The Wizard of Lies: Bernie Madoff and the Death of Trust (26 page)

Madoff conceded that perhaps there were as many as fifteen entities using a trading algorithm he had developed. But they were all foreign investors, and he did not keep custody of the securities for any of them. Sure, he’d give the examiners a list of the entities, no problem. Account statements, too? Sure.

Initially, he said, the model involved trading baskets of blue-chip stocks and hedging them with options. But the model stopped using options about a year ago, Madoff added—no doubt to discourage the examiners from asking for the nonexistent counterparties for these fictional option trades. Frank DiPascali had the faked account statements ready, but not even he could fake options trading records. And, of course, the first phone call to an alleged options counterparty would have blown the whole fraud sky-high. The guy would have said, “I’ve never done OTC options with Madoff,” and it would have been over.

So Madoff acknowledged the hedge fund business but shrugged off its significance, assuring the embarrassed examiners with a trace of condescension that it was all old news to the SEC anyway. They’d cleared up the whole thing back in 2003.

The next day, at about 4:30
PM
, the supervisor in New York sent an e-mail up the chain to Lori Richards’s associate director in Washington, reporting Madoff’s claim that he had already told the SEC about his hedge fund business. “We are hoping that if what he is saying has any truth at all to it that you might have some info related to his hedge fund related activities you could send us,” the e-mail read.

It took some time to find the boxes marked “Madoff” they were stacked in a hallway, heading for the archives. It took a while longer for Ostrow and Lamore in New York to get access to the computer system in Washington where some data files were stored. In telephone conferences, they were told that the earlier exam hadn’t found anything helpful anyway—the staff had never even drafted a closing report on their findings.

Meanwhile, their supervisor was watching the clock. He was satisfied that his team had disproved the front-running allegation. So, at a meeting on June 16, 2005, he told the two examiners that they needed to wrap things up and move on to the next exam. Over the summer, they compiled their report, which would conclude that Madoff was telling the truth when he denied front-running his trading customers to benefit his hedge fund clients.

This was perhaps the only thing he was telling the truth about.

Everybody else in the hedge fund business in the summer of 2005 seemed to be doing fine, but the level of cash in Madoff’s bank account—the JPMorgan Chase account that served as the slush fund for his Ponzi scheme—was starting to drop.

What on earth was happening to the money?

At first there seemed to be a number of possible explanations.

One of Madoff’s biggest feeder funds, Tremont Partners, was in turmoil. Its founder, Sandra Manzke, had announced in April that she was setting off on her own, starting her own fund family called Maxam Capital. She expected some of her clients would leave Tremont and follow her. But there could be some slippage in the process.

Meanwhile, the team at Fairfield Greenwich Group was hit with $175 million in redemptions in April, another $85 million in July, and $30 million in early September. Fairfield Greenwich had hiked its management fees, and some of its clients balked and walked. And the fund’s performance was slipping: Sentry’s returns had been below 7 percent since the previous October. Fairfield Greenwich was discovering that many of Sentry’s investors were simply not willing to accept profits of less than 7 percent a year.

Of course, Madoff was arbitrarily deciding what kind of returns Fairfield Sentry and all the other feeder funds would produce. The only variations were caused by the fees the funds charged their investors. If Fairfield Sentry’s gross returns (before fees) dropped, it was because Madoff had dropped them. Perhaps he was trying to conserve his cash by reducing the profits he was paying. If so, the strategy backfired: he was consuming more of his existing cash to pay redemptions, and since the lower rates made the feeder funds less attractive, less new cash was pouring in.

Even then he might have avoided a real crisis if it hadn’t been for the scandal in the late summer of 2005 that engulfed a collection of hedge funds called the Bayou Group.

The Bayou Group was founded in the mid-1990s by Samuel Israel III, a well-connected trader who worked the hedge fund boom for all it was worth. By 2005, he was living large on the fees from his hugely successful funds, which had assets totaling $411 million—assets that were verified in the independent audits done annually by the small accounting firm of Richmond Fairfield Associates.

On July 27, 2005, not long after one large investor started asking pointed questions about Bayou’s auditor and assets, Sam Israel announced that he was closing the funds. In mid-August the skeptical investor arrived at Bayou’s offices in Connecticut to collect a promised redemption check from the fund’s chief financial officer. The check bounced. When the investor returned to demand an explanation, he found an empty office and what looked like a suicide note in which the CFO confessed that the Bayou Group was a fraud.

The police were called, the CFO was found alive, and on September 1, he and Israel were accused of running a $400 million Ponzi scheme. The fraud had gone on since at least 1998, sustained by the convincing annual audits from Richmond Fairfield Associates, a fictional accounting firm cooked up by the CFO. He and Israel would subsequently plead guilty to federal fraud and conspiracy charges and be sentenced to twenty-year prison terms.

At first, Bernie Madoff may not have paid much attention to the unfolding scandal. His old friend Norman Levy was gravely ill when the crime made headlines. Levy and Madoff had been close for decades, ever since Levy began investing with him in the mid-1970s. Over the years, they had traveled together. Bernie and Ruth toasted Levy’s hospitality and laughed at his garrulous jokes, marveling at the way he continued to squeeze joy out of his steadily diminishing physical strength. By the summer of 2005 his larger-than-life energy had dwindled to almost nothing, but his mind was still sharp. One of his last calls from his deathbed was to say good-bye to his dear friend Bernie. His son would recall that Levy’s last words to his children were: “Bernie Madoff, trust Bernie Madoff.”

Levy died on September 9, 2005, at the age of ninety-three. He had named Madoff as the executor for his financial assets, which included at least $250 million invested with Madoff himself. It was a lot to sort out. And giving him his due, Madoff may have been genuinely grieved by the loss of his old friend, despite the lingering resentment he felt about the withdrawals Levy and his other big clients had made in the late 1980s. For whatever reason, the Bayou collapse did not immediately seem to register with him.

Still, the case triggered a brief spasm of skepticism among hedge fund investors, who started to look more closely at the annual audits and ask more questions about the safety of assets. Moreover, some of the people defrauded in the Bayou scam also had money with Madoff, either directly or through a feeder fund. The skeptical investor who had found the Bayou CFO’s confession had a small stake in one of Ezra Merkin’s funds. The Wilpon family, which owned the New York Mets and had invested with Madoff for years, had had a stake in Bayou through the family’s Sterling Stamos hedge fund. More than a dozen other Madoff investors lost money in the Bayou fraud. If they started looking more closely at their other investments, Madoff was right in their line of sight.

There is clear evidence that the Bayou case sent tremors through parts of the foundation of trust that Madoff had relied on for decades. Some of Fairfield Greenwich’s institutional clients e-mailed the firm after the Bayou scandal to ask explicit questions about Madoff’s auditor and about where their assets were being held for safekeeping. It is likely other feeder funds were getting similar inquiries. In any case, within weeks of the Bayou headlines, Madoff’s cash levels began to drop, despite the healthy growth elsewhere in the business.

Given that Bayou’s tiny auditing firm turned out to be fictional, the fraud focused investor attention on Madoff’s tiny accounting firm, Friehling & Horowitz. When several Fairfield Greenwich partners checked the firm out, they eventually learned it was a one-man operation based in a tiny office park in an almost-rural corner of Rockland County, New York. Its only active CPA was David Friehling, a pleasant middle-aged man who coached his children’s sports teams and served in the local CPA society. Friehling’s partner, Jerry Horowitz, his father-in-law and Saul Alpern’s former colleague, had retired to Florida years ago. Friehling’s only brokerage industry clients were Madoff and Cohmad Securities, the tiny firm that was co-owned by Madoff and shared his suite in the Lipstick Building.

The problem with Madoff’s audit firm, real as it was, was not its size. The problem was that it wasn’t actually auditing Madoff’s firm. David Friehling simply took the information he got from Madoff and turned it into something that looked like an independent annual audit. He knew it was wrong, but he later claimed he never suspected that Madoff was operating a Ponzi scheme. Even though Madoff asked him to cut corners on the audits, Friehling still trusted him. Friehling and his family and many of their friends had most, if not all, of their money with Bernie.

The partners at Fairfield Greenwich never considered Friehling a necessary line of defense against fraud. Their funds were separately audited by one of the world’s largest firms, PricewaterhouseCoopers, not Friehling & Horowitz. Any audits done for the Madoff brokerage firm were Bernie Madoff’s business, not theirs.

They didn’t share what they had learned about the Friehling firm with their concerned investors. Instead, they put out sales material detailing how their firm’s due diligence would have protected investors against a “Bayou-type” fraud. For example, they wrote, “We would question Bayou’s obscure auditing firm.”

What had been a slow drip from Madoff’s slush fund account during the summer of 2005 became a steady leak through the autumn. Between October and the following April, more than $900 million would be withdrawn just from Fairfield Greenwich’s various Madoff accounts—on top of almost $300 million pulled out before the Bayou crisis.

During that period, representatives of various European banks and hedge fund clients insisted on visiting Madoff to review his financial controls—and, although he was running low on cash, he was fully stocked with persuasive documentation and impressive testimonials.

David Friehling was summoned to Madoff’s offices on November 18 for a meeting with the due-diligence team from the Optimal fund family, a Swiss-based hedge fund unit of Banco Santander, the Spanish financial giant, and a popular Madoff feeder fund among Latin American investors. A memo about that meeting reported that Friehling claimed his audits took “250 hours in a year-long process” and that “assets, liabilities, and income are 100% verified.” The team was also told that the audit included “verifying balances with the DTC and other brokers and checking internal statements against customer statements.”

Later such claims would seem preposterous; no one could have actually tried to verify Madoff’s customer accounts with the DTCC clearinghouse without discovering the Ponzi scheme. But the affable Friehling apparently gave some comfort to the Optimal team. “David seemed surprised to hear Madoff Securities described as a secretive organization—he seemed unaware of that reputation and does not encounter any hurdles in his work there,” the memo noted.

At one due-diligence meeting, Frank DiPascali posed as the head of institutional operations and, somehow, got away with it. Federal prosecutors would later assert that Dan Bonventre, Madoff’s longtime director of operations and one of his highest-paid executives, coached DiPascali in the role.

DiPascali’s primary contribution to keeping the fraud alive and concealed during the approaching storm, however, was hidden in the motherboard and circuits of the IBM computer serving his domain on the seventeenth floor. With the right keystroke commands, DiPascali was apparently convinced he could generate computer records elaborate and realistic enough to fool anyone.

The care that DiPascali took to create a convincing computerized environment for Madoff’s fraud was remarkable—the result was worthy of all the high-tech accolades publicly awarded to Madoff’s legitimate brokerage firm. The basic program to generate the mountainous volume of bogus account statements for the Ponzi scheme had been in place since at least 1994. But starting in late 2003, the amount of custom-designed software serving the Ponzi scheme proliferated dramatically. Six separate programs, and the huge data files they manipulated, already were being used to manage, modify, and generate the records that visiting regulators and accountants might require. Four more software programs were in the works in 2005 and would be finished before the end of the year.

There were programs that generated random numbers of share purchases to make the fictional trading records look more plausible. With a few function keys, the fictional trades could be sliced into bits and assigned, pro rata, to customer accounts—after automatically adjusting the prices for the four-cent commission Madoff was supposedly charging. One program changed the identities on a host of account statements in one sweep to make it look as if the securities supposedly in those accounts were being held by a variety of banks and other institutions, not by Madoff. Another program hijacked the monthly DTCC clearinghouse records from the legitimate brokerage firm upstairs and added the Ponzi scheme’s bogus trades to it, producing a scrupulously accurate-looking DTCC report that Madoff could use to verify his fictional stock positions.