Australia: What Are Trustees Madoff?

The global financial crisis and the subsequent credit crunch has unwittingly exposed what appears to be the world's largest "Ponzi Scheme" exploited by Bernard Madoff via his investment brokerage company, Bernard L. Madoff Investments Securities LLC ("BLMIS"). BLMIS has been placed in liquidation pursuant to the US Securities Investor Protection Act ("SIPA").

This scheme appears to now involve $50 billion USD and at least 8000 investors from around the world. These investors range from individuals (including some high profile actors) to charitable organisations, banks, professional investment firms, feed funds and superannuation/pension funds. Yes, it will be a lawyers picnic with approximately 5000 lawyers from around the globe joining a global alliance of at least 35 law firms (the author's firm is included) to join a global class action for some sort of recovery. This article examines some of the lessons trustees can learn from the Madoff case.

What is a Ponzi Scheme?

A Ponzi Scheme is a fraudulent investment operation that pays returns to investors from their own money, as money paid by subsequent investors, rather than from profit. It usually offers abnormally high short term returns to entice investors. This requires an ever increasing flow of money from investors in order to keep the scheme going as early investors are paid from the receipts of later investors. They are always destined to fail (Wikipedia 'Ponzi Scheme').

How did Madoff do it?

Initially BLMIS was a pure brokerage business that evolved into a market maker handling more than 5% of the trading volume on the NYSE and ultimately ran a separate investment advisory firm as a separate floor below the brokerage business. BLMIS never actually ran a hedge fund but claimed to execute a conservative strategy delivering annual returns of 10%-12% per annum by actively trading a very specific portfolio of stocks and options (Gregoriou & Lhabitant 2009 page 6, EDHEC Risk and Asset Management Research Centre ). The strategy was called a split-strike conversion strategy, a combination of a protective put and a covered call, whereby the cost of purchasing the puts is mitigated by the proceeds from selling the calls (Ibid page 7).

What features did Madoff use/have to attract investors?

  1. Be exclusive
    Madoff personally courted clients from exclusive country clubs and rejected many others leading to investors thinking how lucky some were to get in. Once in, any investor that questioned his methods were threatened with expulsion (Ibid page 12).
  2. Be likeable and well connected
    Madoff was well respected, having helped develop the NASDAQ Stock Exchange where he was once Chairman of the Board of Directors.
  3. Use "friends"
    Madoff had a network of "friends" who recruited on his behalf across the United States and ultimately internationally (Gome, 17 December 2008 - Smart Company). Later he generally refused to meet with investors personally which enhanced the exclusive aura (Wikipedia 'Bernard Madoff').
  4. Repayment of Funds
    Madoff certainly repaid investors within short periods of time giving the appearance of a well run organisation.
  5. Use Feeder Funds
    Many investors in BLMIS were through feeder feeds or hedge funds. These investors may not have even known that they had exposure to BLMIS.

Why wasn't BLMIS exposed earlier?

This article will not delve into this important question and will leave it to the United States regulators and the inquiries that will be set up to find this answer.

Potential Recovery of Funds

BLMIS and Madoff's personal assets have been frozen and a liquidator has been appointed to both entities. The US Securities Exchange Commission (US SEC) has filed a civil suit against Madoff on 11 December 2008. Investors may also have access to funds from the US Government Agency known as the Securities Investor Protection Corporation (SIPC), however payment is limited to only USD$500,000.00 per investor, but only for cash and securities missing or stolen from their brokerage account (How SIPC Protects You, Securities Investor Protection Corporation). Out of approximately USD$50 billion that is missing, there is no indication of what will be left to be divided amongst the creditors. A very bad outcome for investors who were actually lucky enough to withdraw funds before the fraud was discovered may be that they will have to repay those funds to the liquidator under the US law doctrine of fraudulent conveyance (Wikipedia 'Bernard Madoff') which appears to be similar to the Australian legal doctrine of "preference payment" in bankruptcy and insolvency law.

Lessons for Trustees It appears that Trustees of superannuation funds will need to conduct better due diligence on their fund managers or on the managers of their fund managers.

Issues with BLMIS identified by Messrs Gregoriou and Lhabitant (2009) which have universal application include:

  • Lack of segregation amongst service providers

    BLMIS conducted all the investment functions. The more independent the service providers to any investment manager, the lower risk of fraud due to independent oversight and conflicts of interest can be mitigated.
  • Use of reputable auditors

    With no disrespect to very small audit/accounting firms, the use by any global investment manager with billions under management of an unknown audit firm with 3 staff must raise some concern.
  • Unusual fee structures

    The absence of a normal fee arrangement (management and performance fee) may raise questions. BLMIS changed a "material rate" commission on each trade.
  • Heavy family influence

    If all the main positions in a fund manager are held by one family, it might raise concerns as to oversight and fraud control procedures as there is no independence.
  • Poor disclosure in Feeder Fund Information Memorandums

    By definition, wholesale funds have lower disclosure requirements but if they fail to mention who they ultimately invest with, then certain questions should be raised by trustees.
  • Lack of Staff

    BLMIS had between one and five employees. Trustees would expect their managers to have large, dedicated staff investing and monitoring their portfolio especially when they are in the billions.
  • Registration with the Authorities

    Obviously being regulated by the relevant financial Authorities does not guarantee freedom from fraud but it should give some comfort. BLMIS until 2006 was not registered by the US SEC.
  • Failure to give access to records

    BLMIS never gave clients electronic access to their accounts. Trustees should be wary of any manager that does not provide full transparency of its investment strategy and client accounts. Full accountability is the key.
  • Returns are "too good to be true"

    Can a manager be too good? Trustees should have independent verification of results that significantly out-perform the market. All markets have volatility and these should be reflected in returns. Asset Consultants and auditors should be central players here to weed out false players. Whilst due diligence will never produce better returns, it should help minimise fraud and give trustees some comfort. Trustees should consider looking beyond the feeder funds they invest into and ask the hard questions as to where their members' money is actually being invested? It will cost more in due diligence fees but it will be the basis of any defence against a claim by members for loss by way of negligence.

Reference List:

  • Wikipedia 2009, 'Ponzi Scheme',
  • Gregoriou, G.N. & Lhabitant, F.S. 'Madoff! A riot of red flags', EDHEC Risk and Asset Management Research Centre January 2009 p. 6
  • Ibid
  • Gome, A 2008, 'How Bernard Maddof fooled the world's banks, investors and high profile rich; A scammers guide', Smart Company 17 December
  • Wikipedia 2009, 'Bernard Madoff',
  • Securities Investor Protection Corporation 2008, How SIPC Protects You, USA

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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