Investments, Fraud and Fairness

Bernie Madoff is currently in jail for master-minding the largest Ponzi scheme in history. But the saga is far from over for his investors. Irving J. Picard is the bankruptcy trustee appointed by the court and charged with recovering funds and then ensuring the fair distribution of any recovered money. So far Mr. Picard has filed lawsuits seeking to recover money from Madoff’s immediate family, from the so-called “feeder funds” whose directors profited from the fraud, and from major individual investors who profited. One lawsuit, against the estate of investor Jeffrey Picower, was recently settled for 7.2 billion dollars. Another, against the owners of the New York Mets, is currently in mediation.

One of the features of a Ponzi scheme is that investors who enter the scheme earlier have the possibility to profit from the fraud, whether or not they are aware what is going on. Since the funds of later investors go to pay for the “earnings” of earlier investors, investors signing on later in the fraud have less possibility to recover any “profits” and are at risk of losing more than the earlier investors. Mr. Picard has asked any investors who recovered more money than they invested in the last six years of the fraud to return their “earnings.” For example, if someone had invested $100 000 with Madoff and withdrew the annual “profit” of 11% each year for six years, that investor is being asked to return $66 000. This seems fair. There was, in effect, no profit from investments because the funds weren’t really invested. The $66 000 “profit” was the money paid into the fund by later (unluckier) victims. Even though our $100 000 investor didn’t know what was going on, he or she benefited from the fraud at the expense of others.

Now here is where it gets a little more complicated (and ethically interesting): We can assume that our imaginary investor is fairly unsophisticated. He or she was not in a position to suspect that Madoff was a fraudster. (Presumably, if our investor had suspected as much, he or she would have invested elsewhere.) But not all of Madoff’s investors were equally unsophisticated. Mr. Picard has argued that “sophisticated” investors, such as the owners of the Mets, should have suspected Madoff, although there is no evidence that they did. These investors should be treated, in effect, as if they did know. This would mean treating them as if they acted “with actual intent to hinder, delay or defraud creditors.” Mr. Picard is asking Fred Wilpon and his associates for the return of the “profits” from the last six years (requested from all investors), as well as the $132 million in “profits” from earlier years. He has also argued that because Mr. Wilpon ignored numerous “red flags” about Madoff, he should pay back all of the money he invested – around $700 million.

Mr. Picard suggests, in effect, that there are two kinds of Madoff victims – “sophisticated investors” who should have known better and “unsophisticated investors” who can’t be expected to have known better. The legal issues here are very intricate and turn on past interpretations of the doctrine of caveat emptor (“let the buyer beware”). The ethical issues strike me as just as intricate. If Madoff was not a fraudster, but rather a legitimate investor whose holdings were wiped out in the economic downturn, would we want to say that sophisticated and unsophisticated investors should be treated differently? It can be argued that large investors, such as the owners of the Mets and the various banks who invested with Maddoff, contributed to the perception of legitimacy that the fund enjoyed. I can imagine an unsophisticated investor thinking, “If J.P. Morgan is invested, it must be a good bet.” If the actions of large sophisticated investors did contribute to the losses of unsophisticated investors, should the former be held financially responsible? Perhaps most importantly, what mechanisms should be in place for the future, so that all investors, whatever their level of sophistication, have adequate information to make informed decisions?