How Long Has This Been Going On?


Sixteen years ago the Securities and Exchange Commission cracked down on what was then one of largest ever sales of unregistered securities. Investors handed $440 million to two Florida accountants who promised unbelievable annual returns of 13.5% to 20%. Authorities figured it was just a huge scam, and prepared themselves for a major catastrophe.

Shockingly, however, the money was actually there. Authorities shut down the unregistered securities business despite the money and the profits seeming to be in place because it was operating illegally. The number of investors had grown to 3,200 in nine accounts, and the two accountants had given up their accounting business to run this business full time.

“They took in nearly a half a billion dollars in customer money totally outside the system that we can monitor and regulate,” the SEC’s New York regional director said at the time. “That’s pretty frightening.”

How did the two investors deliver the promised returns? They had help from a powerful New York figure. You see, at the centre of the scam was a mysterious money manager who authorities declined to name because they never charged him with wrong-doing. He claimed he had no idea that the two accountants, Frank J. Avellino and Michael S. Bienes of Fort Lauderdale, were raising money illegally.

That man was Bernie Madoff.

In 1992, the Wall Street Journal revealed the indentity of Madoff in an article that is now stunning in light of revelations that Madoff had long been running a giant Ponzi scheme. It’s simply amazing how much of what now seems obviously a “red flag” about Madoff’s operation was known for decades.

Madoff’s returns have long been too good to be true.
Although he wasn’t delivering stunningly high returns, Madoff’s returns were so steady—regardless of market conditions—that people thought of them almost as a fixed income investment. No one could figure out how Madoff did this year in and year out, and so they were reduced to guessing. Now, apparently, we know the truth: he couldn’t do this, and probably no one could do it. Madoff probably just made up the returns.

From the Journal’s 1992 report:

In an interview, the 54-year-old Mr. Madoff says he didn’t know the money he was managing had been raised illegally. And he insists the returns were really nothing special, given that the Standard & Poor’s 500-stock index generated an average annual return of 16.3% between November 1982 and November 1992. “I would be surprised if anybody thought that matching the S&P over 10 years was anything outstanding,” he says.

In fact, most investors would have been delighted to be promised such returns in advance, as the accountants’ investors were. That’s especially true since the majority of money managers actually trailed the S&P 500 during the 1980s.

The best evidence that the returns were very attractive: the size of the pools mushroomed by word-of-mouth, without any big marketing effort by the Avellino & Bienes partnership…

But how did Mr. Madoff rack up his big investment returns? Early investors in the late 1970s were told — and Mr. Madoff confirms — that their money was being used to engage in so-called convertible arbitrage in securities of such companies as Occidental Petroleum Corp., Limited Stores Inc. and Continental Corp. Promised annual returns in this period, one investor said, were 18% to 20%

In such a strategy, an investor buys a company’s preferred stock or bonds that pay high dividends and are convertible into the company’s common stock; the investor simultaneously sells borrowed common stock of the same company in a “short sale” to hedge against a stock-price decline.

The investor earns the spread between the higher dividend paid on the convertible securities and the lower dividend on the common stock, plus interest from investing the proceeds of the stock short sale. Using borrowed money, or leverage, to magnify returns, an investor can reap double-digit returns. But the strategy carries big risks if interest rates rise and stock prices go down.

Mr. Madoff said his investment strategy changed around 1982, when his firm began using a greater variety of strategies tied to the stock market, including the use of stock-index futures and “market-neutral” arbitrage, which can involve buying and selling different stocks in an industry group.

Mr. Madoff said, “The basic strategy was to be long a broad-based portfolio of S&P securities and hedged with derivatives,” such as futures and options. Such a strategy, he said, allowed the investors “to participate in an upward market move while having limited downside risk.” For example, he said, the Madoff firm made money when the stock market crashed in 1987 by owning stock-market index puts, which rose in value as the market declined.

In the mid-1980s, one investor says, the limited reports that Avellino & Bienes sent to investors changed, and investors stopped being told in which securities their money was invested. The interest rate on some new notes sold by the accountants was also lowered to 16% or less. One investor who complained about the vaguer reports and lower returns was told that if he didn’t like them, he could withdraw his investment. He chose to remain.

Perhaps the biggest question is how the investment pools could promise to pay high interest rates on a steady annual basis, even though annual returns on stocks fluctuate drastically. In 1984 and 1991, for example, the stock market delivered a negative return, even after counting dividends. Yet Avellino & Bienes — and Mr. Madoff — maintained their double-digit returns.

The answer could be that Mr. Madoff’s use of futures and options helped cushion the returns against the market’s ups and downs. Mr. Madoff says he made up for the cost of the hedges — which could have caused him to trail the stock market’s returns — with stock-picking and market timing.

Certainly, the investment pools’ returns were less astounding by the standards of the early 1980s, when short-term interest rates briefly topped 20%. But the annual returns on Treasury bills hit a peak of 14.7% in 1981, and remained under 12% in the three other years that bills had double-digit returns, 1979-82, before falling later in the ’80s.

The use of feeders and salesmen to raise capital.
What the accountants were accused of doing was raising money for Madoff to trade outside the purview of the SEC. If only these guys had known to start a fund of funds business, like those smart folks up in Greenwich, Connecticut, they could have carried on their business for decades.

Again, from the Journal:

As the investment pools swelled, two other accountants, Steven Mendelow of New York City and Edward Glantz of Lake Worth, Fla., started their own pool, Telfran Ltd., to invest in Avellino & Bienes notes. Telfran by itself sold $89.6 million in unregistered notes, a separate SEC civil lawsuit charges. The two men, also represented by Mr. Sorkin, declined to comment. The SEC said Telfran made money by investing in Avellino & Bienes notes paying 15% to 19% annually, while paying Telfran investors lower rates.

All the while, Mr. Madoff was scoring investment returns that comfortably exceeded the hefty returns Avellino & Bienes was promising its noteholders. That excess return generated big profits for the two accountants, the SEC suit indicates. The SEC has asked that those profits be returned as “unjust enrichment,” a demand Mr. Sorkin calls “totally unwarranted.” For his part, Mr. Madoff says he charged the investment pools only what he described as standard brokerage commissions. He termed turnover in the accounts “not very active,” almost nil in some years.

The role of Ira Lee Sorkin.
The two 56-year-old accountants were represented by Ira Lee Sorkin. The same lawyer, a former prosecutor turned defence attorney, is now representing Madoff. Sorkin is a well-known white collar crime and securities defence attorney. This doesn’t imply any wrong doing but it’s still an amazing coincidence.