Madoff's Winners

The party is over for Bernard L.Madoff. He was sentenced to 150 years in prison and all his property confiscated. His crime was forging all the financial statements of his clients so as to create the illusion that they were making steady profits. In reality their money was being siphoned out of their accounts and given to others. As is now clear from recent court filings by the bankruptcy trustee, Irving Picard, and the SEC, this amazing Ponzi scheme had both winners and losers. While some 4,900 hapless investors, including retirees, family trusts, and charities lost their nest egg, a handful of financiers, all well versed in the arcana of investing other people’s money, made huge fortunes from Madoff’s notional book-keeping. The reason they could profit so handsomely from this shell game, as the Trustee explains in documents filed in U.S. bankruptcy court, was that "The money received from investors was not set aside to buy securities as purported, but instead was primarily used to make the distributions to – or payments on behalf of – other investors." So people who redeemed the imaginary profits in their account got the actual funds put in by the new investors. According to a lawyer involved in the bankruptcy case, the redemptions in excess of investments, as calculated by the Trustee, amount to over $10 billion. If so, the major redeemers took home many billions of dollars. As it turns out, almost all of fortunate redeemers turn out to be close business associates of Madoff who had been involved in his money game for two decades. Consider, for example, Jeffry Picower, who, as a lawyer, accountant, deal-maker, and tax-shelter promoter, who was well-experienced in financial arrangements, and who had dealt with Madoff for more than 30 years. According to the complaint of the Trustee for the bankruptcy of Bernard Madoff’s firm, Picower had 24 Madoff accounts under his control from which he withdrew a staggering $6.7 billion from which he got, for himself and his entities, "at a minimum, more than five billion dollars of other people’s money." Madoff kept meticulous records of correspondence with his early investors which show that Picower, according to the court filings of the Trustee, "was one of a handful of clients with special access" to what Madoff called his "targets" for profits each year. These "targets" could be then achieved by since Madoff since virtually all his trades were fictitious for each accounts. So, If any of his clients with special access requested a higher or lower number than his target for tax or other purposes, Madoff simply adjusted the "profits", and, if necessary, backdated them Picower, the Trustee alleges, frequently specified the profits he wanted for different accounts and, in one case cited by the Trustee, even supplied backdated documentation that Madoff then used in his fabricated book-keeping. Madoff also allegedly shifted billions of dollars of taxable income for Picower’s entities into future years by phony trades. In December 1999, for example, he trustee alleges that Madoff forged nearly $11 billion in short sales in Picower’s accounts in December 1999 "to increase the net cash deficit across these accounts by $2.5 billion" in tax-year 1999. And then reversed these fake trades in January 2000. Such artful legerdemain could defer taxable income and, by doing so, further enhance the value of the $5 billion that Picower, and the entities he controlled, walked away with.
Another intriguing winner, according to a civil fraud complaint filed by the SEC this week (June 22nd), is Stanley Chais. Chais, an unregistered investment advisor with a long roster of wealthy clients in Beverly Hills, Hollywood and elsewhere, also knew Madoff for some 30 years. He was indeed in such close contact with Madoff that his name came up first on Madoff’s office speed dial. Chais had, or controlled, 60 separate Madoff accounts. Some were for himself, his family members, and his foundations; other were for outside investors he had consolidated into 3 feeder funds The SEC states in the complaint , that "unlike the thousands of investors who lost money in the Madoff scheme, Madoff’s enterprise ultimately proved to be extremely profitable for Chais." The SEC says that Chais, along with his family and foundations, "withdrew approximately a half billion dollars more than they had invested with Madoff." As for the outside investors, Chais levied a heavy performance fee of 25% on their putative profits each year based on Madoff’s performance. which, according the SEC complaint, amounted to $269.7 million. Chais also had impressive access to Madoff, according to the separate complaint filed by the Trustee in bankruptcy court, that alleges that Chais was able to specify the size of the "profits" and "losses" in his different accounts "presumably for tax purposes." In all the entities under his control– which includes his fees on :profits", the Trustee calculates Chais withdrew $1.2 billion.
A third winner, according to another SEC complaint filed this week (June 22nd), is Robert Jaffe. A well-know investor in Palm Beach and Boston, Jaffe is a son-in-law of Carl Shapiro, a 95 year old multi-millionaire philanthropist, who was one of Madoff’s earliest financial backers in 1960. He has known Madoff for over 30 years and his brokerage firm Cohmad, which was partially owned by Madoff, operated out of Madoff’s offices in the Lipstick building. The SEC alleges in the complaint it filed against Jaffe and other members of Cohmad, that Jaffe received hidden side payments directly Madoff of over $100 million for recruiting more than $1 billion of investments from his social circles in Florida and elsewhere for Cohmad (which put 99.7% of its investments in Madoff’s scheme). According to the SEC, Madoff channeled this money to Jaffe by crediting his account with at least three times the "profits" that he was crediting to Cohmad investors, and then allowing Jaffe to redeem between 1996 and 2008 over $150 million. Jaffe also made, according to the SEC, "specific requests" to Madoff for "a specific dollar amount of gains for a given period," including ones for "long term gains." A Madoff employee "would then insert a backdated trade going back days, weeks or even months that afforded Jaffe's account that particular gain." By transforming short term gains into capital gains, these "trades" may have helped reduce Jaffe’s tax bill on the $150 million he withdrew.
Picower, Chais, and Jaffe all deny via their lawyers that they had any knowledge of the Ponzi scheme. If so, they presumably believed that Madoff had been gifted with a Midas touch– indeed one so deft it could produce the precise results for which they wished . Was this willful blindness? Financiers’ capacity for self-deception should never be underestimated, especially when it serves to rationalize hundreds of millions of dollars in profits. But to depict such major redeemers as victims of Madoff’s Ponzi scheme stands on its head Balzac’s dictum that "Behind every great fortune is a crime."
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Madoff's Secret Service

A missing piece in the Madoff puzzle is the motive of his early wave of investors in Madoff’s operation before he had established an impressive track record. Why did a dozen or so multi-millionaire businessmen put both a large share of their personal wealth and that of their tax-exempt foundation in multiple accounts with Madoff? If these financially savvy investors only wanted to compound their wealth, other highly-regarded money managers, such as George Soros, Julian Robertson and Paul Tudor Jones, offered better track records over longer periods as well as much safer financial controls, including outside custodian and auditing services. Presumably Madoff was able to offer these wealthy investors some other service they could not obtain elsewhere. But what?

The secretive way in which he personally ran his operation from a small office in the Lipstick Building in New York may well have been part of the inducement. Since he alone handled each account and determined its profits and losses from each putative transaction, he was in a unique position to custom-tailor how they were allocated between a client’s taxable personal accounts and his tax-exempt charitable accounts. In fact, presumably unknown to these investors, Madoff was running a Ponzi scheme in which he forged the paperwork to create imaginary profits. Even without such notional book-keeping, it would have been child’s play for Madoff to provide his clients with the results that helped them minimize their annual tax bills. This service became particularly valuable to wealthy individuals after Congress in 1982, at the behest of Senator Daniel P. Moynihan, amended the Economic Recovery Tax Act to prohibit a common practice in which wealthy investors used commodity trades to shift their taxable profits into future years. Madoff’s correspondence with his clients, according to one lawyer involved in the ongoing civil suit, shows that this was precisely the secret service Madoff was supplying his early clients. "If a client needed to offset taxable income in a given year," the lawyer explained, "Madoff would give him a paper loss, and put the off-setting profit in his tax-exempt account and then presumably return it in the next year, or when he needed it." As far as how he did this legerdemain, he apparently had a "Don’t ask, Don’t Tell" policy.

Irving Picard, the court-appointed trustee in the bankruptcy liquidation of Madoff's firm, found correspondence in Madoff’s files showing that investors specified the loss that would be helpful. Indeed, he charges in court papers that one of these early investors, who had $178 million in different Madoff accounts requested, as reported by The Wall Street Journal, "fictitious losses from Mr. Madoff's firm, apparently to offset gains he made through other investments in order to avoid taxes." He cites another early investor, who had nearly a billion dollars in 12 different accounts for his family and foundation who, according to Picard, had an assistant at his foundation request a $12.3 gain for his foundation. According to him, there were wide variations in different accounts. Even though allocations between accounts might raise tax evasion issues, all the investors cited in the Trustee’s suit deny any wrongdoing, and no charges have been brought against anyone to date except Madoff himself, who pleaded guilty to fraud in March 2009, and his firm’s auditor, David Friehling, who is out on bail awaiting trial.
The bespoke tailoring of taxable income was not the only special service. Madoff also provided these early clients with a steady increase in the reported value of their total investments in both good and bad times (such as in the crash of 1987). We now know that he achieved these results by inventing them. And they provided him with the sort of enviable track record he needed to attract a second wave of investors in his Ponzi scheme. As word spread among the rich of Madoff’s amazingly steady returns in both good and bad years, he was approached by numerous"feeder funds." These are essentially money-raising operations that turn virtually all the money they raise over to another money manager. As compensation, they usually get a relatively small placement fee from the money manager, who then charge the investors his own performance fee– typically 20 percent of the profits– and an annual charge– typically one percent of the value of their total investment.

Madoff offered these money-raising funds a far more lucrative deal in which he would waive his fee entirely, allowing the feeder funds to charge the investors a performance fee as well as an asset fee on the profits that Madoff would generate each year. Madoff explained that he could afford to provide this zero-fee service to funds because he earned commissions buying and selling options on the shares. Rather then looking a gift horse in the mouth, feeder funds eagerly outsourced their investors’ money into Madoff. The profits they earned from these fees were staggering. For example, in 2007 alone, Fairfield Sentry, a unit of the Fairfield Greenwich Group, raked in $160 million in fees on the money it had outsourced to Madoff. Such fees, of course, were based on the fake numbers Madoff supplied. After the Ponzi scheme was exposed in 2008 by Madoff himself, many of these funds claim to be victims of his fraud. Perhaps so, but certainly the investors in these feeder funds qualified as the prime victims. As lawsuits brought by bankruptcy trustee Picard and the ongoing federal investigation proceed, and we learn more about the special services Madoff provided "victims," including the bespoken allocations that allowed them to reduce their taxable income and the zero-fee management that allowed feeder funds to harvest a huge bounty from his phantom profits, it may be useful to ponder W.C. Fields famous dictum "You can’t cheat an honest man."
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