Casting a Wider Net: Deconstructing the Supposed “Winners” and “Losers” of Investment Fraud

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There’s an old pun making a comeback among New York securities lawyers: “Don’t count your check-ins before they’re cashed.” The divide between so called “net winners” and “net losers” is a hot topic, particularly with regard to the defrauded victims of vilified Ponzi schemer Bernard Madoff. A thorough explanation of affinity fraud can be found in our Investors section, with a set of Ponzi scheme red flags available here from

In August, the U.S. Second Circuit Court of Appeals upheld Madoff trustee Irving Picard’s decision to award upfront recovery payments of as much as $500,000 solely to the scheme’s “net losers”: investors whose withdrawals from Madoff’s fund did not match their initial investment. “Net winners” – those who withdrew more than their initial entry into the fund – seek the same recovery, but have been denied by Picard in a motion that has now held up in court.

Branding either party winners or losers is problematic, and discredits the fact that all of these investors suffered and were betrayed by the same scheme. Moreover, a precedent was set favoring “net winner” restitution in the case of Randall v. Loftsgaarden 478 U.S. 647 (1986), in which the Supreme Court ruled that “[t]his deterrent purpose is ill-served by a too rigid insistence on limiting plaintiffs to recovery of their ‘net economic loss'”. A 2001 ruling in California Ironworkers Field Pension Trust v. Loomis Sayles, 259 F.3d 1036, (9th Cir. 2001) binds respondents to an “Anti-Netting Rule”, concluding that gains in one investment do not offset losses in another. Why then might Picard’s whims prove to be, as one Wall Street Journal headline wonders, “the Final Word on This Issue?

Encouraging trends in recent rulings and arbitration have favored the “Well Managed Account Theory”, a method of calculating damages by taking the initial value of the investor’s portfolio, adjusting by a percentage change in an appropriate index during the relevant period, then subtracting the value of the portfolio at the end of that period. The theory is better suited for today than the prevailing wisdom of old, commonly known as the “Net Out of Pocket Theory”, in which claimants receive only the amount they originally invested less their subsequent withdrawals.

This latest Madoff ruling thus seems outdated (albeit still the industry norm), lacking both fair compensation for investors and accountability from the brokerage industry. Consider but one example, Leigh v. Engle, 858 F.2d 368, (7th Cir. 1988), where the court “undertook the straightforward approach of comparing the return on the improper investments with that of a reasonably prudent alternative investment” and “adopted the ‘most generous’ of the reasonable damage calculations submitted”.

In March 2010, the SIPC (Securites Investor Protection Corporation) determined that Madoff’s net losers were entitled to up to $500,000 in up-front recovery payments, while net winners were not. Picard totals losses at $17.8 billion, while a recent figure from investor representatives cites as much as $64.8 billion squandered. Picard and federal prosecutors have recovered $11 billion, about 60% of their loss estimation. The appeals court’s criticism of compensating both parties equally is that to do so would give the same merit to presumptions of profit as it does to quantifiable cash investment.

In fact, what these “winners” seek is a reasonable estimate of net worth had their money been invested with genuine, sensible regard. Not a “best-of-all-worlds” fantasy complete with mountains of Apple and Facebook stock, but a fair sum in step with how their investments would have performed in the hands of any legitimate professional. The Net Out of Pocket theory discourages investment altogether, offering these supposed “winners” less than they would have made by putting their money into a savings account, and the same amount made by placing it under their mattresses. Yet Picard’s lawsuit against one high profile client, the owners of the New York Mets, continues to move forward on the grounds that these fleeced investors should have better investigated their broker, or risk accusations of “willful blindness” and “conscious avoidance”. Validating such baseless claims not only allows broker-dealers to regulate their own fraud, but offers impunity to those who defraud investors up to the point at which losses would equal prior gains.

While there is logic to insuring the worst hit victims get compensated, a view of “net winners” is flawed. Someone who invested in 1980, then received only their net sum back by 2010 is in a far worse predicament than someone who invested in 2008 and received their investment alone. Through litigation, Madoff’s supposed “Net winners” are seeking adjustment for inflation on their claimed earnings and losses, arguing that a sum invested in Madoff in previous decades was worth more in the past than it is today, required greater investment and commitment, and would have benefitted from subsequent boom periods. One million dollars invested in 1980, they argue, would be worth much more than the same sum invested shortly before the ’08 collapse. Presently, the SIPC does not permit inflation or interest adjustments in the dispensing of investor compensation.

This leads us to a lynchpin of SIPC claims: that investors must prove that their loss was a result of insolvency – the inability to pay debts – and not of fraud, misrepresentation, or poor stock selection. A high profile case such as Madoff’s brings conscious deceit to light as the very cause of such insolvency. Thus, if Wall Street seeks to rebuilds its contract with Main Street, it seems imperative for the SIPC and like-minded organizations to enforce the responsibilities that the professional securities market has towards victims of fraud.