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Authors: Harry Markopolos

No One Would Listen: A True Financial Thriller (33 page)

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The bigger problem was that he claimed to be holding T-bills worth roughly $160 million at those year-ends and had no trading positions. The obvious question that should have been asked was: What happened to the rest of those billions? But the auditors had no way of knowing what wasn’t there. If Madoff claimed all his money was in T-bills, there was nothing else for them to look at. I wrote to Neil that “the audits that show only T-bills worth $160 million or so on a $1.47 billion portfolio have me wondering where did the missing $1.31 billion go? There’s more holes in the Madoff portfolio than all the golf courses in Florida. Why is he in T-bills at year-end? Name a broker that he trades thru?”
 
If the auditors had only bothered to conduct a simple examination, they, too, would have discovered that this was a fraud. Instead it appears that they just assumed that one of the most powerful men on Wall Street could be trusted to actually own the $160 million in T-bills he claimed. It would have been simple to check. When you buy a T-bill, there has to be a counterparty selling it to you. There are a limited number of places from which you can buy them. Madoff could have bought them from the Federal Reserve Bank of New York directly or from a primary dealer. He even could have bought them in a secondary market, although most people don’t do that. What the accountants could have done was ask him, “Say, Bernie, who’d you buy these things from?” Bernie would have told them something, and then they could have gone to that party and asked, “Did you sell Bernie Madoff a hundred sixty million dollars’ worth of T-bills? Mind if I take a look at the trade confirmations?”
 
My guess is that the party’s answer would have been “No,” because I doubt that those T-bills ever existed, except on Bernie’s fantasy audits. This raises the question: What good are Big Four accounting firm audits if these accounting firms aren’t checking for fraud? Why pay for an audit if the auditors are not also trained as fraud examiners? What good is a clean audit opinion on a crooked company, anyway? Enron, WorldCom, Global Crossing, Adelphia, HealthSouth, and all the other corporate felons all had clean audit opinions from the most respected accounting firms. Believe me, a lot of the hedge funds of funds had clean audit opinions, and these audits didn’t detect that Madoff was a fraud.
 
There is one other noninnocent explanation for why Fairfield Greenwich Sentry Fund had three different auditors in three different countries for three consecutive year-ends. Accountants have something called accountant-client privilege, and some states recognize it but usually in a much more limited sense than attorney-client privilege. Shockingly, especially in a profession like accounting where you would at least hope that they held fast to some sort of code of conduct, you’d think that once external auditors discovered accounting fraud they’d immediately go to law enforcement and report it. But you’d be wrong. Instead what most accounting firms do in these situations is “make a noisy withdrawal” by resigning the account but telling nobody why they resigned and, in effect, firing their client. Board members, law enforcement, and investors are supposed to be able to immediately know that whenever accountants resign, the reasons for it are serious and should be delved into. This may or may not be the case with Fairfield Greenwich Sentry’s use of three different auditors, but if it was the case, that says all you need to know about accounting firms and professional ethics. One would hope that this profession would require its members to report criminal activity upon discovery.
 
Lots of large banks, particularly European banks, ended up in bed with Bernie Madoff—which should give all investors pause when trusting any financial institution with their hard-earned money. In finance, 90 percent of the skullduggery takes place beneath the surface.
 
One thing that galls me about the hedge fund of fund business is how many of these charlatans claimed to be using large, prestigious banks as their custodians to keep control of the securities in investors’ accounts. Yet, somehow, Madoff and these HFOFs were able to subvert even this commonsense safeguard. Investors may have wired their money to prestigious Custody Bank A but unbeknownst to them, this bank then wired the money straight to Bernie Madoff who, acting as sub-custodian, “self-custodied” the assets himself and then stole every dime. Obviously these large custody banks “rented” their “good names” to these HFOF charlatans but unfortunately investors didn’t realize they were being hoodwinked.
 
Third party plan administrators who are charged with record keeping and performance accounting were also fooled by Bernie Madoff—or were they? HFOFs like to brag about their use of these so-called third party plan administrators as an additional investor safeguard, but do they really offer investors an impervious shield against fraud? Definitely not! If a third party plan administrator does come across fraud, he’ll likely just resign the account and remain silent.
 
The other thing you should know about these third party plan administrators is that they are supposed to be providing independent valuations of the securities held in your account, but all too often they don’t have a clue how to value complex securities. Instead, the hedge fund manager ends up telling the plan administrator how to value the securities. In other words, these plan administrators aren’t nearly as independent as they would have you believe.
 
Personally, I wouldn’t want any third party plan administrator hired on my behalf
unless
they had a policy of mandatory fraud reporting to the authorities as soon as they spotted something amiss. Otherwise, I don’t see how a Big Four accounting firm, custody bank, or third party plan administrator offers me any value whatsoever. My view is that if you hold yourself up as a professional you have to uphold a sense of ethical duty to your clients.
 
Another glaring shortfall is in the sad state of HFOF due diligence. For the most part, these fund of funds are nothing more than marketing machines that pretend to conduct exhaustive due diligence. If you don’t believe me, ask what their budget for due diligence is this year in both dollar terms and as a percent of revenue. If they can’t give you an immediate answer, then they aren’t even taking the time to measure what is supposed to be their most important function—preserving your capital! My observation is that most fund of funds spend a lot more effort on their marketing than on their due diligence which, of course, doesn’t help their investors very much.
 
A well run HFOF can provide a diversified portfolio and generate attractive returns for their investors. While too many HFOFs got caught up in the Madoff Ponzi scheme, I applaud those organizations that did their homework and helped their investors avoid this disaster. In the United States, almost 11 percent of the HFOFs had Madoff—so 89 percent avoided him. But in Europe, particularly Switzerland, the HFOFs got hit hard. Switzerland had Madoff exposure in almost 29 percent of its HFOFs. On the plus side, most of those HFOFs are no longer operating. The key for investors is to conduct their own due diligence of their HFOF to determine that the people behind it really do know what they’re doing and actually do what they say they’re doing.
 
But as usual where Madoff was concerned, the numbers didn’t work. If he returned 1 percent net a month to his investors and in addition effectively paid the funds 4 percent, he had to gross 16 percent annually. He claimed that six to eight times a year, when his magical black box told him that the moon was in the seventh sun or the bones had fallen in a promising way, or whatever way he supposedly was getting the word, he would sell his T-bills and buy 35 stocks from the S&P 100 and protect them with options. Weeks later when the genie awakened again to tell him the market was going to tank, he would get out with large profits. So he wasn’t continually in the market. And when he wasn’t in the market, his money was in T-bills. That was where his math made no sense: How is he earning those returns when he isn’t in the market? He needed to be buying 16 percent T-bills in a world in which Treasury bills haven’t yielded 16 percent since the early 1980s.
 
Sometimes it seemed like there were more red flags in Madoff’s claims than in the former Soviet Union.
 
But Neil had opened a potentially very valuable link. Neil had given no reasons for this adviser to suspect his interest in Madoff was anything but responsible due diligence. This adviser still believed Neil was seriously interested in investing millions of dollars in Fairfield Greenwich Group (FGG), so he was willing to do whatever was necessary to nail it down. He even offered to set up a conversation for Neil with Amit Vijayvergiya, FGG’s chief risk officer. Neil couldn’t believe it. He immediately sent me an e-mail, wondering what questions he should ask. Even though I was busy with a dozen active cases, I dropped everything and started writing just a few thoughts. And then a few more. Eventually I had three pages of questions, more than 80 of them, although, as I wrote, “Gee, I could write questions all night. Somehow I think they’re not going to answer many of these questions in great detail in order to protect their proprietary trading methodology.”
 
The questions covered all of the red flags we’d been waving for so long: If two stocks with a total portfolio weight of 4 percent drop 50 percent due to company-specific risk (say subprime exposure), how are you protected against a 2 percent portfolio loss? What are your total assets under management? I’m hearing numbers in the $30 billion to $50 billion range.
 
Who are your leading brokers for stocks? How do you guard against front-running? How do you explain your lack of a down month?
 
Who are your traders? Where did they learn how to trade your strategy? Can I sit on your trading desk for a day to get a feel of how you run your operation?
 
What scenario keeps you up at night? What are your strategies’ worst-case scenarios?
 
I was having fun writing them, and I continued writing them even though I knew there was absolutely no hope he would be able to answer many of them. If he was to be honest, his answers would all have to be nothing, zero, we don’t, I don’t know, and (most often) never. How large is your compliance staff? We don’t have one. Who does your trades? We don’t make trades. How do you explain your lack of a down month? We just make up the numbers. What scenarios keep you up at night? Getting exposed. What is the maximum size that your strategy can handle without watering down returns? As much money as you’re willing to hand over to a Ponzi scheme.
 
I was actually very excited about this conversation. In all the years we’d been investigating, other than Mike’s 2001 interview and the few questions we’d asked the former employee of his broker-dealer operation, we’d had very few opportunities to get a really good look inside Madoff. As we later verified, the Fairfield Sentry Fund was his single largest feeder fund. When we’d started our investigation, it had about $3 billion in assets; by this time that had increased to more than $7 billion—and every penny of it had been channeled to him. The fund charged its clients 20 percent of profits and a 1 percent management fee, so on a 16 percent gross return, which is roughly what Madoff supplied, it earned close to $40 million for every billion invested. Considering that Fairfield Sentry had $7 billion with Madoff they were earning approximately $280 million per year in fees to look the other way and not ask the tough questions.
 
So Fairfield Sentry had several million reasons to protect Bernie.
 
As Neil told me later, Vijayvergiya was pleasant but officious. He certainly wasn’t prepared for the barrage of questions Neil asked, and wasn’t able to answer many of them. He began by explaining the relationship between Madoff and Fairfield Sentry. Madoff was registered with the SEC—he didn’t mention he had been forced to register after the 2005 SEC so-called investigation—and his broker-dealer had $640 million in capital. FGG had been investing in Madoff since 1990 and at that point, according to Vijayvergiya, had slightly more than $7 billion with him. “So about how much is he managing overall?” Neil asked.
 
Vijayvergiya admitted he didn’t know, but estimated Madoff had a total of $14 billion under management with a dozen people. The head of risk management didn’t know how much money the man who was handling $7 billion for them was managing? Neil took a deep breath—that was astonishing. Within five minutes, he told me, “I was thinking this whole thing was a joke, an absolute joke. He couldn’t have been serious.”
 
It wasn’t a joke; it was a tragedy. When Neil started asking specific questions, it got worse. Neil asked who took the other side of all the trades Bernie was making. Amit replied that for large trades Bernie got quotes from three or four big brokers and took the best one, then instantly got filled on the option side.
 
Neil was sitting at his desk in Tacoma shaking his head in disbelief. One of the first things I’d taught him was to be very careful about approaching multiple buyers for a quote on the same trade, because there was nothing to prevent a buyer who didn’t get the trade from front-running—buying or selling before I could make my deal, knowing that my deal was going to move the market. It’s illegal, but it’s absurd to believe that someone with this information isn’t going to take advantage of it. It’s part of the reality of the marketplace.
 
Neil pushed Amit on this, asking repeatedly who was taking the other side of these deals, because these large deals Madoff supposedly was making didn’t seem to be showing up anywhere. “If they’re off-loading it,” Neil said, “the easiest way of doing it would be to go into the S&P or the OEX pit, and how come no one’s ever been able to find a trace of any of these trades in the market?”
BOOK: No One Would Listen: A True Financial Thriller
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