Four Years Later

“GetInvolved Nonprofit Guide” Article for November 2012 from Cover & Rossiter, P.A.

By Pete Kennedy, CPA, CVA – Director at Cover & Rossiter, P.A.

It’s hard to believe that only four years ago, few people outside of Wall Street insiders would have known of Bernard Madoff.  Today the Madoff name has entered the lexicon as being synonymous with fraud and greed in the same way Hitler is synonymous with evil.  The announcement of the massive fraud scheme in mid-December 2008 sent many endowment holders racing to their phones with the burning question, “Did we own any Madoff investments?”  So what has happened in the ensuing four years?  What are the lessons that can be learned from this debacle?

What really happened?

The question in the immediate aftermath of the discovery was, “where did all the money go?”  The total of all Madoff accounts was listed at $65 billion, but in reality the bulk of it was never there to begin with.  The total on a “cash in / cash out” basis has been estimated at $17.3 billion.  While Madoff assuredly took some of that for personal use, as is the case with all Ponzi schemes, the vast majority of the money was used to payout earlier investors.  As Warren Buffett famously noted, “You can’t tell who’s not wearing a swimsuit until the tide goes out.”  When the housing bubble began to deflate earlier in 2008, Madoff account holders began redeeming their shares until there was nothing left to pay them with.

Once the scheme was discovered, an army of lawyers began sorting through the records to try to determine what money or assets remained, how they should be apportioned, and if funds could or should be recovered (“clawed back”) from those who redeemed more cash than originally invested.

The Madoff investors received a major windfall when the estate of Jeffry Picower acceded to the demands of the bankruptcy trustee and signed over $7.2 billion, which make up the bulk of the amounts recovered to date.  Mr. Picower had reportedly invested $700 million and withdrawn more than $7 billion over the years.  Through other legal action and recoveries from Madoff’s assets, the trustee has amassed $9.2 billion and has begun making distributions to investors who invested more than they withdrew.  While the jury is still out on the final recovery, it is likely that between SIPC claims, clawback recoveries and other lawsuit proceeds, those who were cash negative on their Madoff investments will recoup $0.70 on the dollar.  Facebook IPO investors are jealous.

Lessons Learned

If something sounds too good to be true …yeah, yeah, yeah, we’ve all heard that before.  Beyond the obvious, there have been some other tidbits.

There is an interesting dichotomy between folks who invested directly with Madoff and those who invested in one of the so called “feeder funds.” These were offshore funds that did nothing but funnel massive amounts of money to Madoff.  The total of these funds was (on paper) roughly $10 billion of the (paper) $65 billion.  In spite of that, there are more than 4 claimants through the feeder funds for every direct claimant.  While the loss is no less real for the feeder fund investors, the outlook for recovery is considerably poorer.

From the US Madoff Trustee’s perspective, the feeder funds are each an investor in and of themselves and so the net loss (cash in / cash out) is a small fraction of the $10 billion.  The signed agreements between the US Trustee and the Feeder Fund Trustee basically left the feeder funds on their own to pursue legal action against its investors who were cash positive and other service providers. The feeder fund investors will not benefit significantly from the Picower and other settlements in the US.  Further, the feeder fund litigation is not going well. In a marked departure from the US legal action, the British Virgin Islands courts have held that the feeder funds may not pursue clawbacks against its investors (being appealed).  I guess that would be good news for those that stood to be “clawees,” but not so good for those who were cash negative. Also, numerous lawsuits by individual investors against the auditors of the funds (PricewaterhouseCoopers’ Canadian and Netherlands offices) have been unsuccessful in recovering any substantial amounts. I’m glad I don’t have to argue for PwC that the audits were adequate or that no investors should have been relying on them (I’m certain that many were) – PwC must have some pretty sharp lawyers.  The feeder fund lawsuits against PwC with similar claims are now winding their way through the BVI court system with the investors hoping for a different outcome.

In the end, if the purpose for moving a fund to an offshore domicile is to avoid the “red tape” (read controls) of the US regulatory system, it should come as no surprise that the rules are different there when “the tide goes out.”

Another one of the big losers in the Madoff scandal was Yeshiva University.  The university’s Chairman of the Investment Committee was J. Ezra Merkin, a buddy of Madoff’s and a noted hedge fund manager who had full authority to make investment decisions – and his decisions were often to steer the university’s endowment monies to his own hedge funds. Sadly, Merkin’s three hedge funds were nothing more than Madoff feeder funds with the main difference being that Merkin was taking a 1.5% fee off the top.  The paper value of $112 million evaporated overnight.  It is estimated that Merkin had paid himself over $10 million based on these investments.  The conflicts of interest here are numerous and blatant.  Sad to say, the university had no conflict of interest policy in place – their 6/30/2011 Form 990 indicates that they have one now.

If your organization has questions regarding conflict of interest policies or controls, please contact Pete Kennedy, or any other member of our Nonprofit Practice team, at Cover & Rossiter at (302) 656-6632.

Cover & Rossiter, P.A. is one of the most respected and experienced CPA firms serving the accounting, tax and audit needs of the nonprofit community in Delaware. 


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