Like
the mythic vampire, a Ponzi scheme needs to find new blood
to sustain itself. So while Bernard L. Madoff had no problem
creating the illusion of constantly expanding profits through
the simple device of wholly inventing the transactions in
accounts he managed, the only way he could meet requests
for redemptions was to find new money. The amounts he needed
became staggering in the 1990s, as a handful of his longtime
associates cashed in billions of dollars of imaginary profits
in their accounts.
To replace these billions, Madoff needed a new source. The
mother lode he turned to was the ganglia of so-called feeder
funds.
A feeder fund, unlike a hedge or private-equity fund, does
not manage investments. It is simply a marketing operation.
Its principals raise money from investors—often through
their social, country club, and professional connections—that
they then consolidate into a single account, which they
funnel to a money manager with whom they have an arrangement.
Typically, in return for finding investors for the money
manager, the feeder gets a relatively small placement fee
of about 1 percent. The money manager then charges for his
investing skills, typically deducts a performance fee of
20 percent from the profits as well as an annual “net
asset” fee of 2 percent on the investor’s nest
egg.
But Madoff offered feeder funds a much more alluring deal
for finding him money. Instead of merely giving them the
standard placement fee, he allowed them to take the entire
cut of profits usually reserved for the money manager by
waiving all his fees. This generous accommodation became
extremely lucrative for them because Madoff reported profit
annually of about 15 percent. So the principal of the feeder
could deduct 20 percent of that putative profit from all
their clients’ accounts, transfer it to their own
“carry” account, and redeem it, with the result
that they got cash while their clients’ fictitious
profits grew each year.
But why would a highly successful money manager like Madoff
make such an accommodation and essentially work for free
for feeders? The explanation Madoff gave was that he was
not greedy and content making a mere .04 cents a share from
trading stocks in the accounts (which he could have made
anyhow if he charged them a fee). As incredible as this
rationale might sound, feeders had little incentive to look
a gift horse in the mouth. This amazing inducement, together
with the track record Madoff had totally invented, brought
in enough from feeder funds to more than cover the $8 billion
in withdrawals made by his longtime associates.
For their part, his feeder funds fared well, earning hundreds
of millions of dollars in fees from their 20 percent cut
of Madoff’s imaginary profits and their equally imaginary
“performance.”
Consider, for example, the success of Fairfield Sentry,
a unit of the Fairfield Greenwich Group, whose principals
included the socially prominent financier Walter Noel Jr.,
his four well-connected sons-in-law, and Jeffrey Tucker,
a former Securities & Exchange Commission official.
According to the complaint filed by Irving Picard, the court-appointed
trustee for the liquidation of Madoff’s business,
between December 1, 1995, and 2008, “it invested approximately
$4.5 billion with Bernard L. Madoff Investment Securities
through 242 separate transfers via check and wire.”
From its cut of Madoff’s notional profits, the Fairfield
Greenwich Group “reaped massive fees, in excess of
hundreds of millions of dollars, purportedly for investment
performance which has proven to be nothing but fiction.”
The Wall Street Journal, which reviewed Fairfield Greenwich’s
own records, reported that the firm earned $160 million
in the fees it garnered from the money it outsourced to
Madoff in 2007 alone. Before the Ponzi scheme collapsed
in 2008, the trustee alleges that Fairfield Greenwich, and
the entities under its control, withdrew more than $3.5
billion from Madoff. Presumably part of those redemptions
included its own fees. Fairfield Greenwich denies it engaged
in any wrongdoing and insists that it informed its investors
of its relation to Madoff.
But some feeder funds failed to disclose their cozy relationship
with Madoff, according to complaints filed by authorities
in New York, Massachusetts, and Connecticut.
Consider, for example, the charges files against the entities
of investment guru Ezra Merkin, who sits on the board of
and invests for a number of universities and charities.
Merkin’s three funds had (at least on paper) some
$2.4 billion invested with Madoff, according to the 54-page
civil complaint filed by New York State Attorney General
Andrew Coumo.
Cuomo alleges that Merkin collected hundreds of millions
of dollars of performance and net asset fees based on the
fictional transactions of Madoff while he “actively
obscured” that Madoff, not he, was managing money.
Merkin’s three funds, called Ascot, Ariel, and Gabriel,
all had money with Madoff. Ascot was purely a feeder fund
for Madoff, whereas Gabriel and Ariel, which were supposed
to perform complex arbitrages on distressed debt, divided
their money between Madoff and two other money managers.
“The incentive fee Merkin collected included 20 percent
of the profits reported by Madoff, which, of course, were
fictitious,” the complaint notes. “Even after
subtracting expenses and fees paid to other outside managers,
Merkin’s fees for Ariel and Gabriel totaled more than
$280 million.”
Meanwhile, Ascot produced an additional $169 million in
net asset fees. And, according to the complaint, these fees
were paid directly to Merkin, who did not reinvest them
with Madoff via the feeder fund. While collecting these
fees, Cuomo alleges, “Merkin’s deceit, recklessness,
and breaches of fiduciary duty have resulted in the loss
of approximately $2.4 billion” to his investors.
Merkin denies any wrongdoing. In the court papers filed
on July 1, 2009, he asserts that his dealings with Madoff
were known to his investors and there was no deceit or breach
of his duty. Perhaps so, but if Cuomo’s assessment
of Merkin’s financial records is accurate, Merkin
raked in nearly $450 million in fees by giving Madoff the
lion’s share of his investors’ money.
1. Madoff may have provided even more extraordinary emoluments
to some other of his feeders. Consider, for example, what
the trustee describes as “The Curious Case of Sonja
Kohn.” Kohn met Madoff in the mid-1980s, when she
had her own brokerage company in New York. She then founded
the Bank Medici AG in Vienna and used it as a feeder fund
for Madoff.
Raising money from the newly rich oligarchs of Russia and
Eastern Europe, she eventually placed (on paper, at least)
an estimated $3.5 billion with Madoff. After the collapse,
the trustee sorted through the records of one of Madoff’s
front companies and found that sizable transfers had been
made to Kohn, even though she did not work for that company.
Next, as The Wall Street Journal reported, prosecutors in
the U.S., Britain, and Austria launched their own investigations
of alleged payments she received from Madoff. According
to the affidavit filed by U.S. prosecutors in Vienna, some
$32 million was paid by Madoff over a course of 10 years
to a New York company that was “owned by Sonja Kohn
personally,” while, according to a similar British
affidavit, $11.5 million was paid by Madoff’s London
subsidiary to another company she allegedly controlled.
If such payments were indeed made by Madoff, they provide
an additional inducement for money-raisers to feed Madoff’s
insatiable Ponzi scheme. Kohn states through her spokeswoman
that neither she nor the Bank Medici received any kickbacks
from Madoff and describes herself as “the greatest
Madoff victim.”
Even excluding such alleged side payments, Madoff’s
feeders extracted more than $1 billion in performance and
net asset fees from his phantom profits. While there is
no evidence in any of the litigation that indicates that
any of these feeders were privy to Madoff’s grand
Ponzi scheme, they had intriguing clues that might have
cast their golden goose in a different light, such as Madoff’s
inexplicable generosity in relinquishing his entire performance
fee just to get his hands on their money, his curious practice
of exiting the market entirely at the very end of each quarter
so that his quarterly statements to the feeder funds would
list nothing but Treasury bills and cash, and, even curiouser,
his employment of an unknown two-man accounting firm in
New York's Rockland County—operating out of a 13-by-18
office, no less—to audit all his multibillion-dollar
operations.
Missing such flashing signs that something was amiss while
they harvested their rich bounty of fees may be understandable
on Wall Street but, in my book, it hardly qualifies them
for victimhood
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