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The IRA | It's All About the Fraud: Madoff, MF Global & Antonin Scalia

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This is an everygreen post of last week's IRA comment.  To read our new comment on JPMorgan, "Questions for the Fed on JP Morgan; Walker Todd on Bernanke, Ed Kane on TARP," click here.  To view the slides for my presentation to FINRA this week, click here.  

Chris

The Institutional Risk Analyst
May 8, 2012

"It's all for nothing if you don't have freedom."

 

William Wallace

 

In this issue of The Institutional Risk Analyst, we return to the Lehman Brothers, Madoff and MF Global bankruptcies to talk about how the largest banks have wired US bankruptcy laws to their own advantage. Specifically, the 2005 changes to the bankruptcy code, combined with the traditional American caution regarding pre-judgement restraint on the parties surrounding a bankruptcy, has provided American banks with a free pass to facilitate fraud with no accountability.

 

On May 17th, IRA co-founder Christopher Whalen is making a presentation to the economic advisory committee of FINRA entitled "Policy issues regards customer account protection and bankruptcy." This edition of The IRA is meant as a background to that discussion, which unfortunately is closed to the public. In that regard, thanks to Max Keiser for the quotation from his kinsman William Wallace.

You may also read our earlier comment, "Should the Courts Appoint an Equitable Receiver for Bank of America?," where we argue that the degree of obvious fraud present in the operations at BAC and Countrywide justifies the appointment of a federal receiver now to run the bank.

But before we jump into this discussion, we just have to take a moment to note that Ally Financial has apparently received the blessing of the US Treasury to file a bankruptcy for the ResCap real estate unit, according to Dakin Campbell at Bloomberg News. This is a profoundly bad idea, as we have noted in past issues of The IRA. The subsidiaries of bank holding companies cannot default, especially when the sub has its own bond holders with a different agenda than the parent company creditors. Hello! Read Gretchen Morgenson in the Sunday NY Times: "Mortgage Unit Troubles Ally Financial" 

Neither Secretary Geithner nor President Obama wants to deal with Ally before the election. The incompetence of Geithner in dealing with the portfolio investments of the US is a national scandal, but Ally is first among his failings because of the politics of GM and big labor. The obvious thing to do was sell the auto business back to GM and the servicing book to somebody a year or more ago, but the policy of "extend and pretend" continues in Washington. Sad thing is, though, that the business community is still abandoning the White House in droves despite or maybe because of such behavior.

The Case for Equitable Receivers in Bankruptcy 

Article III of the US Constitution created the judicial branch of the American government and made it independent of the legislative and executive branches. District Courts, Courts of Appeal and the US Supreme Court are all authorized under this part of the Constitution and are thus known as "Article III" courts. The Supreme Court has ruled that only Article III courts may render final judgments in cases involving life, liberty, and private property rights, with limited exceptions.

Article I tribunals consist of certain federal courts and other forms of adjudicative bodies, including federal bankruptcy and administrative law courts, and many federal agencies such as the Fed, FDIC and OCC in the banking world. Article I, Section 8, Clause 4 authorizes Congress to enact "uniform Laws on the subject of Bankruptcies throughout the United States." These bodies are creatures of the Executive Branch and the decisions of these "adjunct" tribunals are subject to comprehensive review by the Article III courts, as noted above.

The historical separation between bankruptcy courts and the US judiciary is complex and reflects the imperfect, often conflicted nature of the governances structures of the American republic. The concept of checks and balances, after all, implies conflict, not the phony notion of consensus. The policy on bankruptcy evolves with the country.

When it comes to business insolvencies, both Congress and the Courts have tended to want to leave bankruptcy courts in the commercial realm, operating more like mediators for corporations and social welfare agencies for individual, than as "equity courts" in the ancient sense. Out of this tradition has grown a great reluctance on the part of US Article III courts to allow the bankruptcy courts to operate outside the narrow confines of the interests of the estate of the failed individual or entity.

In the 1920s and 1930s, when financial fraud reached an apex, the Courts were not afraid to empower bankruptcy trustees also as receivers in order to protect the public from various types of criminality in existence at that time. In the landmark 1925 case Benedict v. Ratner, where Justice Louis Brandeis laid down the law on collateralized borrowing, the bankruptcy trustee in the underlying case was also appointed as a receiver.

The difference between a trustee and receiver is very significant. The trustee in a bankruptcy represents the estate and has no power to pursue other parties nor to make decisions affecting equity. The bankruptcy of the Madoff firm, for example, shows how the trustee in unable to act on behalf of the victims of the fraud. Irving Picard may only represent the interests of the failed broker dealer. Under the bankruptcy code, the trustee may only pursue money's owed to the estate and may not pursue third parties for their actions against the victims of the fraud.

While many people are confused by the fact that the Madoff trustee has been unable to recover billions in funds stolen from the customers of the Madoff firm from JP Morgan and other banks, this situation simply reflects US law and the Constitutional limitations imposed upon the bankruptcy process. The well-established general rule was that a judgment fixing a debt was necessary before a court in equity would interfere with the debtor's use of his property.

Thus in the case of Madoff, the bankruptcy trustee is unable to pursue claims against the third parties, in part because this "adjunct" tribunal lacks the authority to make such a final judgment. In addition, because the trustee's authority stems from his association with the estate of the bankrupt entity, the concept of "in pari delicto" blocks the trustee from acting. Two key concerns for investors and risk managers are illustrated by the Madoff and MF Global bankruptcies:

o Unequal legal status of segregated accounts in bankruptcy vis-à-vis other creditors due to "safe harbor" changes to bankruptcy laws in 2005.

o Inability of bankruptcy trustees to pursue third parties that cause losses to investors due to fraud, other bad acts.

As a result of these two defenses working in tandem, today financial institutions can aid frauds such as Madoff and MF Global, to mention just a few, without being brought to task in civil proceedings. Because the federal courts and other agencies still do not recognize fraud as the paramount problem facing the US economy, the victims of the fraud are left defenseless. And once the perpetrator of the fraud files for bankruptcy, the individual victims often are left without any means of seeking redress and the bad actors among management and other customers literally walk away. As Peter Henning wrote for The New York Times last month:

"Most investors lose almost all of their money once a Ponzi scheme collapses, and the trustees appointed to clean up the mess try to find any deep pocket available to recover something. Unfortunately for the trustees, the legal doctrine of "in pari delicto," Latin for "in equal fault," may block any recovery."

In a major 1920s case decided a few years before the Benedict v. Ratner decision, Brandeis famously precluded any right for unsecured creditors to seek a receiver, except the right to have freedom from fraud. This decision was upheld decades later in 1999 when Justice Antonin Scalia, writing for a unanimous Supreme Court in Grupo Mexicano de Dessarollo, S. A., et al, held that:

"This case presents the question whether, in an action for money damages, a United States District Court has the power to issue a preliminary injunction preventing the defendant from transferring assets in which no lien or equitable interest is claimed… [T]he English courts of equity did not actually exercise this [Mareva] power until 1975, and that federal courts in this country have traditionally applied the principle that courts of equity will not, as a general matter, interfere with the debtor's disposition of his property at the instance of a nonjudgment creditor. We think it incompatible with our traditionally cautious approach to equitable powers, which leaves any substantial expansion of past practice to Congress, to decree the elimination of this significant protection for debtors."

The problem with the prose used by Scalia in the unanimous Supreme Court opinion is that the justices still do not "get it" when it comes to fraud. While the decision in Grupo Mexicano was correct, the problem with the cases coming before the bankruptcy courts today such as Lehman Brothers, Madoff and MF Global is that fraud is once again the key problem. And many lawyers and judges, with all due respect, do not understand the fraud exemption to the general rule set forth by Brandeis, Scalia and many other members of the Supreme Court.

Bankrupt firms such as MF Global, Madoff and all of their officers and business counterparts deserve greater scrutiny that only an equitable receiver appointed and empowered by a federal District Court judge can provide. Unfortunately, many victims of fraud do not understand their rights and duties in such situations. Worse, their lawyers who've never read Brandeis or the brothers Learned and Augustus Hand on these core Constitutional issues often fail to appreciate that there is a way to demand the appointment of a receiver by a federal court in a bankruptcy where fraud is present.

The unspoken truth of 2007 financial crisis is that fraud on and off Wall Street just as pervasive in 2005 as in the 1920s. Lehman Brothers, Madoff, and MF Global all featured systemic fraud. Congress and the Supreme Court took a decade from 1929 to 1938 to wake up to root cause of Great Depression, namely securities fraud of 1910s through 1929, and acted accordingly. But today we have come full circle. A servile Congress and federal Courts have precluded just about every means for controlling fraud by large banks and have destroyed investor confidence in the process.

In the Grupo Mexicano case, Scalia's opinion relies on (and favorably quotes) opinions of Brandeis for when a receiver is proper. That case is still good law and Scalia quotes that case as his primary authority. The facts of Grupo Mexicano involved only "preferences," not "fraudulent transfers" (because they discharged obligations to creditors) and were not direct or indirect transfers to insiders or shareholders.

So while the Scalia decision is technically correct, the way his language is being misused today in the Madoff and MF Global litigations is the problem. Brandeis would agree with Scalia on the Groupo Mexicano "holding" that simple preferences of creditors should never be the basis for appointing a receiver. But that also means the use of receivers is allowed when there is evidence of insider dealings and actual or constructive fraud and thus is consistent with the "ruling" of Grupo Mexicano (though perhaps not reading Scalia's prose). Scalia could rule in favor of receivers at any time he wants and wrap himself in the "garb" of Brandeis. Bottom line: The Grupo Mexicano case should never be used as a preclusion from use of a receiver whenever there is evidence of fraud on unsecured creditors in a bankruptcy.

There are a number of examples where a receiver function plays an important role in fighting fraud. In case of The Stanford Group, an Article III receiver was appointed by a federal District Court without any bankruptcy to pursue a wide ranging investigation, which included efforts to conserve customer funds and pursue third parties via criminal and civil means.

The FDIC is another excellent example of how receivership powers enable that bank agency to limit losses to the mutual insurance fund supported by insured banks and also pursue claims against bank officers, directors and other parties. Unlike a trustee in a bankruptcy, the FDIC acting as receiver has broad authority to seize assets, sue officers and directors, reject contracts and even make criminal referrals related to a failed bank.

The FDIC example is instructive for what a receiver's role should be. The first job of counsel to any FDIC receiver is by regulation and practice to pursue claims against officers, directors, auditors, appraisers and attorneys (and their respective insurers). That is because when a financial institution goes bust, those are the ONLY sources for recovery of losses by taxpayers. Financial institutions NEVER go bust when their assets (loans) exceed their liabilities (deposits and debts) and losses, therefore, are all a result of asset deficiencies.

So what can be done to fight fraud and restore investor confidence? There are two key changes that Congress must make in current law. First, there needs to be a requirement for referral (by any trustee in bankruptcy AND by all bankruptcy judges) to the related District Court for appointment of receiver in ANY case where:

1. "in pari delicto" is asserted as a defense or as a basis for not proceeding in an adversary proceeding against any third party that the trustee or bankruptcy judge believes to be liable to the estate and/or its creditors, or

2. the trustee, any creditors' committee or bankruptcy judge determines that "in pari delicto" is likely to restrain collection of an otherwise collectible sum, unless, after a hearing, the Bankruptcy Court rules that it is not in the interest of the estate to pursue such claim.

A trustee and/or any affected creditor can then appeal to the related District Court without limitation by reason of the bankruptcy stay.

It should then be up to the District Court to determine whether a separate limited receiver is to be appointed (like a "special master") with respect only to those claims or to appointment of a full receiver.

When a full receiver is appointed, the District Court should be allowed to elect the trustee as a receiver, in the event there is found to be no conflict of interest, or to merely add receivership authority to the role of the trustee appointed by the District Court.

Empowering Bankruptcy Courts to use receivers appointed and empowered by federal District Courts restores the faith of investors that fraud is NEVER a "defense" and overcomes the desire of trustees (and even some bankruptcy judges) to keep Article III courts out of bankruptcy issues.

Expanded use of receivers in bankruptcy is also consistent with centuries of law that fraud overcomes any discharge of debt in bankruptcy. So this proposal is not so much a "change of law" but rather a recognition that markets suffer whenever fraud is an effective "defense" in bankruptcy or other venues.

Questions? Comments? info@institutionalriskanalytics.com 

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Tue, 05/22/2012 - 14:31 | 2451871 drdj4425
drdj4425's picture

This piece made me think of the movie "GODFATHER 1" where the Italian immigrants who had no power did not go to the authorities for justice. Instead they went to the godfather who delivered appropriate justice. As a nationis this the direction we are going?

Mon, 05/14/2012 - 07:55 | 2423076 shovelhead
shovelhead's picture

Great!

JPM can vaporize my kids college funds account and

I can stand at the courthouse with my dick in hand while they waltz away.

Account closing letter in mail today.

Anyone know if there is a cap gain gift liability for a student with no income? Oddly enough, I can't seem to find current info about student funds @ IRS that makes sense.

No surprise there. I'll stick silver and gold in the hidey-hole for him and his pre-med classes will get plenty of practice with truama and GSW treatments very soon.

Mon, 05/14/2012 - 07:33 | 2423052 rufusbird
rufusbird's picture

Good read on a difficult subject. Well written, even I understood it! Interesting reference to the Fraud preceeding the Great Depression. Very interesting. Would like to see more on that.

Mon, 05/14/2012 - 01:53 | 2422815 lynnybee
lynnybee's picture

just another day of looting & rigging the system in the United States of America.    yes, great article; another great article exposing the fraudster, the criminals & the treasonous acts .... so, what the hell is going to be done about it all ?    who's going up against these criminals & removing them from their seats of power ?      who ?    i don't see anything being done about it; just more bitching & moaning about the gang of criminals running this country into the ground at the expense of the decent & honest citizens.    wake me up when things hit rock bottom & the pitchforks are ready to be used.    another great article, add it to the pile of great articles.

Mon, 05/14/2012 - 03:46 | 2422902 bunnyswanson
bunnyswanson's picture

Well, there are people doing something about it.  And they are being beaten back into the house with threats of imprisonment and felony charges (labeled as terrorists). 

Mon, 05/14/2012 - 01:49 | 2422807 q99x2
q99x2's picture

If you are not good at this legalease stuff coast to coast tonight has an interview with a guy that teaches one how to beat up a bigfoot.

Mon, 05/14/2012 - 01:22 | 2422794 bigwavedave
bigwavedave's picture

Superb work this. Kudos.

Mon, 05/14/2012 - 01:18 | 2422790 tony bonn
tony bonn's picture

a symphony of erudition - good article....the 2005 bankruptcy law was premidated psychopathic obstruction of justice to favor banksterism....fuck the banksters and congresshits all to hell.....

Mon, 05/14/2012 - 00:26 | 2422757 q99x2
q99x2's picture

Too big and fraudulent to survive. Hope they take Obummer with them on the way out.

Nice article.

Tue, 06/12/2012 - 07:02 | 2517255 JimS
JimS's picture

And you really think Rummy is going to be better? You are fucking dreaming. Better take a double dose of your meds, as they aren't working. Got out of your Red vs. Blue shit, neither of them give a God Damn about the bottem 80% of the economic pie.

Mon, 05/14/2012 - 02:50 | 2422788 gangland
gangland's picture

GEE, YOU DON'T SAY? REALLY????

CONTROL FRAUD? 2005 BANKRUPTCY LAWS??

WHAT THE FUCK ARE YOU TALKING ABOUT? WHAT WORTHLESS CLAP-TRAP PSEUDO-INTELLECTUAL TOTAL BULLSHIT YOU POSTED. EPIC. AND THE PARROTS LAP IT UP!

HEY FUCK WAD WHALEN, YOU JUST FIGURED THIS OUT???

SCALIA AND THOMAS ON THE COURT IN 1982? KOCH BROTHERS?

WHERE THE FUCK WERE YOU WHEN THE ST GERMAIN ACT OF 1982 WAS PASSED?  YEAH I THOUGHT SO.

NEXT TIME TRY READING THIS YOU WORTHLESS ASS HOLE, BILL BLACK HAS BEEN AHEAD OF YOU FOR YEARS.

NOW STFU.

Looting: The Economic Underworld of Bankruptcy for Profit BY AKERLOFF & ROMMER CIRCA 1993! doh!

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=227162

 

brusca shit and now more crap from libertad rc whalen, this site has gone so far downhill its pathetic, now add some clap trap from jim quinn and jim grant and youre good to go to douchville. 

perfect for all the gold guns ammo end of the world idiots who just lap this shit up with nary a modicum of critical thinking. 

spoon fed cows show more cognition than zh readers. 

this site lost whatever value add it had a long time ago and now it's exposed as basically cross-posts and 800 word crap with barely any original analysis.

 

DUMBFUCKS: MAYBE TRY READING SOME THINGS INSTEAD OF PARROTING THIS DOUCHBAG OR JIM GRANT OR PETER SCHIFF,

 

TRY MIKE NORMAN. OR YOU KNOW WHAT, NEVER FUCKING MIND YOU COCKSUCKERS DESERVE ZH.

KEEP BUYING GOLD RACIST JUVENILE INTELLECTUAL MIDGIT DISEASED LIBERTARD DUMBFUX.

NEXXXXXXXXXXXXXXXt!

 

 

Mon, 05/14/2012 - 07:18 | 2423026 The Limerick King
The Limerick King's picture

 

 

Gangland is losing his edge

Insulting the gang at the "Hedge"

Wake-up you shill

Try the red pill

And get yourself down from that ledge

 

Mon, 05/14/2012 - 22:21 | 2425600 gangland
gangland's picture

please, just...will you PLEASE keep an open mind and read this a few times, and ....think abou tit?

please.

 

http://neweconomicperspectives.org/2012/04/why-does-uncle-sam-borrow.html

 

regardless..i proly overreacted we're not enemies..

Mon, 05/14/2012 - 07:52 | 2423093 shovelhead
shovelhead's picture

At least we know who is on Bernankes other tit.

I still can't get WB7's deeply disturbing pic out of my mind...

 

I'm a friendly-fire casualty of visual combat.

Mon, 05/14/2012 - 03:06 | 2422755 ebworthen
ebworthen's picture

Sounds like I need to buy more Gold and Silver and have as few "Corzineable" deposits and accounts as possible.

Sun, 05/13/2012 - 23:51 | 2422729 msjimmied
msjimmied's picture

Scalia's son...interesting how Scalia and Thomas shows up for the Koch Bros shindigs. They should have gone in their robes, they really don't care what you think. 

"In an appropriately loathsome touch, the Chamber's legal team was led by one Eugene Scalia, son of Supreme Court Justice Antonin Scalia. The younger Scalia, who looks like the product of a twisted test-tube experiment that crossed his father with Ari Fleischer, pitched a federal appeals court on the idea that the proxy access rule was "arbitrary and capricious," and that the SEC hadn't spent enough time studying the rule's effects on "efficiency, competition and capital formation." 

Matt Taibbi.


Read more: http://www.rollingstone.com/politics/news/how-wall-street-killed-financial-reform-20120510#ixzz1uoQHnX6E

Sun, 05/13/2012 - 22:37 | 2422570 sof_hannibal
sof_hannibal's picture

Scalia bitchez. Antonin Scalia, not understanding the real world and how it works since 1933...

Sun, 05/13/2012 - 23:52 | 2422732 Eireann go Brach
Eireann go Brach's picture

The real IRA from Ireland need to put a few bullets in the skulls of some of these Yankee fucking bastard bankers like Corzine and do the world a favor!

Sun, 05/13/2012 - 22:28 | 2422561 Cheyenne
Cheyenne's picture

"Because the federal courts and other agencies still do not recognize fraud as the paramount problem facing the US economy, the victims of the fraud are left defenseless."

Yup. What is more, Congress, the Executive Branch, and virtually the entire Fourth Estate likewise refuse to acknowledge fraud as the driving factor behind the ongoing financial crisis.

By sharp contrast, Whalen is right on the money, going so far as to appear in "Bailout," a new documentary that drills down on Wall Street's massive fraud against Main Street:

http://maxkeiser.com/2012/05/12/kr287-keiser-report-central-bank-monarchs/

Cue to 13:25 for a film clip that includes a fine blast from Whalen.

Sun, 05/13/2012 - 22:16 | 2422542 illyia
illyia's picture

Thank you Chris Whalen and Tylers... fine work.

Of course, you realize how dangerous this makes you all.

 

Tue, 05/15/2012 - 04:07 | 2426098 MeelionDollerBogus
MeelionDollerBogus's picture

Space monkeys ready to be fired into outer space.

Ya, pretty much anyone signing on to be a Tyler really better have spent those 3 days on the porch without question about being too fat to get in.

Sun, 05/13/2012 - 22:04 | 2422529 Clowns on Acid
Clowns on Acid's picture

RC - Great article in its insight and granularity. Bravo !

Don't worry about Scalia _ I believe that he fully undestands the diff between a legit bankruptcy and fraud by the likes of Madoff and Corzine.

The Feds immediately went after Madoff, as most  of his clients (getting steady 15% returns for 10 or more years) wre of the same socio-economic group. Indeed the only way one might "get into" Madoff's schema was thru a particular referance.

Once it all went down, they was shock amonsgt tha referenced community, that they and not others would be defrauded.

Of course the Feds were on it immediately. Juxtapose this approach with MF Gloibal and Corzine. Corzine has been treated w/ kid gloves and investors / commercial hedgers like typical creditors s in a bankruptcy.

If you focussed on this anamoly, I would think the valued article would be exponentialy more valuable.l

 

Mon, 05/14/2012 - 02:13 | 2422827 azusgm
azusgm's picture

Madoff had his kids call the feds. He had to drop a dime on himself to wake up the justice system. That call probably never would have been made if he hadn't recognized his own need for protective custody (penthouse arrest under private security guards + US marshalls.)

Sun, 05/13/2012 - 22:00 | 2422522 disabledvet
disabledvet's picture

This is quite exceptional work indeed. I simply have no basis upon which to understand your claims vis a vis General Motors or Ally Financial. We shall see how the market opens Monday and go from there...but "assumptions about risk" are fast becoming mere "assumptions about liability" and nothing more. Who knows...at some point maybe even a Governor or two will have something to say...

Sun, 05/13/2012 - 21:59 | 2422520 Hulk
Hulk's picture

Very, very interesting...

Mon, 05/14/2012 - 01:17 | 2422789 StychoKiller
StychoKiller's picture

Hmm, excuse me while I close this barn door...anyone seen some horses lately?

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