Madoff and Merkin: A $410,000,000 Resolution

Photo from NY Times

We've written before about Ezra Merkin's hedge funds that fed Madoff billions of investor dollars. Merkin collected his fee and then apparently went to the beach to rest from his hard work. Occasionally he took a break from the beach and the golf course to write to his investors and tell them how he actively managed the funds.

Merkin has now settled part of the lawsuits against him for claiming to actively manage his funds and then giving Madoff the money. Here are some details from the NY Times...

Ponzi Schemes and Sophisticated Investors

So when you read about a small, $50 million dollar, Ponzi scheme coming to light, you almost always read about some gullible investors who had no idea they couldn't make 50% returns in a legitimate business deal. The list of victims was recruited from friends or family in an affinity fraud and almost always includes a bunch of doctors and dentists who have too much money and think they need a bunch more but don't understand risk and return. It is very rare that the so-called sophisticated investors who understand risk and return get duped. The following story was sent to me by a former student, Robert Madsen, who pointed out that this is what makes this story incredible...

Did Madoff's feeder funds commit fraud?

Over the past month or so, many of the hedge funds that fed billions into Bernie Madoff's Ponzi scheme (i.e. his feeder funds) have been sued or charged with fraud. For example, former GMAC Chairman, Ezra Merkin, was sued by the trustee who is collecting assets for Madoff's victims. Merkin's hedge funds apparently fed $2.4 billion from universities and nonprofit ogranzations into Madoff's scheme. Madoff's biggest feeder fund, Fairfield Greenwich Group, channeled $3.5 billion into the scheme and was also sued this month. In both cases, the trustee claims the funds "should have known" Madoff was engaged in fraud.

As for criminal charges against the feeder funds, Massachusetts regulators are prosecuting Fairfield on fraud charges and New York's Andrew Cuomo has charged Merkin with fraud. The challenge will be to show that these hedge fund managers committed fraud.

On page 7 of my favorite fraud text it explains that fraud must involve an intentional representation about a material point which is false. It also must be believed and acted upon by a victim to his or her damage. As for victims' damages, these fund managers took investors' funds and gave them to Madoff and collected hundreds of millions of dollars. Cuomo's complaint says that Merkin collected $470 million in fees for his work managing the $2.4 billion that he turned over to Madoff.

I believe that the key point to whether the funds will be shown to have committed fraud is whether the funds made false and material representations. Cuomo's complaint says that Merkin's three funds promised that he "actively managed" the money in the funds. As evidence Merkin was not actively involved in managing the funds, Cuomo claims that Merkin ignored many warning signs including one of Merkin's money managers who warned him not to invest with Madoff because achieving Madoff's returns was impossible. In addition, Cuomo's complaint says that Merkin kept two 2001 news articles written about Madoff's funds that questioned Madoff's ability to produce such steady returns.

So, back to the question of whether Madoff's feeder funds committed fraud, I suppose that will have to be resolved in the courts. In deciding how active Merkin was in his management, I'm pretty sure he will have to answer questions such as whether he looked at the audit report on Madoff's fund. As a follow up, I would ask if it occurred to him that it was odd that a fund the size of Madoff was audited by a three-person auditing firm?

I'm pretty sure these questions will show that these fund managers were actively managing their handicap on the golf course much more than they were actively managing the billions of dollars that they collected and gave to Madoff.

As for me, whether the courts decide that Merkin and company committed fraud or not, I do believe these hedge fund managers were extremely greedy. Imagine taking roughly one-half billion dollars of investors' money and then turning the rest over to a person to invest. All I can see that these hedge funds did was act as a sales conduit for Madoff and then they took their cut before putting billions into the largest Ponzi scheme ever! If this isn't fraud then there ought to be some law against it!