A hedge-fund manager friend called last night to talk about Madoff. He wanted to talk about just how ugly the unraveling of the Madoff saga was likely to get. And if the first name on his lips was (obviously) Madoff, the second was Bayou. Bayou was a fund that blew up and was revealed in 2005 to be a fraud with some $450 million in investor losses. Bayou is memorable for two reasons. One is founder Samuel Israel III's staged suicide. (He eventually rose from the dead and turned himself in after prosecutors went after the girlfriend who helped him disappear.) The other is a legal precedent set in the Bayou case that should scare the heck out of anyone who once invested with Madoff but who managed to get out safely in the last few years: Any investors who managed to take out profits from a fund like Bayou before the fraud was revealed had to give the money back.
On the face of it, the Bayou ruling (which stories in the Wall Street Journal and Forbes have, to their credit, noted) seems reasonable: If some early investors made outsized gains, doesn't it make sense for them to pay back the money to those who lost everything? But, as this fund-manager friend pointed out, it has some pretty extreme implications.
The obvious consequence of Bayou is that a country-club friend who'd given his money to Madoff and then gotten suspicious can't just take his money out and then go to the cops. If he reports his suspicions, he's likely to be asked to repay any of those 10-percent-a-year "profits" he'd accumulated for a decade. This is bad enough. But there's more to it here.
Much of the money that Madoff managed came from people who'd written a check not to Madoff directly but to so-called "funds-of-funds": hedge funds that had raised money from investors. A few of these funds-of-funds, such as Fairfield Sentry and Tremont Group's Rye Investment, had billions of dollars invested with Madoff and teams of auditors to track it. These companies should have wised up to what was going on much earlier.
Thanks to the Bayou court decisions, however, the moment Madoff was revealed as a fraud, any money that these funds-of-funds would have managed to take back would become gains that have to be given back to be redistributed among all the losers in the Madoff scheme. Now, this sounds bad enough, but ... again, there's more. There's no time limit on the gains they'd have to give back, so any fund that outed Madoff could be on the hook for any profits it had gained from its Madoff investments for years back. So, as my fund-manager friend puts it, "The question people have to ask is not, 'Do I have money in a fund that has exposure to Madoff now?' but, 'Do I have money in a fund that that has ever invested with Madoff?' "
At this point, the complexity of the situation should be clear. But maybe not the whole potential for absurdity. Imagine that Rich Folks Capital Management--RFCM--placed its money with Madoff 10 years ago and then decided, five years ago, that something didn't feel right and pulled it out. Well, now RFCM is on the hook for any of its gains from the time before the fraud was discovered. But what happens if the people who'd invested with RFCM 10 years ago aren't the same as the people who invest with it now? Tough noogies. RFCM's current investors are probably responsible for paying back gains in the RFCM fund that they never even saw. Or, possibly, RFCM needs to go after its own former investors. No one's really sure.
The technical Wall Street term for this is a nightmare. The Bayou precedent means that the discovery of a huge fraud leads to a whole chain of liabilities that stretches back for years and may hit investors who hadn't dealt with Madoff in a decade. A few folks who think that they've lost everything may, at the end of the process, get back some portion of their money. But many others who thought they'd escaped, or didn't even know they had any link to Madoff, will turn out to have huge losses.
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Apparently, the Madoff fun is just getting started:
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IANAL, but wouldn't this be an ideal time for someone to challenge Bayou and get rid of these perverse incentives?
A couple of questions come to mind:
1) If Madoff wasn't always a Ponzi scheme, then should the requirement to disgorge profits be limited to those who invested funds during the period that it was a Ponzi scheme?
2) Might not the fund-of-fund managers be liable for even greater damages than this post suggests? Think about it: their main job, aside from perhaps asset allocation, was to due diligence. Couldn't an attorney claim that a fund-of-fund's inclusion of Madoff Investments is evidence of a lack of due diligence and then blame the fund-of-fund manager's inclusion of some other funds with lousy performance on a similar lack of due diligence? A lot of these fund-of-funds collected some hefty fees for putting their clients' money into hedge funds that had their own hefty management fees. The Maddoff affair raises the question of what, exactly, those funds-of-funds did to earn their hefty fees.
IAAL, but I'm not familiar with the details of Bayou. Why isn't there a bona fide purchaser defense for investors who cashed out without notice of the fraud?
This is a bit overblown. The Bayou precedent is based fradulent conveyance law - the only investors who might be forced to return gains are those who withdrew money knowing that the fund was insolvent or committing fraud. Investors who took their money out of Bayou's or Madoff's scheme in good faith shouldn't be caught. Of course, there is plenty of room for lawyering around the issues of who knew what, when, and what type of knowledge on the part of the investors is required before a court will find the claw back remedy to be appropriate. The most interesting question will be what to do about investors who got out because they suspected, but did not know for sure, that Madoff's returns were made up. Regardless, I don't see courts reaching back more than a couple of years to claw back money from otherwise innocent investors.
thebigmoney writes:
Meanwhile, Fairfield Greenwich which appears to have invested $7.5B, and be the biggest loser, in Madoff describes its due diligence as follows:
Even though as the Wall Street Journal points out:
It beggars belief that any company would allow a vendor to kibosh a significant corporate investment through its refusal to allow due diligence - especially, when that vendor represents half its business as in this case. Whether or not Fairfield Greenwich's claims regarding due diligence meet the legal standard of fraud they are certainly and obviously lies.
So a fund manager who sees he has invested in a possible fraud has will be punished for reporting it? So instead, he'll use the asset as collateral, passing along the loss to the next guy.
The next guy finds out, sees that he too is stuck, and passes it to a third. And so on. It becomes like fiat money instead of gold-standard money. Maybe it will work out, once everybody is equally contaminated.
dsr, that's not a correct statement of fraudulent conveyance law.
The bankruptcy trustee should be able to show actual fraud on the part of Madoff. In that event, fictional profits distributed to previously redeeming investors would certainly be liable to be clawed back into the bankrupt estate. The good faith of the redeeming investors would be no defense.
Moreover, the trustee can even claw back distributions to previously redeeming investors that represent their originally invested principal, unless they can show "objective" (not merely "subjective") good faith. That means that the claw back may succeed if the redeeming investors knew, or should have known, that the deal was "too good to be true" and should have inquired further.
From a law review article on the subject: "If the investor knew or should have known that the debtor's investment scheme was too good to be true, then the investor fails to carry his burden of proving that he accepted sums from the debtor in good faith, and the trustee is entitled to recover all amounts the investor received from the debtor."
Having said all that, I think there is a two-year time limit on how far back the trustee can go.
I think agentzero's analysis is an advance over dsr's, but the issue is still more complicated. Bayou was a hedge fund, which means that, legally, it was set up as a limited partnership with the investors as limited partners, i.e., equity investors. Any distribution to an equity investor at a time when the entity making the distribution is insolvent is fraudulent, because it is not made for consideration, since the equity investors aren't owed anything.
In contrast, the Madoff fraud was set up as a set of discretionary broker accounts. Each investor had a property interest in his, her or its own accounts. Madoff Securities was a bailee, and the return of property by a bailee is not fraudulent with respect to the bailee's creditors, since the bailee is merely giving the investor his own property.
Mind you, it's a little more complicated, because it isn't clear that there ever were any securities, or any accounts, or exactly where the money went. But the relationship of a broker-dealer to its customers is definitely not the same as the relationship of a hedge fund limited partner to its investors/partners.
Also, the relationship between a hedge fund that had an account with Madoff and the investors in that hedge fund is even more complicated, and beyond the scope of this comment. My firm will be happy to do some research and write a memo, if you pay us.
First, an update to my prior comment: there is a six-year lookback under New York debtor-creditor law.
Second, y81, Madoff is a bailee only to the extent he is actually sitting on the securities he claimed were in your account. I think that is going to prove to be almost entirely not the case.
agentzero - I'm not a bankruptcy lawyer, but I'm pretty sure that Section 548(c) of the Bankruptcy Code provides a "good faith" defense to fraudulent conveyance claims. I admit that the defense is an affirmative one (it will be the investors' burden to prove), but it is a defense nonetheless, as you appear to acknowledge later in your post.
Obviously, what constitutes "good faith" will be, as I said, argued heavily, and whether Madoff's steady returns put his investors on "inquiry notice" (should have known) of his fraud will probably be one of the most hotly contested parts of this argument (as it was in Bayou). But regardless, the investors' "good faith" in connection with their withdrawls will most certainly be a defense that they will try to use against any efforts at claw back by the bankruptcy trustee.
where did all those people get so much money in the first place? THAT is what i'd like to know.
This is sounding like Superfund. Sigh.
OMG lawyers' heaven. Fraudulent conveyance, bankruptcy etc. Christmas has come early to some sections on the bar. They will be clawing money back from former investors just to cover legal fees.
How do the judges make out on cases like this?
Madoff is under, get this, house arrest. I suppose it's taking some time to make the formal charges since after all nobody knows what the crime was, only that about $20b in cash is missing and the 'investors' thought it was $50.
Still it is easy enough to reach the conclusion that he is getting treated with kid gloves and super deference because.....Well because he's such a great guy and then too there are others who might be in trouble as well so best to keep him out of sight and happy so nobody else important gets thrown under the bus.
As always with the SEC the first order of business is to find the fewest number of scapegoats and bring the absolute fewest number of criminal cases possible because after all these people are the elites. In the sense they have or had lots of money.
As de Tocqueville noted, in not quite this way; Americans will always lick the boots of the rich. Be nice to the rich guy so maybe the rich guy will get you in on some deal down the road. Everybody in Chicago from the mayor to the baseball stars were glad to have their picture taken with Capone. People loved to rub elbows with Gotti too. Those are the extreme cases. The leaders of our formerly great now defunct investment banks still mingle among the elites. Are given deference by everyone.
I'm not sure if there is a Libertarian explanation for this which points to how the general good is served by giving deference to pigmen.
How do the judges make out on cases like this?
It is a massive, unimaginable pain in the ass. I've worked one for a judge. I had the good fortune to be on the tail end after most of the hard work was over.
agentzero - Apologies. I spoke too soon earlier, and now understand your original point better. 548(c) is only available if the transferee gave "value" in exchange for the transfer. If you conclude that Madoff's investors could not possibly have given "value" in exchange for fictitious profits they recieved on redemption (as it appears the Bayou court drew a similar conclusion in that case), then you are correct that there would be no good faith defense to the claw back of those amounts.
dsr, thanks. That is what I was saying.
As you note, there is a "good faith" defense investors can raise with respect to their receipt of their "principal," i.e., originally invested money. It will be very interesting to see how that plays out here, for the reasons you say.
agentzero, you may be right. But I am still not sure the transfers are fraudulent, because if you send money to a broker, you are at a minimum a creditor of the broker, whereas if you sent money to a limited partnership in which you are a partner, it is a capital contribution. And transfers to creditors are not fraudulent, though they may be preferential. But it is more complicated if the broker is paying you unearned returns, and you may not be a creditor in that situation. I would have to do some research.
I think we can all agree with Gene that there will be a lot of work for lawyers, although that work will involve entirely a zero-sum quarrel over claims to a very small pot.
Rapier, he was given an extra day to post bail of $10 million and needed a minimum of four cosigners. He got only two - his wife and brother (his sons refused). If he doesn't post bail, the house arrest is revoked and it's into the pokey with him.
Bail is a time-honored American tradition, embedded in the bill of rights. We don't deny it in this country merely because we don't like the defendant. That's the libertarian answer. And it should be the liberal and conservative one, too.
From New York to Geneva, corruption is rampant and complex on Wall Street.
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http://pacificgatepost.blogspot.com/2008/12/is-madoff-really-anomaly.html
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MADOFF IS NOT SO UNIQUE
Well it's the first time I have heard of a case where the authorities told the guy he could wait at home until he made bail.
One interesting but not political aspect of the case is it seems probable that Bernie never made a lot of money out of this thing. I don't know what kind of fees he was charging but in any case in the big picture I don't think it was a big part of his income. Rather I suspect it was simply that he started losing and couldn't admit to being a loser.
Old school I guess. Now days hedge fund guys blow up funds all the time and just start up a new one. Nobody gives a rats ass.
He couldn't admit to losing for his early clients so kept taking in more in hopes of making the losses up.
Rarely if ever has a Ponzi scheme been run not for profit but for vanity. Maybe I'll be proved wrong. I suppose we will eventually hear a believable history of the whole sad tale. Then again.......
When I see so many consistencies, I see 'conspiracy'. When I see an SEC that was literally in bed with Madoff, refusing over 10 years of calls to investigate him; When I see all investors 'surprised' by their losses, when I see the so-called 'intellectual creme-de-la-creme' suddenly all 'non-culpable fools', I see a conspiracy.
Evil people know it is far better to appear a fool than a willing accomplice. George Bush is proof of the success of disguising evil deeds with playing the fool. There are still people in this country who think he is only a fool.
Anyone who believes the cover story being doled out in the press that this is a mere 'Ponsi Scheme' is truly foolish and a simpleton. This was beyond mere crime. It was finanacial sabotage against nations and a subversive act of war. Because no tanks and planes were involved, people don't understand this. Subversion is war by another means.
The private investors were most likely, not the unwitting investors they universally claim to be, but were more likely, full or half-witted receivers in stolen goods. (Let the left hand not know what the right doeth). "'Ere look, we is all well met in our professions! We knew pretty well we was helpin' ourselves."
The scheme was to soak large megabanks in one section of Madoff's firm, low-ball reports back to them and dole out the skimmings to the 'investors'. It was like being a parasite on a healthy body. It wasn't a Ponsi scheme; it was supposed to go on forever.
What they didn't expect was the sudden collapse of the markets and the huge and rapid losses. It was these losses, like water suddenly draining out of a burst dam, that exposed both the mechanism of deceit and the fish, flapping and gasping on the mud flats.
Now these pathetic, gasping fish want the world to know they were only innocents victims 'taken in' by Madoff. This is disingenuous, given the tiresome propensity of the rich to scrutinized where every dime of their money is going. Maybe one or two were foolish: That ALL of these investors, from Senators on down to the Palm Beachers, couldn't figure things out stretches credulity past breaking. Various lower non-members of the financial world and the SEC could see it and were silenced for their due diligence; but these people couldn't...Their single universal excuse holds no water and doesn't even have any imagination. Again, only simpletons believe this.
Personally, not only would I like to see these people lose all their money, but I would like to see a REAL criminal investigation into just what the investors knew and then if they are guilty of abetting this financial sabotage, they be sent to jail and the key thrown away. The apple never falls far from the tree. I don't hold my breath, however. This act of sabotage is going to be defended and trivialized by the very people charged with ensuring justice, because they are one and the same. Orwell's pigs have taken over the barnyard.
It is time for the American people to stop putting up with this type of activity. Both Wall Street and Washington DC are thoroughly and probably irredeemably corrupt. If Obama doesn't pursue all these rats down into their holes, the American people are going to have to take up their duty in the Roman Republican sense of Vox Populi and overthrow these cretins. I smell a 2nd Civil War coming.
The Bayou roundup is complicated, but it needs to be tried.
Fairfield was nearly 50% into Madoff, based on reports, so it's fair game for a look through.
Meanwhile, in the WSJ, today, this nugget enforces the point:
"A friend says he knew a fellow who specialized in sniffing out Ponzi schemes, so he could be the first one into the pot and then the first to ask for his winnings before the posse arrived."
C'mon!
http://online.wsj.com/article/SB122956170176216623.html
There does have to be some mechanism like this: otherwise Madoff just tells an associate that it's time to get out, and they walk away with all the money. This ain't a casino. This wasn't a failed investment strategy, this was a straight swindle, and I don't like presuming the innocence of the people who ended up with the money.
Wow, the things glibertarians worry about these days. $700 billion of taxpayer funds not being used for intended purposes? Who cares. Millions of auto workers being thrown to the wolves right before Christmas? That's life.
The possibility that investors who made a killing based on fraudulent financial chicanery may have to give some of that money back? Bone chilling.
There are hundreds perhaps thousands of investors that were NOT on the Hedge fund side of Madoff. They were on the broker dealer side where there have been NO Allegations. Everyone has lumped these two sides together and in fact they are NOT. Evidence of this is that the brothers who ran this operation on the 18th and 19th floor were not arrested. It was the 17th floor hedge fund that has taken this hit.
Why aren't you writing just a sentence or two to give people that invested on the Securities side (Like my parents) SOME HOPE that their funds, securities and IRAs may still be in tact? I pray it is not because it wont sell newspapers.
John Coffee, a Columbia University Attorney and Professor, spoke to this issue last night on the Lehrer report. Don’t take my word listen to what he says.
http://www-tc.pbs.org/newshour/rss/media/2008/12/17/20081217_sec.mp3
Can you answer this question?
Bill
Bill,
At this moment, there is no way to know what type of account individuals actually had at Madoff. This whole thing could be a fraud. We don't know yet.
I totally agree with: Posted by James | December 18, 2008 2:48 AM.
All those country club folks did was "investing" their cash to Bernie the Jewish T-bill and relax waiting for fat annual 10-12%. For generations! One could think how, for so many years, there was no trumpet to wake business veterans to go to NY and check for themselves whether their money is in good hands. If only for the peace of minds' sake or for fun, or to check how much of old days' sharpness they preserved. Prefered golf and canasta? Now all of them express cries of surprise, outrage and other smoke (like obligation to keep it secret) to fool the public and to give authorities the clue what questions they see most welcome.
Looks like Bernie haven't run any hedge fund but many separate accounts (even if it had the form of entries in an old pocket calendar :)). For over 30 years peddled cash to his folks and finally found the target to extort: overseas investors. Of course it would have been foolish to pay back all own folks and keep the target victims alone. This is why some "individual investors" or noble-purpose funds and charities had to be sunk too.
To extort target group it was necessary to employ the buffer (feeder funds). The buffer who is not inquisitive and can be trusted. That was easy. This father of five doughters came handy, others followed.
The crisis came suddenly, withdrawals too substantial and the king was seen naked.
Surely lawyers are happy with all the mess.
ps
Sorry for clumsy english.
This is definitely complicated.
It seems to me that it will be very hard to go after principal of redeemers with a satisfactory good faith defense based just on a "should have known" inquiry notice because so many people, form institutional investors to the SEC itself remained unaware for so long (decades). In fact, the SEC remained unaware even after an investigation. There was a similar precedent in the Bayou case where it was ruled a hedge fund advisory firm was not liable for reckless disregard in due diligence in not discovering the fraud BECAUSE so many people including institutional investors and the SEC were similarly fooled for so long (and in this case the extent of that is an order of magnitude larger).
From what I saw, in the Bayou case, all fraudulent conveyance claims were made only to direct redeemers, either individual investors, funds, or fund of funds. I recall no case where the claim was made directly to investors of the funds or funds of funds who redeemed. In that case, all satisfactory good faith defense resulted in settlements where the investors kept their redeemed principal but returned all fictitious profits.
What makes this case compelling is that most of the direct investors appear to be feeder funds of one type or another. So say an investor in a feeder fund redeems in good faith. Based on the Bayou precedent, it appears to me that Madoff trustee would pursue the feeder fund. The question is whether the feeder fund has a legal claim on the redeeming investor. I say this because 1) The transfer from the feeder fund to the redeeming investor was not fraudulent in that the feeder fund was not itself operating a ponzi scheme (even if it was inadvertently investing in one) and depending on the fund (some are backed by large financial institutions) it itself may or may not be bankrupt by it's investment in Madoff, and 2) The feeder fund may be claimed to have exercised insufficient due diligence so it's possible it may be liable for it's own losses.
I'd appreciate other peoples thoughts on these matters.
One question I'm not seeing addressed which further complicates issues relates to previously paid taxes on fictitious gains. Many of the Madoff investors were long term investors who paid taxes yearly on the gains as they were reported (as short term gains taxed as ordinary income). Lets say a good faith redeemer returns profits and keeps their principal. I would think they would need to refile their prior year taxes with the IRS to get refunds for previously paid taxes since the gains were fictitious and any redeemed gains have been returned. I'm not a tax person but in looking at the IRC, it's not clear to me if they are subject to a 3 year lookback under 6511(a) or would qualify for a 7 year lookbacdk under 6511(d) pertaining to worthless securities or 6511(g) pertaining to partnership items (since the feeder funds were typically implemented as limited partnerships).
Also, since the SEC has effectively perpetuated this fruad by not acting on credible evidence that was apparently provided to it as early as 9 years ago, I wonder if investors who paid taxes on fictitious gains since then (particularly if they made their investments since then without the benefit of an adequate investigation) might have a justifiable claim against the SEC?
Any comments would be appreciated.
For sure, you can't recover from the SEC for inadequate regulation or auditing. All the other issues are more complicated. I think that, from a tax standpoint, the best thing would to (i) file amended returns for the last three years, removing all Madoff gains and requesting a refund and (ii) file a return for 2008 claiming a loss for the balance of the taxpayer's Madoff investment. The loss should be ordinary and deductible from other income. If you don't have other income, the carryback and carryforward rules are sort of complicated. But investors should definitely consult their own tax advisors.
Rapier,
You say some crazy things sometimes...
But, what you wrote is one of the most brilliant insights I've read.
It all stuck me when they mentioned he had to post his $7 million park avenue apartment as part of his bail. I thought to myself - there are $100 million aparments in NYC and even a above average townhouse will set you back +$20 million. They said he liked to entertain people on his 55' yacht, and I thought to myself - there are guys with 550' yachts. If he stole even a billion dollars he'd be living far better than he was.
Also, when we talk about red flags, I think what people were looking for is someone stealing their money. No one was looking for a guy who was doing it so he wouldn't look like a looser.
Think of it, say he stole 20% or between $5 and $10 billion and used it to buy mansions, art, yachts etc. People would have said, based on his fees, he must be stealing from us. But, living so modestly no one became suspicious.
There's a simple word for these "funds-of-funds." PARASITES.
Re clawback, sit back and take the time to read this: [I ghost wrote it, I'm the guy from NYC mentioned therein.]
http://www.worldreports.org/news/108_subprime_slide_that_masks_fraudulent_finance
If such type clawback were enforced against all parties in the mortgage business, as it is a complete fraud, then most all the banks would be declared insolvent. A can of worms that I think will force the overturning of Bayou. So you attorneys out there will love to get your teeth into this analysis.