The financial crisis, investor protection, and lessons learned
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In October 2011, the Securities Investor Protection Corporation (SIPC) received a pre-dawn call from the U.S. Securities and Exchange Commission stating that MF Global had failed and could not immediately return all assets to customers. That same day, SIPC successfully initiated the liquidation proceeding in New York.

Since then, securities customers have had their assets transferred, and commodities customer accounts, although not eligible for funds from SIPC, were also transferred in full. All securities and commodities customers with valid claims have been made whole, and general creditors have received 95 cents on the dollar.

SIPC has a simple mission in a complex industry. SIPC protects the “custody” function of securities brokerage firms. When a firm cannot return customer assets, SIPC initiates a court proceeding and asks the court to begin a specialized form of bankruptcy. Under the Securities Investor Protection Act (SIPA), SIPC’s funds are used to replace missing customer securities and cash, and to pay for expenses in the proceeding.

Now that the financial crisis that surfaced in 2008 is winding down, it is time to consider lessons learned and plan for the next financial crisis.

When Lehman Brothers failed in September 2008, SIPC and the SIPA trustee for the firm transferred more than $105 billion in customer property to 110,000 customers within days of the failure. This had a profound calming effect on markets worldwide and gave control of investment decisions back to the customers as quickly as possible.

The failure of Bernard Madoff’s brokerage firm in December 2008 brought to light Madoff’s astonishing theft of $17 billion of customer assets. Using tools provided by the Bankruptcy Code and SIPA, the trustee has recovered $11.5 billion. Combined with funds from SIPC, any customer who left $1.75 million, net, with Madoff has been made completely whole. Customers with larger balances have received slightly more than 60 percent of their assets back, with a prospect of more recoveries.

Lessons learned

The exceptionally large sums involved in the Lehman, Madoff and MF Global cases generated similarly large lawsuits. Those lawsuits involved interpretation of either SIPA or the Bankruptcy Code. In many cases, SIPC’s and the SIPA trustees’ construct of the law has been upheld by the courts. Two legal principles, involving the trustee’s attempt to recover assets for the benefit of customers, warrant either judicial reconsideration or legislative amendment.

First, a proceeding under SIPA is essentially a Chapter 7 liquidation, with some modifications under SIPA as a result of the unique nature of a brokerage firm’s business. This is very different from a Chapter 11 reorganization, where management typically remains in control. But in the Madoff proceeding, when the trustee sued a number of large financial institutions, those defendants successfully claimed that the trustee stood in the shoes of the wrongdoer and could not sue other purported wrongdoers. I believe that a trustee stands in the shoes of the victims. Individual victims do not have the resources to take on such litigation. A trustee, using SIPC’s resources, should have the opportunity to pursue a suit of that nature.

Second, and very technically, Bankruptcy Code section 546(e) has been interpreted to render invulnerable literally nonexistent securities transactions. A trustee cannot reverse a fictional transaction. This is far beyond the reasoning of the drafters of that section, who sought to protect securities markets from after the fact reversal of actual transactions made in good faith.

The next crisis

Planners must assume that a future financial crisis would involve the failure of a conglomerate even larger than Lehman Brothers. The resolution authority under the Dodd-Frank Act for such mega-firms is the current blueprint for winding up such a giant enterprise. Using a completely new procedure in what will be—literally by definition—the largest insolvency of any kind in history, is a recipe for uncertainty, and possibly, disaster. The Bankruptcy Code has proven to be a remarkably flexible vehicle for resolving the cases in the last financial crisis, and should be the first option in the next such crisis.

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Now for the question of the hour for policymakers: What will cause the next financial crisis? Prudent regulation has made it extraordinarily difficult to steal customer assets systematically, over an extended period of time. That same regulatory model has the ability to recognize when a major financial institution is in a slow downward spiral. So what should keep regulators up at night? Cybersecurity, cybersecurity, cybersecurity.

The largest financial firms do millions of transactions at blinding speed. A robust denial of service (DoS) attack, or the insertion of fraudulent trades in overwhelming numbers, or massive tampering with automated trading algorithms could immediately disrupt the financial services world as never before.

As a first priority, both the regulators and the regulated need to prevent such attacks and plan to recover from, and reverse, a successful attack. The work of the Financial and Banking Information Infrastructure Committee, spearheaded by the Treasury Department, must be given prominent priority in the coming year.

Stephen Harbeck is president and chief executive officer of the Securities Investor Protection Corporation (SIPC), a nonprofit organization created by Congress to oversee the liquidation of member broker-dealers that close when the firms go bankrupt or face financial trouble, and customer assets are missing. SIPC has returned $138 billion in assets for an estimated 773,000 investors since its creation in 1970. SIPC, as a matter of policy, disclaims responsibility for any private publication by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of SIPC or the author’s colleagues on the staff of SIPC.


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