for the maximum $500,000 claim. In combination with the fraudulent transfer laws incorporated into bankruptcy law, it might be possible for the victims to receive a more equitable portion of their original investment, but undoubtedly the measures will not provide full compensation. Investors looking into any brokerage or investment firm would be well advised to ensure that the firm is in fact a member of the SIPC, and to consider the maximum amount of coverage available when deciding how much to invest in any one financial institution.
Concerning the SEC, was it negligent of not pursuing the matter further, considering the reports of tips of possible fraud it had received about Mr. Madoff’s operations? While it is true that securities laws in general allow for sophisticated or high net worth individuals to invest in firms which do not have to fully comply with all aspects of securities laws, the intent being to allow for such individuals to invest without having to deal with the costs of reporting and to prevent others from duplicating their methods of attaining high returns, it is also true that the securities laws contain anti-fraud provisions which can never be waived. In fact, on the same day federal agents arrested Mr. Madoff, the SEC filed a civil suit against him accusing him of violating the anti-fraud provisions of the securities acts and seeking an injunction to cease Mr. Madoff’s operations (http://www.sec.gov/litigation/litreleases/2008/lr20834.htm). So there were in fact provisions in the regulatory framework which the SEC could have invoked to initiate an investigation against Bernard Madoff years ago, meaning that there does not necessarily have to be any change in the regulations, but there does have to be enforcement of the existing laws to ensure protection for all classes of investors.
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