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Madoff Scandal and How it Affects Customers of BMIS

December 2008
People: Alan M. Reisch

Following last week’s shocking news, detailed in the complaint filed by the SEC alleging that former NASD chairman, Bernard Madoff, had allegedly perpetrated a multibillion dollar Ponzi scheme on clients of his firm, Bernard L. Madoff Investment Securities LLC (“BMIS”), the United States District Court for the Southern District of New York has ordered the liquidation of BMIS. The Securities Investor Protection Corporation (“SIPC”), which maintains a special reserve fund authorized by Congress to help customers at failed brokerage firms, will administer the liquidation in the bankruptcy court for the Southern District. Irving Picard of the Gibbons Law Firm has been appointed as trustee for the liquidation. The purpose of this Client Alert is to provide a general overview of where the BMIS liquidation stands today and what issues may arise for BMIS customers as the liquidation proceeds.

All actions against BMIS or property of BMIS, including actions by BMIS’s customers to recover assets, are automatically stayed and prohibited. Assets of Madoff remain frozen pursuant to the district court order entered in connection with the SEC’s filing.

The purpose of the liquidation of BMIS is, among other things, to make payments to and for the account of the customer “insofar as [the firm’s] obligations are ascertainable from the books and records of the debtor or are otherwise established to the satisfaction of the trustee.” Customer property will be shared ratably on the basis and to the extent of the firm’s obligations to customers. As has been widely reported, it is expected to take the trustee several months to sort out BMIS’s financial records, and given the very nature of a Ponzi scheme, which likely involved a large volume of fictitious transactions, determining the relationship of the assets held by BMIS to individual customer accounts based on BMIS’s records will be an extremely challenging task. In light of these poor records, the trustee will most certainly require substantial documentation from BMIS’s customers. Therefore, it is imperative that customers collect and preserve all records relating to their accounts.

What Are Customers’ Protections under SIPA?

Under the Securities Investor Protection Act (“SIPA”), which governs SIPC’s activities, each customer is insured by the SIPC up to a maximum of $500,000 for claims of lost or misappropriated securities (encompassing stocks, bonds, options, CDs and other forms), including a maximum of $100,000 for claims for cash. Again, customer claims will have to be established to the satisfaction of the trustee or the court. Investments that are not eligible for SIPC protection include commodity futures contracts and currency, as well as investment contracts not registered with the SEC. The SIPC’s funds may not be used to pay claims of brokers, dealers or banks acting for themselves rather than for their own customers. A customer who holds multiple accounts with BMIS in “separate capacities” (e.g. individually and as a trustee for others) may be entitled to greater SIPC coverage. The SIPC is not a guarantor of market losses for authorized investments. If SIPC funds do not cover customer claims, customers may participate in distributions from BMIS’s general estate (i.e., proceeds from the sale of personal property and real estate of BMIS, etc.) as unsecured creditors.

The SEC’s enforcement actions may lead to additional recoveries for BMIS customers. Given the magnitude (and potential duration) of the alleged fraudulent activity by Madoff and BMIS, determining what the firm’s obligations are to its customers will be difficult. Madoff reportedly provided consistent profits to his investors throughout many years despite market fluctuations. Based on the allegations, it is now presumed that some of those profits were likely fictitious. Thus, accounts may be adjusted to eliminate fictitious profits and add previously unrecognized losses, reducing the amount of obligations deemed to be owed by BMIS as of the filing date.

For information about how the BMIS liquidation will affect your rights as a customer, we urge you to consult your own lawyer.

Are There Tax Strategies that Might Offset Customer Losses?

If the SEC’s allegations are true, some BMIS customers may be able to claim theft losses to offset capital or ordinary income from other sources. The portion of the theft loss that is deductible generally will be reduced by $100, 10% of adjusted gross income, and any amount that the taxpayer has a reasonable possibility of recovering from the liquidation. If allowable deductions exceed taxable income for the year, the taxpayer should be able to carryback the loss to offset income reported in prior years. Theft losses qualify for a three-year carry back period. Generally, the loss must be claimed in the year the loss is first discovered.

To the extent that income reported in prior years was fictitious (i.e., not in fact realized), the taxpayer may be able to file amended returns excluding that income and claiming a refund of taxes previously paid. Generally, the statute of limitations for filing an amended return for a refund is three years.

As the available information will change over time and individual circumstances will differ, it is particularly important that customers consult their personal tax advisors and keep them abreast of developments as they become known.

What Can Customers Expect Next in the Liquidation?

At some point in the coming days, the trustee should notify customers of BMIS of the commencement of the liquidation by newspaper publication as well as by mail to each customer that had an open account at any time during the last year. That notice should provide relevant information concerning the filing of claims, including the instructions for completing customer claim forms, deadlines and relevant contact information for the trustee or trustee’s claims agent. In other SIPC liquidations, the claim instructions have usually required a separate claim form for each account and as to each, a copy of the last account statement, an explanation of cash balances and securities claimed, purchase and sale confirmations, cancelled checks and copies of any relevant correspondence with the firm as well as any written complaints about the handling of accounts to any person or regulatory authority. Written claims are necessary to be eligible for distributions from the trustee, and should be completed by the deadline set forth in the notice. Claims that are received after six months from the date of publication of the notice will be disallowed and will not entitle the holder to any distribution from the trustee (from SIPC’s funds or otherwise) and except in circumstances not applicable to most customers, the court has no power to permit late claim submissions.

It is conceivable that customers who withdrew account funds may be required to pay some of those amounts back. But at this early stage of the liquidation, it is very difficult to know whether and when any disgorgement will be sought and against whom. To best prepare for any inquiries into account transactions, it is imperative that customers review, organize and preserve all documentation relating to the transactions in and out of their accounts with BMIS.

Additional information concerning the SIPC’s role and customer rights as well as information about the liquidation of BMIS can be found at www.sipc.org.

For questions related to the information contained in this alert, please contact:

Alan M. Reisch

Richard J Rosensweig

This client advisory should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer concerning your situation and any specific legal questions you may have.

Pursuant to IRS Circular 230, please be advised that, this communication is not intended to be, was not written to be and cannot be used by any taxpayer for the purpose of (i) avoiding penalties under U.S. federal tax law or (ii) promoting, marketing or recommending to another taxpayer any transaction or matter addressed herein.

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