L’Affaire Madoff

February 13, 2009
By Martin Muskin

L’Affaire Madoff continues to be all over the U.S. financial news and there have many been articles about European investors having been badly taken. March 4, an important filing date, will be here soon. Please read on.

Investors are lining up to sue Greenwich Fairfield, one of the largest intermediaries which invested with Madoff, and report that JP Morgan may have knowingly pulled its own money out of the Madoff Fund while leaving money of its customers in the fund. The U.S. Securities and Exchange Commission only has civil authority. Criminal jurisdiction is in the hands of the U.S. Justice Department. Undoubtedly, many state governmental units will investigate. Even local police departments will get into the act. This morning, the police chief and other officials of Fairfield, Connecticut, home of the Fairfield-Greenwich Fund were discussing their investigation of how their pension funds were so badly taken. One could write about this daily for years and dozens of books will start appearing soon. Here are a few thoughts for people who may need to bring claims and those who may need to defend themselves against those claims.

The public reports are very skimpy on how the Madoff Fund was operated, BUT…. The Trustee in the liquidation proceeding has asked for more time to marshal the assets, stating a few weeks ago that it has had “limited access” to the Fund’s books and records.

The Harry Markopolos Report and the SEC’s Investigation: Harry Markopolos, a private investigator, submitted a memorandum to the U.S. SEC in 1999 and again in 2005. His full memorandum may be found here. He initially wrote his report because he was asked by an investment banking client to study Madoff’s modus operandi and figure out why they couldn’t do the same for their customers. He concluded that the Madoff operation was mathematically impossible, was probably a fraud, and also a Ponzi scheme. Gravely concerned, he opined to the SEC:

BM allows third party Fund of Funds (FOF’s) to private label hedge funds that provide his firm, Madoff Securities, with equity tranch funding. In return for equity tranch funding, BM runs a trading strategy, as agent, whose returns flow to the third party FOF hedge funds and their investors who put up equity capital to BM’s broker-dealer and ECN operations. [Emphasis in the original.]

He went onto say that he thought the Madoff operation was probably a Ponzi scheme. The SEC investigated. It closed its case in November 2007. Presumably the SEC Closing Memo on that Closing is a result of the Markopolos letter to the SEC. In 20-20 hindsight, its dull bureaucratese is astounding reading. You can see it here.

Of course, we now know that raising money through funds of funds is only part of the unfolding story. The writer of that memo went on to say that he thought the Madoff Fund was mathematically impossible to carry out in the real world and was a huge Ponzi scheme. Another part of that memorandum is prescient:

The French and Swiss Private Banks are the largest investors in Bernie Madoff. This will have a huge negative impact on the European capital markets as several large fund of funds implode. I figure one-half to three-quarters of Bernie Madoff’s funds come from overseas. The unwinding trade will hurt all markets across the globe but it is the Private European Banks that will fare the worst.

At this writing it looks like the percentage of the money Madoff took from European sources is lower than that estimate, but that is little comfort to those whose money he stole.

What to do? There are two sets of proceedings. First is the Madoff Fund liquidation. The other is the claims between third parties. Thirdly, there are government investigations.

The Liquidation Proceeding and Filing Claims (“Direct” Claimants)

The Liquidation Proceeding and SIPC coverage: A liquidation proceeding – i.e., a bankruptcy proceeding – was filed against Mr. Madoff’s investment vehicle, Bernard L. Madoff Investment Securities, LLC (“the Madoff Fund”) in mid-December 2008. The Madoff Fund is a registered securities dealer in the U.S.; that is, a “broker-dealer” registered with the SEC pursuant to the Securities Exchange Act of 1934. As with most U.S. securities brokers, it was also a member of the Securities Investors Protection Corporation (“SIPC”), a U.S. government-established company which, in effect, acts as an insurance company. Customers of members of SIPC are automatically insured up to $100,000 in cash and $500,000 aggregate of investments if their broker-dealer becomes insolvent. That, at least, gives customers some protection. But if the customer was one of the many people whose account was aggregated into a single account, by a bank for instance, that account may be limited to the $500,000. In such a case, the customer may be able to augment the pittance it gets back from the SIPC payoff by third party litigation (see below).

List of Creditors: The Trustee appointed to oversee the liquidation has filed a list of over 13,750 direct creditors of the Madoff Fund. The list is extraordinary for its size and the breadth of the fraud. You can examine the list here.

Deadlines for Filing Claims in the Madoff Fund Proceeding: “Customer” claims against the Madoff Fund must be filed by March 4, 2009. However, not every investor is a “customer” of the Madoff Fund. Some people may be customers of intermediaries, such as investment banks, and may not be able to file in their own names. All other claims, including those of intermediaries, must be filed by July 2, 2009. Filing a claim does not mean that it will automatically be accepted as valid. The claim must be carefully crafted.

Clawback of Earlier Redemptions: Whether or not a claim is filed, the Trustee may bring actions to cause those who received redemptions to return those funds to the Estate of the bankrupt company. There are several theories that the Trustee might use. The different theories set up time periods for clawbacks from one year before the bankruptcy filing to six years before the filing. There may be defenses to claims for clawback depending on the circumstances of each redemption.

Federal Income Tax Theft Deduction: Federal income tax law contains a provision for those who lose money through theft to receive a tax deduction of a portion of the loss. The loss is to be taken in the year it was learned about. State tax laws contain similar provisions. There are also provisions which might allow a portion of the loss to be carried over to future years. Each tax deduction must be examined to make sure it fits the Internal Revenue Code. Rest assured that these deductions will be large and therefore more likely to be examined by the IRS.

Claims Between Third Parties (Indirect Claims)

Note that the bankruptcy (liquidation) proceeding only covers claims against the Madoff Fund; it does not cover claims between others, such as intermediaries and their clientele. These indirect claims will involve the feeder funds, funds of funds, finders who earned fees, banks, independent professionals hired to do due diligence, accounting firms who conducted audits, lawyers, actuaries, broker-dealers, investment advisor, and people wearing any number of other hats. Unfortunately, litigation between third parties regarding the Madoff Fund will be going on for years. In comparison, the bankruptcy proceeding will be a mundane affair. Government investigations will produce some money. Some third parties will be implicated and some will be exonerated. The third party litigation will simply use the information gleaned from the government’s work and vice versa.

Intermediaries – Herein Of Claims Between Third Parties: Investors will bring claims against intermediates; and intermediaries will need to defend themselves against investors’ claims. Intermediaries will also need to bring actions against those who they relied upon.

For example, investment banks frequently acted as intermediaries. Investment banks and other intermediates – see the varieties of names they go by above –may be accused of not having performed adequate due diligence on behalf of their clientele, having failed to carry out their fiduciary duties, and having breached their contracts with their customers. As well as defending themselves, intermediaries will bring actions against those they hired to do the necessary due diligence. They may well bring actions against those who received a finder’s fee for recommending investment in the Madoff Fund, or who got a brokerage fee or other kind of fee and made representations regarding Madoff which are alleged to be false. Under U.S. law, whether the parties performed their duties will depend on the nature of their specific relationship with the specific client, and the contract with that client.

Investors – Claims by Direct and Indirect Investors in the Madoff Fund: As noted, investments fall into two broad categories, direct investments and indirect investments. Investment banks may be both direct investors and indirect investors. Investment banks may have invested for their own account directly with the Madoff Fund. If they did, they have claims against it. Banks investing for their own account, rather than for their customers’ account, may not be entitled to much coverage. They and other kinds of claimants may have to file as general creditors. Nevertheless they should file in a timely manner. Care must be taken in drafting the claim to get as much SBIC coverage as possible, small as it is for a bank investor.

Individuals and non-bank investors who invested directly in the Madoff Fund may be better off since they may have some SBIC protection. Also, they may have actions against those who advised them. Such actions will not be open-and-shut. There may be defenses to those claims; those issues are noted above. Care must be taken in bringing those claims and defending against them.

As you can see, the subject is quite complicated. We remain at your service.