From the July 01, 2009 issue of Futures Magazine • Subscribe!

Investment fraud: Doing your due diligence

Bernard Madoff created a pyramid scheme so massive that he may ultimately usurp the name Ponzi. Madoff’s enterprise had two essential requirements: first, an ever increasing flow of fresh investor money; and second, clients willing to trust him (or the entities he controlled) with their investments without asking too many questions. His success relied on a suspension of disbelief and leads to two seminal questions that investors must answer before letting anyone manage their money: “Does it seem too good to be true?” (the correct answer to which would have ended the Madoff episode much earlier) and, “Do you know where your children are?” a question that is harder to answer, even for sophisticated investors. The usefulness of the answer is a function not simply of the detail or frequency of the reports from your investment advisor, but also of the independence of those who create the reports.


This question has two parts: first, are the manager’s returns too high and/or too steady for the stated strategy?

Within the investment world there are strategies and there are managers who execute them. There are differences, of course, between skilled and unskilled execution (typically called manager “alpha”), but such alpha is relatively small when compared with the absolute return of any underlying strategy.

A given manager’s alpha tends to be fairly consistent over the long term, for it is more a function of alertness and the crispness of execution than of some underlying theoretical superiority. Thus, investors are investing in a strategy first, and in a manager second. This fact is too easily forgotten by investors who pride themselves on gaining access to an exclusive investment club.

Madoff’s firm claimed to utilize a strategy it called a “split-strike conversion,” a fancy name for a simple option “collar” (long a stock, short an out-of-the-money call and long an out-of-the-money put). Many managers have employed this technique, but none of them has had the consistency of returns reported by Madoff. He was never willing or able to give any remotely credible explanation for this. A good manager can outperform his peer group, but returns will inevitably fluctuate in a direction and to an extent which is consistent with the performance of those peers.

The second part of the question is, are the manager’s terms too good and the fees too low to be true?

Madoff’s returns were so “good” that they were almost bankable, and were indeed the subject of some bank loans. Anyone who had so good a strategy would in all likelihood have exercised it on his own behalf and not for third- party investors. That Madoff did so and did so in return solely for low commissions is on its face not credible. At the very least, an enterprise with a multifaceted, multiple-moving-parts strategy with high and consistent returns will ask for the traditional “2% management plus 20% of performance” stipend. Such fees may well lead to fewer investors and/or more scrutiny, but most strategies would have market-derived size limitations, and competent managers may welcome some such limitations.


The main reason Madoff’s scheme worked as well for him as it did was his investors’ willingness to blindly entrust their money to an opaque enterprise. Transparency is the enemy of investment fraud.

Although Bernard Madoff Investment Securities (BMIS) had a few large direct investors, its primary function was to act as the investment manager for a number of independent funds, such as Fairfield Sentry Ltd. We call these last “solicitor-managed” funds, not “feeder funds,” for the latter term does not fully describe them (see “Master-feeder structure”).

The three most important safety measures an investor should require from any fund — feeder, master, or solicitor-managed — are to have:

• an independent fund administrator who keeps track of each investor’s accounts and must authorize the funds’ banks to make payments either to the investors or to third-party service providers

• a large and reputable independent auditor who reviews the funds’ activities and balance sheets at least once a year

• independent directors whose concurrence is needed for major decisions, including any change in the identity of or the agreements with the funds’ independent fund administrator, auditor, clearing broker, or bank(s)

The following sections compare how BMIS handled and reported on its investors’ accounts compared with how responsible managers handle their investors’ money.


BMIS: BMIS’ clients did not invest in Madoff’s funds, nor indeed were there any such things. Rather, BMIS was an independent broker/dealer that managed discretionary accounts listed on its own books, generally in the names of the funds’ solicitors or of solicitor-managed funds that had opened such accounts with Madoff and had given Madoff full authority over the funds. These solicitor firms received subscription money from the ultimate clients in their own bank and thereafter deposited that money to BMIS’ account at BMIS’ bank.

Safe Manager: Investors in safe funds typically have their money deposited directly to an account held in the name of the fund in which they are investing. Such funds enter into agreements with a fund administrator that is independent of the ownership of the investment manager, in accord with which this administrator provides the fund’s administrative, accounting, registrar and transfer services and is the sole signatory for all transfers or payments from the account.


BMIS: Madoff had not, it turned out, actually executed any trades for the last 13 years, but had he done so, such trades would have been both executed and cleared through his own broker/dealer, BMIS, and all of the clients’ money would have been held and administered within the Madoff organization. Once BMIS opened a brokerage account (which it did almost exclusively for the solicitor-managed funds which — for a fee, and a high one at that — gathered investors for it and purported to monitor its legitimacy and performance), BMIS generated (or fabricated) every piece of information about the status of the alleged trades and accounts and had full and unsupervised discretion over the deployment of money. It is irrelevant to know whether or not there were agreements in place between BMIS and any other parties, for such agreements would have left all assets within BMIS’ control.

Safe Fund: When the feeder fund’s bank account receives money from an investor, it notifies the independent fund administrator which then notifies the investment manager that the money is available for investment purposes. The investment manager and administrator then authorize the feeder fund’s bank to wire money to the master fund’s bank account, which then transfers some of that money to the master fund’s collateral account and the rest to its clearing broker’s customer segregated margin account. (The funds should not be held in the feeder fund or master fund’s bank account for a moment longer than necessary, as these accounts — unlike the collateral and the clearing broker accounts — are not secure against the banks’ failure.)

In an unleveraged fund, the collateral account typically receives the majority of the original investment, and the remainder is sent to the clearing broker’s segregated customer margin account. It uses this money as the initial and daily variation margin support for the master fund’s futures trades. How this money is divided depends on the margin requirements of the exchanges on which the master fund executes its trades.

Additionally, depending on market volatility, there are variation margin transfers between the master fund’s collateral account and the clearing broker’s segregated customer margin account.


BMIS: One of the Madoff firm’s many effective boasts was that it had a long history of honoring redemption requests quickly. When money was flowing in, this was a relatively inexpensive marketing technique and served to enhance Madoff’s reputation. Because BMIS had complete discretion over client accounts, as long as there was enough money in the totality of the accounts, there was no impediment to executing the requests or, more important, to misdirecting the money.

Safe Manager: The only times that the independent fund administrator should authorize the master or feeder fund’s bank to move money to an account that is not either the feeder or master fund’s bank account, the master fund’s collateral account, or the clearing broker’s segregated customer margin account, are:

• To return to the investor who seeks to redeem some or all of his ownership in the feeder fund; to do this, the investor sends his redemption request directly to the independent fund administrator and it authorizes the feeder fund’s bank to transfer to the investor’s bank account the amount that it calculates that the investor is due, or

• To pay bills rendered by specific identified third-party service providers of the funds for such contractually specified services as administration, accounting, auditing, and legal services. All such payments must be based on support documents and authorized both by the investment manager and the independent fund administrator.


BMIS: Many of Madoff’s solicitor-managed funds were audited by large and reputable firms, but these auditors did not (as they could have if they had had standing to do so) also audit the BMIS accounts. As a fully autonomous body, BMIS administered and custodied all client money and was able to generate bogus statements and otherwise fabricate a plausible paper trail. It remains to be determined whether the solicitor-managed funds or the firms that audited them will or should be held accountable for not digging deeper.

In addition to falsifying paperwork, BMIS appointed family members to all of its key oversight positions, including, for example, naming Madoff’s brother, Peter, as its chief compliance officer. It also identified a little-known, two-person accounting firm as its auditor, even though there has not to the present been any record of audits ever occurring.

Safe Manager: The administration agreement between the feeder and master funds and an independent fund administrator provides that the latter continuously receives independent notification directly from the clearing broker and banks of all trades and transfers made by and for the master and feeder fund. As a result the independent fund administrator knows at all times just how much the funds and the individual account’s value has changed. Using this information, it independently calculates at least monthly the net asset value (NAV) of each fund and of each investors’ ownership interest in it and sends these to each investor. The independent fund administrator obtains all of the information it uses to calculate such an NAV directly from the responsible parties, (i.e., not from the investment manager, but rather from the funds’ bank(s) or clearing broker(s)).

The fund administrator should use its own independently calculated NAV to confirm that no unauthorized transfers have occurred. It does so by merging trading profits or losses and the account balance information it has with its records of each investor’s subscription and redemption activity. If there is any discrepancy between the calculated and actual value, the fund administrator must contact the investment manager for an explanation and, if it does not receive one, decline to issue a monthly NAV report to investors. In addition, it must notify the funds’ independent directors of its unwillingness to issue its usual monthly statements. (We assume that — even though it is not currently required by law — any safe fund would have directors who are independent of the investment manager.) Such directors would inevitably be vigilant to a contact by the independent fund administrator: their failure to act in such circumstances, (i.e., to notify fund investors and perhaps even relevant regulatory bodies), may well make them personally liable for any incurred losses.

Investors should not, however, rely solely on the fund’s independent directors, but must take responsibility for continuously receiving monthly NAV reports directly from the fund administrator to ensure that the fund continues to employ an independent fund administrator and that this administrator has found the NAV to be consistent with the actual account value. Investors should also confirm that the fund subscription documents stipulate that the funds’ investment advisor cannot fire or change the funds’ administrator or auditor, or alter any of the governing agreements without the prior approval of the funds’ independent directors.

In addition to mailing NAV reports directly to investors, many independent fund administrators make it possible for investors to access their account information online. Lastly, the funds’ books and records should be audited at the end of each calendar year by an independent auditing firm, and each investor should receive a copy of any fund’s audited annual financial statements within six months of the close of the fund’s fiscal year.


The management and control efforts described above may seem tedious but are surely not as tedious as chasing lost money. Equally important, once the initial due diligence is completed, they require only a few monthly or annual checks. It is thus doubly puzzling that so many sophisticated investors were taken in by a scheme that seems to have violated so many basic truths about investing. The secret may be that Bernard Madoff, like every great magician, was able to conjure up in his investors’ minds a world in which the everyday rules do not apply. His victims substituted a façade of trustworthiness for a system of checks and balances that has evolved to ensure the safety of investor funds. But such safety is never simply a matter of trust, it is a function of structure. Things that are too good to be true usually aren’t true and if you don’t know where your children are, they may well be getting into trouble.

Dr. Henry G. Jarecki is one of the pioneers of commodity futures investing in the United States. He is the founder and chairman of Gresham Investment Management LLC. Jason Ungar is the director of marketing for Gresham Investment Management LLC.

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