Wall Street Confidential

Madoff's Secret Service

June 13,2009

by Edward Jay Epstein

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, then 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 then 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 asset fee on the profits that Madoff would generate each year. Madoff’s 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 outsource 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 based. 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, and certainly the hapless investors in these feeder funds, some not even knowing that their in nest eggs had been outsorrced to Madoff's money machine. qualify as the prime victims. As civil law suits brought by bankruptcy trustee Picard 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. ”