The Huge Hidden Risks to Your Brokerage Account – Reply to SIPC’s CEO

Source: Forbes

Stephen P. Harbeck, President and CEO of the Securities Investor Protection Corporation (SIPC) has written a strongly worded response to my Forbes column entitled “Close Your Brokerage Account.”  A longer version of this column entitled, Why No One Should Use Brokerage Accounts was published by PBS NEWSHOUR.

I respond below to each of Mr. Harbeck’s statements on a line-by-line basis.  I indicate my response with my initials, LJK.  I indicate his statements by the initial H.

Mr. Harbeck claims that my article entitled “Close Your Brokerage Account!”  (Forbes, June 30, 2014) is misleading in the extreme.

LJK:  I omitted no facts that were relevant to the point that investing funds in brokerage accounts runs the extreme risk of a) paying taxes each year on the reported appreciation and b) withdrawing those funds, spending them on a legitimate purpose (charity, supporting older parents, tuition, etc.),and then being sued by a SIPC-appointed trustee because it turns out that your broker or the broker at the next desk was a crook.  If you are sued, you will potentially have to pay back every penny you withdrew in the last two years (six years if the trustee gets his way in federal court).

This leaves customers of brokerage firms unable to safely spend the fruits of their investment.  This is why, until H.R. 3482 and S. 1725 or some comparable law is passed by Congress and signed by the President, I very strongly advise everyone with a brokerage account to immediately close their accounts and move their money to mutual fund companies operating with one of the major, trustworthy custodial companies that is not, itself, in the brokerage business.

This critical fact, that a SIPC-appointed and SIPC-controlled trustee might sue you for withdrawing funds from your own brokerage account is entirely omitted from SIPC’s homepage in what I consider to be an act of consumer fraud.

H:  Mr. Harbeck criticizes me for not mentioning that the brokerage firm I described was Bernard Madoff’s firm and that the fraud in question was a Ponzi Scheme.

LJK: For the record, I have relatives, friends, acquaintances, and colleagues (including Eli Wiesel at Boston University) who were victims of the Madoff fraud.   But my column was not about the Madoff fraud or about its victims.  It is about the SIPC fraud and SIPC’s victims.

We should not be surprised that there are Madoffs.  The world is full of crooks.  But we should be stunned that there is a SIPC, formed to protect brokerage customers, that actually exists to penalize them.

SIPC insurance is a scam – indeed a bigger scam than Madoff.  And investors should realize this.

LJK: When Congress enacted SIPA in 1970, Charles Ponzi had been dead for 21 years (1882-1949).  If Congress had wanted to deny victims of Ponzi schemes the protections of SIPA, Congress could easily have done so by including the following sentence:   “The protections of this statute do not apply to victims of Ponzi schemes.”  It is not for SIPC to re-write the statute; only Congress can write a statute; SIPC is legally bound to abide by it and it has breached the statute in the Madoff case.  The egregious treatment of customers in the Madoff case was proposed by SIPC and by the SIPC-appointed trustee.

LJK:  Madoff was an SEC-regulated broker for over 40 years.  If his customers can be denied SIPC insurance at the whim of SIPC, then so can every customer of every other SEC-regulated broker.  If SIPC’s members had paid more than $150 per year, per firm (including the nation’s largest investment companies), for SIPC insurance, SIPC would have had enough money to fund SIPC insurance up to $500,000 based on each customer’s last statement.  It is solely because the brokerage firms decided to provide essentially free insurance to themselves that the customers were victimized.  Should we be surprised that Wall Street wanted something for nothing?  SIPC induced innocent, honest Americans to entrust their life savings to brokerage firms with the promise of SIPC insurance.  But when it came to honoring that promise, SIPC decided it was cheaper to betray the investors and protect Wall Street.

As for the Madoff fraud being a Ponzi scheme, the clearest definition of a Ponzi scheme that I can construct as an economist is a financial enterprise that knowingly cons the public.  Under that definition, SIPC itself is a Ponzi scheme.  It is claiming to provide insurance against fraud in your brokerage account when it is, in fact, a) providing you no insurance whatsoever if you withdrew over the entire history of your account what you understood to be your assets and those withdrawals exceeded your contributions and b) also, in that case, suing you for all withdrawals you made for the past 2 years up to that excess.

Mr. Harbeck is bringing up Madoff and calling that particular con job a “Ponzi scheme” for a reason.  He wants to suggest that Ponzi schemes are unique and extremely rare and, hey, not to worry, chances are your brokerage account isn’t running a Ponzi scheme.

The key thing that Mr. Harbeck is not telling you, however, is that SIPC is free to define any fraud it comes across as a Ponzi scheme and then can sue you if you fall into their to-be-sued bucket, which is very easy to do!

LJK:  In fact, Madoff had an enormous trading operation with 200 employees.  188 of those employees operated a legitimate trading operation; only 12 were involved in the fraudulent investment advisory business.  If that is a Ponzi scheme, every brokerage firm is, potentially, a Ponzi scheme.

Mr. Harbeck states that the  account statements the victims received in the Madoff case were complete fictions.  But how do we know whether the statements we receive from any brokerage firm are accurate?  As customers of an SEC-regulated broker, how can we verify the statements sent to us?

Moreover, if the statements are complete fictions, why is the SIPC-controlled Trustee suing innocent customers based on those statements?

H: No investments were ever made for them.

LJK:  “No investments ever” contradicts SPIC’s own website that states that “At the start of the (Madoff) liquidation the trustee took custody of approximately $860 million in cash and proprietary securities.”  Those were investments.   So Mr. Harbeck and his website make my point.  SIPC is free to decide what is and is not a Ponzi scheme and, consequently, free to decide whether or not to sue you after processing in its own chosen manner statements that it claims are “complete fictions.”

H: Under the law, what each investor was entitled to receive was the return of the net amount deposited with Madoff.  The court overseeing Madoff’s fraud agreed, and stated that using the phony account statements to determine what each victim should receive was “absurd.”  Using those statements would have allowed the thief, Madoff, to decide who wins and who loses.

LJK:  Mr. Harbeck is completely misleading his readers.  Madoff did not tell customers when to invest and when to withdraw funds.  It was the customers who, for almost 50 years, made those investment decisions.  Thus, it is absurd to say that we can’t allow the thief, Madoff, to decide who wins and who loses.  Madoff didn’t decide.  His customers did.

Now, however, it is SIPC and the SIPC-controlled trustee who are deciding.  SIPC decided that all customers will lose because it failed to fund the insurance fund.  Not a single Madoff customer has been compensated for the loss of the use of his money, in many cases for decades, and the return it would have produced in legitimate investments.  If SIPC had used the last statement balance, as the law required it to do, every customer would have received SIPC insurance up to $500,000 based on his last statement.  Using the last statement balance  would have required SIPC to do what its homepage says it does — protect investors in brokerage account fraud — up to $500,000, i.e., honor its insurance commitment.   It would have also required SIPC to act as a proper fiduciary in checking that all brokerage accounts it insured were being properly custodied.

And, by the way, there are other ways to determine losses, namely taking contributions and accumulating them up at concomitant average market rates of return in comparable, non-fraudulent investments.  Had the Trustees advanced this definition of a victim’s loss – the net amounts contributed accumulated at prevailing comparable returns — the courts would likely have approved it.  But that would have left SIPC, i.e., its Wall Street handlers, with a much larger bill to pay and would have prevented SIPC from suing any victim.

H: The Court of Appeals also agreed, and stated that using those statements “would have the absurd effect of treating fictitious and arbitrarily assigned paper profits as real and would give legal effect to Madoff’s machinations.”

LJK: Again, neither SIPC nor the Court of Appeals proposed an alternative, economically appropriate means for assessing losses.  Instead, SIPC and the Court of Appeals, ignoring the statute, took the economically absurd position that investors are not entitled to a return on their investment – even over 50 years.  And because SIPC took this position, it has, I believe, gravely damaged the industry it serves.

H: The author fails to note that any money a participant receives in such a case, over and above the amount deposited, is money stolen from other innocent investors.

LJK:  Mr. Harbeck, let me ask a question on behalf of the thousands of victims of Madoff and other frauds that SPIC and its trusty Trustee have further victimized.

Have you no shame?

If you, Mr. Harbeck, had invested in Madoff and had done well and thought all was above board and then taken your account balance and spent it, maybe on charity, maybe on your older parents, maybe on your children’s educations, would you proclaim yourself to be a thief?  Would you wish to be treated like a thief?  Would you like to be publicly labeled a thief? No sir, you would not.

If there is any thief at large here besides Madoff and those who assisted him or turned a blind eye, it’s SIPC.

H: To enable other victims to recover the amounts they invested, a trustee has a duty under the law to those other victims to recover funds where possible.

LJK: You and your organization are saying that someone who, say, took out all their money exactly 2 years before Madoff was discovered is a thief.  But someone who took out all their money exactly 2 years and 1 day before Madoff was discovered is not a thief???

SIPC’s duty is to recover funds where possible from criminals, not from innocent victims.   And its main duty is to honor its promise to pay SIPC insurance up t $500,000 per account based on the last statement.

H: A Ponzi Scheme is a zero sum game.  A dollar of fictional “profit” given to one person who has received more than he or she contributed is a dollar that can’t be given to a victim that was unlucky enough to have lost principal.

LJK:  That is precisely why Congress enacted SIPA: to provide insurance to protect Wall Street’s customers.  Legitimate honest people don’t claim to be providing insurance and then sue the injured party.  That’s fraud in my book.  Furthermore, your statement is untrue.  The first $500,000 that each customer receives is to come from SIPC – the Wall Street firms, not from other customers.

H:  The trustee in the Madoff case didn’t sue people like Frank and Sally, the hypothetical victims mentioned by the author. To deal with situations exactly like the one described in Mr. Kotlikoff’s article, the trustee instituted a hardship program.  The trustee exercised discretion in instances where suing to recover assets would not be appropriate.

LJK: I made no mention of the economic situation of Frank and Sally in my column.  So you are simply assuming they are poor in order to claim the Trustee is only suing rich thieves, which is certainly not the case.  I have also been told by highly knowledgeable sources that the Madoff trustee’s “hardship” program was a sham – that he has pursued hundreds of elderly people with no assets but their IRA accounts. Moreover, insurance is not supposed to be up to the insurer’s discretion.  That’s another thing not disclosed on SIPC’s homepage.

H:  Further, if the trustee had sued Frank and Sally, it would have been because they withdrew more than they deposited and received other people’s money.

LJK: Everyone who took out a penny from Madoff accounts over his long history of operation could be said to have stolen other people’s money.   What Frank and Sally took out was the fruits of their investing as they understood them at the time.   They could have invested that $40,000 in plenty of other places and earned, on average, the $160,000 I referenced.  Spending what you understand to be your property is not theft.  Theft is when you know or have reason to know that you are taking money to which others may or do have a claim.

H: The author’s proposed solution was not thought through.  He proposes a boycott of brokerage accounts in favor of investing directly in mutual funds.  There is certainly nothing wrong with investing directly in mutual funds.  But if Madoff, or someone like him, establishes a mutual fund, and runs a Ponzi Scheme of the same magnitude and duration, avoiding regulatory scrutiny and making no actual purchases of securities for that mutual fund, the investors would receive nothing.  This is precisely what has happened, on a smaller scale, in a number of hedge fund frauds.

LJK:  This is a reasonable and important point.  But I referenced mutual funds with safe custody arrangements.  I have in mind mutual funds using major custodians who do nothing but custody securities.

H:  Fifth, the legislation the author champions has the unintended effect of legitimizing Ponzi Schemes.  Indeed, under that legislation, taxpayer money could be used to pay fictional Ponzi Scheme profits.  The legislation would make the outcome the Court of Appeals called “absurd” the law of the land…and an obligation of the taxpayers.

LJK: This is perhaps the crux of the matter — that SIPC was and remains grossly under-funded for the insurance it promised and promises investors.   Mr. Harbeck is suggesting that the taxpayer would have had to have bailed out SIPC in the Madoff case had HR 3482 and S. 1725 been the law of the land.  But here again Mr. Harbeck is misleading.  SIPA requires the Wall Street firms to fund SIPC – and not on the token basis of $150/year per Wall Street firm.  If anything was a fraud, it was the SIPC insurance program with no funding but plenty of promises.

And, to repeat, imputing an average return in comparable investments on past net contributions to brokerage accounts would be a reasonable way to determine what one actually lost.   So if SIPC is opposed to HR 3482 and S. 1725, it was and remains free to advocate other measures of investors’ losses that don’t invoke the remarkably Marxian notion that the fruits of one’s legitimate or assumed to be legitimate investments are not the properly insurable property of the investor.

H: Finally, the author’s disparagement of the SIPC program in the article is without foundation.  SIPC has advanced approximately $700 million to the trustee to satisfy Madoff’s customers and spent $1 billion in administrative expenses in that case.  This has resulted in the trustee’s recovery, through litigation and settlements, of $9.8 billion.  Over $5.2 billion of that has already been distributed. Any investor who gave Madoff $925,000, net, has already received all of his or her original investment back, with more distributions to come.

LJK: Congressman Garrett who co-sponsored HR 3482 very strongly disagrees.    I suggest that every investor read this statement by the Congressman.

H:  The legislation championed by the author would rob future trustees of the tools that made those recoveries possible, and rob future victims of potential compensation.

LJK:  No, the legislation or a modification of it, along the lines I mentioned, would simply prevent SIPC from criminalizing innocent victims and force SIPC to pay its obligations to all victims.  It would also prompt SIPC to exercise due diligence in insuring brokerage accounts.  The big unasked question is why SIPC failed to check that Madoff and other brokerage firms actually had the assets they claimed to be holding.  This is a gross failure of SIPC’s fiduciary responsibility, whether legally mandated or not, to its real clients — individual investors.

H:  Further, the trustee’s investigation of the Madoff fraud, financed by SIPC, has been instrumental to the convictions in the Madoff criminal cases and to the recovery of assets forfeited to the Government.  Not one cent of those administrative costs has been taken from the funds recovered for customers or paid out of taxpayer monies.

LJK:  Good to hear.  But the payments in general to the Trustee and others “settling” the Madoff case border on the obscene.   And Harbeck does not reveal that the SIPC-appointed Trustee personally earns 15 percent of every dollar in fees paid to his law firm. This is an outrage to all the Madoff customers who have been denied the promised SIPC insurance.

H:  SIPC is sympathetic to all of the victims of the Madoff fraud.  But the legislative proposals proffered by Mr. Kotlikoff are replete with unintended results that perpetuate even greater unfairness, and do not improve the statutory program SIPC administers. For more on SIPC, go to

LJK:  I could not disagree more fully.  The proposed legislation or reasonable modifications of it would make the use of brokerage accounts much safer than is now the case and eliminate one of the major risks of investing in brokerage accounts, namely being called a thief by SIPC for doing what every responsible American is supposed to do — save and invest.