David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs, including Morning Call, Power Lunch, Kudlow & Company, Squawk on the Street, Squawk Box Asia, and Worldwide Exchange. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).
“This is a major disaster for a lot of people. You work all your life, you finally manage to save up something, and somebody who’s entrusted with it, it turns out suddenly he’s a crook. Lots of people are getting fully or partially wiped out.”
-Lawrence Velvel, 69, Dean of the Massachusetts School of Law who said he and friends had lost millions among them.
“Those with the biggest financial gains generally had their money managed by Madoff. It was an honor having him handle your fortune. He didn’t take just anybody. He turned down all kinds of people, and that made you want to give the man even more of your money. When he took your fortune, he told you that he would tell you nothing about how he achieved his returns.”
-Laurence Leamer, a Palm Beach based journalist, writing in the New York Post, December 13.
First to the structural business issues.
Cumberland Advisors did not and does not have a single penny in any fund directly or indirectly positioned with, having custody with, or in any way associated with Madoff. The Madoff structure violates all of our internal disciplines. Madoff required that investment management, brokerage, and custody all be with him under the same roof. At Cumberland we require that each of these three functions be separated by task, separately evaluated, and separately reported.
Cumberland will not invest in any conduits or vehicles where the sponsor refuses to disclose the contents of the investment. Furthermore, we recommend that our clients avoid any investments they do not understand. We also avoid any investment about which we cannot obtain a full and completely clear description, so that the investment’s merit may be independently evaluated.
Moreover, at Cumberland, all discretionary managed accounts separate asset custody from brokerage and from Cumberland as manager. Our performance reports and asset lists are separate and independently compiled from those of the custodian broker or bank. Managed accounts that are in custody at a broker have explicit permission for us to trade “street wide” when it benefits the client. We will not accept a managed account where the brokerage transactions are captive to the broker custodian unless there is a specific pricing of transaction costs and the client knows what their broker will charge them. Cumberland never acts as broker and never mixes commissions with fees. We are a fee-for-service only manager.
We recommend this structure for all of our institutional consulting clients where we are not the discretionary manager but only consultants on the strategy. We also recommend this for those whom we are advising on boards and as trustees. In fact, we advise that those who place funds as a fiduciary in any other format should consult their legal counsel before doing so, in order to ascertain if they are in compliance with fiduciary standards.
The Madoff affair’s implications for lawyers, accountants, trustees, boards, etc…
How the dean of a law school (quoted above) or the trustees of the charities that were allegedly burned by Madoff acted based on a standard that concentrated all the exposure with Madoff is incomprehensible to us. Placing investment management, custody, and brokerage in one institution and agreeing to opacity about the activity is viewed as the riskiest structure by skilled professionals. How their lawyers and accountants and advisers allegedly sanctioned that decision also triggers many questions.
A separate issue is the role of those conduit funds that were the alleged “feeders” to Madoff. Some of them allegedly charged investors separate fees and then placed the money with Madoff; they allegedly did so without doing full diligence. They failed to ascertain that the above separation structure was in place. Alternatively, they determined it was not in place and took no action. We expect many investors in “fund of funds” structures will assert claims against those funds for money lost by them. One case describes how one of these funds allegedly placed 100% of the money under its supervision with Madoff while charging its clients incentive fees for doing so.
This raises many more questions about custody. The FT reports that $1.4 billion of Madoff money was placed in a form where there were conflicting sets of instructions. In one set, the client waived the bank custodian’s requirement to due diligence and to provide “safekeeping.” The other document sets out the obligation of the bank to do so. If not settled, that will make for an interesting court case.
Lawyers are going to have a field day as the alleged losses from the collapse of the Madoff scheme become the substance of claims against trustees and custodians and accountants and other professionals who had co-fiduciary responsibilities. Daily we are seeing more and more revelations as the investigation unfolds.
Madoff and the aftermath will consume media attention for a whole year. And while we naturally tend to feel compassion for victims because they were innocent and acted in good faith, we need to remember that our emotional response must be accompanied by the realization that no one was forced to invest with Madoff.
Madoff was allegedly involved in a criminal fraud. He purportedly practiced skilled seduction and deception. He used his communal and charitable relationships to expand his scheme. His victims were all motivated to grow their money. Some were driven solely by greed. True: they were seduced and are now hurt. But also true: they acted volitionally. We argue that the true victims are the innocent millions of people throughout the world who are the beneficiaries of the charities that have now have lost their funding because of their board’s or trustee’s decision to place money with Madoff.
The Securities and Exchange Commission and other regulators.
We have already heard remarks from SEC Chairman Christopher Cox and former Chairmen Harvey Pitt and Arthur Levitt. We see their admissions that the SEC had received information about Madoff for years and that it had been ignored. We see their recommendations for transparency and their prediction that the new SEC under Chairwoman Designee Mary Schapiro will be proactive in changing the way the SEC acts to protect investors. And we see them repeatedly state that a designed and intentional fraud is hard to detect.
But what about the depth of this embarrassment for the SEC? We see evidence that the SEC used Madoff as an example of compliance achievement. No SEC audit found any wrongdoing. This is true even though the structure of combining investment management, custody, and brokerage is a “red flag” on the SEC checklist, according to many experts in the compliance field.
The SEC’s embarrassment is even greater when one considers that the SEC received warnings as long as a decade ago. Furthermore, there is evidence that many prospective investors refused to place money with Madoff. They suspected the returns Madoff represented were not possible, and they advised the SEC of their suspicions.
Why did the SEC and other regulators fail to find Madoff’s flaws? And were there other regulators who had supervisory roles and also failed? Questions must also be asked about what the regulators’ liabilities are when they fail. If a state or municipal government fails to perform an assigned and legislated role, it can be sued for negligence and may have to pay damages to innocent victims for its governmental failure. What is the obligation of the federal government? Will that subject be tested here? Can the United States avoid all liability for its failure?
The Madoff case certainly opens these issues to legal inquiry. It also requires Congress to address them. We expect both to occur in 2009.
In that spirit we worry about a regulatory backlash. In an effort to redeem itself, the SEC may impose rules that have unintended consequences. And they may add costs to the law-abiding practitioners. History is replete with examples of regulators chasing the horse after it left the barn and wounding the well-meaning and honest instead.
Congress, Madoff and money.
We expect the new Congress to hold hearings on the Madoff affair. And the new SEC chair will get the usual earful from Senators and Representatives. This is our system and these are the folks we elect to represent us. They are supposed to be acting in the interest of the citizens and to be concerned for the country’s welfare. Their supervisory role and legislative role are supposed to be in that direction.
They fund the budgets of the enforcement agencies. They write the laws that the regulators are empowered to enforce. In the Madoff case, they determine the depth and strength of the SEC. There are 11,000 registered investment advisers and 8,000 hedge funds. In addition there are the so-called self-regulatory organizations (SRO), of which Madoff was certainly a pre-eminent member.
So why is this Madoff story so filled with failure and why is the system so sick? And why is the legislative oversight provided by the Congress so poor? And why do Americans have such a low opinion of the Congress?
Madoff’s political contributions included several for $25,000 each to the Democratic Senatorial Campaign Committee. Other contributions were made to individual campaigns of folks like former Senator Hillary Clinton and present Senator Charles Schumer, as well as Congressmen like Charles Rangel. Madoff did nothing illegal in making those contributions. At least that is how it looks from the cursory review we conducted on disclosure services.
The recipient politicians argue that these contributions were only individual in nature and are legal. They do not discuss what motivated Madoff. Maybe it was Madoff’s sense of citizenship and his patriotic concern for the ethics of the United States. Ok, I admit sarcasm. More likely these contributions were part of the collective enterprise of political fundraising from the very industry that lacked the transparency and regulatory supervision to prevent an alleged Madoff-type swindle to occur. We see the political money everywhere and intertwined with the financial industry and its problems. It plainly stinks. We will leave it to others to dig into the amount of political influence Madoff had over the years.
How Ponzi schemes work and how they collapse.
So far, it appears that Madoff’s undoing was driven by European investors who withdrew money because of their fear of the US dollar weakening. That triggered the large withdrawals that ran this alleged Ponzi scheme out of money. History shows that the end of a swindle can be triggered many ways, but the result is nearly always the same. The swindler runs out of cash and the house of cards collapses.
The end of the original Ponzi swindle ended the same way. In 1920, Charles Ponzi established the fraud of using one investor’s money to pay another while advertising that the payment was the result of a little-known investment idea. Ponzi’s undoing came because he promised a 50% return in less than two months’ time. Ponzi ran through millions of his suckers’ money. When the scheme collapsed he had $61 left.
Madoff was telling his investors the investment results were much lower (10% to 13%) and were derived from a “proprietary” method involving stock option structures. His scheme was sold to victims who were looking for consistency. Professionals who could not replicate the strategy warned the SEC as much as a decade ago. Madoff persisted for years because he promised a lower return and, therefore, his need to raise new funds to pay off older investors was not as acute as the original Ponzi’s. As with all such schemes, he ultimately exhausted his cash and failed.
We do not yet know how many years of effort were applied by Madoff to this fraud. We do know that it was a protracted period. We know it grew and grew over time. We know Madoff used subtle and social relationships to attract more investors. We know he turned some away, and that only made him more desirable. Oh, how the seduction works. And in the very high-profile social circles of Palm Beach it developed its own momentum. And it appears that Madoff played the crowd quite well.
Unanswered questions about Madoff and Ponzi.
In the business area there are many lawsuits ahead. A bankruptcy judge will rule on who got paid out with a “preference.” Those parties will be asked to return the money to the general fund for redistribution. This is a lawyer’s field day. So is the litigation to come against the funds of funds and the board trustees and other co-fiduciaries. Accountants will be busy, too. Many thousands of tax returns will have to be amended and refiled for multiple years. For those who received payments from Madoff, these are “ill-gotten” gains. Their tax treatment is different from what they reported to the IRS. International arrangements and multiple national jurisdictions make this accounting/legal complexity extraordinary. That is the cleanup that lies ahead.
What history doesn’t tell us is how these things start. What gets in the brain of a crook and when does it first get there? Do swindlers really believe they can continue forever? Does the scheme’s momentum create its own force and overwhelm the perpetrator?
Was Madoff a cheat and faker when he was born in 1938? Was he a cheat in college? Was he a crook when he started his firm in 1960? When he brought his brother, Peter, into the business? Or when his sons Andrew and Mark first reached young adulthood? Or when they joined the firm with him? Was he a thief when he used internet technology to move quotations from the “pink sheets” to what eventually became the NASDAQ that he chaired?
By the time the Madoff affair recedes into history, there will have been books and movies and TV specials about it. Millions of words will have been written. Many victims will be revealed. Their stories are already being told in TV interviews. One at a time, we see the journalists asking how the victims “feel” and inquiring about their sense of “trust” and “betrayal.”
Fewer interviewees were asked the question “why?” Their choice of Madoff is not probed. Why did they allow themselves to get “sucked in?” Didn’t they realize that the results promised were not reasonable? Weren’t they wondering how they could receive an investment return which was inconsistent with what they saw in the market? Did they balance their desire for money with the risk they took when dealing without transparency and without separating the three functions that we outlined at the beginning of this commentary?
Going forward after Madoff.
The basic lesson remains, and the Madoff affair has affirmed it. Separate custody from brokerage from investment management. Have each reported differently and accounted for independently. If you cannot understand the investment, beware of participation. And remember, there are no free lunches. Clichés become so because they are true.
This is the season of festivities in Western traditions. Holidays affirm faith and ask those who are more fortunate to give to those who are less so. We then pass the solstice, enter the New Year, and begin the process of renewal.
Madoff has dealt a huge blow to charity. We’ve talked about the trustees and boards who failed to review his activity and who breached their fiduciary requirements.
But what about the beneficiaries of those charities? They did nothing wrong. They are sick or hungry or poor or isolated or weak. They are global, since Madoff’s tentacles reached afar. And, in this year of global recession, they need assistance in great numbers and with earnest commitment from the donors.
Perhaps we can remember an ancient teaching as we thankfully close this year of 2008.
“For this reason, man [i.e. the first human being] was created alone to teach that whoever destroys a single life is as though he had destroyed an entire universe, and whoever saves a single life is as if he had saved an entire universe. Furthermore [the first man was created alone] for the sake of peace among men, so that no one could say to another, ‘My ancestor was greater than yours.’”
Mishnah: Sanhedrin 4:5
For our clients, colleagues, readers, friends, and others, we wish peace, good health, and prosperity for 2009. Travel in safety.
David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok-at-cumber.com
Copyright 2008, Cumberland Advisors. All rights reserved.
The preceding was provided by Cumberland Advisors, 614 Landis Ave, Vineland, NJ 08360 856-692-6690. This report has been derived from information considered reliable but it cannot be guaranteed as to its accuracy or completeness.