A curious tidbit lurks in section 1505 of Chapter 15 of the Bankruptcy Code. Most practitioners know that Chapter 15 applies to the recognition in the United States of a foreign insolvency proceeding. Section 1505 permits a U.S. bankruptcy court to authorize a domestic “trustee” to act in any foreign country on behalf of an estate created under section 541 of the Bankruptcy Code. Among the various parties specially defined as a “trustee” for this unique purpose is a debtor under Chapter 9 of the Bankruptcy Code – a municipality! Why might a municipality need to interact with the foreign representative of a foreign bankruptcy? How might a foreign jurisdiction react to the appearance of a U.S. municipality in its local affairs? And, because there is no estate created in a municipal Chapter 9 case, exactly what authority might a municipality be able to muster? Not unexpectedly, the answers to these questions are rather elusive.
Chapter 15 was enacted in 2005 and is the vehicle under which the foreign representative of a foreign insolvency proceeding enlists the aid of a U.S. bankruptcy court in order to protect and administer the property of a foreign debtor. Chapter 15 presumes the existence of a foreign debtor – i.e., an entity organized abroad. Chapter 15 is intended to be flexibly interpreted to achieve cooperation among domestic and foreign insolvency participants.
Chapter 15 applies in three principal settings: (1) where parties to a foreign proceeding seek assistance in the United States, (2) where parties to a domestic bankruptcy case seek assistance in a foreign country, and (3) where a foreign proceeding and a domestic case for the same debtor are pending concurrently. 11 U.S.C. § 1501(b) (unless otherwise noted, all section references are to the Bankruptcy Code, i.e., Title 11 of the U.S. Code). A case under Chapter 15 is known as an ancillary case (as compared to a plenary case under Chapters 7 or 11 of the Bankruptcy Code), and is commenced by filing a petition with the Bankruptcy Court for “recognition” of the foreign proceeding.
Where can a Chapter 15 ancillary case be commenced? An ancillary case may be commenced in any district: (a) where the foreign debtor has a principal place of business or assets in the United States or, if none, (b) where an action against the debtor is pending in a federal or state court or, if none, (c) where consistent with the interests of justice and the convenience of the parties. 28 U.S.C. § 1410.
Who may be a debtor under Chapter 15? Almost any foreign entity may be a debtor under Chapter 15, except mainly banks with U.S. branches, stockbrokers, or individuals with debts below the Chapter 13 thresholds. A foreign insurance company, although ineligible to be a debtor under other chapters of the Bankruptcy Code, is explicitly eligible for recognition under Chapter 15.
However, there is some ambiguity in the use of the term “debtor” under Chapter 15. “Debtor” is defined in Bankruptcy Code section 101(13) as a person concerning which a case under this title has been commenced. The Bankruptcy Code (i.e., Title 11), embraces cases under Chapters 7 (liquidation), 9 (municipalities), 11 (reorganizations, railroads and small businesses), 12 (family farmers), 13 (individuals with regular income) and 15 (cross-border). Section 109(a) provides that “only” a person that has a domicile, place of business, or property in the U.S. may be a debtor under Title 11 (again, under any of its various chapters, including Chapter 15). But Chapter 15 has a separate definition of a debtor applicable solely to Chapter 15: “an entity that is the subject of a foreign proceeding.” Thus, although not free from doubt, Chapter 15 only permits the commencement of an ancillary case if the debtor is both the subject of a foreign proceeding and has a domicile, place of business, or property in the U.S. See In re Barnet, 737 F.3d 238 (2nd Cir. 2013).
All of Chapter 15 is qualified by a public-policy escape hatch – the Bankruptcy Court may refuse “to take an action governed” by Chapter 15 if it “would be manifestly contrary to the public policy of the United States.” 11 U.S.C. § 1506. The cases that have considered this public policy override have concluded that it is a narrow exception intended to be applied only in exceptional circumstances concerning matters of “fundamental importance” (e.g., constitutional guarantees). E.g.,In re PT Bakrie Telecom Tbk, 601 B.R. 707, 724 (Bankr. S.D.N.Y. 2019) (key consideration is whether the procedures used in the foreign proceeding meet “our fundamental standards of fairness”); Jaffé v. Samsung Electronics Co., Ltd., 737 F.3d 14 (4th Cir. 2013).
The process to launch a Chapter 15 case is relatively straightforward. A foreign representative may commence an ancillary case by filing a petition for recognition. 11 U.S.C. §§ 1504, 1509, 1515. Section 1509 – which is the source of a foreign representative’s direct access to the Bankruptcy Court – applies whether or not another case for the debtor is pending under any other provision of the Bankruptcy Code. 11 U.S.C. § 103(l)(2). Once filed, Chapter 15 contemplates an expedited process to either grant or deny recognition of the foreign proceeding.
A foreign proceeding might be a main proceeding (i.e., located in a country where the debtor has the center of its main interests, or “COMI”), or a nonmain proceeding (i.e., located in a country where the debtor has an “establishment,” that is, “any place of operations where the debtor carries out a nontransitory economic activity”). 11 U.S.C. § 1502(2). Chapter 15 does not define the COMI, although it is presumed to be the debtor’s registered office under section 1516(c). The COMI determination is often a matter of some dispute, particularly in light of the differing rights that flow from recognition of a main instead of a nonmain foreign proceeding.
The entry of a recognition order by the Bankruptcy Court under section 1517 is the predicate for triggering the various rights and remedies available to a foreign representative under Chapter 15. Chapter 15 entrusts the Bankruptcy Court as the “gatekeeper” for a foreign representative’s access to the Bankruptcy Court and other domestic courts. Indeed, if the Bankruptcy Court denies recognition (either because it refuses to act on the petition if contrary to the public policy of the U.S. or because the petition is otherwise flawed because it does not comply with the requirements of § 1517), the Bankruptcy Court may enter any order necessary to prevent the foreign representative from obtaining comity or cooperation from courts in the United States. 11 U.S.C. § 1509(d). On the other hand, if recognition is granted, the foreign representative will have the capacity to sue and be sued in any court in the U.S.
Once a foreign main proceeding has been recognized, certain provisions of the Bankruptcy Code (such as the automatic stay and the restrictions on the use or sale of property under § 363) will, pursuant to section 1520, automatically apply to the foreign debtor and its tangible property located “within the territorial jurisdiction” of the United States. Chapter 15’s “territorial jurisdiction” provision is intended to replicate the scope of an “estate” otherwise created under the Bankruptcy Code, which concept does not apply to an ancillary case.
This provision will also reach any intangible property of a foreign debtor that is “deemed under applicable nonbankruptcy law to be located” within that territory. 11 U.S.C. § 1502(8). For example, under the UCC, patents, trademarks, copyrights, and software are each generally considered a “general intangible” to which a security interest may attach and be perfected (although in some cases not merely by filing a financing statement). The deemed location where that security interest is enforceable would establish territorial jurisdiction.
In addition to the relief that is automatically granted upon recognition of a foreign proceeding, Chapter 15 identifies further categories of discretionary relief that the Bankruptcy Court may grant to the foreign representative at various stages of the recognition process. These categories are: “provisional relief,” “appropriate relief,” and “additional assistance.”
First, once a petition is filed, and an ancillary case commenced, the Bankruptcy Court can order “provisional relief” if urgently needed pending a decision on recognition (such as staying execution against the debtor’s assets). 11 U.S.C. § 1519. This provisional relief expires upon entry of the recognition order unless expressly extended in the order.
Second, if recognition is granted, the foreign representative can also request “appropriate relief” from the Bankruptcy Court under section 1521 (such as the selected application of other provisions of the Bankruptcy Code) to bolster the automatic relief granted under section 1520. It is not uncommon for a recognition order to be festooned with further “appropriate relief,” particularly because section 1521(a)(7) permits the court to also grant any “additional relief” that may be available to a trustee.
Notably, however, the Bankruptcy Court may not extend the reach of sections 547, 548 and 550 (avoidance and recovery of preferential and fraudulent transfers) to the ancillary case. Accordingly, a foreign representative does not have authority in an ancillary case to commence garden-variety avoidance actions, and must instead commence a plenary case in order to invoke those rights. On the other hand, turnover proceedings under sections 542 and 543 are not excluded from the “additional relief” that may allowed in an ancillary case under section 1521.
Any appropriate relief that is granted under section 1521 may also be modified or terminated upon request of the foreign representative or an entity affected by such relief. 11 U.S.C. § 1522(c). In other words, if a recognition order initially makes a provision of the Bankruptcy Code applicable to the ancillary case (such as § 365, regarding the treatment of executory contracts), either the foreign representative or another affected party may later seek to modify that relief.
Third, after recognition, a foreign representative can also (i) ask for “additional assistance” under the Bankruptcy Code or any other laws of the U.S. pursuant to section 1507, and (ii) commence a plenary domestic bankruptcy case pursuant to section 1511. See 11 U.S.C. §§ 1511, 1520(c) and 1528. The commencement of a plenary case under Chapter 11 or 7 would entitle the foreign representative to further remedies not otherwise available in an ancillary case, but would also require the invocation of certain coordination and cooperation provisions under section 1529.
Why might a foreign representative whose foreign proceeding has just been recognized (thus invoking the stay of acts against the foreign debtor and any of its assets in the U.S.) also commence a domestic Chapter 11 case? One reason is to obtain the benefit of avoidance powers that are otherwise unavailable in an ancillary case (compare § 1523(a) and § 1521(a)(7)). Another reason is to invoke the expanded reach of an “estate” created under section 541 (which applies to all property of the debtor “wherever located”). This expanded reach, however, is limited only to the extent that such other, non-U.S. assets are also beyond the “jurisdiction and control” of the foreign proceeding. Even if a plenary case is commenced, section 305 empowers the Bankruptcy Court to dismiss or suspend proceedings in that case if the purposes of Chapter 15 would be best served by such dismissal or suspension.
This brings us back to section 1505. Section 1505 permits a Bankruptcy Court to authorize any “trustee” to act in a foreign country on behalf of an estate. It is seemingly misplaced in Chapter 15 because it has no specific tether to either the existence of a foreign proceeding or the commencement of an ancillary case. Rather, it is intended to facilitate the ability of a representative in an existing domestic case to act abroad in an officially enrobed manner. Thus, section 1505 applies whether or not a Chapter 15 case is pending and perhaps more properly belongs in Chapter 1 of the Bankruptcy Code (which contains general provisions applicable to all chapters). Indeed, section 103(l), which provides that Chapter 15 applies only to an ancillary case under such chapter, has an exception for section 1505 that makes it applicable in all cases under the Bankruptcy Code (e.g., a liquidation under Chapter 7, a reorganization under Chapter 11, or the adjustment of municipal debts under Chapter 9, among others).
Section 1505 is derived from Article 5 of the UNCITRAL model law on cross-border insolvency (which was the platform for Chapter 15 of the Bankruptcy Code, enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005). UNCITRAL is the United Nations Commission on International Trade Law. The model law was enacted by the general assembly of the U.N. in 1997. See G.A. Res. 52/158, UNCITRAL Model Law on Cross-Border Insolvency with Guide to Enactment (Jan. 30, 1998). Its main purpose was to serve as a recommended textual platform for countries to legislate a framework to handle instances of cross-border insolvency.
The model law was accompanied by a detailed guide explaining the intent behind each provision. The remarks accompanying Article 5 (the basis for § 1505) suggest that its purpose is to “equip administrators or other authorities appointed in insolvency proceedings in the enacting State to act abroad as foreign representatives of those proceedings. The lack of such authorization in some States has proved to be an obstacle to effective international cooperation in cross-border cases.”
The domestic legislative history to section 1505 is also illuminating. Section 1505 varies from the model law because, according to that history, it requires a trustee to “obtain court approval before acting abroad.” The model law, by contrast, automatically permitted an administrator to act abroad. This change was made to “ensure that the court has knowledge and control of possibly expensive activities, but it will also have the collateral benefit of providing further assurances to foreign courts that the United States debtor or representative is under judicial authority and supervision.” In fact, the legislative history suggests that “first-day orders in reorganization cases should include authorization to act” under section 1505. See H.R. Rep. No. 31, at 108-09, 109th Cong., 1st Sess. (2005).
Notwithstanding the requirement for court approval, section 1505 is permissive, not mandatory. Very often, trustees or other representatives in domestic bankruptcy cases are able to act abroad, quite capably, without the court’s seal of approval under section 1505. Section 1505, thus, is perhaps best employed when a foreign entity either disputes a trustee’s mandate or requires further corroboration of a trustee’s credentials. Conversely, in fact, there is no requirement that a foreign representative of a foreign proceeding actually commence a Chapter 15 case as a condition to exercising control over U.S. property owned by the foreign debtor. Neither federal nor state law requires a foreign representative to obtain a prior order from a court in the United States before disposing of property located in the United States. In re Iida, 377 B.R. 243 (B.A.P. 9th Cir. 2007). Likewise, section 1509(f) does not affect any right that a foreign representative may have to sue in a U.S. court to collect a claim that is property of the debtor, whether or not an ancillary case has been commenced or recognized.
Another domestic adaptation in section 1505 is to specifically identify the various parties qualified to act abroad. Section 1505 empowers any trustee, as defined in section 1502(6), or “another entity (including an examiner)” to act abroad. A trustee can be any trustee appointed under the Bankruptcy Code, a debtor in possession, or a municipal debtor in a Chapter 9 case. The express inclusion of a municipality was needed because Chapter 9 does not permit the appointment of a trustee to exercise municipal affairs. Rather, for purposes of Chapter 9, whenever a provision of the Bankruptcy Code that otherwise applies to a trustee is invoked in Chapter 9, it is deemed to refer to the municipal debtor itself. (There is an odd quirk in Chapter 9, however, that permits the court to appoint a trustee to pursue avoidance actions that the municipality refuses to pursue; this type of trustee, if appointed, would likely fit within the catchall bucket of trustees that may be empowered under § 1505.)
According to the legislative history, section 1505 “also contemplates the designation of an examiner or other natural person to act for the estate in one or more foreign countries where appropriate. One instance might be a case in which the designated person had a special expertise relevant to that assignment. Another might be where the foreign court would be more comfortable with a designated person than with an entity like a debtor in possession. Either are to be recognized under the Model Law.” This flexibility – to appoint a particular, named individual – would certainly be worthwhile to overcome the resistance that foreign entities might have to distinctive U.S. concepts such as the debtor in possession.
As noted, section 1505 applies whether or not a foreign proceeding involving a foreign debtor is pending abroad. It also applies whether or not the foreign country where the trustee appears has enacted its own matching legislation based on the UNCITRAL model law. Hence, a trustee in a domestic case can be authorized to take steps in any foreign country to advance the administration of a domestic estate. This might entail the sale of property located abroad but titled in a domestic debtor. Or, regulatory approval to domesticate cash or other assets maintained in a foreign financial institution. Or perhaps obtaining testimony or other evidence that might aid the prosecution of an adversary proceeding in the domestic case. If, however, a foreign proceeding is in fact pending abroad, section 1505 works in tandem with sections 1526 and 1527 of Chapter 15 to provide that the trustee, if authorized by the Bankruptcy Court and subject to its supervision, may “communicate directly with a foreign court or a foreign representative.”
It will, at this point, come as no surprise that there is no such creature as a cross-border municipal bankruptcy case. Yet, just like any other trustee of a domestic bankruptcy case, a municipality may need to act in a foreign country to facilitate a consensual adjustment of its debts, perhaps because municipal bonds may be registered for the benefit of foreign owners. Another plausible scenario where foreign cooperation might be needed is in the case of municipal special revenue bonds based on cross-border projects or systems (such as flood control or irrigation districts). It is, of course, quite natural that municipalities, like private debtors, will increasingly enjoy the advantages of foreign investment and trade.
Section 1505 marshals a potentially unlimited toolbox to maximize the value of a domestic estate. Whether and how the need to act abroad might arise, practitioners in any case under the Bankruptcy Code should keep in mind this overlooked statutory nugget. Although buried within Chapter 15, any debtor in any case under the Bankruptcy Code has the power to seek the court’s imprimatur to act abroad. Indeed, the court can tailor the relief to appoint any person with “special expertise” relevant to the task – even, potentially, an elected official of a municipality. There appear to be no limits to the ingenuity of a court, debtors and creditors to dispatch a bankruptcy envoy to roam abroad.
What a stressful, scary, “who knows what is the right thing to do” time to be considering a return to the office. They say COVID-19 is abating. They say the Delta variant is more dangerous. They say you are to return to the office in September. They say you could consider a hybrid work arrangement.
If you were anxious in 2020, you are probably terrified in 2021. Today, the health-inducing anxieties continue as work options become real. If you were hired or hope to be hired during this pandemic-influenced time period, your decisions today could influence your career for decades to come. This is especially true if your firm goes hybrid and you decide to work remotely some or all of the time.
Let’s look at some of the issues you could face and some actions you may want to consider.
Flexibility Is a Requirement
The details of back to work decisions are especially important for the “Born Digital” generations, Millennials [ages 25 to 40] and Gen Z [ages 9-24]. According to a report from Citrix Systems, 90 percent of them do not want to return to full-time, in-office work. The 90 percent break down into
three categories:
51% want to work from home all or most of the time,
21% would like to split their time evenly between home and office, and
18% want to split their time with more time in the office.[1]
The survey found a sizable disconnect between what leaders thought these workers want and what they said they want. For example, among the Born Digital respondents, 87 percent “are focused primarily on career stability, security and a healthy work-life balance. … Nearly 60 percent of business leaders thought that younger workers want to spend ‘most or all’ of their time at an office.”[2]
Leaders have to make decisions with far-flung consequences in an ever-evolving situation that seems to have no end. “The decisions business leaders make in the coming months to enable flexible work will impact everything from culture and innovation to how organizations attract and retain top talent.”[3] Nowhere are decisions more important than in regard to Born Digital workers.
Advantages of Working in the Office
Microsoft 365 CVP Jared Spataro sees in-office encounters as an important way for leaders to connect with employees to assess their frame of mind. “Those impromptu encounters at the office help keep leaders honest. With remote work, there are fewer chances to ask employees, ‘Hey, how are you?’ and then pick up on important cues as they respond.”[4]
The Citrix survey found that most young workers want engagement with colleagues and bosses. Many of them have been very lonely during lockdown. According to Donna Kimmel, Citrix executive VP, while younger workers want the flexibility of a hybrid schedule, they also “understand the need for in-person interaction, and companies need to provide opportunities for employees to come together both physically in offices and virtually from home to keep them connected, engaged and prepared for the future of work.”[5]
Disadvantages of Working from Home
“Being the lone remote member of a mostly in-office team isn’t just a recipe for FOMO─that is, fear of missing out. It can also be an obstacle to your productivity and professional advancement, not to mention the pleasure you get from work.”[6]
In-office colleagues have the chance to rub shoulders with their boss, hit the proverbial water cooler for time with friendly colleagues, and make themselves visible, effective members of the team. “When they work apart, younger employees lose chances to network, develop mentors and gain valuable experience by watching colleagues close-up, veteran managers say.”[7]
How “Born Digital” Generation Lawyers Can Level the Playing Field
Begin by reviewing your goals for the next few years. Then make a list of people you need to get to know and create a plan to incorporate coffee-chats, breakfast meetings, shared beers and lunch with someone three-four days a week.
If you like your firm but not your practice area, identify people you want to get to know in other practice areas as a way of learning more about what they do.
If you like your current work, list colleagues in your age cohort and older whom you want to get to know better, as well as your boss and other partners you would like to work with.
Look to become friends with your “class” of new lawyers as well as others in your age cohort. As you move through your career these people will be not only your friends, but also key referral and knowledge resources.
Prioritize time with your mentor because they can help you understand the culture of the firm and your practice area. Explain your career ideas to them and ask them to point out approved behaviors and routes to personal success.
If your firm has not set up rules designed to make meetings inclusive for those joining remotely, research the options and then make suggestions. In the meantime, try to find a “meeting buddy,” someone who will cue you in to in-person meeting currents you might miss, and make sure you are included in the conversation.
“It is especially important to connect with colleagues you may not know well, or have lost touch with during the pandemic. Reach out on social media, in addition to setting up a rotation of one-on-one sessions to ask questions about what is going on at the office or to offer your concrete assistance on projects.”[8]
Encourage your colleagues to use a mixture of online chat options and in-person meetings. On the days you do go into the office make a point of exchanging greetings with as many people as possible. Leave time in your schedule for in-person informal, ad hoc or planned, get-togethers. Think ahead about topics you want to discuss, issues you want to know more about, training you need. By planning these conversation points ahead of time, you will be more likely to find opportunities to insert them into conversations, and express your pre-planned points more coherently.
Conclusions
Millennials and Gen Zers are the workforce of the future. As such you have leverage in creating a new way of thinking about work. Use it to help traditional work-only firms begin to include flexibility and work-life balance issues into their culture. For yourself, create a one-on-one visibility program to make sure your physical absence doesn’t preclude an effective team presence.
[1] Rachel Tillman, “How do Gen Z, Millennials feel about returning to full-time work?” https://spectrumlocal.com/nys/centrail-ny/news/2021/06/16/ millennial-gen-z-work-force-pandemic-office–
[2] Jonathan Greig, “90% of millennials and Gen-Z do not want to return to full-time office work post-pandemic,” May 25, 2021, https://www.zdnet.com/article/90-of-millennials-and-Gen-Z-do-not-want-to-return-to-full-time-office-work-post-pandemic-report/
[3] Microsoft 2021 Work Trend Index: Annual Report, p. 4.
On July 7, 2021, Erin Gilmer, a lawyer and disability rights activist, died of suicide at age 38. Her work centered on the view of health as a human right. Erin fought tirelessly for patient-centered care and for a health care system that was more responsive and compassionate to the needs of patients.
Gilmer’s advocacy was based on her firsthand experience as a patient. She had an array of complicated health conditions, including rheumatoid arthritis, diabetes, borderline personality disorder, and occipital neuralgia. She shared her own experiences to illustrate the barriers, difficulties, and degradations she found to be inherent in the modern medical system, from the 15-minute doctor visits to the trauma of the health care experience, and to being dismissed as being “difficult” when she tried to advocate for herself.
Gilmer encouraged people to advocate for themselves, writing a free guide entitled What You Should Know as an Advocate. She included the voices of over 100 advocates from every walk of life to share what they wish they knew going into advocacy and what advice they’d give to other advocates. The guide focused on what it really means to be an advocate, in particular “the challenges you’ll face, the ups and downs you’ll experience, the realities of the commitment involved, the people skills that will impact your work, and the toll it can take.”
Erin demonstrated the realities involved in being an advocate, how hard it is and the amount of perseverance it takes. She shared her health struggles and the pain she felt worsening daily, calling on those in the medical profession to acknowledge patients’ lived experiences, truly listen to them, believe that they are suffering, try to find a reason for their suffering, allow patients to become colleagues in their care and share in decision-making, find humility, and extend compassion. Erin let us see into the reality of her struggles. In the end, she didn’t feel heard, believed, or cared for by the medical profession and decided she could not keep living in so much pain. The hope is that we can carry on her fight.
The ABA Young Leaders in Securitization and Structured Finance is a growing subcommittee of the Business Law Section (BLS) Committee for Securitization and Structured Finance. The committee and the Young Leaders are at the forefront of discussing and tackling new issues in the growing field of structured finance. Among the many topics discussed are cutting edge vehicles that manages leverage and risk, issues with warehousing and collateralized loan obligations and the effects of the latest Supreme Court decisions, such as, Collins v. Yellen, and their implications for the mortgage market. The Young Leaders take an active role in these discussions. Most recently, the Young Leaders hosted a practical workshop on the payment waterfall.
The workshop, hosted by the Young Leaders and joined by the panelists Alfredo Moreira, a Director at BofA Securities, Inc., and Nikolas Ortega, an associate at Cadwalader, Wickersham & Taft LLP, was a practical introduction taking attendees through how the priority of payments is crafted from term sheet to final document. The workshop was a great success and useful not only for associates and newcomers into the securitization sector,but served as an important refresher for more seasoned market participants in the intricacies of structured financial products.
The BLS Committee for Securitization and Structured Finance, and the Young Leaders subcommittee are both planning to hold additional events furthering interest and development in the securitization sector The Young Leaders also hope to continue to host events for young lawyers who are in the sector or are interested in it.
A decade ago, almost no one even had heard the word “cryptocurrency,” and gambling was a subject reserved to those who visited Las Vegas, Atlantic City, offshore poker websites, and, as ever, the movies. In 2021, both are mainstream and—increasingly—converging.
Supported by blockchain digital infrastructure, cryptocurrencies purport to offer the possibility of commercial and wealth-management activities outside the purview of publicly regulated markets and state treasuries and central banks. While employing currency-related terminology like “coins” and “tokens,” the adaptability and seemingly unconstrained purposes of cryptocurrencies present fundamental questions about their nature. Existent only in digital form and not created by any government mint, are they nevertheless akin to conventional currencies? Often volatile in value and not issued by a particular corporate entity, are they nevertheless akin to securities?
Of course, traditional currencies also bear features of both media of exchange and securities, and the facts that government actors neither create nor fully understand something do not necessarily prevent them from trying to regulate it. Indeed, to varying degrees, this is the circumstance of many business-lawyer clients, who are responsible for the generation of their business outputs and, vis-à-vis public regulators, tend to be the real experts in their respective fields. When it comes to cryptocurrencies, however, that degree of variance can be so extreme, and their relatively recent emergence and growing popularity coupled with a core identity that is openly hostile to state oversight, has thus far made it difficult for governments to develop workable regulatory models.
That regulatory uncertainty appears to have done little to slow the use of cryptocurrencies, which is not expressly outlawed. Cryptocurrency ownership requires a blockchain wallet, and available statistics show that the number of unique blockchain wallets has been growing at high rates in recent years. Anecdotal indicators, such as financial news sources like CNBC regularly displaying the live value of Bitcoin, perhaps the most popular cryptocurrency, alongside major stock exchange indices, also are consistent with the increasingly mainstream status of cryptocurrencies. Even government actors in countries like El Salvador and states such as Wyoming have expressed approval of the legal use of cryptocurrencies.
Meanwhile, gambling has pressed its way into the mainstream milieu in recent years as well, largely kickstarted by the Supreme Court’s decision in Murphy v. NCAA (No. 16-476, 584 U.S.___ (2018)) that the federal statutory prohibition on state-run sports wagering (the Professional and Amateur Sports Protection Act (“PASPA”)) was unconstitutional. Since then, about a dozen states, including New Jersey, Tennessee, Pennsylvania, and Michigan, have authorized sports and other gambling activities, with similar initiatives churning through many other state legislatures. Driven, to varying extents, by public interest, prior experience with online daily fantasy sports (“DFS”) and other games, and COVID-19-induced stay-at-home requirements, these state gambling authorizations and bills increasingly allow for mobile gaming applications that require little or no player interaction with brick-and-mortar casinos.
The Murphy decision was not quite the broad-scale legalization measure that some in the general public thought it to be, but there is little doubt that it signaled a call to entrepreneurs large and small to begin exploring in earnest the development of gambling and gambling-adjacent products. Some of these products, naturally, came in the form of sports books at land-based casinos that had not previously hosted them.
Far more of these new products, though, were mobile apps. Past experience with online poker, DFS, conventional fantasy sports, and internet casino (“iCasino”) games showed that an audience for mobile gaming exists, and it certainly seems easier to build a smartphone app than a brick-and-mortar casino. Incorporation of cryptocurrency compatibility and blockchain infrastructure made both practical and cultural sense: why not use the latest technology and do so in a way that might appeal to player preferences toward confidentiality in a so-called vice activity? Open, distributed, and decentralized technologies also lend themselves to the creation of different types of gaming experiences, such as peer-to-peer structures that, at least on their face, appear to bypass or invert the traditional concept of “the house.”
While the Supreme Court, in Murphy, ended a nationwide prohibition, the practical consequence was not nationwide, uniform legalization. As referenced above, the way forward was and remains a patchwork quilt of unique state-by-state authorizations that, for developers, represent another layer (or many other layers, depending on the scope of operation) of regulatory obstacles to navigate. Including cryptocurrency components might make engagement easier or more enticing for players, but it adds yet another regulatory web to an already highly regulated industry.
Gambling and currency are not remotely new to the human experience. Today, though, technology is permitting them to interact in new ways that pose new and exciting questions. Business lawyers navigating these overlapping regulatory environments also must think beyond basic licensing and compliance matters and consider significant security and privacy responsibilities.
Some of the most valuable assets for any company are its employees, key service providers, and advisors. This is particularly true for startups and emerging companies. A talented and dedicated team is essential to a company’s growth and scaling its operations. Yet, it can be hard to find and retain qualified employees, advisors and consultants. Established companies can typically offer more competitive salaries, generous benefit plans, perks and the promise of stability. In an integrated global economy where there is a worldwide competition for top talent, the reality is that startups and emerging companies need to be innovative, not just in their technology and services, but also in how they attract and retain talent.
One way startups and emerging companies can attract talent and incentivize employees, advisors and consultants (“Service Providers”) is by offering equity in the company. This is typically in the form of issuing shares or granting options to purchase shares in the future. By granting Service Providers equity in the business, organizations can ensure that the interests of these key stakeholders align with those of the company. This article will explore how startups and emerging companies can effectively use options to attract talent and scale.
What are Options?
An option grants the Service Provider the right to purchase shares at a predetermined price in the future. The assumption is that the company’s value will increase over time and that the Service Provider will be able to purchase shares at a significant discount at the time of exercise, or cash-out on a liquidity event such as the sale of the company. For a high-growth company, this offers Service Providers significant upside. Notably, as options are only a contractual right to purchase shares in the future, an optionee is not the same as a shareholder. Optionees do not have the rights or privileges of shareholders, such as the right to vote or receive dividends – until the optionee exercises the right to purchase shares.
Vested options are exercisable at the discretion of the Service Provider. Thus there is little downside to the optionee as the optionee may choose when or if it will exercise the options. Options also result in more favorable tax treatment for Service Providers when compared to issuing shares directly. This is because the Service Provider will generally only realize a taxable benefit in the year the options are exercised (assuming that the Service Provider is not paying fair market value for the shares). This ability to defer taxes may not apply in certain circumstances, such as where the entity issuing options is a non-Canadian controlled private corporation with consolidated group revenue of more than $500 million. The tax treatment of options is beyond the scope of this article and should be discussed with a tax advisor who has experience with options.
Stock Option Plan
Before issuing options, startups and emerging companies will generally put a Stock Option Plan (“SOP”) in place. SOPs are not required, but are recommended as they outline the rights and restrictions related to any issuance of options. A SOP is a policy document that outlines the terms and conditions of how a company will issue and manage the options it has granted. A SOP also outlines the rights and obligations of the optionee. It specifies what will happen to the options on the occurrence of a specific event, such as the sale of the company or the termination of the employment or engagement of a Service Provider. Typically, each optionee will enter into an option agreement with the company that will specify key terms associated with their options, such as the number of shares being awarded to the Service Provider, the exercise price the Service Provider will eventually pay for vested options and the vesting schedule.
Startups and emerging companies typically grant options to Service Providers based on a predetermined vesting schedule. This means that the options will not vest, and the Service Provider will conversely not have the right to exercise its options, until a predetermined event or events have occurred. This vesting schedule can be tied to years of service or the successful accomplishment of a milestone, such as securing a key client. If the vesting schedule is tied to years of service, a portion of the options may vest on each anniversary of the Service Provider’s start date. This will assist in incentivizing the Service Provider to remain with the company.
When devising a SOP, many factors need to be considered for the plan to be effective. Some key considerations are outlined below.
Considerations
1. Optionee Selection
Careful consideration should be given when choosing which Service Providers should be granted options. For example, long-term key employees in management roles who can directly impact the growth and performance of the business are usually preferred over roles subject to high turnover.
2. Selecting the Option Pool
A SOP will specify the total number of shares and class of shares that may be allocated pursuant to the SOP. The size of the option pool is typically a percentage of the company’s cap table and is negotiated by the key shareholders of the company, including the founders, key investors or other significant shareholders. The bigger the pool, the more the dilution in ownership can occur for each shareholder. The company must balance the risk of dilution with the need to ensure that the option pool is large enough to attract key talent. Though option pools typically range between 5%-20% of the company’s cap table, stakeholders should determine the appropriate size based on the unique factors the organization faces. The size of the option pool will typically be “topped up” on future equity financing rounds.
3. Strike Price
The strike price (or exercise price) is the predetermined price that the optionee must pay for the shares underlying the options. The strike price is usually set at fair market value at the time of the option grant unless there is a desire to reward past service by allowing the strike price to be set at less than the current value. Early-stage companies may set the strike price at a nominal amount to reflect the fact that the company’s valuation is typically low.
4. Vesting Period
The vesting period is the length of time that an optionee must wait to be able to exercise their options. Typically, options are not immediately available to be sold, exercised or transferred. The vesting period should be carefully considered because it could seem unattainable if the period is too long. However, if it’s too short, the optionee may exercise their options and then leave the organization, defeating the intended retention goal. It is common for startups and emerging companies to set a four-year vesting period for their Service Providers with 25% of the options vesting after the first year with the balance vesting monthly, quarterly or annually in equal installments over the following three years. Companies looking to reward past work of current employees may consider having a portion of the options vest immediately.
5. Termination of the Service Provider
The SOP will stipulate when the options will expire. This option expiry date is when the Service Provider will no longer be able to exercise their options. There are certain instances under which the option expiry date will be brought forward, for example, if a Service Provider is no longer engaged by the company. What will happen on termination is usually dependent on the reasons surrounding the termination of the relationship. What is typical is that if the Service Provider’s relationship with the company is terminated for any reason other than cause, the Service Provider will have a limited period following termination to exercise their vested options (e.g., 30 days following termination). If a Service Provider is terminated for cause, then the Service Provider’s right to exercise any vested options usually terminates immediately. In either scenario, the Service Provider’s unvested options are typically canceled. Startups and emerging companies should also consider including the option to repurchase any shares held by the Service Provider following termination. There are numerous reasons for doing so, including the desire to limit the company’s ownership for those who have received “sweat equity” to only those actively involved in the business.
6. Triggering Events
The SOP should also address what will happen if certain defined triggering events are to occur. This could include the termination of the employment or engagement of the Service Provider, the sale or restructuring of the startup or emerging business or a going public transaction. In the context of a sale of the company, organizations may want to consider if all or a portion of the unvested options will automatically vest. In addition, the company should ensure that it can force the exercise and sale of any vested options at the time of the sale of the company as a potential purchaser may be unwilling to acquire the business if it cannot acquire all of the shares of the company. If the exercise of the options takes place concurrently with the sale of the company, the options could be subject to a cashless exercise that would allow the optionee to exercise its options without having to pay cash to cover the exercise price. This is achieved by decreasing the number of shares the optionee will receive by an amount equal to the exercise price that the optionee would have been required to pay for exercising its options.
Conclusion
Options offer startups and emerging companies a method to attract and retain one of their most critical assets. Although there is significant upside in using options, companies should carefully consider how they structure options and SOPs to ensure they limit their exposure to risk, the ambiguity of terms and avoid unintended consequences in terms of the alignment of the company and the optionee.
The Supreme Court of Pennsylvania recently affirmed a Superior Court order in Pittsburg Logistics Systems, Inc. v. Beemac Trucking, LLC et al., No. 31 WAP 2019, finding a no-hire provision between competing, sophisticated businesses to be void as a matter of public policy and enforceable.[1] While the Supreme Court reviewed out-of-state and federal case law discussed by the parties on the enforceability of no-poach provisions and noted the federal government’s recent efforts to curb no-poach use, it focused its analysis and ruling on the balancing test set forth in the Restatement (Second) of Contracts. Under that test, the court reasoned that while there was a legitimate interest for the no-hire provision in the first instance, the restraint was both overly broad and harmful to the public on balance in this case. Therefore, although the outcome represents a victory for Beemac after a long road of litigation, the impact of this decision on future no-poach/no-hire cases remains unclear.
Background
The case concerned a preliminary injunction to enforce a no-hire provision that Pittsburgh Logistic Company (“PLS”) sought to impose against certain shipping companies, Beemac Trucking LLC and Beemac Logistics LLC (“Beemac,” collectively). Through the no-hire provision, Beemac agreed that during the one-year contract and for a period of two years following the contract’s termination, it would not “directly or indirectly hire, solicit for employment, induce or attempt to induce any employees of PLS or any of its Affiliates to leave their employment with PLS or any Affiliate for any reason.” But while the contract was in force, Beemac hired four former PLS employees, causing PLS to seek a preliminary injunction. The trial court denied the preliminary injunction request because it found the no-hire provision was void as a matter of public policy and therefore, PLS could not meet its burden to show a likelihood of success on the merits. An en banc panel of the Superior Court was convened after one of its panels affirmed the trial court decision. In exercising a highly deferential standard of review as to the grant or denial of preliminary injunctions, the court affirmed that the no-hire provision was an unenforceable restraint on trade, finding that it violated public policy because it allowed PLS to restrain employees without providing the employees with consideration. In reaching its decision, the Superior Court noted there was no Pennsylvania law on point, and therefore it relied entirely on out-of-state or federal decisions.
The Supreme Court allowed PLS’s appeal to consider whether “contractual no-hire provisions which are part of a services contract between sophisticated business entities [are] enforceable” under Pennsylvania law.
Supreme Court Opinion
The Supreme Court acknowledged that “Pennsylvania common law has treated restrictive covenants as restraints of trade that are void as against public policy unless they are ancillary to an otherwise valid contract.” If the restraint is ancillary, the court employs a balancing test to determine if the provision is reasonable, using the Restatement (Second) of Contracts test for evaluating the reasonableness of the provision. Specifically, the Restatement balancing test reads:
A promise to refrain from competition that imposes a restraint that is ancillary to an otherwise valid transaction or relationship is unreasonably in restraint of trade if
the restraint is greater than is needed to protect the promisee’s legitimate interest, or
the promisee’s need is outweighed by the hardship to the promisor and the likely injury to the public.
—Restatement (Second) of Contracts § 188(1)
Applying the Restatement test, the court found that the no-hire provision was an unreasonable restraint on trade because two commercial businesses used the provision to limit competition in the labor market “ancillary to the principal purposes of the shipping contract between PLS and Beemac.” The court recognized PLS’ legitimate interest in preventing its business partner from poaching its employees. However, the no-hire provision was “greater than needed to protect PLS’s interest and create[d] a probability of harm to the public.” The provision was overbroad because it precluded Beemac from hiring, soliciting, or inducing PLS employees for the one-year term of the contract plus an additional two years regardless of whether the PLS employee had worked with Beemac during the contract. Under the Restatement, the Court’s overbroad finding should have been enough to void the provision.
Nevertheless, the court went on to find that the no-hire provision created a likelihood of harm to the public in both specific and general ways. First, the provision specifically “impair[ed] the employment opportunities and job mobility of PLS employees” not party to the contract without their knowledge or consent. Under the facts of the case, this represented “real” rather than “hypothetical” harm because PLS sought the preliminary injunction to prevent Beemac from employing former PLS employees who had already taken a position with Beemac. Second, the court found that the provision generally undermined free competition in the labor market, creating a likelihood of harm to the general public. The court’s analysis did not explicitly weigh Beemac’s hardship and the public harm against PLS’ legitimate need except in a conclusory fashion in a statement at the end of the opinion.
Takeaways
The opinion is notable because it represents the first Pennsylvania state case to weigh in on the enforceability of a no-hire provision between two commercial businesses. The true import of the decision, however, will come only with time. One could argue, based on this decision, that any ancillary no-hire provision that impairs employment opportunity and mobility is unenforceable under Pennsylvania law. At the same time, the analysis used by the Pennsylvania Supreme Court indicates that every restraint on trade is subject to the balancing test under the Restatement and therefore, the outcome is based on the facts of each case. One wonders if the legal outcome would have been different had the no-hire provision been effective only for the life of the service contract and only applied to PLS employees who worked directly with Beemac.
The precedential value of the court’s analysis regarding harm to the public is also questionable. While the court found harm to the public in the record, it weighed that harm against PLS’ legitimate interest — an express requirement under the Restatement — only in a conclusory manner. This is significant because any no-hire or no-poach provision can be said to harm employee mobility in some regard. That is the purpose of the provision. On the other hand, one could argue that the court’s public harm analysis is merely dicta because the court had already determined that the restraint was overly broad. Put another way, once the court found the provision as overbroad, it did not need to also find that it harmed the public to be unenforceable. In the end, the court’s analysis here (while short) could have a significant impact on how employers in the state of Pennsylvania use no-hire provisions in their commercial contracts.
About the authors: Troutman Pepper Business Litigation Practice Group litigators A. Christopher Young, Jan P. Levine, Robyn R. English-Mezzino and Christopher J. Moran help clients analyze and solve their most emergent and complex problems through negotiation, arbitration, and litigation.
[1] See previous Troutman Pepper article on the Superior Court’s decision and its potential ramifications here.
Appraisers are not prognosticators; they apply professional judgment to available data. And what information is available? Transactions and market trends that occurred in the past. Looking to past market behavior after a crisis – be it financial, natural disaster, terror attack, or pandemic –may not provide useful data to support decisions regarding future behavior. This article discusses the issue with regard to property appraisals.
Using any of the three most common approaches to value presents the same problem. In the cost approach, the appraiser must determine the value of the subject land as if vacant based on the recent past sale prices of similar parcels of vacant land. The sales comparison approach depends on the recent past sales of physically similar properties. The income approach relies in part on the analysis of past rents for similar space and in part on the yield rates indicated by recent past sales of similar properties.
When markets are disrupted as suddenly and steeply as they have been during the COIVID-19 pandemic, how does relying on recent past transactions and market behavior support an opinion of current market value? How can an appraiser develop a credible opinion of market value in the aftermath of a disaster? Putting the human tragedy aside, business transactions and financial arrangements continue. How can appraisers provide value opinions and other analyses when markets are unstable at the least and more often downright chaotic? If appraisals are required during such times, the appraiser must do his or her best. It is up to the client and other users of the appraisal report to determine its reliability and usefulness as well as the durability of the value opinion.
What is required to determine market value of an interest in real property? Market value is defined as:
The most probable price that a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:
Buyer and seller are typically motivated;
Both parties are well informed or well advised, and acting in what they consider their best interests;
A reasonable time is allowed for exposure in the open market;
Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and
The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.
(12 C.F.R. Part 34.42(g); 55 Federal Register 34696, August 24, 1990, as amended at 57 Federal Register 12202, April 9, 1992; 59 Federal Register 29499, June 7, 1994). (emphasis added)
Following a crisis, how can sale prices not be affected by undue stimulus? In fact, after a disaster most if not all of the criteria of market value may be unmet. In the last year, we have seen hotel occupancies plummet if not disappear; office leasing has fallen drastically, along with rents. Cinemas, restaurants, even summer camps have not been exempt from plummeting revenues while property taxes, insurance premiums, mortgage payments and rent for those properties that are leased have remined the same. Owners of such properties often sold when they were desperate to get out from under the costs of ownership; they were not willing sellers as we normally understand that term.
If an appraiser is required to value a commercial property as of March 1, 2021, relying as it should on recent past transactions and market behavior, the appraised value most likely will be significantly lower than the appraised market value as of March 1, 2020. The 2021 valuation may trigger default provision of a mortgage or reduce the asking price for the property to something significantly less than the seller had expected to realize. It has been reported that appraised values of shopping malls nationwide were 65% lower than the appraised values of the same properties at the end of 2019. If the data were available, something similar would likely be seen for hotel and office properties. The appraisal for the same properties as of March 1, 2023 will likely indicate values closer to those in 2019, significantly higher than in 2021 and even in 2022.
If the appraiser takes the position that transactions that occurred during the pandemic are not reflective of market value and relies on pre-pandemic transactions, the value will reflect the actions of market participants prior to the date of value, rather than the market participants temporally adjacent to the subject transaction, and so over-value the property.
It must be recognized that appraisers are required to use the available data; appraisers cannot fabricate comparable transactions. It is up to the users of appraisal performed in tumultuous times to assess the reliability and durability of these value opinions.
Contracts are essential to ensure legal obligations are met by both parties (primarily businesses) with their mutual consent, which in turn maintains a healthy commercial relationship. It is therefore vital to keep contract-relevant papers secure and organized because failing to meet obligations can lead to costly fines in the long run. This reflects the difficulty level of a lawyer’s fundamental job responsibilities.
Most businesses rely on lawyers and law firms for contract management services to prevent contract-related issues, such as a contract breach. However, companies lose 9.2% of their annual revenue due to poor management of contracts, according to the International Association for Contract & Commercial Management. Here, lawyers and other legal professionals can embrace LegalTech to enhance contract management efficiency, helping their clients prevent this hefty damage.
How is the Legal Industry Benefiting?
There are plenty of artificial intelligence (AI) tools on the LegalTech market that legal professionals can use to simplify various tasks. For example:
Clause identification & extraction – legal software can identify and extract specific clauses more precisely.
Contract review – this job has become easier with contract review tools and can be done in less time.
Contract management – software can be used to analyze a contract against a standard.
However, there are many firms that have not adopted new technology simply because of the lack of time and resources required to make the shift successful. Lawyers must realize the potentials of AI that can genuinely improve contract management. Instead of relying on traditional methods of drafting, consolidating, storing, and tracking contracts that consume a lot of time, legal practitioners can get better control with the help of AI tools by automating routine tasks and centralizing contract management.
Let’s now get into details of how legal technology benefits the industry.
Contract Drafting
For contract drafting, AI-powered software allows lawyers to use several standardized contract templates, ensuring the usage of the latest and most accurate language. Also, there are tools that are integrated with both AI and Machine Learning (ML) technologies that lawyers can use for language assessment, especially while adding new contracts to the system and screening existing contracts for confidential data.
Contact Review
Lawyers know how demanding the task of contract review can become. Considering the need for highly secured systems for contracts, many legal professionals are adopting new technologies to minimize their workload. Otherwise, since a contract is comprised of various important documents, many law firms depend upon an outside counsel or external, specialized document review services.
The latest LegalTech tools can automate the entire contract review process:
Reading contacts
Identifying key information
Presenting the information in a certain way so that it can be easily read and understood
Moreover, many law firms are experiencing the benefits of such software, which makes the review process a lot easier – it can even be automatically carried out within a few minutes.
Contract Management
Many lawyers and law firms consider contract management an intricate and labor-intensive task that requires them to track terms, conditions, obligations, and deadlines for each contract they manage. However, with new technologies, lawyers can upload contracts to a central location where AI software adds tags to each document automatically according to a predetermined set of criteria (for example, contract’s starting and end date, parties involved, type of contract, etc.). This enables users to view a snapshot of ongoing workflows and upcoming events, which means monitoring important dates and deadlines becomes easier that used to be one of the most challenging jobs related to contract management.
Catching up with a Changing Legal World
While the most suitable technology may vary as per the needs of individual law firms, one thing is certain: LegalTech adoption is a necessary step. Law firms should now know that AI is helping legal teams to streamline processes, making contract management a lot easier, efficient, and cost-effective. Such software also helps lawyers free up their time to focus on other, more critical practice areas.
With more and more lawyers, law firms, and in-house counsel turning to new technologies, affordable contract management may become common, and no one wants to be left behind. Moreover, the need for more efficiency and productivity will remain forever; hence, it is vital for legal practitioners to stay updated with the latest technologies and systems to catch up with industry-leading competitors.
Increased Visibility
Moving from paper-based contact management to digital contract management systems can be a smart step. Storing all contract-relevant documents in one centralized, secure location helps ensure optimal compliance and reporting. With this, law firm owners can ensure their staff is using the latest contract templates and clauses.
Additionally, in the current times when most employees are working from home, law firms can empower their mobile workforce by allowing them access to the platform using a password-protected panel. This way, all the latest contact templates and clauses can be made available for authorized team members from anywhere at any time.
Efficiency Enhancement & Time-Saving
Automation-powered contact management systems offer several great features, including:
online redlining,
negotiation,
editing,
approval cycle,
e-signatures,
emails,
alerts, etc.
The systems are very easy to utilize. Such tools are best for busy law firms handling a lot of contracts at a time as they help boost efficiency and improve the core of the entire process. All of this leads to fewer errors, helping lawyers and law firms save time.
Conclusion
Contract management software gives legal practitioners a competitive advantage, helping them create more value for clients. It moves the client’s organization way beyond a transactional approach using a complete, interlinked system that also offers valuable insights that grow with their business deals and help comprehend the value of their contracts.
The legal industry has entered an era where innovative & tech-focused legal service providers have a myriad of new opportunities. At the same time, clients stand to reap multiple benefits from better service and affordable legal fees. With this, we can say that LegalTech is helping the legal industry not only with contract management but also with a variety of functions and processes, taking center stage within this highly professional and vast industry.
What the SEC Should do to Prevent Another “Madoff” Scandal[1]
Introduction and Background
Bernard L. Madoff died recently[2]. I knew Bernie and want to explain why he was so successful at keeping regulators at bay. I also think that the Securities and Exchange Commission (“SEC” or the “Commission”) needs to do more to prevent another “Madoff” scandal.
Bernie was a world class crook – I would rename the “Ponzi” scheme as the “Madoff” scheme, in recognition of the scope of his treachery. Saying “I knew Bernie” was always a conversation starter at a cocktail party. Inevitably, the person with whom I was speaking would ask, “Could you tell he was a crook?” My answer was always, “No, of course not.”
The Madoff fraud is a lot more complicated than the versions I have read in several different accounts. Very few have explained why Bernie not only fooled his “investors,” but how he managed to fool the regulators for so long. Most people don’t have the patience for the details. If you want to understand what separated Bernie from your average fraudster, you need to understand the context. Below are my recollections, as best as I can remember them, with additional discussion to put them in context.
Background on How I Knew Bernie and Peter Madoff
Among my reviewers’ helpful suggestions for this article was that I needed to explain the basis for my interactions with Bernie Madoff. Bernie Madoff is a household name, albeit a disgraced one. Stuart Kaswell is not a household name, so I agree that some explanation of my background may be helpful.
I graduated from law school in 1979 and began my career at the U.S. Securities and Exchange Commission’s Division of Market Regulation, now known as the Division of Trading and Markets (“Division”).[3] In 1975, Congress enacted the Securities Acts Amendments that overhauled many aspects of securities trading and processing in the U.S.[4] One of the most important provisions, Section 11A of the Securities Exchange Act of 1934 (the “Exchange Act”), directed the SEC to foster the development of a National Market System for securities. Congress also added Section 17A of the Exchange Act, which directed the SEC to facilitate the establishment of a national system for the prompt and accurate clearance and settlement of transactions in securities. The SEC assigned the Division of Market Regulation primary responsibility for adopting rules to implement these two congressional mandates.
Initially, I worked on the clearance and settlement issues, staring as a staff attorney and later becoming a special counsel. After a few years, I moved over to become branch chief of the over-the-counter regulation, which meant primarily oversight of the National Association of Securities Dealers (“NASD”),[5] Although I did not have primary responsibility for National Market Systems issues, I was involved with them to some extent. Certainly, I was aware of the Division’s extensive work on that topic.
It was during my years at the SEC that I first became acquainted with Bernie and Peter Madoff. As a freshly-minted lawyer, my more experienced colleagues made clear to me that they held Bernie and Peter Madoff in very high regard.
After more than six years, I left the SEC and became Republican securities counsel for the Committee on Energy & Commerce of the U.S. House of Representatives from 1986 to1990. (The Commerce Committee had securities jurisdiction at that time.) During that time, the Committee focused on issues such as insider trading and the 1987 Stock Market Crash.
After ten years of government service, I accepted a position as an associate at the law firm of Winthrop Stimson Putnam & Roberts (now Pillsbury Winthrop). One of my clients was the Securities Industry Association (“SIA”), now called SIFMA. SIA was the primary trade association for investment banking and retail brokerage.
In 1994, Marc Lackritz, President of SIA, appointed me Senior Vice President and General Counsel of SIA. During those years, the SIA had a leadership role with a broad range of issues, such as market structure, litigation reform, federal/state regulation, Y2K, decimal conversions, computerization of retail brokerage, and Regulation Fair Disclosure. Like any trade group, one of SIA’s main functions was to interact with regulators and Congress on issues of keen interest to its members. I worked with senior personnel at the SEC and NASD, and other self-regulatory organizations, and worked with members of the House and Senate, as well as their staffs.
As SIA’s chief legal officer, I would interact with senior executives and lawyers at many member firms, including the Madoffs. Again, like most trade associations, SIA staff worked with its members on a continuous basis as SIA developed its policy positions. Bernie, Peter, and Shana Madoff were very active participants in SIA’s board or committees. The Madoffs sought to have their firm’s interests reflected in SIA’s policy agenda. To be clear, I was never involved in the day-to-day business of any SIA member firm, including Madoff.[6]
I left SIA after nearly ten years, to become a partner at the law firm Dechert, LLP. I saw the Madoffs from time to time at industry conferences or elsewhere, but I never represented them. After private practice, I became Executive Vice President and Managing Director, General Counsel at the Managed Funds Association (“MFA”). MFA hired me in December 2008, just as the Great Recession was unfolding and before the Madoff scandal broke. As an experienced Washington lawyer, MFA hired me to help the hedge fund industry navigate the political fallout from the 2008 financial crisis. In my role as general counsel, I helped guide legislators and regulators in the U.S. and E.U. to develop a workable framework to regulate hedge fund managers. I don’t recall any interactions with the Madoffs after joining MFA. I retired from MFA in 2018.
I was privileged to hold these positions during my career and am proud of the work that I did. Because of my role in public policy, I worked on a regular basis with Bernie and Peter, along with many other senior people in the financial services industry and in government. As I discuss below, I only was aware of the Madoffs’ broker-dealer, not the so-called investment adviser.
The Madoff Scandal – Background
Back in the 1970s, when companies (“issuers”) went public and matured, their stocks would trade in increasingly liquid and prestigious markets. Most issuers started with market makers trading their shares in the Over-the-Counter Market, originally called the Pink Sheets. The Pink Sheets, literally pink pieces of paper, listed yesterday’s closing stock prices in thinly traded stocks. The prices were stale before the ink dried. Market makers would call around on telephones and try to get the best price they could when buying or selling for a customer. (The market was a dealer market, meaning dealers sold out of inventory; they rarely acted as agents putting a buying customer and a selling customer together.) It was a primitive trading environment and even the most diligent dealer would have a difficult time finding the best price.
In 1971, Gordon Macklin, who was the head of the NASD, wanted to use the new electronic computer systems to trade over-the-counter (“OTC”) stocks.[7] The NASD created Nasdaq, which was an early computer linkage of dealers with screens showing prices. The dealers still had to execute by phone, but at least they had a more accurate picture of the market than they could get by making a few phone calls.[8] In 1972, the SEC adopted Rule 17a-15,[9] which created the framework for a consolidated tape, i.e., a central repository of the prices of executed trades. The SEC attempted to adopt a consolidated quote rule, i.e., a rule that would require markets to display their prices in a central facility. Many in the industry opposed the creation of a consolidated quote until Congress insisted.[10]
As issuers progressed in size and breadth of ownership, they would abandon the OTC market and list on the American Stock Exchange (“Amex”). Amex was a step up from the Pink Sheets and Nasdaq, but was still the minor league. The next step was the New York Stock Exchange (“NYSE”) or the “Big Board.” America’s best-known companies listed on the NYSE, notwithstanding the high fees and lack of competition. The NYSE, like the Amex, relied on specialists or market makers – individuals on the trading floor whose participation helped ensure price continuity.
At the time, the NYSE probably had the most liquid and deep markets for trading stocks. But not all of those advantages were the result of innovation and competition; the NYSE’s rules helped undermine competitive alternatives. Its “off board” trading rule, Rule 390, prohibited NYSE member firms from trading of NYSE listed stocks other than on an exchange. NYSE Rule 500 made it nearly impossible for a company voluntarily to delist and move to another market. The net effect was to make it difficult for broker-dealers to trade stocks NYSE listed stocks anywhere but at the NYSE or for an issuer to go elsewhere.
Of course, the NYSE had public policy justifications for its off-board trading rules. The NYSE argued, correctly, that concentrating the trading interest in one place would ensure that the most buy and sell orders would interact, achieving the best price.[11] That’s true to a point. If I want to sell my car and I put a sign on it in front of my house, I won’t know if someone on the other side of town would like to buy it. As the saying goes, “liquidity begets more liquidity.” But rules like Rule 390 eliminated competition among marketplaces. Moreover, the NYSE was very astute politically and worked hard to protect its market share. New York State was very powerful politically in Congress. The NYSE was not embarrassed about seeking support for a home town industry.
In 1975, Congress enacted the Securities Acts Amendments of 1975 (1975 Acts Amendments),[12] a major overhaul of the federal securities laws that Congress first enacted during the New Deal. Although Congress left the basic framework of the securities laws intact, it expanded and modernized a number of provisions. Congress added Section 11A of the Exchange Act, which directed the SEC to facilitate the development of a national market system.[13] The system for trading equity securities was antiquated and anti-competitive. Congress enacted Section 11A with instructions to modernize the system. Congress did not specify the changes that it wanted in a National Market System; it only stated the objectives and granted the SEC new authority to implement those changes. In general, Congress is wise not to enact laws that will have the effect of micromanaging an industry. Nonetheless, Congress often wants to avoid hard decisions and the ensuing political fallout over resolving complex debates with significant economic implications. Accordingly, it punts complex issues to the regulator, in this case the SEC, and lets the agency sort it out. Bernie exploited that situation for his benefit.
Armed with its mandate to facilitate the development of the National Market System, the SEC had to proceed carefully, so as not to antagonize powerful political players.[14] Confronting the NYSE directly was politically dangerous, possibly suicidal. More importantly, the SEC did not want to wreck the crown jewel of American capitalism as it explored different approaches to improving market structure. On the one hand, concentrating liquidity improves the price discovery process. On the other hand, competition among stock markets, like any market competition, encourages innovation and lower prices. Striking the balance between concentrating orders and fostering competition among markets is not easy. The stakes were high and the price of failure was formidable.
Rather than trying to implement sweeping reform, the SEC tried a step-by-step approach. Section 19(c) of the Exchange Act allowed the SEC to rewrite the rules of a self-regulatory organization (other than a clearing agency). In other words, in addition to adopting SEC rules, Congress gave the SEC the authority to revise the stock exchanges’ own rules. The SEC adopted Rule 19c-3 under the Exchange Act.[15] That Rule required exchanges to allow trading in stocks other than on the exchange where the issue is listed for stock listed after April 26, 1979. The SEC “grandfathered” existing listings subject to the NYSE’s Rule 390. But Rule 19c-3 provided that newly listed NYSE stocks could trade elsewhere.
Years before, Bernie had established a broker-dealer, Bernard L. Madoff Investment Securities (“BLMIS” or “Madoff”), that was a market maker. It was not a NYSE member firm, so it could ignore the NYSE’s rules. Over time, BLMIS attracted orders from other broker-dealers by paying them for their orders, called “payment for order flow.”[16] It was, and is, an entirely legal practice. When equities traded in eighths of a point, Madoff could pay for order flow and still provide better pricing (better executions) than other market makers or the NYSE. Madoff embraced computer technology ahead of others and could price stocks quickly and aggressively. Peter, Bernie’s brother, was also active in running the business. Both Bernie and Peter were involved in many SIA meetings and also participated in many regulatory meetings. It was clear that Bernie was the head of the firm and Peter was not co-head. But Peter was fully involved in running the broker-dealer and participated in regulator meetings.
The SEC loved the idea that Madoff provided a road map to creating more competition for the NYSE, which would help the SEC accomplish the congressional mandate in Section 11A. Bernie and his brother Peter were fixtures at the SEC, explaining the intricacies of trading to the lawyers and inviting SEC staff to visit his trading room. Recall too that most SEC lawyers, with the possible exception of a few like Richard G. (“Rick”) Ketchum, Director of the Division only understood the theory of stock trading, not the nitty gritty of how it actually worked. Bernie and Peter were happy to share their knowledge. Of course, the staff understood that the Madoffs were trying to grow their own business and shape regulation to their benefit. Nonetheless, it was a happy coincidence that their interests generally coincided with the SEC’s goals. Everyone in the Division though the Madoffs were great guys who were extremely helpful.
I remember participating in an SEC staff trip to New York City sometime in the early 1980s to visit various broker-dealer trading operations. Peter Madoff gave a tour of his nice, but relatively small, trading room to perhaps half a dozen Market Regulation staffers. Peter patiently explained what his firm was doing to a group of us baby lawyers who were clueless. On the primitive screens of the day, he bought or sold 100 shares of some issue to demonstrate what his firm did. I remember that a chime in the room kept pealing and Peter would turn to his colleagues and shout “Phones!” I realized that other broker-dealers were calling and instead of a conventional telephone ringer, Madoff had a more civilized chime. Peter was not happy that his traders were not answering the calls quickly. By inviting SEC staff to visit the Madoff trading room, Bernie and Peter were demonstrating that they had nothing to hide and welcomed the opportunity to educate the staff. Of course, we were junior regulatory staff members, not staff from the SEC’s Division of Enforcement.
Rule 19c-3 was just one milestone in a long journey to alter the market structure for trading equity securities. The battle over 19c-3 was part of the evolution of the relationship of broker-dealers and stock markets. The SEC made additional changes as the years progressed. Over time and with other developments such as Reg ATS,[17] competition among market centers became much more fierce.[18] When Congress originally established the self-regulatory system in the original Exchange Act in 1934 and 1938, the exchanges and the NASD were creatures of their members. As SROs, the exchanges and the NASD had quasi-governmental authority to supervise their members. By the 1980s, the broker-dealers saw the exchanges more as competitors, and less as their advocates. As competition grew, it became increasingly difficult for the NYSE to maintain its anti-competitive rules. Eventually, the NYSE could no longer stem the tide and agreed to rescind Rule 390[19] and Rule 500.[20]
When the stock market crashed in October 1987, the Reagan Administration,[21] Congress, the SEC, the Commodity Futures Trading Commission, and others all rushed to figure out what went wrong. Nasdaq was embarrassed since critics charged that market makers didn’t answer their phones as prices plummeted. Nasdaq established a committee to examine Nasdaq’s role and to suggest improvements. Nasdaq appointed Bernie as co-chair of its committee to study the problems on Nasdaq and to recommend improvements.[22] It’s important to remember that Nasdaq must have appointed Bernie because he had stature and expertise in the market operations. Bernie’s presence enhanced the credibility of Nasdaq’s efforts. By the same token, Bernie further burnished his credentials as an industry leader. Bernie didn’t shrink from the spotlight; on the contrary, he sought it.
My next interactions with Bernie and Peter came a few years later. In January 1994, I became Senior Vice President and General Counsel of SIA. Bernie was on the Board of Directors and served on the Federal Regulation Committee, the SIA committee that had the greatest impact on formulating the association’s views on SEC issues. Bernie also chaired or served on various trading committees.
Bernie always participated in SIA meetings and always was fully prepared. Trading committees included representatives from firms trading floors, who understood market structure issues as well as Bernie. Bernie may have been the only CEO at those meetings, but other members could go toe to toe with Bernie on the divisive market structure issues.
By contrast, whenever SIA’s Board considered a market structure issue, Bernie simply overwhelmed everyone else. The Board had a cross section of the industry – a person (usually a man) who had made his career as an investment banker or head of retail sales, knew very little about market structure minutiae. Bernie knew more than everyone and could discuss market structure in excruciating detail.[23] The Board simply would defer to Bernie on market structure issues.
At the same time, Bernie never over-played his hand. Market structure issues were particularly divisive. Firms had differing perspectives, depending on their business models. Bernie didn’t try to “roll” the Board and push through issues on which there was not consensus. In the trading committees, he would try to find a middle ground, such as offering a market-wide trade through rule. His approach was shrewd – if he had pushed the Board to adopt positions with which their firms disagreed, he would have damaged his own credibility once the other firms realized what Bernie had tried to do. Such a strategy would have made it even more difficult for SIA to play any role in market structure issues. Bernie didn’t always get everything he wanted, but he sought to shape consensus and used his SIA relationship astutely.
At one SIA Board meeting in New York, Richard (“Dick”) Grasso, the CEO of the NYSE, came to address the Board. Market structure issues were among the contentious issues between some SIA members and the NYSE. Of course, Bernie was the most outspoken SIA member on trying to dismantle the NYSE’s huge market share and add competition. At the end of his presentation, Dick walked around the entire board room and warmly shook hands with all of the board members and staff. Everyone watched when Dick came to Bernie. They embraced like two Mafia Dons in a scene from The Godfather. The whole room erupted in laughter.
Bernie also was involved in the regulatory details and did so conspicuously. The SEC often invited him to participate in roundtables on market structure issues. At one of the roundtables,[24] the topic was transparency of limit order books. Bernie said that most market makers want to see what other market makers were holding, but were reluctant to share the details of their own limit order books. Bernie said, in other words, it’s a matter of “if you show me yours, maybe I’ll show you mine.” Everyone laughed. Bernie also testified before Congress on market structure issues.[25]
Bernie was involved in issues beyond market structure. There had been a dispute between the state securities regulators and the big broker-dealers over access to books and record. When state regulators came in for an inspection, the regulators would demand to see the records. If the inspection occurred at a local office, i.e., in another state, of a big New York-based firm, the firm would say that they didn’t have the records and that they were in New York. Frankly, the firms were not always speedy about providing records to a regulator at another state. The state regulators got frustrated and working through their trade association, NASAA, they started to consider passing state laws to require broker-dealers to keep records within that state. If they had been successful, every state could have instituted its own unique record keeping rule for broker-dealers. The result would have been a nightmare of expense and complexity.
Fortunately, Congress intervened and enacted the National Securities Markets Improvements Act of 1996 (“NSMIA”). Section 103 of NSMIA preempted states from adopting their own broker-dealer book and records rules or capital rules. At the same time, Congress directed the SEC to work with the states to develop a rule for books and records that would accommodate the states’ legitimate need for access to books and records. The SEC organized a meeting in New York City, a few weeks after 9/11, to hammer out a compromise with the firms and NASAA. Bernie was the only CEO who attended and participated in detailed discussion of record keeping rules.
BLMIS frequently sponsored SIA events. SIA always needed member firms and other vendors to sponsor conferences and meetings. Bernie was willing to step up, often on new conferences that had little or no track record. Of course, he was looking for other firms, particularly the retail wire houses, to route customer orders to his firm for execution. Nonetheless, his sponsorship was part of his camaraderie and effort to demonstrate that he was trying to help the industry and not just his own parochial interests. After every SIA conference, I came home with Madoff canvas bags, notebooks, or binoculars. Our kids slept in Madoff tee shirts.
As I have noted elsewhere, after the 9/11 attack when the lawyers in SIA’s New York office needed an alternative place to work, Bernie offered space at his midtown office. I had offers from other firms that were sincere, but I felt the most comfortable accepting Bernie’s offer. I figured that SIA’s lawyers would encounter fewer difficulties than if they went to another firm. When Bernie, as the CEO, issued the invitation, nobody was going to question who the SIA lawyers were and why were they taking up space at the firm. Other, much bigger firms, had much bigger bureaucracies to traverse, even if a very senior executive at that firm issued the invitation. No doubt those firms would have sorted out the mechanics, but I figured it would just be easier. Plus, I just liked Bernie.
SIA had an annual meeting at the Boca Raton Resort and Club. It was a very lavish affair and it attracted many of the most senior people in the securities industry. SIA sponsored entertainers like Ray Charles and Tony Bennett, and speakers, like John Major, Joe Torre, and Walter Cronkite. The meeting included an annual election of officers and a Board meeting, which was my responsibility. It was my responsibility to ensure that the chairman of the SEC attended to give a keynote address at the meeting. I also organized a meeting with the SEC chairman, the heads of the SROs, and SIA leadership. There was a dinner with the SEC chairman, Board, and SRO heads. Although the surroundings at Boca were luxurious, I had many responsibilities over the course of the meetings.
For reasons that I can’t recall, one evening at Boca, my wife Sherry and I were at loose ends for dinner, as was Bernie. We had dinner together, which was not something that I would have expected. As a staff guy, I was not a peer of Bernie and dinner with me would do nothing for his business. Nonetheless, we had dinner together and he was charming. He told us a self-deprecating story of how his family rented a house in Tuscany for a summer. One day, Bernie drove off to do an errand and in the days before Waze, got completely lost. He also realized he had not brought the address or the telephone number of the rental house. Bernie said that he got so lost that he was afraid that he would have to pull into a hotel and stay overnight until he could reach his secretary, Eleanor, when she was back in the office. She would have to provide him with the address and phone number of the rental house. Eventually, he found his way back later that day.
One year, I remember Bernie introducing me to his wife Ruth briefly at the lobby of the “Tower” i.e., one of the hotel buildings at Boca. I also remember asking if Bernie was staying in the Tower, but he said that he was on his yacht that he had docked nearby.
Peter’s daughter, Shana, an attorney, was head of compliance at BLMIS. She also was a member of the SIA Compliance and Legal (C&L) Division, and served on its Executive Committee.[27] Shana was very active in the Division and attended the monthly Executive Committee meetings and at other SIA conferences or committee meetings. I also remember meeting one of Bernie’s sons at an SIA meeting in New York, but I can no longer remember which one. All of these actions helped establish the Madoff family as thoughtful industry leaders, with Bernie as the great statesman.[28]
Proximity to, and familiarity with, regulators achieved two goals for Bernie and Peter Madoff. First, the regulators trusted Bernie and Peter. As a result, regulators were much less likely to scrutinize BLMIS’s activities than they would have with a firm unknown to them. Second, Bernie and Peter’s familiarity with regulators conveyed a sense of legitimacy to investors. A quick internet search would have revealed Bernie and Peter’s working relationships with the SEC and Congress. It also would have shown their leadership roles with organizations such as Nasdaq[29] and SIFMA.[30] Absent more information, it would have been logical for investors to assume that Bernie and Peter were completely honest.
The Madoff Scandal – The News Breaks
On December 1, 2008, I started as general counsel at the Managed Funds Association, just as the Great Recession was under way. Shortly thereafter, Bernie announced that his investment adviser was a Ponzi scheme. The SEC charged him on December 11, 2008. When the news broke, I was in shock. I called my wife Sherry and said “You won’t believe the news.” We both reacted with “Not Bernie!” Friends of mine in the securities industry had exactly the same reaction.
The news reports indicated that Bernie’s Ponzi scheme employed his investment adviser. I didn’t know that Bernie had an investment adviser; I only knew about the broker-dealer.[31] As far as I knew, the broker-dealer, which he used to innovate and compete with the NYSE, was legitimate.[32] A few weeks later at an MFA conference, I heard some fund of funds’ operators say that they didn’t invest with Madoff because the numbers were too good to be true. I never heard anyone say that before the scandal broke.[33]
Certainly, competitive pressures and regulatory changes reduced market makers’ profits. For example, in the late 1990s, SEC Commissioner Steven Wallman[34] and Congressman Mike Oxley[35] and others began to pressure the securities industry to move from pricing stocks in eighths or even sixteenths and adopting decimal pricing.[36] The market makers weren’t excited about that change, partly because of the cost of implementation, but more importantly because it would hurt their profitability. They argued that pricing in decimals would mean less liquidity at each price interval, such that the over price of executing a big order might not be less with decimal pricing. Nobody cared. The only real issue was that the timing for the conversion was not great. The securities industry had to adopt the changes for decimal pricing at the same time as preparing for Y2K. No doubt that the pressures of decimalization reduced the profitability of BLMIS, along with other market makers.
But the competitive and regulatory factors pale before the size of the fraud relating to Madoff’s so-called investment adviser. In fact, BLMIS, the broker-dealer, was “deeply insolvent,” as a result of the Ponzi scheme. According to the expert that the Securities Investor Protection Corporation trustee retained, BLMIS was insolvent from at least December 11, 2002, by over $10 billion.[37] The Report states that “there is strong evidence to suggest that BLMIS was insolvent even decades before December 2002.”[38]
The Expert Report and indeed the whole scandal raise the obvious question of “When did Bernie stop running a legitimate broker-dealer and start defrauding his advisory customers?” Did the fraud begin when Bernie and Peter were working with the Division of Market Regulation on market structure issues in the late 1970s and early 1980s? BLMIS supposedly used a “split strike” options trading strategy. The trading strategy, when done legitimately, involves using options to hedge positions in large cap stocks.[39] In one interview, Bernie said that “by 1994 or 1995, I basically stopped doing the split strike entirely. I just had the money housed in treasuries.”[40] Bernie was an experienced liar, so it is difficult to know whether this statement was accurate. Nonetheless, this statement seems consistent with other information, such as his sworn allocution as part of his guilty plea.[41]
Would it matter if the Madoffs were engaged in a pyramid scheme starting in the late 1970s and 80s, i.e., when Bernie and Peter were giving public policy advice to the SEC regarding the National Market System? Even if that were true, the development of the National Market System had nothing to do with the fraud. Of course, Bernie and Peter were urging the SEC to make policy decisions that would favor their business. Nearly everyone who submits a comment letter to the SEC does that. Nonetheless, their insights (along with others) and their market making (again, along with others) demonstrated that U.S. equity markets could be more competitive. Their market structure advice had nothing to do with the fraud conducted through the investment adviser.
The SEC’s failure to uncover the fraud was unrelated to SEC rulemaking. The OIG Report documents repeated oversight failures. If BLMIS had been using the split strike strategy, it would have held large positions in equities and options, Unfortunately, the SEC never verified whether BLMIS owned the amounts of securities that it claimed. The OIG Report notes:
A January 2005 statement for one Madoff feeder fund account, which alone indicated that it held approximately $2.5 billion of S&P 100 equities as of January 31, 2005. On the contrary, on January 31, 2005, DTC records show that Madoff held less than $18 million worth of S&P 100 equities in his DTC account
Similarly, the SEC’s Division of Enforcement failed to pursue inconsistencies about BLMIS that it uncovered. When the SEC’s Division of Enforcement asked colleagues in the Division of Market Regulation to inquire whether BLMIS held a large position of options on May 16, 2006, the Division of Market Regulation reported that they “had found no reports of such options positions for that day.” Unfortunately, the Enforcement Division did not seek further information about the discrepancy.[42] In other words, the public policy advice that Bernie and Peter Madoff gave to the SEC had nothing to do with the fraud.
Because of the Enforcement staff’s inexperience and lack of understanding of equity and options trading, they did not appreciate that Madoff was unable to provide a logical explanation for his incredibly consistent returns. Each member of the Enforcement staff accepted as plausible Madoff’s claim that his returns were due to his perfect “gut feel” for when the market would go up or down.[43]
Further, Bernie’s understanding of trading allowed him to overwhelm SEC Enforcement staff that did not have adequate expertise. “The Enforcement staff’s lack of experience not only contributed to their failure to understand that Madoff’s returns could not be real, it also was a factor in their failure to conduct an effective investigation regarding how Madoff was creating those returns.”[44]
In summary, BLMIS was a simple Ponzi scheme and did not depend on the SEC’s National Market System rulemaking. Bernie used his knowledge of markets and carefully cultivated his reputation with regulators to avoid close scrutiny for years. According to the OIM’s report, the Madoffs intimidated SEC Enforcement Division staff, who lacked expertise and were embarrassed to admit that they did not understand what Bernie was claiming.[45] It was a perfect storm of failure.
The Madoff Scandal – Aftermath
As Bernie’s lies unraveled and the news media revealed the scope of the fraud, everyone I knew who had respected Bernie felt like a fool, including me. I came to realize that Bernie was a world class “confidence man” who astutely exploited human weakness to achieve his goals. I was in good company.
After telling people that I knew the Madoffs, the next question was inevitably, “Did you lose any money?” The answer was “No,” because I didn’t know that he had his crooked investment adviser. I wondered why Bernie never invited me to invest. Had I known, I would have given him every cent I had. When I raised this question with colleagues, I posited that the amount I would have “invested” with Bernie was too little for him to bother about. A more flattering view was that Bernie was afraid that I would figure out that he was running a fraud. Before the scandal broke, my friend and former colleague, Stephen Blumenthal, Esq. told me that Norman F. Lent (R-NY), by then a retired Member of Congress for whom we both had worked, told Steve that he (Norm) had invested his retirement money with Bernie. Steve wondered, if Bernie is so smart that he can produce such high, consistent returns, why does he need Norm Lent’s money? Why indeed?
Bernie created a persona as a person above reproach who wouldn’t steal a postage stamp.[46] Bernie’s proximity to senior regulators and Members of Congress further enhanced his credibility. He established credibility with regulators and legislators by working with them constructively on broker-dealer regulatory issues, particularly the vexing market structure matters. Bernie and Peter understood both Wall Street and Washington, D.C. They operated with great skill in both milieus, which is rare.
Bernie did a stunning amount of human as well as financial damage across the world. He caused particularly great harm to numerous Jewish communities, both at the individual level and to Jewish philanthropic organizations. He employed the well-established technique of “affinity fraud.” He used his shared religious connection to cause people to trust him, when they otherwise might have been suspicious or undertaken more due diligence.[47]
After the scandal erupted, everyone involved pointed fingers at everyone else.[48] For example, in a hearing examining the Madoff scandal, the Senate Banking Committee asked FINRA if its examinations of Madoff’s broker-dealer revealed any fraud. FINRA responded that their:
Examination staff reviewed books and records related to the Madoff broker-dealer’s activities and areas of our examination focus. BLMIS did not record any of Madoff’s investment advisory business on its books and records. Consequently, those books and records did not indicate that Madoff was engaged in a Ponzi scheme through his separate advisory business.[49]
Precisely. FINRA (and the SEC’s oversight of FINRA) could not reveal the fraud because BLMIS’s records made no mention of it. Only a fool would have shown evidence of the fraud on the broker-dealer’s books and records. Because Bernie, and to a lesser extent Peter, had established themselves as statesmen, the regulators never suspected anything, notwithstanding the concerns that some repeatedly raised.[50]
The SEC subsequently produced a list of reforms that it instituted to prevent a repetition. These and other changes are important. Nonetheless, I hope that the SEC takes my advice and amends Rule 206(4)(2) its custody rule.[51] The SEC should require that all SEC registered investment advisers use a custodian that is unaffiliated with the adviser. Nothing can prevent another Madoff fraud with complete certainty, but ensuring that the adviser does not control the custodian broker-dealer would make a similar fraud much more difficult to achieve.[52] It also would help reduce the chance of another Madoff pulling the wool over the eyes of regulators and legislators.
Perhaps the more vexing issue that the Madoff scandal raises is the challenge of how regulators can prevent seemingly helpful regulatees from deflecting meaningful oversight of their activities. Regulators need public input on proposed regulations to ensure that the rules they adopt will work well and balance competing concerns.[53] Regulators need comments from those whom the regulation will most directly affect, including affected industries. Regulated industries often provide essential information to regulators about how those industries operate as a practical matter and the real-world implications of a proposed rule. Regulators may choose to ignore industry comment, but without it, they are likely to overlook important information.
It is important for regulators to distinguish BLMIS’s views on public policy questions, with its actual practices. Bernie was able to use the goodwill he generated to deflect close regulatory scrutiny of his fraudulent activities. Examiners need to evaluate carefully the activities of all market participants, including those who have cultivated a good relationship with regulators on policy questions or other matters. Bernie’s manipulation of regulators should serve as a warning to all.
[2]Bernard Madoff, Architect of Largest Ponzi Scheme in History, Is Dead at 82, D. Henriques, N.Y. Times, April 14, 2021, updated April 15, 2021. Ms. Henriques wrote The Wizard of Lies, Bernie Madoff and the Death of Trust (2011, 2012), (“Wizard of Lies”) which HBO adapted for a movie.
[3] On November 14, 2007, the SEC renamed the “Division of Market Regulation” the “Division of Trading and Markets.”
[5] NASD, a self-regulatory organization (“SRO”), is registered with the SEC under Section 15A of the Exchange Act. Pub L. No. 291, 48 Stat. 881, 73d Cong., Sess. II (June 6, 1934). In 1938, Congress amended the Exchange Act by adding Section 15A to provide for the registration of securities associations as SROs. Pub. L. No. 719, 52 Stat. 1070, 75th Cong., 3d. Sess. (June 25, 1938), commonly referred to as the “Maloney Act.”
[6] After serving as general counsel of two trade associations, my experience is that members do not share their trade secrets with the association staff or other members, their competitors. Further, at both trade associations, I instituted strict antitrust policies and procedures.
[7] In 1964, Congress added what is now Section 15A(b)(11) of the Exchange Act, which provides that the rules of an association must “include provisions governing the form and content of quotations relating to securities sold otherwise than on a national securities exchange which may be distributed or published by any member or person associated with a member, and the persons to whom such quotations may be supplied.” Pub. L. 88–467, Subsec. (b)(12). Pub. L. 88–467, §7(a)(7), added par. (12). Congress renumbered paragraph 12 as paragraph 11 in the 1975 Acts Amendments. 89 Stat.128. See also Phillips and Shipman, An Analysis of the Securities Acts Amendments of 1964, 1964 Duke L.J. 706.
[8]SeeInterview with Joseph Hardiman, Conducted by Kenneth Durr, Securities and Exchange Commission Historical Society, on October 29, 2009, discussion of Gordon Macklin and the early days of Nasdaq. (Hardiman Interview).
Over time, the NASD spun off Nasdaq as it grew. Eventually, it obtained registration as a stock exchange, like the NYSE. Its trading model differs from the NYSE, but it is a world class market. For reasons unrelated to trading, NASD reorganized itself and is now called FINRA. See Becker, Kaswell, et Al.,Is it Time to Revamp the Current Regulatory Structure of the Markets?, Journal of Investment Compliance December 2000. Nasdaq management must have concluded that the Nasdaq brand was very valuable and have kept it, even though its original parent organization changed its name.
[9] The SEC adopted Rule 17a-15 in Exchange Act Release No. 9850, (Nov. 8, 1972), 37 FR 24172 (Nov. 15, 1972). The adopting release notes that the rule requires “registered national securities exchanges, national securities associations and broker-dealers who are not members of such organizations to make available through vendors of market transaction information price and volume reports as to completed transactions in securities registered on such exchanges.”
Using its authority under the 1975 Acts Amendments, discussed infra, the Commission substantially expanded the display standards for trade reporting. Section 11A(c)(1) of the Exchange Act grants the SEC authority over the manner in which vendors display quotations. It redesignated the rule as Rule 11Aa3-1. Exchange Act Release No. 16589 (Feb. 19, 1980); 45 FR 12377 (Feb. 26, 1980).
In 1981, the Commission adopted rules the effect of which was to designate approximately 40 over-the-counter securities as national market system securities and to require that transactions in such securities be reported in a real-time system and that quotations for such securities be firm as to the quoted price and size. Exchange Act Release No. 17549 (Feb 17, 1981); 46 FR 13992 (Feb. 21, 1981).
In 2005, the Commission again revised the rule and redesignated it as Rule 601. Exchange Act Release No. 51808 (June 9, 2005); 70 FR 37496 (June 29, 2005), at 37569.
[10] Harman, The Evolution of the National Market System—An Overview, The Business Lawyer, American Bar Association, Vol. 33, No. 4 (July 1978), at 2275, 2285.
[11] It also argued that it would allow execution of trades without a dealer, another objective of the Exchange Act. See Section 11A(a)(1)(C)(v) of the Exchange Act. See alsoSEC, Report on the Feasibility and Advisability of the Complete Segregation of the Functions of Dealer and Broker, 1936.
[12] Pub. L. No. 94-29; 89 Stat. 97; June 4, 1975. The unfixing of commission rates played an important role in expanding securities trading. The SEC adopted Rule 19b-3 to allow market forces to set commissions. The rule took effect for most transactions on May 1, 1975. Exchange Act Release No. 11203 (Jan 23, 1975); 40 FR 7394 (Feb. 20, 1975). The 1975 Acts Amendments also deregulated commissions. 89 Stat. 107; 89 Stat.128.
[13] Section 11A(a)(2) states that “the [Securities and Exchange] Commission is directed, therefore, having due regard for the public interest, the protection of investors, and the maintenance of fair and orderly markets, to use its authority under this title to facilitate the establishment of a national market system for securities…’
[14] The 1975 Acts Amendments added Section 11A(c)(1) of the Exchange Act, which granted the SEC new authority over the manner in which vendors display quotations. In 1980, the Commission substantially revised the provisions of Rule 17a-15, and redesignated it at Rule 11Aa3-1. Exchange Act Release No. 16589 (Feb. 19, 1980); 45 FR 12377 (Feb. 26, 1980).
In 1981, the SEC took another major step in implementing its mandate to facilitate the development of a national market system. The Commission adopted a rule, “the effect of which was to designate approximately 40 over-the-counter securities as national market system securities, to require … that transactions in those securities be reported in a real-time system, and that quotations for such securities be firm as to the quoted price and size.” Exchange Act Release No. 17549 (Feb 17, 1981); 46 FR 13992 (Feb. 21, 1981). The release included conforming changes to Rule 11Aa3-1.
In 2005, the Commission again revised the rule and redesignated it as Rule 601. The SEC consolidated a number of market structure rules into Rule 601 of Regulation NMS. Exchange Act Release No. 51808 (June 9, 2005); 70 FR 37496 (June 29, 2005), at 37569.
[15] Exchange Act Release No. 16688 (June 11, 1980); 45 FR 41125 (June 18, 1980). See alsoOpening Remarks of the Honorable Harold Williams, Chairman, SEC, at the Occasion of the Commission’s Consideration of Rule 19c-3, Proposed in Securities Exchange Act Release No. 15769, June 5, 1980.
[16] Active trading in AMC Entrainment Holdings, Inc. and GameStop Corp. has brought new interest to the practice of payment for order flow. Michaels and Osipovich, SEC to Review Market Structure as Meme Stocks Stir Frenzy, WSJ, June 9, 2021. The article notes that SEC Chairman Gary Gensler “who took over the SEC in April, renewed his criticism of the system that sends many of the orders placed by individual investors to be filled by high-speed traders known as wholesalers, including Citadel Securities and Virtu Financial Inc., instead of routing them to public exchanges.” See alsoFINRA Reminds Member Firms of Requirements Concerning Best Execution and Payment for Order Flow, FINRA Regulatory Notice 21-23, June 23, 2021.
[23] Bernie was patient with those who knew less than he did. For example, at some SIA meeting I asked Bernie to explain a marketable limit order. I wasn’t embarrassed to ask or fearful that he would criticize me in front of others for not knowing something that was very basic for him.
[27] The C&L Division is a professional society for compliance and legal professionals. As SIA’s general counsel, I was an ex officio member of the C&L Executive Committee.
[28] I am not commenting on whether members of the Madoff family, other than Bernie or Peter, had any knowledge of the fraud. I have no first-hand knowledge about what they did or did not know.
[29] Bernie Madoff was a chairman of Nasdaq. Bernie Madoff Dead at 82; Disgraced Investor Ran Biggest Ponzi Scheme in History, D. Rothfeld and J. Baer, Wall St. J., April 14, 2021.
[30] Peter Madoff resigned from SIFMA’s board after the scandal broke. Family Filled Posts at Industry Groups, E. Williamson and K. Scannell, Wall St. J., Dec. 18, 2008.
[31] I was not alone in not knowing about Madoff’s so-called money management firm. In 2001, Barron’s reported:
Folks on Wall Street know Bernie Madoff well. His brokerage firm, Madoff Securities, helped kick-start the Nasdaq Stock Market in the early 1970s and is now one of the top three market makers in Nasdaq stocks. Madoff Securities is also the third-largest firm matching buyers and sellers of New York Stock Exchange-listed securities. Charles Schwab, Fidelity Investments and a slew of discount brokerages all send trades through Madoff.
But what few on the Street know is that Bernie Madoff also manages more than $6 billion for wealthy individuals. That’s enough to rank Madoff’s operation among the world’s five largest hedge funds, according to a May 2001 report in MAR Hedge, a trade publication.
What’s more, these private accounts, have produced compound average annual returns of 15% for more than a decade. Remarkably, some of the larger, billion-dollar Madoff-run funds have never had a down year.
When Barron’s asked Madoff how he accomplishes this, he says. “It’s a proprietary strategy. I can’t go into it in great detail.”
Arvedlund, Don’t Ask, Don’t Tell: Bernie Madoff is so secretive, he even asks his investors to keep mum, Barron’s May 7, 2001. As discussed infra, BLMIS was not a hedge fund. In a letter from Bernie Madoff responded to some questions from the SEC, he notes that “neither Madoff Securities, nor any entity affiliated with Madoff Securities, manages or advises hedge funds.” Bernard L. Madoff to Eric J Swanson, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, Jan. 16, 2004. Mr. Swanson later married Shana Madoff, Peter’s daughter. The SEC’s Office of Inspector General’s (OIG) report into the Madoff scandal stated that “the OIG also did not find that former SEC Assistant Director Eric Swanson’s romantic relationship with Bernard Madoff’s niece, Shana Madoff, influenced the conduct of the SEC examinations of Madoff and his firm.” Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme – Public Version, OIG, SEC, Report No. OIG-509, Aug. 31, 2009, (OIG Report) at 20. See alsoExhibits.
[32] Many news reports and other accounts of the Madoff scandal referred to Madoff as a “hedge fund.” E.g., The 10 Biggest Hedge Fund Failures, Investopedia. That description is incorrect for two reasons. First, BLMIS purported to invest its clients’ money in individual securities. It did not purport to create a fund. The sine qua non of a hedge fund is that the investors purchase shares in a pooled investment vehicle that, in turn, invests in various securities. Investors in the fund do not own individual securities in the fund’s portfolio. Second, BLMIS was not running a hedge fund, separate account, or any other legitimate activity. It was a fraud.
[33] In fairness, the OIG Report indicates that some hedge fund managers reported to the SEC that they believed that Madoff’s investing strategy was too good to be true. Unfortunately, the SEC did not pursue these reports adequately. See discussion below.
[35] I had worked for Congressman Michael G. Oxley (R-OH) when I was counsel to the Committee on Energy & Commerce of the U.S. House of Representatives between 1986 and 1990.
[In 1997,] third market market-maker Bernard Madoff, not yet known as a fraudster, was upset that the NYSE was not sending order flow his way. He contacted the SEC and threatened to “break the eighth” if that continued. Division of Market Regulation Director Rich Lindsey told him, “Go ahead.” Madoff’s resulting move to sixteenths was taken up by all other exchanges within days.
Transformation & Regulation, supra [citations omitted].
[37]Securities Investor Protection Corporation v. Bernard L Madoff Investment Securities, LLC, U.S. Bankruptcy Court, Southern District of New York, Adv. Pr. No. 08-01789 (SMB), Expert Report of Bruce G. Dubinsky, Exhibit 2 at 161 (11/25/2015) (“Expert Report”).
[39] N. Abe, Split Strike Is a Valid Strategy, Despite Madoff Scandal, SeekingAlpha, Dec. 22, 2008.
The split strike strategy involves buying a basket of stocks, then writing call options against those stocks, and finally using the proceeds from writing the call option to purchase a put option.
The strategy, in theory, should provide market returns minus extremely bullish or bearish results, depending on how far out of the money the call and put options are. For example, a manager might buy the S&P 500 (which we’ll use the SPYs as a proxy for) at $91 and sell the January 09 $95 strike calls for $2.22 and buy the January 09 $87 strike puts for $2.92. In effect the manager is paying $0.70 for the insurance that the SPY position will not be worth less than $87 and not more than $95 on Jan 16th 2009. Rinse and repeat this every month and the performance of this manager will more or less be market performance minus the cost of insurance. It would be impossible, as Madoff critics point out, for the manager to avoid losses in months where the market goes down.
[40] Soltes, Why They Do It, Inside the Mind of the White Collar Criminal (Inside the Mind), 2016, at 296.
[41]Transcript of March 12, 2009 Allocution in the Matter entitled U.S. v. Madoff, Case No. 09 CR 213, U.S. District Court for the Southern District of New York (March 12, 2009), also cited in OIG Report, at note 30. See alsoWizard of Lies at 92: “As the 1990s began, Bernie Madoff was running a legitimate and apparently successful brokerage firm, with 120 employees and profits approaching $100 million a year.” Ms. Henriques cites an NASD examination letter as evidence.
[42] OIG Report, at 39-40. The report explains how the SEC overlooked several reports that indicated it was impossible for BLMIS to achieve the results it claimed using the split-strike strategy. Id., at 66.
[46] Bernie’s ability to manipulate regulators and investors was extraordinary. For example,
For some time he had cultivated the impression that new investors simply couldn’t get in – he had all the money he wanted; he wouldn’t even discuss the business with would-be clients. It was akin to winning the lottery if he agrees to add you hedge fund to his coterie of institutional clients. This approach was masterful, of course. It proved that Groucho Marx’s famous rule also worked in reverse: everyone wanted to join the club that wouldn’t let them in.
Wizard of Lies at 116-117.
Yet despite Bernie’s shrewd judgment of human weaknesses, he largely excused his own massive fraud as not that bad and no different from “the prevailing norms in the financial industry.” Inside the Mind at 304.
[47] The SEC’s Investor.gov website describes “affinity fraud” as follows:
Affinity frauds target members of identifiable groups, such as the elderly, or religious or ethnic communities. The fraudsters involved in affinity scams often are – or pretend to be – members of the group. They may enlist respected leaders from the group to spread the word about the scheme, convincing them it is legitimate and worthwhile. Many times, those leaders become unwitting victims of the fraud they helped to promote.
[48] Senate Banking Hearing; SEC Office of the Inspector General, Investigation of Conflict of Interest Arising from Former General Counsel’s Participation in Madoff-Related Matters.
[49] Response of Stephen Luparello, Interim Chief Executive, FINRA, to written questions, The Madoff Investment Securities Fraud: Regulatory and Oversight Concerns and the Need for Reform, Hearing before the Committee on Banking, Housing and Urban Affairs, United States Senate, 111th Cong., 1st. Sess. Jan. 27, 2009, at 111.
[53] The Administrative Procedures Act, 5 USC Part I, Ch. 5. Subchapter II. Among other things, this legislation requires federal agencies to seek public comment on proposed rules. The U.S. Constitution’s Due Process Clause also requires public notice. Cf. Panama Refining Co. v. Ryan, 293 U.S. 388 (1935).
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