MAJOR BROKERAGE FIRM FAILURESIN THE UNITED STATES

LEHMAN BROTHERS INC.

BERNARD L. MADOFF INVESTMENT SECURITIES LLC

STEPHEN P. HARBECKPRESIDENT & CEO

SECURITIES INVESTOR PROTECTION CORPORATION

BEIJINGNOVEMBER, 2009

PRELUDE: 2007

• No Brokerage Failures Requiring SIPC To Assist Customers

• The First Year With No New Liquidation Proceedings In 36 Years

• SIPC’s Resources At Year End 2007 – $1.52 Billion in SIPC Fund$1.0 Billion Commercial Line of Credit$1.0 Billion Credit With United States Government$3.52 Billion Available

• 2008• The Most Dramatic Year In SIPC’s History

• Three Small brokerage firm failures—Typical of a “normal” year at SIPC.

• Three Major Events:Bear Stearns – March, 2008Lehman Brothers (“LBI”) – September, 2008 Bernard L. Madoff Investment Securities (“Madoff”) –

December, 2008

BEAR STEARNS

• When we last met on July 31, 2008 in Hohhot, Inner Mongolia I briefed many of you on the collapse of Bear Stearns in March, 2008.

• We should review what happened with Bear Stearns as a basis for discussing the collapse of Lehman Brothers Inc. (“LBI”) and Bernard L. Madoff Investment Securities Inc. (“Madoff”).

Sudden loss of confidence in Bear Stearns –

• Two Hedge Funds sponsored by Bear Stearns failed.

• Ratings services downgraded mortgage backed securities issued by a Bear Stearns affiliated entity.

• Lenders refused to renew outstanding loans to Bear Stearns.

• Bear Stearns was forced to pay higher prices to insure credit default swaps.

• Counterparties refused to trade.

• The value of Bear Stearns fell dramatically.

• Complex products held by Bear Stearns were difficult to value.

• Each of the foregoing events caused a “downward spiral” in counterparty confidence- other corporations refused to do business with Bear Stearns under any circumstances.

• The corporate structure involved two SIPC member brokerage firms.– Bear Stearns as principal: proprietary trading– Bear Stearns as agent for customers

• The separation of the "customer" business was fortunate.

• Bear Stearns was purchased by J.P. Morgan Chase, but only after the United States Federal Reserve Bank guaranteed many of Bear Stearns’ obligations.

• In other words, the federal government intervened to prevent a collapse which might have spread to other firms.

• SIPC was NOT called upon to protect the customers of Bear Stearns because of the government guarantee.

• The guarantee was unprecedented.

• Has the United States government taken a “pro-active” stance which is similar to many positions taken by the government of China?

My answer in July was:

Yes, and No.

My answer now is:

YES.

The Financial Crisis Spreads.

• More securities backed by “subprime” mortgages lost value.

• Many securities products which were thought to be liquid were very difficult to price. Market Values plunged. (“Auction Rate” securities; Money market mutual funds).

• Many of the largest brokerage firms concluded hasty mergers with banks.

• The “Troubled Asset Relief Program.”

• The Collapse of Lehman Brothers in September.

LEHMAN BROTHERS INC.

• Many of the same factors that caused the collapse of Bear Stearns played a role in the failure of the Lehman Brothers financial empire.

• Huge positions in mortgage-backed securities lost value. Pricing the LBI bond portfolio became impossible. The bonds could not be sold.

• Unlike the Bear Stearns case, however, the United States government refused to intervene.

• The parent company, Lehman Brothers Holdings, Inc. (“LBHI”) was placed in bankruptcy on September 15, 2008.

• The brokerage firm, Lehman Brothers, Inc. (“LBI”) was placed in bankruptcy on September 19, 2008.

• Very novel use of the Bankruptcy Code: The immediate sale of the core business.

THE SCOPE OF LEHMAN BROTHERS

• Daily Operations Financed with a One Trillion Dollar ($1,000,000,000,000) Secured Loan Which Was “Marked-To-Market” Daily.

• Transfer of One Hundred Billion Dollars ($100,000,000) to 100,000 Customers in First Week.

• The Work of Unwinding the Business Occupies Thousands of Accountants and Attorneys.

• The Unusual “Sale” of the Brokerage Firm’s Assets.

BERNARD L. MADOFF INVESMENT SECURITIES, LLC.

(“MADOFF”)

A Chinese Sculptor’s View of the Madoff Case:

WHILE THE FAILURE OF LEHMAN BROTHERS WAS DIRECTLY RELATED TO THE OVERALL FINANCIAL CRISIS, THE MADOFF CASE WAS NOT

The Madoff Case Was Indirectly Related to the Financial Crisis.

Investors Tried to Withdraw More Than Madoff Could Liquidate.

THE MADOFF CASE INVOLVES TWO MAJOR FACTORS:

1. Massive fraud, extending for decades

2. A regulatory failure to identify and stop the theft of customer assets

MADOFF’S FRAUD: THE BASICS

• He told customers he had a secret, sophisticated trading strategy.

• He required customers to give him complete discretion to trade for their brokerage accounts.

• He would only accept accounts with large opening balances.

• He sent each customer statements reflecting trading activity each month.

• Month after month, each customer’s account showed profitable trading

• IN FACT, NO TRADING ACTIVITY TOOK PLACE.

• Mr. Madoff stole money to live well.

• Distributed money to other customers when they asked for a withdrawal.

• At the end of each month, Madoff would pick stocks that had gone up, and backdate a purchase and a subsequent sale. Each customer believed he had bought a “basket” of stocks and sold the “basket” for a profit.

• This activity went undiscovered for more than twenty years.

• Customers believed they held, in the aggregate, $64,000,000,000 in stocks.

• When the brokerage firm closed, it actually had less than $1,000,000,000 of securities.

MADOFF

THE BASIC CONTROVERSY:

HOW TO VALUE EACH CUSTOMER’S CLAIM?

Two Competing Methodologies:

“Money In Minus Money Out” = “Net Equity”

“Last Statement” Methodology

General Rule in Fraudulent Schemes:Claims are valued on a “money in minus money out basis”

A reason:Basing the claim on the fictional last statements allows the thief to determine which claimants win and which claimants lose.

THREE SAD STORIES• CUSTOMER ONE—A LONG TIME CUSTOMER

Elderly customer deposits $1,000,000 in 1990.

Customer withdraws $100,000 per year for living expenses.

This continues for 20 years.

The customer has therefore withdrawn $2,000,000 in total—more than he initially put into the brokerage.

But because of the fraudulent statements, the customer believed he still had $2,000,000 in his account

He has actually received $1,000,000 as a return of his principal. . . .

And he has also received $1,000,000 of assets stolen from other customers.

On a “money in minus money out” basis, this INNOCENT customer owes $1,000,000 to the bankruptcy trustee and has no further claim.

The bankruptcy trustee, after reviewing the financial circumstances of Customer One may not attempt to collect the stolen money if it is not really possible for the customer to repay.

Customer is not entitled to funds from SIPC, and to share “pro rata” in customer property.

• CUSTOMER TWO – A NEW CUSTOMER

Customer deposits $10,000,000 in the final week of the brokerage firm’s operation.

The brokerage firm closes.

The customer attempts to “reclaim” the $10,000,000, asserting that it is his own property.

The Bankruptcy Court holds—correctly—that he has a $10,000,000 claim, but that he is not entitled to a return of the money. The funds are “customer property” to be shared by all customers on a pro rata basis.

Customer Two is entitled to $500,000 from SIPC.

• CUSTOMER THREE

A married couple saves diligently for decades.

Deposits $8,000,000, in total, over many years.

Received a Madoff statement in November, 2008, saying their account has $22,000,000.

They plan to retire, and actually withdraw $20,000,000 in November.

They had to return $19,500,000 to the Trustee. They had received a “preference.”

The Principles of “Preference” and“Fraudulent Transfer”

These statutory concepts prevent luck, or knowledge of fraud, from determining how much a victim will receive.

Persons who have received distributions may be required, by law, to return money to the Trustee.

What is a “preference?”

What is a “fraudulent transfer?”

• Constructive fraudulent transfer• Actual fraudulent transfer

CAN THIS HAPPEN AGAIN?

2009 – No brokerage firm failures require SIPC to act.

Is this a return to normal?

SECURITIES INVESTOR PROTECTION CORPORATON805 15th ST, NW

Suite 800Washington, DC 20005

(202) 371-8300www.sipc.org