The Affinity Ponzi Scheme

The Madoff Ponzi scheme has changed the rules of trust that governed the money game. Many great names in the business will never be the same. And even though Bernie Madoff did not run a hedge fund—he was just a broker who got paid through commissions, not fees and a cut of the profits—his massive scam will help deal a heavy blow to many hedge funds and fund of funds, as well as to other professionals who steered powerful clients into Madoff's hands. But there may be worse to come. In Geneva recently, this writer heard that some private banks, European feeder funds, and American fund of funds were extensively using Madoff in their funds and in client portfolios; and were apparently secretly being paid placement fees by Madoff. If so, this creates a scandalous conflict of interest because the advisers were acting as fiduciaries and charging clients an advance fee. This could be a serious black mark for all involved in wealth management.

Madoff's scam was immense ($50 billion) and classic, but Ponzi schemes are as old as gullibility. It's incredible that he could have sucked in so many rich, sophisticated people. No verification of the accounting was ever made, and no one questioned the investment strategy and resources of the Madoff firm. Somehow worldly businesspeople swallowed the story that this single guy could generate returns of 12 to 13 percent a year trading the stock market, come rain or shine, without a single down quarter. One of the oldest adages of the investment world is that "if it sounds too good to be true, it probably is too good to be true."

Ponzi schemes through the ages have stolen the money of naive, ordinary people. This one scammed the supposedly highly analytical funds of hedge funds and the very wealthy, smart Jewish community that Madoff hung out with. It was an affinity Ponzi. Now Palm Beach, the watering hole of the East Coast upper class, is reeling with mansions for sale, the luxury stores on Worth Avenue empty, the magnificent charity balls canceled, and members resigning from golf clubs. The same plague is already affecting Greenwich, Connecticut, and next summer it will hit the Hamptons. This man Madoff was the most sophisticated and charming huckster of all time to have been mingling socially with his fellow members and their guests at the very exclusive Palm Beach Country Club even as he was taking their money.

He never overplayed his hand. At a club where social climbing is common but mocked, the Madoffs were modest, never ostentatious, unassuming people. Bernie never obviously hustled anyone. He let them come begging to him, and he knew they were rich. A friend of mine who retired and moved to Palm Beach subsequently commented to me: "When I joined the Palm Beach Country Club I thought I was old and rich. Now I know I'm neither."

Some people applied for membership and paid a massive initiation fee not for the fine golf, the gourmet food or the black-tie dances but simply so they could meet and be accepted by Bernie. Many members, beguiled by the consistency of the returns, leveraged up their investments in Madoff and so have suffered double or triple losses. But no one will shed tears for very wealthy people who have lost a lot of money by being greedy, following the herd and not checking for themselves. I doubt this will be a major issue for the Obama administration.

The same cannot be said for the fund of funds and consultants who are paid a fee (usually 1 percent fixed and 10 percent of the profits) for finding and exercising exhaustive due diligence, checking out hedge funds and investment strategies. They have an implied fiduciary responsibility, which they utterly failed to fulfill in this case. If, in addition, they took placing fees they are in deep doo-doo. Pension fund and endowment money is down the drain. The consultants never verified the books and records because they didn't exist, and they never understood Madoff's investment strategy because there was none. He maintained it was highly sophisticated, tactical trading. Almost anyone in the investment business in their right mind knows that there is no such thing and even if there was, it could not have gone on for decades without even one losing quarter. It is simply inconceivable, and the many professionals who rejected Madoff—including this author—did recognize this.

The managements of the fund of funds that did invest in Madoff will be sued for all they've got. After all, they not only failed as fiduciaries, they pocketed huge incentive fees on phony profits. The fund of funds and hedge-fund consultants provide a valuable service for clients that want exposure to hedge funds and don't have the time or resources to monitor their investments. Their failure to check out Bernie Madoff has shattered trust in the service they are supposed to provide. It's bad news for everybody.