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. ”
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