What Feeder Fund Managers Suspected About Madoff

It turns out that many of Madoff's feeder fund managers--the people who brought much of the money from individual investors into Madoff's Ponzi scheme--had long suspected that Madoff was engaging in illegal activity. According to Bloomberg, they just assumed that they were benefiting from the illegal activity and not being victimized by it. They thought that Madoff was using his position to "front-run" trades by his clients.

The purported mission of such feeder funds was to vet hedge funds for wealthy clients. Instead, the line between victim and perpetrator was blurred. Middlemen like Littaye funneled billions of dollars to Madoff, even, in some cases, when they suspected he was engaged in questionable trading practices. In return, they reaped hundreds of millions of dollars in client fees.

Lower Returns

Wolfer says he heard of traders trying to replicate the split-strike conversion strategy Madoff told investors he used -- buying shares of large U.S. companies and entering into options contracts to limit the risk -- and getting far lower returns. He also says he heard Littaye and other middlemen talk about how Madoff may have used the knowledge he gained from his market- making firm, New York-based Bernard L. Madoff Investment Securities LLC, to get in and out of stocks ahead of market swings.

That’s front-running, a term usually applied to brokers’ trading for their own account -- and profit -- ahead of clients.

It’s also applicable to Madoff’s purported practice, says Peter Henning, a law professor at Wayne State University in Detroit and a former federal prosecutor.

“Front-running isn’t who’s getting the benefit; it’s who’s paying the price,” says Henning, noting that Madoff’s market- making customers expected the firm to obtain the best price available when buying or selling stocks. Instead, their interests were apparently subordinated to those of Madoff’s investment clients.

Front-Running

While front-running is illegal, it didn’t horrify Madoff’s champions.

“They were convinced that the risk was only that the Securities and Exchange Commission would do something about breaches of the Chinese wall in the Madoff organization,” Wolfer says. In the worst case, he says, “what could be expected was that at a certain point the SEC could say stop.”

It was obvious to anyone who looked that something fishy was going on with Madoff's trades:

"An executive at a fund of funds that invested in Kingate says he once examined Madoff’s trading records to see whether they reflected the stocks’ publicly reported activity. He found Madoff consistently bought stocks at their lows and sold them at their highs.

The executive, who wouldn’t be identified, says he reported back to his boss that he thought Madoff was front-running his clients. He says the boss’s reply was 'Yeah, so what? That’s his edge.'"

Why did the manager's of these feeder funds turn a blind eye to what appeared to be blatantly illegal activity and take such risks with their clients' money? Answer, they were raking in huge fees in return for being Madoff's willing accomplices:

"If a fund charged its clients 1 percent of the assets under management and 20 percent of the gains, as the largest one did, that translated into $41 million in annual fees.

Assuming Madoff didn’t do any investing on behalf of his clients, as investigators now suspect, the feeder funds were, in effect, being paid out of principal, which would have been depleted after 15 years.

In other words, much of the money invested in Madoff through feeder funds wound up in the pockets of fund managers."

Barry Ritholtz of the Big Picture is right in part when he says that the Trustee should "confiscate the Funds of Fund managers’ houses, cars, watches, jets and boat — as the illegal proceeds of a crime. Auction ‘em off, put the proceeds into a fund for the scam’s victims."

But the investors don't have to wait for the Trustee to act, and many are not:

"Chais’s Brighton Co.; Bank Medici, which was taken over by Austrian regulators; Fairfield Greenwich; Merkin’s funds; and Tremont have all been sued by investors claiming the firms should have known better than to invest with Madoff."