Bernard Madoff Sentenced: An Aftermath of Old Lessons, New Laws
Investor Services Update 07/20/09 John P. Vail
[Our] entire capitalist system is based on trust. It's not based on an investment model that's taught in business school. It's not based on the price earnings ratio. It's not based on an income statement or a balance sheet. It's not based on any of these rational concepts, and it's not based on the numbers. It's based on whether people believe in the numbers and in the people who are supplying them. If people don't trust those who handle their money, their livelihoods, and their lives, they'll just not participate.
-- Kouzes and Posner, "Credibility, How Leaders Gain
and Lose It, Why People Demand It," p. xvii, 2003.
For better or for worse, there is significant truth to the views of Mr. Kouzes and Professor Posner. Trust is the foundation of all human relationships, including relationships in the business world. Although numbers, calculations and financial acumen are important to the business world, it is basic trust in businesspeople and financial systems that enables business to move forward. Laws and regulations assist businesses in creating a framework for trusting relationships to develop. The Madoff fraud is already prompting additional laws, new regulations and heightened enforcement to enhance the level of protection for the investing public. However, investors must not rely solely on laws to protect them. Their trust in those who manage their money must not be a blind trust but one that is developed out of appropriate due diligence. This client update highlights the key lessons from the Madoff fraud, of which investors should be reminded, and the steps investors can take to build appropriate trust in their money managers. It also summarizes new laws and regulations that have been adopted or are contemplated in the wake of the Madoff scandal.
On June 29, 2009, Bernard Madoff was sentenced to the maximum of 150 years in prison for conducting the largest Ponzi scheme in history. Although investigations into the full scope of his scheme will continue for years, investors may have lost as much as $50 billion from his criminal activities. Federal and state prosecutors and investigators may take years to unravel the details of the scheme. Reports further indicate that prosecutors are investigating a number of other individuals who may have actively or passively participated in Madoff's massive fraud - it is hard to believe a single person perpetrated this crime that probably continued for years, until the market crash brought the scheme into the light of day.
The current recession appears to be unearthing other similar frauds by money managers. There has recently been a flurry of enforcement actions by the Securities and Exchange Commission, involving Ponzi schemes. On June 9, 2009, the SEC charged two California men and two companies they control with conducting an $80 million Ponzi scheme targeting Korean-American investors with false promises of extraordinarily high returns from foreign currency trading. The SEC alleges that Peter Son and Jin Chung lured approximately 500 investors in the United States, South Korea and Taiwan into a scheme in which monies from investors were not actually traded in foreign currencies but instead used to pay earlier investors. Since June 9th the SEC has taken action against six other fund operators with respect to their alleged Ponzi schemes.1
Much has been written regarding Mr. Madoff and his pyramid scheme since the fraud came to light late last year. The list filed in bankruptcy proceedings for Madoff's broker-dealer entity indicates there may be well over 13,500 victims of the fraud. The victims include wealthy and sophisticated individual investors as well as numerous investment funds and other institutions such as international banks, public charities and private foundations.2 As discussed below, many of these victims invested in "feeder funds" and had no idea that their money was indirectly under Bernard Madoff's control. It may have been difficult for them to see the "red flags" that were present and that could have warned them of the ongoing fraud. However, there are certainly many victims who could have spotted the warning signs if they had been more alert. Some potential investors steered clear of Madoff's operation because they correctly identified one or more red flags that triggered their skepticism.
The lessons investors should learn from the Madoff scandal are for the most part not new. However, they bear repeating to serve as a reminder that investors need to take responsibility for knowing how their monies are invested. Through the exercise of basic due diligence practices, investors can spot warning signs, follow up with questions and possibly avoid financial disaster.
It is beyond the scope of this client update to describe the extensive details of Madoff's fraudulent activities. In fact, it will be a long time before investigators determine the extent of the fraud and the intricacies of how it was structured. Purportedly even his sons who were involved in the business did not know of the fraud.3 However, it is clear that, at some point during the many years of Madoff's management of funds, his operation turned into a "Ponzi scheme" or "pyramid scheme." The SEC's Web site defines this fraud in the following manner:
"In the classic 'pyramid' scheme, participants attempt to make money solely by recruiting new participants into the program. The hallmark of these schemes is the promise of sky-high returns in a short period of time for doing nothing other than handing over your money and getting others to do the same.
"The fraudsters behind a pyramid scheme may go to great lengths to make the program look like a legitimate multi-level marketing program. But despite their claims to have legitimate products or services to sell, these fraudsters simply use money coming in from new recruits to pay off early-stage investors. But eventually the pyramid will collapse. At some point the schemes get too big, the promoter cannot raise enough money from new investors to pay earlier investors, and many people lose their money."
Investigations appear to show Madoff started his securities business around 1960, under the name of Bernard L. Madoff Investment Securities ("BMIS"), which traded stocks and acted as a market maker in certain stocks. After initially acting for its own account, BMIS began to engage in trading activities for a limited number of clients but never registered as an investment adviser under the Investment Advisers Act of 1940 until forced to do so by the SEC in 2006. Significantly, BMIS claimed it was not an investment adviser because it only received compensation in the form of commissions for trading transactions. A typical investment adviser to a hedge fund is compensated by the "2 and 20" approach, which is an annual fee of 2% of the fund's net asset value plus 20% of the investment gains, sometimes over a certain threshold.
As noted above, the largest clients of BMIS were actually funds themselves that fed investment monies to Madoff. Some of these funds were single hedge funds or single-manager "feeder funds," while others were part of a "fund-of-funds" structure ("FOF"). In a typical FOF structure, investors invest in the FOF with the expectation that they will compensate the FOF's manager for its expertise in selecting other funds in which the FOF's assets will be invested. Although FOFs generally provide their investors with some level of diversification, certain FOFs investing with Madoff actually placed all or substantially all of their assets with him.4
Madoff's written materials claim he used a strategy called the "split strike" approach. This strategy generally invests in large-cap stocks that are part of an equity index while simultaneously buying and selling options against those stocks. As discussed below, this strategy can be successful over a long term but would not have consistently produced positive returns.5
Harry Markopolos, an accountant with a small Boston investment firm, was asked by his employer in 2000 to deconstruct Madoff's strategy and try to replicate it. In the course of his work, he investigated Madoff's operation in detail and worked with the split-strike strategy but was unable to replicate Madoff's results. His review caused him to conclude that the operation was a Ponzi scheme, and he reported his findings to the SEC on three occasions. In fact, he identified most of the red flags discussed below. In each case the SEC engaged in some level of investigation but never uncovered the massive fraud.
Reminders for Investors
- No matter how great the opportunity looks, an investor should remember the importance of diversification. In fact, investors who are fiduciaries may have a legal obligation to diversify investments. Diversification is one of the fundamental rules of investing that is intended to minimize an investor's risks from the marketplace. Unfortunately, the Madoff fraud is a story of numerous investors who ignored or forgot this principle. Certain other investors may have thought they had a level of diversification, but this turned out to be wrong. It has been reported that certain FOFs or other fund vehicles placed all or substantially all of their assets with Madoff. These funds therefore lost a substantial amount of their assets. Some of them may have indicated to potential investors that they were going to invest in multiple other funds. The typical FOF, for example, chooses possibly 10 to 14 managers in which to spread its assets. However, for reasons that are currently unclear, they did not diversify. To make matters worse, many investors in the FOFs, and other fund vehicles that lost money to Madoff, also appear to have forgotten to diversify their holdings - they put all of their assets in these funds. As a result, many charitable institutions were forced to shut down operations because their assets were wiped out. In summary, some of the funds directly investing with Madoff placed almost all of their assets with him. In addition, many investors in such funds likewise invested most of their assets in such funds. The principle of diversification was forgotten or ignored at two different levels. To add insult to injury, the funds that directly invested most of their assets with Madoff collected fees for their efforts.
The lessons here are threefold: First, there is substantial risk in failing to diversify one's investments. Second, potential investors must ask questions of their fund managers to become comfortable that investments will be diversified. Third, investors must continue to monitor their managers to ensure that diversification does indeed take place as promised. Although an individual investor's failure to diversify may be an unwise and poor investment practice, it is only such an individual who will pay the price. Many institutional investors, such as pension plans, charities and private foundations, are fiduciaries that are entrusted with legal obligations to protect their assets for the benefit of others. The failure of one of these organizations to diversify may trigger penalty taxes for such an organization and liability for its directors and officers under both federal and state law.6 It is expected that many such institutional investors in Madoff will be facing investigations by federal and state officials in the months ahead.
- Proceed with caution when a manager is wearing multiple hats. Investors in hedge funds and other similar investment operations should be aware of situations in which the adviser also is serving in other capacities such as broker-dealer, custodian and administrator. In connection with its activities, BMIS decided which trades to make through its discretionary accounts, executed the trades and custodied and administered the assets. Performing these multiple functions prevented checks and balances and created conflicts of interest that could not be resolved. Certain potential investors spotted this situation and decided to avoid Madoff for this and other reasons.7 A customary hedge fund has a number of service providers that play different roles. There is usually an investment manager to manage the assets, one or more brokers to execute trades for the fund, a fund administrator to calculate the net asset value of the fund, as needed, and a custodian/prime broker to have custody of assets. Best practices suggest that one or more of these functions be separated.8 A potential investor should inquire whether a fund manager uses third parties to perform certain functions.
- Managers should be transparent with their investors. A potential investor should be concerned about any manager whose activities are conducted in a "black box," where such an investor cannot find out exactly what the manager is doing. Madoff often refused to answer questions posed by potential investors about his business strategies and the performance of his managed accounts. Mr. Markopolos states, "Investors who asked too many questions were told not to invest. If you asked detailed due diligence questions and wanted transparency and an independent-third party bank to custody assets and clear trades, then Madoff would tell you, "It's a take-it or leave-it black-box strategy. I invented this strategy and if I let third parties see what I'm doing, then they will duplicate the strategy and kill my returns by competing away the market inefficiencies I'm exploiting….he was brilliant in letting smart investors walk away and not be offended by it. He knew his targets were investors who didn't ask too many questions."9 Investors should proceed with caution in the event a manager appears unwilling to be transparent as to its operations.
- An investor should investigate the quality of a manager's advisers, consultants and other service providers. The financial statements and related books of BMIS were audited by an accounting firm that was not well known. One potential investor who decided to avoid the Madoff funds conducted due diligence and learned that the auditing firm had three employees, of which one was 78 years old and living in Florida, one was a secretary and one was an active accountant but who conducted business from a small office in Rockland County, New York. Given the magnitude of Madoff's operations, it should certainly have been a concern to an investor as to how such an auditor could adequately service the account.10 This should have been a red flag. The quality of a manager's advisers is important and should be a subject of due diligence by any investor. If an investor does not recognize the name of the auditor as one of the Big Four accounting firms, it is relatively easy to research information on the auditor through professional associations and the Internet; however, Internet information is not always accurate and should not be relied upon to reach definite conclusions. Even so, such online information can often highlight the questions to which an investor should seek answers.
- Investors should be wary of funds for which the management is composed of related individuals. Top-level management positions should ideally be held by independent and unrelated individuals to ensure effective oversight of management's activities without the potential for conflicts of interest. Key management positions at BMIS were held by Madoff's immediate family members, who may have contributed to the lack of oversight at the firm.
- The market has created certain typical structures for compensating money managers. Watch out for alternative structures that appear to be unique, particularly those that are too good to be true. As stated above, money managers have a very typical compensation structure; Madoff, however, did not follow the norm and apparently never charged a management fee or incentive fee for his services in managing money. In an interview with Barron's in 2001, Mr. Madoff stated, "We're perfectly happy to just earn commissions on the trade."11 It is suspected that this "too good to be true" approach to compensation was probably grounded in an effort to avoid taking forms of compensation that would be of a higher profile and would highlight the value of the managed assets. This compensation structure could have been a red flag to investors.
- Institutional investors should conduct their due diligence of managers and funds in accordance with best practices for such due diligence. Such due diligence should include both qualitative due diligence and quantitative analysis. Individual investors with more limited resources should work with a qualified adviser, who should explain the due diligence practices that it uses to vet investment opportunities. There are many resources existing to counsel investors as to best practices for conducting due diligence.12 These practices include qualitative investigations such as interviews with fund managers, analyses of their business practices and operations, background checks on all key personnel and other steps designed to evaluate the quality of the operations. As noted in this update, a close examination of BMIS and its business would have revealed significant flaws in the quality of its operations and policies. Due diligence best practices also include close examination of a manager's investment strategy and an evaluation as to whether the manager's historical returns make sense in the context of such strategy. Harry Markopolos conducted quantitative analysis of Madoff's purported returns and reached the conclusion that they could not be explained or supported by available data. As stated above, experts were of the view that it was impossible to come up with Madoff's results. They looked at Madoff's supposed returns and found that their growth resulted in an almost perfect 45-degree angle. Many potential investors saw this amazing result and decided to trust the data that revealed the virtual impossibility of Madoff's results - they did not invest with Madoff.
- Quality money managers should utilize sophisticated tools to engage in their investment activities and provide investors with detailed and computerized statements of account. Bernard Madoff, who served as chairman of NASDAQ, is often recognized as one of the founders of electronic trading. It is therefore ironic that his clearing and settlement process was evidenced by paper tickets, and the account statements received by clients were in paper form. Clients apparently had no electronic access to their accounts. This unsophisticated process should have served as a warning to potential investors. Inquiry by a potential investor to a manager as to its state-of-the-art processes is important.
- Understand the role of middlemen in your investment. Investors should understand the role of funds or other managers who are acting as conduits to other investment opportunities. Middlemen such as FOF managers can play an important role and offer many investors opportunities to participate in investments to which they may ordinarily be excluded. However, in other cases middlemen offer very little, if any, benefit while charging fees for such efforts (that are in addition to those at the underlying investment level). In the Madoff fraud, a number of funds that invested in Madoff were mere conduits and provided no value to investors. They did not act as a watchman over Madoff's activities.
The Role of Trust in the Madoff Strategy
Bernard Madoff, intentionally or unintentionally, was very clever in designing an approach to his business and its marketing that led to trust by investors in him. This trust in some cases was in the face of the many red flags discussed above. Professor Schweitzer, from the University of Pennsylvania's Wharton School of Business, identified four powerful influences at work that may partially explain investor reactions.13
- Scarcity. Madoff's entire marketing approach always left investors with the feeling that his advisory fund was essentially closed and that he would be doing the potential investor a favor by allowing him or her to invest with him. There are many accounts of Madoff advising investors, "I'll get you in when I can." Richard Rampell, an accountant in Palm Beach, suggested that a mystique developed around Madoff. He stated, "It was almost like you were getting let into the club of investors, and everybody wanted to be in … [it] was like, 'Oh wow! You've got a Madoff account.'"14 The aura of a scarce commodity was always present, and therefore many investors may simply have been drawn to what they were told they couldn't have.
- Authority. Although in some ways a low-key figure, Madoff did run in circles with an air of authority. As noted above, he is considered to be one of the pioneers of electronic trading, served on numerous philanthropic and other boards and actually was chair of NASDAQ for a period. His activities put forth an air of authority that caused potential investors to focus on his persona rather than his actual investment product.
- Social Proof. Many well-known figures - from Kevin Bacon, Steven Spielberg and Larry King to Jeffrey Katzenberg (CEO of Dreamworks Animation SKG, Inc.), Elie Wiesel (famous author) and Fred Wilpon (part owner of the New York Mets) - are on the list of Madoff's victims. The high-profile nature of Madoff's clients may have led some investors into a blind trust - "Celebrities are investing with him so he must be legitimate." Even somewhat disciplined investors may have let their guard down due to the names associated with Madoff and his investment activities.
- The Liking Principle. It appears that Mr. Madoff met people through his philanthropic activities, meetings and events at his country clubs and a variety of other social engagements. Reports seem to indicate that he was a very likable person that people enjoyed being around.
It appears that Bernard Madoff understood the foregoing factors very well and used them to create a trust by investors, which caused them to ignore the red flags that were everywhere. Although an investor should trust his investment adviser or other money manager, such trust should be the result of efforts by such adviser or manager to show it is worthy of such trust. Investors should consider the power of the above factors and their tendency to blind them to facts and information. The receipt of a recommendation from a good friend as to a great investment adviser or investment manager may be a reason for an investor to consider such party. However, it should be followed by due diligence, to enable such an investor to conclude that the manager indeed knows what he or she is doing and will provide advice based upon its own sound investigations.
New Laws and Regulations
The official investigations into the Madoff fraud are only in their early stages and may continue for years. However, the SEC has already responded with new regulations, and the Obama administration and Congress are expected to pass new laws in reaction to the fraud. The efforts to date include:
- The SEC has proposed amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940. This rule regulates the custody practices of registered advisers. Currently under certain circumstances, a registered investment adviser who has custody of client assets must engage an independent public accountant to verify the existence of such assets on a surprise basis at least once during each year. The amendments would require that all registered investment advisers with custody of client assets retain an independent public accountant to conduct an annual surprise examination of client assets. The accountants retained to conduct the surprise examination would be required to notify the SEC immediately of material discrepancies.
The SEC proposals would also require that when an adviser or related person serves as custodian for client funds (rather than an independent custodian), the adviser must obtain, at least annually, a written internal control report that includes an opinion from an independent public accountant registered with, and subject to inspection by, the Public Company Accounting Oversight Board, with respect to the description of controls relating to custodial services, including the safeguarding of cash and securities and tests of operating effectiveness.
Under the current form of the custody rule, an adviser may under certain factual situations be considered to have custody of client assets when a related person holds them. A "related person" is defined as a person directly or indirectly controlling or controlled by the adviser under common control with the adviser. Pursuant to the amendments, an adviser will always be considered to have custody if a related person holds client assets. The SEC is concerned about the risks of having related persons to an adviser holding client funds.
The SEC is also suggesting the elimination of an adviser's right, under certain circumstances, to send account statements directly to clients instead of the qualified custodian. It appears that the SEC believes direct mailings by the custodian, in all cases, provide greater assurance against fraud.
The SEC also proposes to amend Form ADV - the form filed with the SEC by registered investment advisers - to provide more comprehensive information about custody practices.
- On July 10, 2009, the Obama administration delivered proposed legislation to Congress to strengthen the SEC's ability to protect investors from fraud. The key provisions of the proposed Investor Protection Act of 2009 (the "Proposed Act") are:
- Under current law, the standards of conduct for broker-dealer and investment advisers are different. As noted above, for many years BMIS was a broker-dealer but was not registered as an investment adviser, allowing Madoff to avoid the heightened fiduciary duties of advisers. The Proposed Act would provide the SEC with authority to bring consistency to the duties of brokers, dealers and advisers.
- The SEC would also be empowered to promulgate rules prohibiting sales practices and compensation schemes for financial intermediaries that encourage financial intermediaries to steer investors into products that are profitable to the intermediary but not in the interests of investors.
- Currently, most broker-dealer and investment advisory agreements require disputes with clients to be submitted to binding arbitration in a designated venue. The Proposed Act would give the SEC authority to prohibit such mandatory arbitration clauses, believing that investors may be better served by having access to the courts.
- The Proposed Act provides the SEC with expanded authority to establish funds to pay whistleblowers for information that leads to enforcement actions.
- The Proposed Act would provide authority to the SEC, to potentially require registered investment companies to deliver disclosures to potential investors prior to a transaction. Currently, most fund disclosures and prospectuses are not required to be delivered until after a transaction has been completed.
- Under current law, an individual barred from being an investment adviser because of serious misconduct can still apply to be a broker-dealer. The Proposed Act would give the SEC authority to bar individuals from all aspects of the securities industry.
- The SEC's authority to pursue enforcement actions against those who aid and abet securities fraud would be broadened to cover the Securities Act of 1933 and the Investment Company Act of 1940 as well as the Securities Exchange Act of 1934 and the Investment Adviser Act.
Quarles & Brady Comments
Bernard Madoff was obviously a person who engendered trust in others and was able to create an environment that drew investors into his operation. Fundamental due diligence by his victims was never undertaken or was ignored because of the aura surrounding him. The information to date seems to show that there were warning signals that could have steered many of his victims away from him. A primary lesson for investors is that it is important to trust their advisers but only after such advisers have shown that they are worthy of such trust.
Quarles & Brady will be watching for continued legal and regulatory responses to the Madoff fraud and will advise its clients of such developments in the months ahead.
If you have questions about this client update or any portions thereof, please contact John Vail at 312-715-5042 / [email protected], or your Quarles & Brady attorney for assistance.
6 For example, if a private foundation invests its assets in a manner that jeopardizes its exempt purposes, a penalty tax may be imposed on the organization and possibly the participating directors and officers. I.R.C. §§4944(a)(1) and (a)(2). In states that have enacted either the Uniform Management of Institutional Funds Act or the Uniform Prudent Management of Institutional Funds Act, there is a statutory standard of care for directors of charitable organizations in connection with their management of assets. It is possible that, depending on the factual circumstances, directors of a charitable organization that invested substantial assets with Madoff may have liability for violation of these statutory standards or other common law standards.
7Letter from Aksia to Clients and Friends. Available at http://graphics8.nytimes.com/packages/pdf/business/Madoff.pdf; See also, Greg N. Gregoriou and Francois Serge Lhabitant. "Madoff: A Riot of Red Flags," December 31, 2008.
8 See Ennis, supra note 5 at p. 8; and Gregoriou, supra note 7, at p. 10; and Report of the Investors' Committee to the Working Group on Financial Markets. "Principles and Best Practices for Hedge Fund Investors," January 15, 2009.