Madoff: What Happens to Those Who Profited?

The lucky folks who cashed in and got out before Bernard Madoff's $50 billion investment empire came crashing down might not be as lucky as they think. Sources close to the Madoff case say that a recent court ruling in a similar collapse—a Ponzi scheme called the Bayou Group—is likely to provide the legal road map for recovering as much money as possible from the Madoff mess. And if so, those who profited stand to lose not only their gains but also, in some cases, the original principal they invested in the scheme.

Madoff's reputation as a financial wizard evaporated following disclosures that his business was a giant Ponzi scheme in which he paid out generous but fake profits to early investors from funds deposited by later ones. The clean-up is likely to fall under the jurisdiction of the federal bankruptcy court in Manhattan, which is already sifting through Bayou wreckage. That case made headlines last summer when Sam Israel, the fraud's mastermind, disappeared shortly before he was due to report to prison; his abandoned SUV was discovered outside New York City with the words SUICIDE IS PAINLESS scrawled on its hood. A few weeks later, Israel turned himself in to authorities.

In October 2008 a judge in the Bayou case, Adlai Hardin Jr., ruled that investors who cashed out their interests within two years of the scheme's exposure had to hand back their principal as well as their profits—even though they were innocent victims of the swindle—if there was evidence that they got out because they suspected, or had been warned, there was something amiss. (The court also ordered profits made within the last six years to be surrendered.) Legal experts say the Madoff litigation could follow the Bayou ruling's lead. "Even though the potential scale of losses in the Madoff scheme seems to dwarf the $450 million at issue in Bayou," says an analysis by the KL Gates law firm, which represents victims of the earlier fraud, the Bayou case "provide[s] instructive guidance to [Madoff] investors and other affected parties." The lawyer in charge of the Madoff clean-up, Irving Picard, did not respond to a request for comment.

Mitchell Banas, a lawyer who represents an endowment for Christian Brothers High School in Memphis—which got its money out of the Bayou fraud before it collapsed but now must return both profits and principal—says the outcome is "extremely unfair." His client, he says, withdrew its money from the scheme on the advice of financial advisers who smelled a rat; now the school is left "between a rock and a hard place." Eventually, the school and other investors will be able to seek a share of any recovered Bayou money. But in what could be a harbinger for those caught up in the Madoff mess, lawyers estimate that the Bayou fraud victims will do no better than 15 to 20 cents for every dollar originally invested. And, of course, zero profit.