Investors who argue that fake profit in the Bernard Madoff fraud should be included in their repayment claims must wait to see if the judge overseeing the liquidation of Madoff’s defunct business will side with them.

U.S. Bankruptcy Judge Burton Lifland in New York didn’t issue a ruling yesterday after a four-hour hearing in which he listened to arguments from investors and lawyers.

Lifland will determine how much money, if any, victims may get from the industry-financed Securities Investor Protection Corp., which must repay as much as $500,000 for each qualifying claim.

“There are very complex issues here,” Lifland said at the end of the hearing. “No matter how I come down and rule, it’s going to be unpalatable to some degree to one party or another.”

Lifland didn’t say when he would make a decision.

The liquidation of New York-based Bernard L. Madoff Investment Securities LLC is the biggest such case undertaken by SIPC, court records show.

The case is Securities Investor Protection Corp. v. Bernard L. Madoff Investment Securities LLC, 08-01789, U.S. Bankruptcy Court, Southern District of New York (Manhattan).

Thousands of customers have objected to trustee Irving Picard’s methodology, arguing he is wrongfully calculating claims based on their cash deposits minus withdrawals instead of using amounts listed on Madoff’s final account statements.

Picard, hired by SIPC to repay victims of the $65 billion fraud, has said that using account statements to set claims would let the con man decide who gets what, and include fake profit from trades that didn’t really happen.

‘Changed Procedure’

Victims argue that SIPC, which was chartered by the U.S. in 1970 to wind down failed brokerages, is required to set claims based on customers’ legitimate expectations from their accounts. They say Picard changed the procedure to avoid massive payouts.

“They’re wrong — they’re wrong about their positions,” Picard’s lawyer, David Sheehan, told Lifland. “The statute is clear. The legislative history is clear.”

Sheehan told the judge that “the last customer statement, being a concoction of a fraudster, cannot be something upon which you rely. No one in their right mind would suggest you should use the last statement.”

“As soon as we give money to someone who took all their money out, we’re taking money from another customer — stolen money,” Sheehan said.

Sheehan said the claims must be set fairly to ensure no victim gets more than a fair share of money recovered by Picard through lawsuits, which he estimated could eventually be close to $10 billion.

Laughs, Murmurs

Lifland threatened to remove some observers in the packed courtroom after Picard’s lawyer was twice interrupted by laughing and murmurs.

“I’m not swayed by your reactions,” Lifland said. “Let’s have some decorum in the courtroom.”

The U.S. Securities and Exchange Commission in December told Lifland it generally supported Picard’s “cash-in, cash- out” method. The agency said it would be fairer to victims if Picard adjusted the claims for inflation.

“Customer claims should be partly principal and partly earnings,” the agency’s lawyer, Katherine Gresham, told the judge yesterday. “The commission agrees with the trustee that customer claims for net equity should not be based on the securities positions on the final account statements.”

A SIPC payment “is not insurance the way the FDIC insures bank deposits,” Gresham said.

Customer claims in the case will also determine what share victims receive from lawsuits filed by Picard against Madoff’s biggest investors and beneficiaries, including hedge funds and the con man’s wife, Ruth. About a dozen such cases seek the return of about $15 billion in allegedly fake profit.

Owing Money

Under Picard’s calculation, some victims may end up owing money if they took out more than they put in. Last week, the family of deceased New York real estate magnate Norman F. Levy agreed to pay Picard $220 million for victims to settle claims the family withdrew more than it deposited with Madoff.

Helen Chaitman, a victim who is representing other customers in the case, has said Picard’s method is improper and is slowing down the liquidation process by requiring in-depth analysis of customer records to set claims

Chaitman, who testified Dec. 9 in Washington at a congressional subcommittee hearing about the case, earlier sued Picard and accused him of representing the interests of the brokerage industry instead of those of victims.

“I know the people in this room feel they’ve been wronged terribly by Madoff, then the regulatory agencies, and now Mr. Picard,” Sheehan said in court yesterday. “But this is a Ponzi scheme. It’s a zero sum game. I know no one in this room wants to accept that.”

Left Destitute

Karen Wagner, a lawyer for Madoff customer Sterling Equities Inc., told the judge that “many customers who have been left destitute by this fraud will receive nothing under Mr. Picard’s definition of net equity.”

Josephine Wang, an SIPC lawyer, said in court yesterday that “we are not questioning the innocence of the victims in this case. We have great sympathy for them, but there are certain presumptions that are made under the law and if they choose to rely on the bad acts of Madoff then they have to accept the consequences.”

“Both the SEC and SIPC have had their motives questioned in this case, that our intent is not to enforce the law,” Wang said. “That is not only absolutely false, truly it goes beyond the pale.”

Madoff, 71, pleaded guilty in March and was sentenced on June 29 to 150 years in prison for using money from new clients to pay earlier investors in the world’s biggest Ponzi scheme.

Patricia Morgen, 62, of Oakland, California pleaded guilty in federal court in San Francisco yesterday to wire fraud, mail fraud and money laundering, United States Attorney Joseph P. Russoniello announced December 17, 2009.

In his announcement, U.S. Attorney Russoniello restated the Department of Justice’s top priority to vigorously prosecute individuals who commit mortgage fraud and other financial crimes.

In pleading guilty, Morgen admitted that the company she founded and controlled, Chicago Development and Planning (CDP) engaged in two fraudulent schemes: (1) a Ponzi scheme that defrauded more than 400 individual investors by falsely promising that their investment funds would be used to acquire, renovate, and re-sell real estate; and (2) a mortgage fraud scheme that defrauded a mortgage broker and various mortgage lenders by use of loan applications with fraudulent income and asset statements. Morgen admitted that the loss for the two schemes exceeded $8 million. In the plea agreement, Morgen agreed to make restitution in the amount of no less than $8,439,086.

The Securities and Exchange Commission (SEC) began investigating Chicago Development and Planning in 2004, and ultimately obtained a default judgment against Morgen when she failed to appear in any of the civil proceedings. In pleading guilty, Morgen admitted that when she learned of the SEC’s investigation, she instructed employees to destroy documents and then fled to Mexico to avoid federal authorities. Morgen also admitted that she instructed an employee to contact a mortgage broker who had worked on CDP real estate acquisitions in an attempt to convince the mortgage broker not to provide documents to the SEC.

On Sept. 2, 2009, Morgen’s co-defendant, Michael Ware, pled guilty to similar charges involving Chicago Development and Planning’s mortgage fraud scheme.

“This case shows that the appearance of success can be a mask for a tangled financial web of lies,” said Scott O’Brian, Special Agent in Charge, IRS-Criminal Investigation, and Oakland Field office. “Ponzi schemes can thrive for a time on false claims about how the money is being invested and where the returns are coming from. But that time is gone, and as this case shows, it’s time for those responsible to face judgment.”

Morgen was indicted by a federal Grand Jury on Nov. 20, 2008. She was charged with 11 counts of mail and wire fraud, as well as a single count of money laundering. Under the plea agreement, Morgen pled guilty to two counts of mail fraud, two counts of wire fraud, and one count of money laundering.

Morgen is currently in the custody of the Bureau of Prisons. Her sentencing is scheduled for April 7, 2010, before Judge Charles R. Breyer in San Francisco. The maximum statutory penalty for mail and wire fraud is 30 years. The maximum statutory penalty for money laundering is 10 years.