Portfolio Hedging Corporation

July, 2011

After reading Too Good to be True, by Erin Arvedlund (Penguin Portfolio, 2010 edition,
available at Barnes & Noble and Amazon), I am even more distressed at what happened, but satisfied being further enlightened by this book about just how it happened.  There were dozens of enablers, and hundreds of gullible investors involved, some quite wealthy.  The enablers included a network of banks and money management institutions, along with the SEC bureaucracy and a too-trusting SEC staff.  Arvedlund compellingly tells the stories of a number of Madoff’s client finders, feeder fund executives, or “fund of funds” managers:  Avellino, Bienes, Busson, Chais, Cohn, Delaire, Jaffe, Kohn, Littaye, Manzke, Merkin, Noel, Piedrahita, Schulman, Stucki, Tucker, de la Villehuchet, and more.  Many of these people were making a fortune in finder’s fees, ongoing management fees, or participation percentages.  Some of them believed so much in Madoff that they entrusted their own wealth or stream of fee income to him to manage, and so also lost when the fraud collapsed.  On the other hand, Arvedlund postulates that some of the clients such as Chais, Picower and Shapiro would typically get higher returns than others, the favored clients being the ones with a personal relationship or extensive dealings with Madoff.   Arvedlund also discusses the employee involvement in the fraud, manufacturing phony statements to pretend the investors’ monies were invested in stocks and options and even backdating phony purchase and sale records so the statements would conform to the real buy and sell prices on particular days.

The book also contains the stories of my heroes, the skeptics who didn’t invest their funds or their clients’ money.  These include Rob Picard (Royal Bank of Canada), Salomon Konig (Artemis Capital Partners), Oswald Grübel (Credit Suisse), and an unnamed money manager at Lehman, who may have lost his job for asking tough questions.  Other heroes are the people who tried in vain to alert the authorities, (notably Harry Markopolous and his associates, covered in my earlier post), or alert the public (Erin Arvedlund herself, who published an article about Madoff in Barron’s in 2001).  What a contrast to the SEC, which failed to perform due diligence in their firm audits and did not follow up on leads provided by outsiders regarding the fraud.  The author speculates that the regulators may have been influenced in Madoff’s favor because of their long-term cozy relationship with him due to his serving on regulatory committees during his years of pioneering electronic trading and his record of running a legitimate broker-dealer enterprise.  The heroes also include Irving Picard, the trustee who has been working for years on the recuperation of assets and their fair distribution.

 I learned from the book that the investment operation’s compliance was handled by Bernard Madoff’s brother, Peter, who had to have signed off on the annual investment advisory FINRA registration and renewal forms for the only two years they actually registered their operation as an investment advisor.  In that role he was supposed to be monitoring firm trading and employee trading for compliance with a host of rules regarding potential conflict of interest of the employees with the fiduciary duty of the firm.  He would also be monitoring for an equitable pre-determined division of investments in the pooled funds amongst the individual clients in that fund.  In either case, if trade monitoring was attempted, he might have noticed that no actual trades took place.  It appears there may have been a violation of disclosure rules of the Investment Advisory Act, as some of the introducing salespeople did not reveal to their clients their relationship with the Madoff firm or their immediate or ongoing commissions from the investment funds they brought to Madoff.  In many cases, the salespeople were requested by Madoff to not reveal to the clients the name of the investment manager, thus short-circuiting the investor’s ability to vet the money management firm where their funds were placed.  Furthermore, there appear to have been violations of rules that an investment advisor cannot guarantee a minimum return on a portfolio during a performance period.  A compliance officer who conducted spot checks of the positions in customer statements might have noticed when checking statements chronologically that backdated positions were being regularly added to the statements, or that sales took place of old securities positions that had not appeared in the statement of any prior month.

The book explores the theme of greed in the form of the Madoff family’s real estate, parties, jets, boats, cars, expensive clothes, watches and jewelry, charity banquets and lavish donations, 1^st class airfare, and expensive hotels.  Because of the effects of social networking augmenting the effectiveness of investment scams, certain communities were hit especially hard in this disaster, such as Great Neck, NY; Palm Beach, FL; and Minneapolis, MN; along with Jewish charities, foundations, and educational institutions.  It is important to note that many of the investors were greedy as well, going out of their way to receive the “too good to be true” returns that Madoff offered, without doing their due diligence research of his firm, ignoring ‘red flags’, and incredibly, not diversifying their sometimes sizable portfolios amongst several managers.  I thought more than once how the wealthy investors had mostly earned their money by being good in business, being realistic, well-informed, negotiating, managing and monitoring, and on the whole being much more cautious and circumspect than they were when they decided where to invest their hard-earned wealth.

There is a reasonable comparison that could be made with the 2007-2009 financial collapse.  There too, a network of people was profiting handsomely from the fee income.  There too, was a belief in the sacrosanct nature of respected institutions, along with the unquestioned sense of their invulnerability (think Lehman, Bear Stearns, AIG, Citicorp, FNMA, FHLMC, the Federal Reserve Bank, FDIC, SEC, NYSE, Congress including its Financial and Banking Subcommittees, rating agencies, accounting firms, and big Mortgage Lenders.  There too, existed an international spread or contagion of the corruption and heightened risk taking to banks and institutions abroad, following the lead of the Americans in profiting from high-yield, ostensible triple-A financial instruments or other “safe” securities.  There too, were a mere handful of sage economists, savvy investors, and journalists warning about impending catastrophe.  There too, were resources sent in afterwards to figure out what had happened and to clean up the mess.  But in contrast to Madoff, in the great worldwide financial collapse nobody turned himself in as a deceiving manipulator who pocketed millions of dollars of other people’s money or openly admitted they deserved societal condemnation or a period of incarceration!   To this day, each participant in this catastrophe has pinned the blame on everyone else but themselves.

5/23/2010

I've been having a lot of thoughts about whether the revaluation of the Chinese currency would be beneficial to the U.S.; would the the possible unintended consequences of such a move end up being worse than the status quo?  Now that U.S. Secretary of the Treasury Geithner is in China pressuring them to make such a move, I'll share some thoughts about it and provide some links to some informed sources.  My conclusion is that a change in foreign exchange policy could end up making numerous basic products more expensive to the beleaguered U.S. consumer, at the worst possible time in the economic cycle.  Meanwhile, it would not have the intended beneficial effect of re-establishing our industrial base.  If done at all, the devaluation should have been pushed for in the early 1990's, just when many companies were making the decision to relocate their manufacturing plants in China, and would have considered the currency impact on their decision.  Now that so very many products of U.S. corporations are made in China, and quality has gradually improved, it would take huge incentives to bring the factories back here, like a doubling or tripling of the Yuan (Renminbi), and huge tariffs and duties on imports, disallowed by the World Trade Organization of which China became a fellow member under U.S. auspices.  Chinese workers making a small fraction of the U.S. wage would be the overriding factor in keeping plants there, if the devaluation (if any) is in the range under discussion.  In addition to hurting U.S. consumers, large numbers of U.S. corporations would be adversely affected as well, reducing profitability without any offsetting benefits.  A sector that would benefit is the large number Chinese entrepreneurs who travel abroad on vacation, as their native currency would go further.  If you can think of any others who the devaluation would benefit, please let us know.  Check out the following for additional information:

Background -

 http://www.danwei.org/china_information/china_currency_trade_revaluati.php

Recent news -

 http://www.reuters.com/article/idUSTRE63814S20100409

Economic analysis -

http://www.heritage.org/Research/Reports/2010/04/Deadlines-and-Delays-Chinese-Revaluation-Will-Still-Not-Bring-American-Jobs

December 1, 2009     

The $59 billion in Federally subsidized State debt this year (and potentially $110 billion more next year), which are taxable issues, is traditionally known as a "crowding out" of the Corporate debt market. That is, American corporations will have to compete against states and municipalities in this federally subsidized program, in order to borrow from the same pool of money. This will have the net effect of adding to the borrowing costs of companies by some number of basis points to attract the same lenders, and furthermore channeling money into less productive areas of society i.e. the non-profit State sector, already at an advantage since their survival does not depend on operating efficiently, nor do they have to pay taxes. Actions that put increased pressure on the private sector, corporate America, are a cause for concern.  [More information and stats available on Bloomberg.com]

Begun on December 23, 2008, and was added to in the subsequent two years, culminating on January 29, 2011

I am very disturbed by the Bernard Madoff fraud on several levels.  Firstly, the notion that a trusted fiduciary would conduct such a scheme, in complete betrayal of his clients, is unforgivable.  I first became aware of the extent of the damage when a charity I had previously contributed to e-mailed that their operations were impacted because a number of their major contributors incurred major losses due to the Madoff scam.  Other charities and educational institutions were far more severely hurt due to the extent of their own assets invested directly with Madoff’s advisory firm.

Secondly, the misplaced trust his clients had in him and his firm anger me.  Why?  Because these sophisticated investors believed the consistently “too good to be true” performance.  Meanwhile, during the time period 2004-2008, a talented investment professional I know who has spent a lifetime researching improving equity portfolio returns by hedging with options struggled unsuccessfully to get even one additional client.  I guess his returns just could not compare with what Mr. Madoff was “providing”.  On the other hand, while I am still baffled, the phenomenon of so many otherwise intelligent people being fooled is brilliantly examined in How and Why Madoff Was Able to Trick So Many “Smart” People, by Mark Goulston, M.D., Psychiatry, on the Daily Speculations Web site, 12/27/2008: http://www.dailyspeculations.com/wordpress/?p=3447

Thirdly, as someone who would like to conduct business as an investment adviser into my semi-retirement years, this is very, very bad publicity for the profession.  It hurts all of us who are sincerely trying to deliver reasonable returns in a challenging market environment.  This is because someone as high profile as Madoff created the impression that a seemingly reputable investment adviser could magically make all of your money disappear.  Poof!  Where did it go?  Post-Madoff, how can a reputable Investment Adviser assure clients and prospects that they will not ‘pull a Madoff’ on them?  I have a several ideas on this subject, as follows:

Require that a client’s securities and cash be deposited with a custodial firm of their own choosing, usually at a brokerage firm or custodial bank.  Portfolio Hedging Corporation does not take custody of the client’s securities or assets, other than technically by allowing customers to pay their fees directly from their account if they choose to, with safeguards.  New rules with a number of helpful measures governing custody of funds or securities of clients by IAs have recently been adopted by the SEC  in light of the Madoff affair.  See SEC Release# IA-2968 at: http://www.sec.gov/rules/final/2009/ia-2968.pdf

The monthly account statement sent to clients should come directly from their custodial firm or broker/dealer.  Thus, the assets they see on that statement are their assets, pure and simple.

Preferably, each client’s assets are kept separately in their own account, unless there is an audited client investment fund of pooled or commingled assets. No client can withdraw or receive funds or securities that are not their own.

If a client fully or partially liquidates their account, the proceeds come directly to them from their custodial firm.  There is no possibility of inflating the assets, making the returns look good in order to lure additional investors.

Modest goals for portfolio returns.  No promises are made that the returns will be great or consistently exceed the relevant benchmark, nor are there guarantees against losing money.  In fact, these types of assertions are prohibited by the Investment Adviser Act of 1940 as amended; see http://www.sec.gov/about/laws/iaa40.pdf , which is Federal securities law.  The IA should only promise that they will work towards fulfilling your investment objective, if it is reasonable.  If your objective is unreasonable, they should tell you, and if you insist that you want to have unreasonable objectives, they should recommend that you seek a different advisor.

In conclusion, we are fortunate that the Madoff firm is the exception and not the rule.  For every dishonest Investment Adviser, there are thousands that are honest and in their fiduciary capacity they place their clients’ interest foremost.  Most importantly, when considering doing business with an advisory firm, any firm, consider the points made above.  There are also some excellent investor resources available to help individual investors select an adviser, most notably the wealth of knowledge presented on http://www.theskilledinvestor.com (which link does not imply that they endorse, sponsor, or are affiliated with Portfolio Hedging Corporation). Make use of the resources available, take your time, and select carefully based on your individual criteria.  Institutional investors can also review the Skilled Investor site, and should have a due diligence process in place and conduct thorough vetting, which was neglected when it came to investing with Madoff Investment Securities LLC.

Addendum, Additional Elements:

After reading Betrayal: The Life and Lies of Bernie Madoff, by Andrew Kirtzman; Harper Collins, 2009, I feel even more intensely about so many people being taken in by him, investing more and more of their money with him and violating all diversification principles.  This occurred with practically no vetting, even by multimillionaires who were brilliant at managing their own businesses, people who wouldn’t think of giving a free pass to a supplier or customer in their own business.

It is appalling that the Mr. Madoff’s fraudulent behavior continued after the crimes were revealed, namely in his attempt to mail expensive jewelry and watches to relatives while under house arrest.

Madoff’s story has yet more layers of immorality, in the story of a institutional and personal client who he seduced and with whom he carried on an extramarital relationship, as told in Madoff’s Other Secret: Love, Money, Bernie, and Me, by Sheryl Weinstein http://www.amazon.com/Madoffs-Other-Secret-Money-Bernie/dp/0312618379 

The story of the would-be hero, Harry Markopolos, if only he had been heeded by the SEC in his struggle to be heard, is summarized in: http://www.canadianbusiness.com/managing/strategy/article.jsp?content=20100412_10025_10025   and fully explained in his book, No One Would Listen, A True Financial Thriller, by Harry Markopolos http://lp.wileypub.com/markopolos/

The death by suicide in December 2008 of René-Thierry Magon de la Villehuchet, someone who couldn’t live with himself after his own clients suffered major losses of funds that he had guided to Madoff’s firm to manage.  See  http://en.wikipedia.org/wiki/René-Thierry_Magon_de_la_Villehuchet 

The death by suicide in December 2010 of Mark Madoff, Bernard Madoff’s son.  A sobering tale of the deep impact on others of evil and immorality.