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...

The Latest on Bernie Madoff's Victims

An excellent NYT editorial discusses the latest in the Bernie Madoff saga.  For those of you who may not be following the story very closely, last Thursday the judge overseeing the civil suits brought against alleged beneficiaries and enablers of the Madoff fraud threw out a suit against HSBC, dealing a pretty substantial blow to the efforts to recover funds for Madoff's victims.  The entire editorial is worth reading, but here are a few tidbits that stood out to me:

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...

Bernie Madoff Implicates Banks and Hedge Funds

The Correctional Facility that Houses Bernie Madoff

The NY Times is reporting that Bernie Madoff was interviewed in prison and has said that, at least some of, the banks and feeder funds knew he was operating a Ponzi scheme. This is not going to be well received by JP Morgan Chase who is being sued by the Madoff trustee who asserts the bank should have known or did know that Madoff was operating a Ponzi scheme. Here are some key paragraphs from the article:

To What Extent Should We Bail Out Madoff Victims?

For some time now, I've been thinking about the extent to which victims in a Ponzi scheme such as the Madoff scheme should be bailed out by the government. Given the attention in Congress to reform the regulatory environment of the U.S. financial industry, I think this is a timely topic. Also, I've heard many complaints of Madoff investors who think the government should do more for them. (These complaints have been voiced in both the comments on this blog and in the news). To what extent should the American taxpayers help victims of Ponzi schemes? I know this will be a controversial topic but maybe it will generate some comments. I hope you share your thoughts in the comments!

Madoff was taped telling Fairfield how to deal with SEC

As Bernie Madoff's dealings are revealed, it appears clear that he viewed his scheme as a game. Too bad for those who lost billions...

Here is an article describing some of his instructions to others on how to deal with the SEC when they asked questions about him.

PwC now being sued in Madoff case...

Victims in the Madoff case have now expanded their efforts to recover some of their losses by suing PricewaterhouseCoopers. A UK news report states:

The Canadian arm of PwC has been named in seven separate lawsuits claiming as much as $2bn in damages for investors who lost almost everything in the largest fraud in history. PwC Canada was auditor to Fairfield Sentry, the feeder fund that placed $7.2bn of investors' money with Madoff, and which became the biggest single casualty.

At the heart of the suit is the claim that:

As auditors, PwC would have been required to check that the treasury notes existed. However, Madoff was able to conceal any shortfall because he was not just the "execution agent" for Fairfield Sentry's investment strategy but also the custodian of the money. As such, PwC would have received assurances from Madoff that the treasury notes existed.

Investors argue that his dual role should have been a "red flag" that raised suspicions and persuaded the auditors to verify the claim with the US Treasury. Investors also say that Madoff's unusual habit of liquidating the entire Fairfield Sentry investment and converting it into US treasuries for a few days over every financial year-end should have been another "red flag". Since Madoff pleaded guilty to fraud, it has become clear the funds never existed.

This effort to get into PwC's deep pockets followed a similar case where KPMG is being sued for $3.3 billion in the Madoff case for its work on another feeder fund: Tremont Group. I believe BDO Siedman was the first to get sued for its work on a Madoff feeder fund.

My guess is that now that we have two auditors of the feeder funds being sued by Madoff victims that it's only a matter of time before we see more auditor lawsuits related to Madoff.

Madoff's feeders reached all the way to Austria

The WSJ reported that prosecutors in the Madoff case are alleging that a fund manager in Austria, Sonja Kohn, received $40 million in kickbacks to feed Madoff's Ponzi scheme. As we've heard many times now, Mrs. Kohn claims that she is "actually the greatest Madoff victim."

Madoff in the news again...

While Bernie Madoff awaits sentencing next week, the SEC has filed new charges against individuals who allegedly marketed Madoff's scheme to investors. The SEC's complaint released today states:

“Madoff cultivated an air of exclusivity by pretending that he was too successful to trouble himself with marketing to new investors,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. “In fact, he needed a constant in-flow of funds to sustain his fraud, and used his secret control of Cohmad to obtain them.”

James Clarkson, Acting Director of the SEC’s New York Regional Office, added, “These Madoff solicitors collectively received several hundred million dollars in fees over the past few decades while Madoff ruined the finances of countless investors.”

You can read more about the charges here.

Santander Settles

At least one of the Madoff feeders appears to be taking some responsibility for its actions (via WSJ):

Banco Santander SA, one of the largest conduits of investor money to Bernard Madoff, agreed on Tuesday to pay $235 million to settle potential legal claims by the trustee of the defunct Madoff firm.

Santander is one of several banks to have offered its clients compensation for losses from the fraud. In its results in April, Santander said that 93% of clients affected by the Madoff fraud had taken up its offer, which it originally valued at €1.38 billion.

While I am glad that Santander and others have attempted to provide some restitution to their clients, I am still concerned by the apparent lack of due diligence that fueled the fire of this Ponzi scheme. Wall Street seems to thrive by creating obscure financial products that are only truly understood by their creators, and then layering those products until investors have very little understanding of the economic reality underlying their investment decisions. The resulting lack of clarity is a perfect breeding ground for fraud.

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!

Fairfield (Madoff Feeder) Sued

Madoff's largest feeder sued (via WSJ). Per the article:

The lawsuit, in federal bankruptcy court in Manhattan, alleges the funds, which placed client money with Mr. Madoff, "should have known" he was engaged in fraud. The suit doesn't provide evidence Fairfield or its officers had knowledge of the Madoff fraud but says the firm didn't perform the adequate due diligence it promised its clients.

The suit says Fairfield reaped hundreds of millions of dollars in fees from its clients. The suit alleges Fairfield missed numerous warning signs, including trades listed in its accounts that could never have occurred, and seeks the return of money it withdrew on behalf of its clients since 1995.

I am interested to see how this suit and other similar lawsuits will pan out. In my opinion, many of these feeders must have been either complicit in the fraud or completely negligent in their due diligence.