Have SIPC Protectors Run Amok?

That Securities Investor Protection Corp. logo on your office window may give peace of mind to some, but critics say it shouldn't. They complain SIPC's system makes filing claims difficult while its favored lawyers rack up huge legal bills by suing everybody in sight."The only people who win are the lawyers," says Norman Rounds, former president of Littleton, Colo.-based Consolidated Investment Services.

That Securities Investor Protection Corp. logo on your office window may give peace of mind to some, but critics say it shouldn't. They complain SIPC's system makes filing claims difficult while its favored lawyers rack up huge legal bills by suing everybody in sight.

"The only people who win are the lawyers," says Norman Rounds, former president of Littleton, Colo.-based Consolidated Investment Services. CIS was brought down in January 1995 by an independent contractor rep who looted client accounts-a situation Rounds claims he knew nothing about.

When the company closed, Rounds says he transferred the firm's accounts to 10 other dealers at the suggestion of the NASD. He was soon sued by SIPC for a fraudulent conveyance over those transfers.

"It's absolutely bizarre," Rounds says. He claims SIPC has spent 5 million dollars to 6 million dollars in legal fees chasing a 5 million dollars claim against him, while distributing almost nothing to CIS investors. SIPC also sued his wife, his former attorneys and three broker/dealers to which he transferred accounts.

SIPC general counsel Stephen Harbeck has little sympathy for Rounds.

"We believe he, or entities associated with him, have the wherewithal to pay," Harbeck says. "If he'd pay us, we wouldn't have to spend that money."

Registered Reps Caught Up Broker/dealer principals like Rounds aren't the only people affected by SIPC liquidations. SIPC trustees have aggressively pursued registered reps who owe their firms money (from upfront loans or other promissory notes).

"Most of those [loans] are based on written documents and liability is rather clear," Harbeck says.

Reps also encounter SIPC when their dealer goes belly up and it redirects client accounts. Bob DeGarimore, an independent broker with Sunpoint Securities until it went out of business in November 1999, says the firm that bought his accounts-Atlanta-based J.P. Turner & Co.-was badly understaffed and could not handle the onslaught of accounts it acquired. He also says Turner was not registered in several states where he had clients. DeGarimore has since found a new broker/dealer.

"It should distress a customer to see the SIPC logo displayed in our offices," DeGarimore says.

SIPC's Harbeck says that the accounts of a liquidated firm are naturally considered assets and are sold to other broker/dealers whenever possible. Sometimes it's through a bidding procedure and sometimes through a simple transfer, usually in exchange for future expected commissions.

"There's no formal procedure because it has to be done on such an expedited basis," Harbeck says. But potential buyers are evaluated on "a whole host of factors" including whether they use the same clearing firm as the bankrupt firm, which makes account transfers easier, he says.

Trustworthy Trustees? Beyond objecting to SIPC's choice of broker/dealers, DeGarimore faults SIPC for appointing a trustee who couldn't accommodate the workload. "This has put the burden entirely on my clients to fill out their claim forms," he says.

In fact, the trustee-selection process is at the heart of the criticism against SIPC. The Securities Investment Protection Act of 1970 (SIPA), which created the not-for-profit corporation, gave SIPC "sole discretion" over selecting trustees. Some securities attorneys accuse SIPC of handpicking trustees from a privileged crop of law firms. These trustees, with SIPC approval, typically retain their own law firm for the liquidation. The result: Trustees may have an incentive to run up legal bills by suing as many parties as possible.

"A case could be made for conflict of interest," says a scathing July 1999 report by the Public Investors Arbitration Bar Association (PIABA), a group of plaintiffs' attorneys. PIABA says SIPC's discretion in choosing trustees must change.

Irvine, Calif.-based attorney Tom Harris, who is defending investors sued by SIPC (see "Suing Defrauded Investors," Page 112), says bankruptcy trustees in general are carefully screened for conflicts and wouldn't normally be allowed to retain their own law firms. But SIPA condones such practice, so bankruptcy judges go along, he says.

Harbeck doesn't buy that argument. He says that bankruptcy courts review each of SIPC's trustees to make sure they are "disinterested parties" under the definition of SIPA. SIPC and the bankruptcy courts carefully evaluate trustees for their familiarity with bankruptcy law "first and foremost," their experience in the securities industry and the firm's resources (are they large enough to handle the case in question), Harbeck says.

John Burns, a Greenbelt, Md., attorney and chairman of the bankruptcy committee of the American Bar Association's young lawyer's section, says there's no conflict with trustees using their own law firm and that it is customary practice in bankruptcy cases.

Harbeck insists that SIPC picks its law firms, not the trustee, and that it's cheaper not having two separate entities coordinating a case. He says both SIPC and the bankruptcy courts scrutinize trustee expenses carefully.

SIPC boasts that it has returned roughly 2.6 billion dollars to investors since SIPC's formation in 1970 while spending just 111 million dollars on trustee expenses over that period.

But those billions are assets returned to investors. What has SIPC recovered from litigating against alleged debtors of failed brokerages? The corporation can't say.

Denying Claims PIABA President Mark Maddox claims that SIPC is being run "like a for-profit insurance company, doing everything in its power to deny claims rather than protect investor assets." He says just nine investors of 3,368 making claims in the Stratton Oakmont liquidation have received cash or securities. In fact, Maddox says he represents hundreds of clients in the Stratton Oakmont case who have been denied by SIPC because they did not complain about unauthorized trades in writing within 10 days.

The NASD expelled Stratton Oakmont and its owner from the industry in 1996 after repeated violations, including unauthorized trading.

Maddox, an Indianapolis-based attorney and former Indiana securities commissioner, claims SIPC's written-complaint requirement has made it impossible for investors to recover money from failed bucket shops. "This is a requirement that SIPC and its trustees have made up, that does not exist in the statute or the rules," he says. "They made it up to prevent investors from recovering on claims."

But Harbeck says that is nonsense. "What we are asking for, and what Mr. Maddox has not provided in most instances, is some reasonably contemporaneous written evidence that his clients objected to a transaction," he says. "We have never failed to pay a documented claim-ever. ... I think we would be subject to much greater criticism if we paid undocumented claims with quasi-public funds."

Maddox remains unsatisfied. He says that Stratton Oakmont clients have filled out claim forms and signed sworn affidavits attesting to the unauthorized trades. Furthermore, Stratton Oakmont was required to tape record all client telephone conversations during its last two or three years in existence so SIPC could easily confirm the unauthorized trades if it really wanted to, he says.

Time for Overhaul? PIABA has asked Rep. John Dingell, D-Mich., to re-examine SIPC's mandate. Dingell has passed that request on to both the General Accounting Office and the SEC for further review. Maddox says he expects a GAO investigation and a report by late 2001.

The GAO is in the "initial planning stages" of the SIPC-specific study, Maddox says.

A broader GAO study on unpaid arbitration awards, which will include some mention of SIPC, was to be complete around Registered Representative's press time in mid-April.

"I believe that a lot of the issues we've been complaining about for the past couple of years are going to be found to be true," Maddox says. "And then I believe Congress will feel that some action is appropriate."

SIPC doesn't always protect investors who've been taken. Sometimes it sues them.

In March 1997, W.S. Clearing (WSC) of Glendale, Calif., closed its doors when its largest introducing firm left it with an unpaid margin debt of 7.5 million dollars. SIPC then came in to liquidate the clearing firm.

WSC's fatal problem was 900,000 shares of illegally margined Data Race stock held by the introducing firm, Cygnet Securities of Waldwick, N.J. The stake amounted to 18 percent of outstanding shares, which Cygnet held in both its own and customer accounts.

Regulators investigating both firms heard testimony that customers had verbally complained about unauthorized trades. Investigators also found that Cygnet owner George Swan owned 171,000 Data Race shares-some of it in an account with only 1 percent equity. It turns out that Cygnet, with WSC's cooperation, had ignored margin calls for almost a year.

What's more, in testimony taken by SIPC's attorneys, WSC owner William Saydein admitted making and arranging loans to keep Cygnet and its trading scheme going.

The SEC has barred Saydein from the securities business. Swan was censured and fined 170,000 dollars by the NASD for parking Data Race in customer accounts. And SIPC is pursuing Swan for the Data Race debt.

But SIPC is also suing Cygnet customers, claiming they owe 5.7 million dollars for Data Race trades made in their accounts. A bankruptcy judge this past October found that the customers are indeed liable for the debt.

Tom Harris, an Irvine, Calif., attorney representing 12 of the investors, says his clients owe nothing. He claims his clients never invested more than 200,000 dollars in total, never received a single margin call and, in fact, had negative equity at the time Data Race was first purchased.

Harris says the court failed to consider all the evidence of fraud. He is appealing the case in federal court and has complained to regulators and Congress about what he feels is an abuse of power by SIPC in suing the investors.

SIPC won't comment on the case. But it argued in court that the customer debts were "straightforward contract claims." What's more, SIPC argued, the customers were liable even if the trades were unauthorized because they failed to complain in writing as the WSC customer agreement requires.

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