The King of Cons

15 Jun 2011

He had found investment's holy grail: making money off a perfect hedge. If people asked, Bernie told them he used a "split-strike conversion" strategy, buying stocks and hedging them with options. Driving the trades was a complicated algorithm - his closely guarded secret. So no matter what the market did, Bernie Madoff never lost you money. 

The Con

Except that it was all a con. In reality, Madoff had been misappropriating the investors' money, while getting back office workers to fabricate trading reports matching his customers' bogus returns. If any investors required withdrawals, he paid them off with cash raised from hapless new clients.

He didn't call his 55-foot yacht "Bull" for nothing. 

Ultimately, Madoff's lies collapsed under their own weight. Now, he's prisoner 61727-054; projected release date 14 November 2139 - assuming time off for good behaviour.

The Clean-Up

Lawsuits are flying in the aftermath. 

The man who has the unenviable task of sorting out Madoff's mess is Irving Picard, the bankruptcy trustee of Madoff and his investment firm Bernard L Madoff Investment Securities LLC. Relentlessly pursuing recovery of the billions lost, he is testing the reach of United States bankruptcy law as never before.

So far Picard has filed more than 1,000 lawsuits, seeking in excess of US$100 billion.  

He's trained his guns on three broad groups: the investors who got out early enough to profit from Madoff's scheme, the 'insider" investors who knew or had notice of the fraud, and the financial services industry.  

Picard's avoidance actions  

United States law allows a trustee to claw back returns, and in some cases principal, paid out by a fraudulent scheme up to six years before the bankruptcy filing date.  

Using this, Picard is suing all Madoff investors who got out more than they put in ("net winners") for the profits they received. He claims that the amounts they got out were not in fact returns on their investments - since there were no trades - but rather the money of other investors. So they must repay that money, for distribution to the net losers. 

Picard's "bad faith" avoidance actions 

Where Picard has evidence that particular Madoff investors knew or should have known of the fraud, he is seeking to claw back not only their fictitious returns but also their principal. The unprecedented US$7.2 billion settlement with the estate of Jeffrey Picower has made headlines, as has the claim against New York Mets co-owners Fred Wilpon and Saul Katz and their investment fund, Sterling Equities, for more than US$1 billion. 

Picard's claims against the financial services industry 

But Picard's lawsuits against the financial services industry will have the greatest repercussions. He is suing various major players he claims knew or should have known of the fraud for the return of the fictitious profits, principal, fees, and, in certain cases, damages. 

His claims started out as avoidance actions against the so-called "feeder funds". Madoff made some of his biggest deals with large investment firms that were willing to feed him billions of dollars of client money to manage. In return, he paid the feeder funds a fortune in fees.  

Investigating the feeder funds, Picard concluded that some of world’s largest banks and financial institutions aided Madoff's scheme.  

In one action, Picard is suing HSBC and its related entities for US$9 billion, claiming they enabled Madoff's scheme through a network of feeder funds in Europe, the Caribbean, and Central America; as the funds' custodians and administrators, they funneled monies to Madoff regardless of the obvious risks. He argues the bank should have known of the fraud: it knew of concerns that Madoff’s business was fraudulent, and there were obvious red flags. Yet, he claims, the bank took no steps to protect investors. HSBC has rubbished the claim, protesting that it lost almost US$1 billion of its own money investing in feeder funds, “a fact that clearly undermines the trustee’s claim that HSBC was on notice of Madoff’s fraud”.  

In other action, he is suing JP Morgan Chase Bank (with whom Madoff deposited the money he received from investors) for at least US$6.4 billion in restitution and damages. He alleges the bank knew or should have known of the fraud, but didn't report its concerns until two months before Madoff's arrest (when it told the UK Serious Organised Crime Agency that the performance of Madoff's investments was "too good to be true"). Disturbingly, he claims that the retail bankers failed to perform even basic oversight of Madoff's banking activities, despite several transactions as far back as the 1990s indicative of money laundering or cheque kiting. Picard argues that even a cursory glance at Madoff's account activity would have revealed that his business could not possibly have been legitimate.   

The hearing dates for HSBC's and JP Morgan's applications for dismissal are 23 June 2011 and 28 July 2011. If those applications fail, the claims will go to trial. 

Other major banks are also in Picard's sights: he is suing Swiss banking giant UBS for US$2 billion. 

And Picard has brought a racketeering claim against Bank Medici AG and its co-owners - Austrian banker Sonja Kohn, Bank Austria, and UniCredit SpA - seeking damages of US$19.6 billion (punitively trebled to US$59 billion, if he can prove racketeering). He claims Kohn masterminded a vast illegal scheme to funnel some US$9 billion into Madoff's scheme through a labyrinth of feeder funds, and that the banks were complicit. 

Other Claims 

The deluge of lawsuits doesn't stop with claims by Picard. 

The feeder funds' clients are bringing class actions against them, for not doing due diligence or diversifying. In turn, the feeder funds have filed cross-claims against the banks who serviced them. HSBC, the custodian for several feeder funds, is the subject of claims that it did not act as a prudent investor. HSBC has recently settled the claim of investors in Thema International Fund, agreeing to pay US$62.5 million without admitting liability. HSBC said it has good defences and “will continue to defend the other Madoff-related proceedings vigorously". 

The regulators have brought a raft of criminal proceedings. In turn, they are being sued by investors who claim that they were asleep at the wheel, despite numerous red flags and tip-offs as far back as 1999. 

Issues 

The lawsuits have raised several complex issues.  

Notice of fraud 

First, when is a bank or investment professional on notice of fraud? 

Picard is alleging that there were various "red flags" over the years that meant the banks and feeder funds ought to have known Madoff's business was fraudulent. There were some obvious warning signs that Madoff was not doing the trades he claimed. To name but two, he reported trades on days the market was closed, and trades in stocks that exceeded the entire volume of trades in those stocks in the trading period. Many financial professionals had been questioning Madoff's legitimacy, both internally and publicly. And there were the general badges of fraud: Madoff's secrecy about how he implemented his investment strategy; his inadequate auditors; his insistence on acting as his own custodian; his refusal to provide real-time access to trading accounts; not to mention the impossible consistency of his returns. 

If the US courts find the defendants liable, there will be valuable learnings for the New Zealand industry. 

Due diligence

Secondly, can an investment professional properly recommend, or a custodian allow, investments in funds that operate - as many hedge funds do - a black box? If the funds' investment strategies or algorithms are kept secret, how is due diligence possible? 

Regulators' liability 

Thirdly, what level of responsibility should the regulators bear? Should they be liable for negligence in enforcing the securities laws and their powers? Or would that amount to yet another taxpayer underwrite for investors?  

"Dirty hands" 

Fourthly, can a bankruptcy trustee sue the enablers or beneficiaries of the bankrupt's fraud?  

One of the grounds on which HSBC is defending Picard's lawsuit is that a bankruptcy trustee cannot plead the bankrupt's own fraud to recover money - because the trustee represents the bankrupt. HSBC argues that established legal rules bar Madoff's representative from suing HSBC for assistance of Madoff's own fraud.  

This issue has also arisen in New Zealand insolvency proceedings.  

In 1992, our High Court ruled that the liquidator of a futures broking company which had misappropriated client monies held on trust could recover reparation from its director. The court did not accept that the company's "dirty hands" were an absolute bar.[1]  

By contrast, in 2007, our Court of Appeal ruled - without reference to the 1992 High Court decision - that the Official Assignee could not avoid a trust settled by a bankrupt as being a sham, since the Official Assignee could not be in a greater or different position than the bankrupt.[2] Yet in 2009 our High Court, relying on its 1992 analysis, held that the Official Assignee could plead that a company controlled by a bankrupt was a sham - but without explaining why the Court of Appeal's ruling (binding on it) was inapplicable.[3]  

Until our Supreme Court has spoken, the New Zealand position remains in doubt. Bluntly, the Court of Appeal's ruling is a rogue's charter.  Ideally we should have legislation validating proceedings of this nature.  

Distributions to investors 

Finally, on what basis should investors in Ponzi schemes be compensated? Is it correct that (as Picard claims) even innocent net winners must disgorge their profits, and that only net losers' claims are allowable? 

Our courts, too, have recently had to grapple with distributions to Ponzi scheme victims. 

In 2005, the High Court ruled that if investors in Don Rea's grandiose International Investment Unit Trust could not trace their specific investments, they should share pari passu in the fund.[4]  

And earlier this year, the High Court had to contend with the claims of those swindled by Hawkes Bay accountant Warren Pickett.[5] Over some 20 years, Pickett had channelled nearly $20 million, given to him for investment, to his two finance companies. However, as soon as an investor's money came into a company, it went right out again - to failed schemes, to other investors making withdrawals, or into Pickett's own pockets. Because neither company had registered a prospectus, the Securities Act treated the sums invested and the recovered proceeds as held on trust for the investors. However, the Ponzi nature of the scheme raised novel distribution issues. Drawing on the approach adopted by the US courts and regulators in unwinding Madoff's scheme, the court directed: 

• An investor's claim against the trust fund was limited to the principal invested, less any interest actually paid. The court accepted the reasoning in a Madoff judgment that, since no interest had in fact ever existed: (i) an investor's claim could not include non-existent "accrued interest"; and (ii) all "interest" receipts were to be treated as withdrawals of capital.
• Given the 20-year duration, the time value of money should be taken into account in calculating the net principal owed to each investor ("constant dollar" approach). The court said this reflected the US Securities and Exchange Commission's submissions to Congress on compensation relating to the Madoff litigation.  

The Madoff judgments have started making their presence felt here.  It is unlikely that we have heard the last of them. 

 

This article was first published in the June 2011 edition of INnews, the newsletter of the Institute of Finance Professionals New Zealand Inc (INFINZ). It is republished here by the kind permission of INFINZ.

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