The New York Times by Floyd Norris - February 24, 2011
Financial frauds tend to follow predictable paths after they are uncovered. At first, there is outrage and a determination to find and punish the villains. But passions fade and investigations run into ambiguities. Those with the most money to protect — typically accountants or banks whose knowledge of the fraud is at best debatable — fight to avoid legal liability. Government investigators eventually move on to other cases, and victims seeking revenge and compensation conclude that there is little point to spending more money to pursue uncertain suits. Settlements are reached on terms defendants can live with. But the Bernard L. Madoff fraud is proving to be different, and not just because Mr. Madoff ran by far the largest Ponzi scheme ever encountered. This time those pursuing the investigation have no other case to move on to, and no need to worry about costs. They can spend what they want, with the cost ultimately borne by some of the same Wall Street firms they are suing. That spending has risen to levels that would be unthinkable if this were a normal case. Through the end of last year, the trustee appointed by the Securities Investor Protection Corporation had spent $228.3 million — and that does not count the money that has gone to victims. Baker Hostetler, the law firm representing the trustee, received most of the money.
SIPC (pronounced SIP-ick), a Congressionally chartered company that finances itself from assessments levied against brokerage industry revenue, estimates that it will spend a further $1.1 billion on the case. That is equal to the entire annual budget of the Securities and Exchange Commission. That Madoff investigation has produced a lot of information about how Wall Street operated and about the extremely limited influence of those who were looking for signs of fraud. Red flags were seen, but discounted. Surely there were explanations other than fraud, and anyway, there were profits to be made. In one case disclosed this week, the trustee, Irving H. Picard, asserts that some people at Citigroup were suspicious that there might be fraud, but reassured themselves with a different — if equally illegal — explanation for the consistently good returns Mr. Madoff reported. Maybe his legitimate business, which handled a large volume of stock trades, was profiting from front-running customer orders, buying stocks that were about to have big buy orders and then selling them at a profit. It did not hurt that Mr. Madoff’s trading operations were well known on the street, and thought to be highly profitable. Only lately have we learned that those profits ended some years ago.
From 2000 through 2007, the trading business reported profits of $324 million. SIPC, having gone through bank records, says almost exactly twice that was stolen from investors in the Ponzi scheme and diverted to the brokerage business. Citi was not where Mr. Madoff had his banking accounts. That was JPMorgan Chase, which is also being sued by Mr. Picard. If all Citi ever did was run a bank, it would be nowhere near this case. But there were other ways to make money off Mr. Madoff. He generated good, but not great, profits year after year. He never lost much money, even when the market was tanking. So some investors figured they could get fabulous returns by using leverage. That was where several banks, including Citi, came in. They would structure derivative securities that let people get multiples of the profits Mr. Madoff generated — less some very nice fees for the bank, of course. The risk for the banks came in the fact they would have to pay out a lot of money if Mr. Madoff continued to have great results. So they “hedged” their exposure. That is a nice way of saying they invested in hedge funds that served as “feeder” funds for Mr. Madoff. The profits on those investments would offset their exposure. They were taking on no risks, or so they thought. The banks put in terms specifying they had no responsibility for any fraud that might be discovered.
In late 2008, with the credit crisis destroying almost everyone else’s returns, Mr. Madoff kept reporting good profits. Some banks cashed in their stakes — leaving them exposed if the returns were real but producing cash they may have felt was needed at the time. Those transactions strike Mr. Picard as highly suspicious. He has not found any smoking-gun e-mails showing the banks knew Mr. Madoff was a fraud, but he still wants to get the money they took out and distribute it to other investors who lost money in the Ponzi scheme. The trustee has found plenty of evidence that there were people at the banks who had reason to be suspicious, and who at one point or another wrote that the Madoff operation looked fishy. There were ways to check out the suspicions, but no one wanted to needlessly offend Mr. Madoff. One memo cited by the trustee said Citi was looking for someone who “could call Bernie ... without ruffling his feathers.” Why were the banks so oblivious? For some legal purposes, that may not matter. The trustee claims that they knew or should have known Mr. Madoff’s operations were fraudulent, and with hindsight it is hard to argue with that conclusion. But at the time I suspect the power in the banks lay with those who brought in revenue — such as by structuring the Madoff derivatives — and not with those who raised arguments against them. At the same time, the same banks were overriding qualms of those who thought they were making too many risky loans.
Mr. Madoff’s Ponzi scheme collapsed for the reason that all such schemes eventually fail: he could not raise enough new money to cover the withdrawals being made by earlier investors. To the extent the bank withdrawals helped to bring about the collapse, perhaps they do deserve credit, after a fashion, for ending the fraud. SIPC is involved in the case because Mr. Madoff ran his fraud through a registered broker-dealer, and investors were treated as customers of that brokerage firm, which had SIPC insurance that covered up to $500,000 per account in losses. This fraud is costing more than the total of all the other cases SIPC has handled in its 40 years of existence, and has generated a fair degree of controversy. Mr. Picard, backed by the bankruptcy judge, says SIPC insurance covers losses only for investors who put more money into the Ponzi scheme than they took out. Others benefited from the scheme, even though they did not know it, and except for hardship cases he wants them to pay the money back. At the end, Mr. Madoff’s customers had combined fictional positive balances of $73.5 billion. Amazingly enough, Mr. Madoff had allowed some customers to borrow more than $8 billion from the funds at low cost. If he had been running a legitimate operation, that would have made earning good returns for other investors even harder. The investors who borrowed have been forced to repay the loans. One, the estate of Jeffry Picower, a wealthy trader, agreed to a settlement of $7.2 billion. The trustee estimates that investors lost a net $20 billion. It now appears that they might be able to get it all back, particularly if the banks agree to substantial settlements. If that happened, it is possible that the net winners, who were victims of a fraud since they were told they had money that did not exist, might also get some money.
Mr. Picard appears to be a man on a mission. “We believe,” Stephen P. Harbeck, the president of SIPC, told me this week, “that rigorous pursuit of people responsible for brokerage firm failures sends a very important message.” He added that Mr. Picard “has the resources to conduct a serious and intense legal campaign.” Before this happened, SIPC thought it was fully funded, and charged brokerage firms only $150 a year. Now it charges them a quarter percent of net revenue — bringing in more than $400 million a year — and it is likely to keep doing that until it has $2.5 billion on hand. At last report, it had $1.2 billion, slightly more than the amount it expects to spend on the Madoff case in coming years. For now, anyway, major banks and Fred Wilpon, the owner of the New York Mets and a sophisticated investor who managed to take out much more than he invested with Mr. Madoff, are vowing to fight what they view as outrageous suits by Mr. Picard. It will be interesting to see if they stick to that position. If so, the banks could find themselves in the unfortunate position of having to pay for both sets of lawyers — one directly and the other through SIPC assessments — in trials that promise to be both expensive and embarrassing.