Madoff's well-treated "feeder funds" suspected shady trades but backed off
By John Helyar, Katherine Burton and Vernon Silver
Bloomberg News
Sunday, February 1, 2009
For Swiss banker Werner Wolfer, the memory of his first encounter with one of Bernard Madoff's emissaries nine years ago is as clear as the waters of Lake Geneva.
To hear Patrick Littaye talk, the Wall Street money manager could walk on those waters. "It was like a religion," Wolfer says of the promise of steady returns, which would be echoed by other acolytes. "These people firmly believed in the story."
Littaye was co-founder of New York-based Access International Advisors, one of more than a dozen feeder funds that acted as middlemen between investors and Madoff. Wolfer visited Littaye at his office near the Champs Elysees in Paris in 2000, after becoming chief investment officer at Banque Marcuard Cook in Geneva, to learn more about how Madoff made his money.
Banque Marcuard, a private bank catering to the wealthy and now part of Swiss lender St. Galler Kantonalbank, had invested about $50 million of its clients' money directly with Madoff in the mid-1990s on Littaye's recommendation.
Banque Marcuard made money with Madoff along with its clients. They paid fees based on the profits Madoff reported, which averaged 11% a year. There was never a losing year, regardless of whether markets went up or down. The proof was in the trading statements sent to clients every month.
"It all looked so good," says Wolfer, who has a master's degree in economics from the University of St. Gallen.
The truth turned out to be something else — and far more complex than a criminal masterminding a $50 billion Ponzi scheme that bilked investors from Palm Beach to Paris, as Madoff allegedly confessed to doing Dec. 11.
If the 70-year-old money manager was running a con, then his marketers like Access International, wittingly or not, were part of the scam.
The purported mission of such feeder funds was to vet hedge funds for wealthy clients. Instead, the line between victim and perpetrator was blurred. Middlemen like Littaye funneled billions of dollars to Madoff, even when they suspected he was engaged in questionable trading practices. In return, they reaped hundreds of millions of dollars in client fees.
Wolfer says he heard of traders trying to replicate the split-strike conversion strategy Madoff told investors he used — buying shares of large U.S. companies and entering into options contracts to limit the risk — and getting far lower returns. He also says he heard Littaye and other middlemen talk about how Madoff may have used the knowledge he gained from his market-making firm, New York-based Bernard L. Madoff Investment Securities, to get in and out of stocks ahead of market swings.
That's front-running, a term usually applied to brokers' trading for their own account — and profit — ahead of clients.
It's also applicable to Madoff's purported practice, says Peter Henning, a law professor at Wayne State University in Detroit and a former federal prosecutor.
"Front-running isn't who's getting the benefit; it's who's paying the price," says Henning, noting that Madoff's market-making customers expected the firm to obtain the best price available when buying or selling stocks. Instead, their interests were apparently subordinated to those of Madoff's investment clients.
Front-running
While front-running is illegal, it didn't horrify Madoff's champions.
"They were convinced that the risk was only that the Securities and Exchange Commission would do something about breaches of the Chinese wall in the Madoff organization," Wolfer says. In the worst case, he says, "What could be expected was that at a certain point the SEC could say stop."
Wolfer, who says he doesn't speak for his former employer, now manages a fund of funds at Geneva-based Banque SCS Alliance, which invested in another Madoff feeder fund, Fairfield Sentry. He says he handled the risk that Madoff might be front-running by sharing this suspicion with clients who put money into the fund.
"With every year passing, the worries were a little bit less," Wolfer says.
Other money managers made similar winks and nods about Madoff's advantage, according to people who were pitched the funds. One Swiss bank, Geneva-based Union Bancaire Privee, which had $700 million invested with Madoff, told clients in a Dec. 17, 2008, letter that "in essence, the perceived edge was Madoff's ability to gather and process market-order-flow information to time the implementation of the split-strike option strategy."
A spokesman for Union Bancaire Privee says it didn't believe Madoff was engaged in any fraudulent activity. Littaye, who now runs Access by himself and has not been charged with any wrongdoing, says he lost his own savings. His fund had more than $2 billion invested in Madoff.
"I'm ashamed of my foolishness," he says.
Nouveau poor
The alleged crime couldn't have been pulled off without the participation of dozens of enablers. It was a Ponzi scheme built on the respectability of others.
The SEC received complaints about Madoff dating back at least to 1999, including an allegation that he was running a Ponzi scheme, and never uncovered a fraud.
"Where were the watchers?" asks Sally Kimball, who runs a Palm Beach consignment shop piled high with garments of the nouveau poor — among them residents of the Florida resort community who invested their fortunes with Madoff and are now liquidating their closets. "Where were the lawyers and accountants and regulators?"
Fiduciary duty stood no chance against the profit motive. "It was a whole economy unto itself," says Craig Stein, a Boca Raton, Fla., lawyer who represents two Madoff victims. "There were people all along the line taking a cut of the money going to Madoff."
The most important middlemen were the feeder funds that enabled Madoff to evolve from a retail asset manager running money for individual clients to a wholesaler managing large pools of capital. At the end, seven of Madoff's top feeders had a combined $25 billion in assets with him, led by Fairfield Greenwich Group's $7.5 billion.
Royal feeders
The feeders were the gatekeepers, and they qualified for royal treatment. A money manager for a family office recalls accompanying Sonja Kohn, whose Vienna-based Bank Medici funneled $3.2 billion to Madoff, to a meeting with Madoff in New York in 1991.
He says Madoff treated her as if she were the Queen of England. The money manager also says Madoff wouldn't answer any questions about his strategy.
A delegation from Credit Suisse Group, led by Oswald Gruebel, then head of private banking, had a similar experience in 2000. Gruebel, whose bank had about $500 million invested in Madoff funds at the time, wanted to know why the firm had an obscure auditor, why Madoff didn't have a third-party custodian hold his clients' assets and how much money he was running.
After the fifth or sixth query, people who were at the meeting say, Madoff ended the session.
"You guys, if you are not happy with the returns you are getting," he said, "you can take your money."
Gruebel, 65, who retired as chief executive officer of Credit Suisse in 2007, urged clients to withdraw from Madoff's funds, according to three people familiar with the matter.
Only about half of the money was taken out, the people say, indicating that many clients preferred Madoff's returns to Gruebel's advice.
That's why it's hard to weep for some of Madoff's victims, says James Walsh, author of "You Can't Cheat an Honest Man" (Silver Lake, 1998), a study of Ponzi-scheme perpetrators and victims.
"We've become a nation of investors, but nobody wants to do the work of applying Benjamin Graham's analysis tools," Walsh says, referring to the father of value investing. "They want a genius to give them a shortcut. That's what made it a target-rich environment for Madoff."
It's the same mind-set that's behind economic bubbles, which are "naturally occurring Ponzi schemes," says Robert Shiller, a professor of economics at Yale University and author of "Irrational Exuberance" (Princeton University Press, 2000). Successive waves of investors generate gains for the last wave until the bubble bursts.
"The essence of a Ponzi scheme is a story that justifies these enthusiasms," Shiller says, whether the phenomenon is Internet stocks or housing prices or Madoff. "The social feedback loop of other people making money causes people to suspend disbelief."
Madoff's story
Madoff certainly had a good story. A graduate of Hofstra College in Hempstead, N.Y., he pooled $5,000 saved from working summers as a lifeguard to start a brokerage firm in 1960.
One of his first backers was philanthropist Carl Shapiro, founder of clothing maker Kay Windsor and an early Madoff investor, who told the Palm Beach Daily News on Dec. 16 that he gave Madoff, 22 at the time, $100,000 to invest.
Shapiro was frustrated as an investor. The stock exchanges were swamped by paperwork then, and orders could take three weeks to execute.
"This kid stood in front of me and said, 'I can do it in three days,' "Shapiro told the newspaper. "And he did."
By the early 1990s, Madoff had established himself as an early adopter of electronic trading and a leading market maker on Wall Street. He served for three years as chairman of the Nasdaq Stock Market.
And he started acquiring the trappings of wealth: houses in Palm Beach and Montauk, on Long Island; apartments on the Upper East Side of Manhattan and the French Riviera; and a 55-foot Rybovich sport-fishing yacht called Bull.
Investors were clamoring to get into his fund. Those who did spread the word.
While many who made fortunes off the bull markets of the 1980s and '90s courted media attention, Madoff shunned the limelight. He so avoided attention that, until news of the Ponzi scheme broke, his name hadn't appeared in the Palm Beach Daily News, which chronicles society life, in at least eight years.
Instead, his investment business was built on personal contacts in the right crowds, notably Jewish country clubs and charity circles. He preferred to delegate interfacing with prospects and clients to others.
Often, Madoff's lieutenants would make potential investors cool their heels, according to people familiar with the operation. Supplicants were told they didn't have enough money or that Madoff's fund was closed. That only augmented his appeal.
"He knew how to play on scarcity," says Robert Cialdini, a professor of psychology at Arizona State University and author of a book on the subject of influence. "Madoff communicated the exclusivity of membership in his club. You had to be invited in. If you weren't, you would lose the returns. That overwhelmed any caution people might normally have felt."
Where money went
The feeder funds became Madoff's ad hoc sales force. The payoff was the steady flow of fees. Every billion dollars invested in Madoff generated $150 million in paper profits a year for clients, based on a 15 percent return.
If a fund charged its clients 1 percent of the assets under management and 20 percent of the gains, as the largest one did, that translated into $41 million in annual fees.
Assuming Madoff didn't do any investing on behalf of his clients, the feeder funds were being paid out of principal, which would have been depleted after 15 years.
In other words, much of the money invested in Madoff through feeder funds wound up in the pockets of fund managers.
Madoff's sweet business model — if it ever was his business model — started to sour in 1996.
That's when the U.S. Justice Department forced market makers to change their pricing structure to settle an antitrust suit that alleged they were colluding with brokers to inflate investors' trading costs and thus their own profits. The settlement narrowed trading spreads.
Profit margins were shaved again in 2000, when stock exchanges shifted from calibrating shares by fractions to decimals. Before decimalization, stock prices moved in increments of 1/16th of a dollar, or about 6 cents.
After, they traded in penny increments, meaning the ability to make money on the spread between the bid and the ask price was diminished. According to New York Stock Exchange data, net profit for all exchange specialists dropped to $166 million in 2005 from $708 million in 2000.
Madoff's stature in that business also declined. The firm described itself in a 1999 news release as a "leading market maker" in more than 200 Nasdaq stocks. In 2005, it was handling just 0.5 percent of Nasdaq trading volume, according to exchange records.
Madoff suggested, during an October 2007 round-table discussion at the Philoctetes Center for the Multidisciplinary Study of the Imagination in New York, that he had gone into proprietary trading.
"Today, the big money on Wall Street is made by taking risks, and firms were driven into that business, including us," he said. "If you couldn't make money charging commissions, people said, 'I might as well risk my own capital and trade.' "
If Madoff was trading the firm's own money, that doesn't explain what he was doing with his clients' assets. Investigators at the Financial Industry Regulatory Authority say they have been unable to find evidence that Madoff made any trades through his brokerage with funds he had raised as an investment adviser.
"Our examinations showed no evidence of the Madoff broker-dealer executing trades for the investment adviser or any customer account statements being issued by the broker-dealer," says Herb Perone, a spokesman for the regulatory group.
Roots of Ponzi scheme
Just when the alleged Ponzi scheme began remains a mystery. Harry Markopolos, a former money manager based in Boston, started complaining to the SEC in 2000 that Madoff was either front-running his clients' money or operating a Ponzi scheme.
In a 19-page document sent to the SEC in November 2005, he argued that it was impossible for Madoff's firm to collect as much money as it did from feeder funds and still execute his stated split-strike strategy.
SEC investigators focused on the front-running theory and, after encountering obstacles, didn't finish verifying trades Madoff claimed were for the clients of his advisory business, a person familiar with the case said in December. The investigation ended there.
No exit strategy
Whenever the alleged scheme began, there was no exit strategy for the man behind the curtain. In December, Madoff told one of his two sons that he was struggling to meet redemption requests from clients for about $7 billion, according to a U.S. attorney's complaint.
Not even a $250 million investment on Dec. 1 by Shapiro could help. On Dec. 9, Madoff confessed to his sons, Andrew and Mark, both of whom worked at Madoff Investment Securities, that his business was "a giant Ponzi scheme" and that losses could exceed $50 billion, said Martin Flumenbaum, an attorney for the sons, who have not been charged.
Two days later, Madoff was arrested.
Madoff's recruiters say they were duped. Shapiro, who faces losses of $545 million, says through spokesman Elliot Sloane that he felt "betrayed."
Investigators say it could take months to figure out what happened. For Madoff's enablers and victims, that means the fight to assign blame — and to distribute what few assets remain — could drag on even longer. |
