DATELINE: December 14, 2008, Chicago (Updated Dec. 15, 2008)
For our December 16, 2008 post on Yeshiva University's Board of Trustees and the Madoff scandal, click here.
On our journey to New York this past weekend, we had the opportunity to see Horton Foote’s Dividing the Estate. The ending is obvious and lacks punch, but everything that precedes it will bring knowing smiles from estate planning lawyers. Probably the best part of the play was intermission, when we were eavesdropping on audience members who were talking tax and family. We love war stories.
Our journey also provided us a front-row seat as the New York media buzzed...
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with the revelations about Bernie Madoff, the money fund manager who now stands accused of running a Ponzi scheme that may have duped banks, wealthy socialites, and charities out of $50 billion. He apparently was asked by the two FBI agents who arrived at the door of his East Side Manhattan home on Thursday whether there was an innocent explanation. His response, according to the New York Post, “There is no innocent explanation.” Kaja Whitehouse, Bruce Golding and Andy Geller, Invest Big ‘Fesses To $50B ‘Fraud’: Wall St. Legend Busted as Mega-Scammer (Dec. 12, 2008).
The direct hit to the world of philanthropy appears to be heavy. MSNBC reported on Saturday that the Texas-based Julian J. Levitt Foundation had lost about $6 million and that the North Shore-Long Island Jewish Health System was out $5 million. Binyamin Applebaum, David S. Hilzentrath, and Amit R. Paley, Charities Count Missing Millions in Madoff Case: Philanthropic Groups Hit Hard by Ex-Nasdaq Chief’s Arrest on Fraud Charges, MSNBC (Dec. 13, 2008). Also mentioned in the article is New York’s Yeshiva University. Madoff served on its board and is listed as “Treasurer” on the university’s 2006 Form 990. It is “examining how much money it lost,” according to the MSNBC article. The Associated Press reported that Senator Frank Lautenberg’s family foundation had also invested some of its funds with Madoff’s firm. Associated Press, NJ Sen. Lautenberg Among Potential Fraud Victims 2008. The Lautenberg Foundation’s 2006 990-PF reports that the foundation held $12.78 million of assets that were handled by Madoff’s firm as of December 31, 2006.
Today the New York Post is reporting that the Carl and Ruth Shapiro Foundation and the Robert I. Lappin Charitable Foundation had invested funds with Madoff’s firm. According to the Post, the Lappin Foundation has been forced to close, apparently losing $8 million. The Shapiro Family Foundation may be one of the larger charitable victims, with $145 million exposure. Whether it has other assets is unclear.
The Jewish Telegraphic Agency is reporting today that the Chais Family Foundation was forced to close. According to JTA, it annually gave away somewhere around $12.5 million to Jewish causes throughout the world. Unlike the returns of other charities mentioned, the return for the Chais Family Foundation makes no reference to Madoff. It reported yesterday that the Robert M. Beren Foundation had invested funds with the Ascot Partners, which is reported to have invested substantially all of its assets with Madoff. Jacob Berkman, Madoff Scandal Rocks Jewish Philanthropic World (Dec. 14, 2008). The foundations 2007 Form 990-PF reports the association with Ascot. JTA is also reporting that the Jewish Federation of Greater Washington has $10 million invested with Madoff. D.C. Federation Endowment Takes Madoff Hit (Dec. 15, 2008).
The Wall Street Journal is reporting to other prominent victims. The first is Steven Spielberg's Wunderkinder Foundation. The second is Eli Wiesel's Foundation for Humanity. The tax return for Wiesel's foundation may explain a lot. The foundation has assets of between $3 million and $4 million, but the analysis of Madoff accounts included with the return reports $37 million in transactions. It appears that Madoff made his money churning the accounts. Peter Lattman and Aaron Lucchetti, Losses in the Madoff Case Spread (Dec. 15, 2008). It also reported that about 11% of the charitable assets held by the Mortimer B. Zuckerman Charitable Remainder Trust were impacted (presumably that means lost). Peter Lattman and Aaron Lucchettie, Losses in Madoff Case Spread (Dec. 15, 2008).
The Financial Times reported that the Jeht Foundation, a private foundation, will be closing because two of tis donors, Jeanne Levy-Church and Kenneth Levy-Church, had invested funds with Madoff. Madoff Fallout Spreads Worldwide (Dec. 15, 2008). The 2006 tax return reports that the aggregate contributions from Jeanne Levy-Church were $23 million and from the Betty and Norman F. Levy Foundation were $9 million. Not surprising at this point, Madoff makes an appearance in the Levy Foundation's 2007 Form 990-PF Form 990-PF. That tax return reports over $8.8 million of interest income from the Charitable Lead Annuity Trust Under the Will of Norman F. Levy. We can only wonder whether Madoff got his little hands on that money.
So how did it happen? The Washington Post provides the following succinct, but insightful description:
The company made its own trades and held the shares it bought, unusual practices that kept its activities hidden from view. Madoff also avoided filing disclosures of its holdings with the SEC; the firm said that at the end of every reporting period it sold its holdings and held only cash. Such a tactic is highly unusual because it exposes a fund to large losses by forcing it to sell assets without regard to price.
Madoff, though a pioneer of electronic trading, also refused to provide clients online access to their accounts.
It all boils down to internal controls. Good control theory says that the authorization, custody, and recordkeeping functions should be held by different persons because they are incompatible functions. Although we don't want to kick a dog when it is down, those who invested with Madoff apparently violated the maxim. Madoff had custody of their assets. Madoff was authorized to trade those assets. Madoff was charged with recordkeeping. All three functions were vested in one entity/person. The simple fact is that when it comes to money, nobody should rely on trust or personal relationships in lieu of solid internal controls.
Madoff was reported to be quite an investor, achieving a 10.5% annual return for 17 years running. He delivered solid returns in good and bad markets, which is why some of his investors referred to him as the Jewish T-bill. Others recognized that Madoff was achieving results that are virtually impossible to achieve. So once again, we have an investment proposition that was too good to be true, but people ignored the sacred rules of investing.
It may be too late for the charities previously listed, but here are some rules of thumb that boards investing endowment and other charitable assets should keep in mind:
A. Diversify. Pick a number: 3%, 5%, or 10%. Under no circumstances should a board invest more in a stock, bond, hedge fund, or with an investment manger than it is comfortable losing. In the case of each investment, the board should be able to say, “We did our due diligence, but if we lost all of this particular investment, the organization would feel pain, but it could still carry on its mission.”
B. Nobody Has the Answer. If events throughout the financial world during the last six-months have taught us one thing, it is that even the supposedly smart guys don’t have all the answers and often don’t know what they are doing. Investing isn’t magic and nobody has a formula that offers extraordinary returns without increased risk. Boards and investment committees should never rely on just one person. That is just another way of saying, "diversify investments and diversify investment managers."
C. Retain Custody. It is one thing to turn over decisionmaking authority to an investment manager, but that does not mean that the custody of the assets must be held by that manager. It is a best practice to separate custody from decision authority. It is possible, for example, to provide a manager with trading authority over an account held in the charity’s name. The manager can trade, but cannot withdraw the assets from the account. Madoff most likely would have been unable to pull off his alleged scheme had the investors or an independent third-party retained custody of the assets.
Investing in a mutual fund violates this prescription. That is why it is important to diversify across mutual funds and mutual fund families of funds.
D. Don’t Invest in What You Don’t Understand. Madoff apparently claimed to have a proprietary investment strategy that he referred to as “split-strike strategy.” One commentator has speculated that 95% of Madoff’s investors had no idea what that meant. Henry Blodget, Skilled Actor was Perfect in ‘Con’Cept, New York Post (Dec. 14, 2008). If the board or the investment committee don’t understand the investment, they should invest the charity's money elsewhere. During the last five years, it has been fashionable to invest in hedge and private-equity fund investments. These vehicles often are not transparent. Boards should think long and hard before investing in these black boxes.
Madoff told Barron's last year, "It's a proprietary strategy. I can't go into it in great detail." Those words should have sounded the alarm.
E. Don't Invest with Board Members. We feel bad for the charities and others who were duped, but the story is an old one and really is pretty straightforward. We, however, will be very interested to see whether Yeshiva University invested any of its endowment with Madoff. As noted, Madoff was a board member and apparently the treasurer. If the trustees authorized an investment with Madoff, they will face some tough questions about due diligence and their duty of care. As of the close of business on December 15, 2008, the university had posted nothing on its Web site regarding any losses. An article by Jacob Berkman of the Jewish Telegraphic Agency reported rumors that Yeshiva may have lost up to $107 million, or 10% of its endowment. Joel Keeps Mood Light, But Addresses Madoff Mess at Y.U. Dinner Sunday (Dec. 15, 2008).
We contantly advise against conflicts-of-interest transactions, particularly those involving goods and services that are readily available from a large number of persons or entities. Investment management services are a good example of commodity style services. As much as the investment community would like the public to believe otherwise, investment management services are fungible. There are thousands of investment managers who are both knowledgeable and experienced. Although one claims to be the best, the efficient market levels the field over time. Consequently, there is no need to invest endowment with board members.
F. Ignore "I Know A Guy." Boards should not listen to people who say "I know a guy who can get you really good returns." By all accounts, Madoff was not an aggressive seller of his services. He let his clients do the sellling at their country and social clubs. Avoid these suggestions. They are no different than the 1960's dorm room promises "I know a guy who has some really good pot." A different type of smoke, but someone is still blowing it.
G. Trust is For the Birds. Charities and boards should select investment managers based on the cold facts rather than trust. Truly honest managers are not offended by investors who demand controls, reports, and accountability. These managers know that if there is a problem, they and their reputations will fare much better if they have instituted procedures that create audit trails and transparency.
H. Listen to the Street and Common Sense. There were plenty of skeptics. According to the Wall Street Journal, one person filed a complaint with the SEC in 1999. Another person said the structure of Madoff's firm made no sense. Madoff apparently made his money on commissions as a broker-dealer rather than as an investment manager through advisory fees. Another told the Journal,
It seemed implausible that the S&P 100 options market that Madoff purported to trade could handle the size of the combined feeder funds' assets which we estimated to be $13 billion.
One person went so far as to hire a private investigator to support his warnings to clients to stay away from Madof. For the full account of these red flags, see Gregory Zuckerman, Fees, Even Resturns and Auditors All Raised Red Flags (Dec. 13, 2008).
I. Demand Web-based Reporting. It certainly is easy to fake a Web-site, but Madoff didn't offer Web-based reporting to reporters. That is highly unusual in this day and age. This was another tip.
J. Demand an Auditor with a Reputation and Capacity. Our first question was: Where were the auditors? Turns out Madoff had an indepedent auditor. The firm was Friehling & Horowitz, which operated out of a 18-by-13 foot office according to a wide number of reports. Bloomberg is reporting that people who are located close to the office have said that they have seen only one person coming and going--in tight jeans and tie-dyed shirts. Just who we want auditing our $50 billion--a Jerry Garcia look-alike.
By the way, Madoff was not a wealth seeker or a greedy person, as surprising as that may seem. We suspect that Madoff 's primary motivation was to be a "Big Macher."
Internal Revenue Service - Circular 230 Disclosure: As provided for in Treasury regulations, any advice (but none is intended) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.
If you liked this post, please visit http://www.charitygovernance.com for a description of our training and consulting services. You will also want to acquire a copy of Jack Siegel's book, A Desktop Guide for Nonprofit Directors, Officers, and Advisors: Avoiding Trouble While Doing Good." Copyright 2008, Charity Governance Consulting LLC. All Rights Reserved. You may not copy any portion of this post to a computer "clipboard" for re-posting anywhere or e-mailing, or otherwise reproduce this post. If you want others to review this post, you may provide them with a link to this web blog. Any use of the material or ideas in this post by reporters or other publishers shall make reference to Jack Siegel, author of "A Guide for Non-Profit Directors, Officers and Advisors: Avoiding Trouble While Doing Good" and this web blog. For additional information call 773-325-2124
THE FOREGOING IS NOT AND SHOULD NOT BE TAKEN AS LEGAL ADVICE. IF LEGAL ADVICE IS REQUIRED, THE NONPROFIT OR OTHER PARTY IN QUESTION SHOULD SEEK THE ADVICE OF QUALIFIED LEGAL COUNSEL.
If you liked this post, please visit http://www.charitygovernance.com for a description of our training and consulting services. You will also want to acquire a copy of Jack Siegel's book, A Desktop Guide for Nonprofit Directors, Officers, and Advisors: Avoiding Trouble While Doing Good."
Copyright 2008, Charity Governance Consulting LLC. All Rights Reserved. You may not copy any portion of this post to a computer "clipboard" for re-posting anywhere or e-mailing, or otherwise reproduce this post. If you want others to review this post, you may provide them with a link to this web blog. Any use of the material or ideas in this post by reporters or other publishers shall make reference to Jack Siegel, author of "A Guide for Non-Profit Directors, Officers and Advisors: Avoiding Trouble While Doing Good" and this web blog. For additional information call 773-325-2124