 Smug Board Members Had Warm Feeling
About Heat That Turned Out To Be Ponzi Fire
By Rick Cohen
Is there anyone left in the nonprofit sector who has not seen the bevy of articles listing the foundations and charities that have been ripped off by Bernie Madoff and his $50 billion pyramid scheme? The press has been tallying the losses to investors, operating charities, and foundations, but there has been precious little analysis of what this means for the needed monitoring and oversight of how some foundations handle their --our—tax-exempt dollars.
What can we learn from Madoff’s horrific financial shenanigans? What does it all mean for the nonprofit sector? There are some important lessons here for every nonprofit in the U.S., whether victimized by losing the bulk of their resources or simply outraged by the cozy relationships of some investors and foundations -- playing fast and loose with tax exempt moneys.
First, if you were surprised, you shouldn’t have been. We’re in the middle of a deep recession. Were it not for various social safety net protections dating back to Franklin Delano Roosevelt (FDR) and some minor curbs on the stock market, we would be calling this economic freefall a depression, and if unemployment reaches double digit percentages during 2009, that’s what we’ll be doing no matter how much happy talk about the strength of our economic “fundamentals” emerges from Washington and Wall Street.
But in every recession, in the Great Depression, the number and size of embezzlement schemes rises. Commentators have cited John Kenneth Galbraith’s book “The Great Crash: 1929” for his commentary on the role of the “bezzle,” as he termed it, during the Depression. He didn’t say in any way that Madoff-type embezzlement schemes caused recessions.
What he did note, that the commentators missed, is that embezzlement schemes multiply in the boom period before the crash and their exposures cascade after the downturn. The first ones to be discovered, like the mammoth Madoff scandal, tend to be succeeded by more and larger scams.
In Galbraith’s words:
“In good times, people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed...Just as the [pre-Depression] boom accelerated the rate of growth [of embezzlements], so the crash enormously advanced the rate of discovery.”
So, now that we know about Madoff and his many years of escaping from regulatory oversight, look for more down the road. Expect billions more to be ripped off from investors -- foundations, nonprofits, and 401(k) retirement funds, being the concern of this column -- without recourse or recompense. In fact, prior to Madoff, they were already coming to the fore, notably the recent Petters family $3.5 billion Ponzi scheme in the Twin Cities. Among the charitable victims of Petters were evangelistic Christian investors, in contrast to Madoff’s emphasis on his Jewish peers. Petters, Madoff, and there will be successors.
Lots of foundations, their donors, rich folks and their financial advisors were snookered by Madoff’s pyramid scheme. The press called it a Ponzi scheme, but Charles Ponzi’s scams, pre-Depression, were penny-ante compared to Madoff. Isn’t this simply the story of a hugely successful crook who happened to swindle some naïve and gullible foundations among his willing victims?
Hardly. Madoff might have been a thief of the highest order, but he was playing the game of promising astonishing returns, asking investors (friends, associates, socio-economic peers) to trust his genius, and somehow no one --including some famous and highly paid investment advisors working on behalf of a few foundations -- looked closely enough behind the veil to see exactly where the money really was.
Therein lies the second lesson -- foundations were wrong to sink all of their funds in one narrow, dubious investment vehicle. These foundations, of various political and programmatic hues, invested so much of their corpus in Madoff’s investment vehicles that they went out of business overnight when he was exposed, That’s more than getting snookered by the man whose just-about-guaranteed investment returns earned him the sobriquet of “the Jewish bond.” That’s such bad investment behavior that it suggests that these foundations might be open to charges of improper and legally questionable investment of tax-exempt funds.
Remember, once these dollars were dedicated to foundations and charities, really good ones and well known ones like JEHT or less publicized family foundations like Chais and Lappin and even Madoff’s own family foundation, they were tax-exempt funds. For these foundations and their donors to sink them all with their good friend and social partner Bernie Madoff, it isn’t just having made a bad investment bet. There’s a question of whether tax-exempt funds -- yes, funds that would have been public funds BUT for the tax exemption -- were misappropriated.
That’s the question that the attorney general of Connecticut is asking, in so many words, and well they should. Investors in the various commercial funds that sunk their millions with Madoff are now contemplating or actually filing litigation against those firms for investing so much in a fund like Madoff’s which would have failed most basic due diligence standards. Why shouldn’t the representatives of the American people, at least the state AGs, ask similar questions on behalf of the taxpayers who trusted tax-exempt dollars to these foundations and their diligence-impaired investment advisors?
Realize that the law is not on the side of the taxpayers who gave these foundations their tax-exempt play money. As Connecticut AG Richard Blumenthal noted, the liability of the foundation boards for dumping their money brainlessly into Madoff’s investment pit “is, obviously, by no means crystal clear.” But the governmental appetite for digging into this is also apparently limited. One of Blumenthal’s AG peers issued a statement on Madoff that “we”, meaning the AG’s office representing the state’s taxpayers, “assume that [the charities’ boards] have performed as a board with due diligence to make investments on behalf of their charities [and] we can’t hold them responsible for anticipating that someone would engage in criminal activity, particularly someone who was as clever and convincing as [Madoff].”
Malarkey! These foundations sunk huge portions, sometimes all of their charitable assets, in this one fund, which was palpably dubious regarding audits and controls. Maybe you or I might not have figured this out with our tiny 401(k) investment dollars, but these big money people and their investment advisors should have and could have known. The issue, according to New York University Professor Richard Marker, is not to pursue people for stupidity -- there were plenty of those in the Madoff imbroglio -- but to pursue “charities or foundations that ignored their own investment policies, or conflict of interest policies, in an ill-conceived gamble on the Madoff firm.”
Especially with Madoff, whose operations were generally termed “black box” investments, there was plenty of opportunity to raise due diligence questions. How about Madoff’s questionable audits done by a relatively unknown three-person firm? One of the firm’s employees was 78 years old and living in Florida, a second was a secretary, and the third was an accountant in Rockland Co., New York, operating in a 13’ x 18’ office auditing a $50b hedge fund.
How about the lack of third party involvement in stock transactions? How about Madoff’s unwillingness to provide investors with online access to their accounts? How about Madoff’s refusal to file with the Securities and Exchange Commission (SEC), claiming that he sold all holdings by the end of the year (or reporting period) and only held cash? How about Madoff’s multiple sets of books to avoid scrutiny? How about the fact that Madoff generally recruited investors, even up to nearly a week before he was arrested, almost totally through his religious and social networks, the canary in the coal mine warning of the likelihood of “affinity fraud”?
A neat letter from a firm named Aksia outlined a bunch of very obvious reasons why it had constantly told its clients not to invest dollars in Madoff or its feeder hedge funds, all obvious to capable investment advisors --except for those who put their foundations’ money at risk with Madoff, apparently. In the clandestine operations of hedge funds, Madoff’s operations were akin to Maxwell Smart being treated like he was James Bond. (And he didn’t miss it “by that much. Would believe that much? Would you believe a country mile?)
The third lesson concerns regulation or the lack of it: Madoff and his investing foundations needed critical scrutiny that was absent at both the SEC, for Madoff, and the IRS, for the foundations. Madoff’s attractiveness to foundation investors was that his hedge funds, offering astronomical returns, were among the category of hedge funds that sit outside of most of the regulatory regimes covering equity investments. These hedge fund investments are increasingly sought by foundations, themselves among the least regulated sector of our society.
Why were the foundations and their donors so comfortable with Madoff? While a number of the victims are Jewish foundations, religion doesn’t explain it. The connection of Bernie Madoff in 2008 to Charles Ponzi in the early ‘20s is that both promised investors improbable, stunning, insane returns on their investments, operating outside of operable regulatory regimes. Madoff’s pitch was that his vehicle was a “fund of funds,” a hedge fund that invests in other hedge funds and in doing so is therefore diversified, but just about guaranteed double-digit returns year after year.
Think that all your money in one fund that says it is diversified is really a strategy of investment diversification? Anyone want to buy Charles Ponzi’s prime Florida swampland?
Like Charles Ponzi, Bernie Madoff’s pyramid scheme wasn’t caught by the SEC -- or the foundations’ investment advisors. As a pyramid scheme, it simply collapsed when the required payments to early stage investors exceeded the inflow of capital from new investors.
The foundation sector, led by the Council on Foundations, has long been advocating less restrictions on foundation investment alternatives, notably its drumbeat to permit foundations to sink money into on-shore and off-shore hedge funds and other “alternative investments.” According to the Council of Foundations, hedge funds now account for 7.5 percent of community foundation investments in 2006 and 8.4 percent of private foundation investments in 2005.
The SEC isn’t going to catch many of the Madoff emulators, because this is a sector that has, through political contributions and more, done a bob and weave to sidestep most regulatory oversight. If foundations think that the path to their ever increasing endowments is through sinking money in hedge funds or in putting money in off-shore entities created to avoid U.S. tax laws, operating on the margins of regulatory oversight, they will reap what they sow.
It’s high time for the AGs to do what the Internal Revenue Service (IRS) is obviously reluctant to do, to question what the heck was going on in the minds of the foundations’ investment advisors to allow them to trust Bernie Madoff with all or nearly all of the money that the U.S. taxpayers had entrusted to them?
There’s the fourth lesson -- we have to start devoting critical attention to the “cowboy economy” and “cowboy philanthropy.” Although foundations of all sorts seem to be warming to the hedge fund alternatives, the foundations that lost their shirts in the Madoff scandal don’t appear, at this moment, to be the institutional foundations. They appear to be family foundations established and controlled by a few living family members, running their philanthropies at the same time that they run their money-making vehicles.
Many of the foundations did good work, notably JEHT, which supported a variety of human and civil rights projects before closing its doors in December. But there’s a feel to some of these foundations in the Madoff vortex that they were, as Brandeis University Professor Jonathan Sarna described them, “cowboy mega-donors,” the philanthropic equivalent to the “cowboy economy” of plentiful resources, extreme individualism, no regulation, and, as noted by Jim Chen, dean of the University of Louisville Louis D. Brandeis School of Law, wealthy donors with resources to supply outside of an ethic of investment stewardship.
The Aksia letter referenced above notes several of the disreputable Madoff practices that are all too emblematic of the operations of cowboy philanthropists: The secrecy, the resistance to transparency, the unwillingness to reveal inside operations are all all-too-common in U.S. philanthropy.
Add this finding from Aksia, and the affinity between Madoff and these family foundations is all too evident: “Key Madoff family members (brother, daughter, two sons) seemed to control all the key positions at the firm. Aksia is consistently negative on firms where key and control positions are held by family members.” Do check how many of these victimized foundations were family affair governance structures. It might be time to turn a very tough eye on family foundations, large and small, where the stewardship of tax-exempt moneys is left to a handful of people all with the same surnames.
A Boston University professor, Mitchell Zuckoff, suggested in Fortune magazine that the foundations made perfect fodder for Madoff. Since his pyramid scheme required taking in new money to pay off claimants looking for payments of principle and earnings, Madoff was able to rely on foundations’ keeping 95 percent of their funds in his coffers, having them withdraw their 5 percent payouts, enabling him to use these tax exempt funds to respond to payment demands by other investors. According to Zuckoff, “For every $1 billion in foundation investment, Madoff was effectively on the hook for about $50 million in withdrawals a year.” The combination of these foundation investors’ willingness to dump nearly all their tax-exempt assets in Madoff Securities and their self-limiting demands for the money served Madoff’s pyramid scheme perfectly.
Madoff might have just established one of the best arguments possible for spending down foundation assets, that leaving the funds sitting in hedge funds like Madoff’s constitutes giving speculators virtual “play money.” Putting those funds to work, in the hands of operating nonprofits, takes away the speculator’s almost irresistible incentive to play fast and loose with no-recourse money. The insatiable appetite for foundations to grow their endowments and limit their payouts makes even progressive donors into partners with investment funds promising hefty returns while dodging or fighting governmental scrutiny.
So a number of foundations and endowed nonprofits, to the extent that the information is available even now, lost most or all of their assets, or better put, lost most of the tax-exempt funds entrusted by the American public to them. Of course, they really don’t know exactly how much they lost, since they were relying on Madoff’s representations of the value of their investments. Already, some of the charities and foundations are revising their losses downward, realizing that their estimates of the value of their endowments were based on Bernie’s estimates of earnings, now exposed as Ponzi-illusory. You can’t claim Madoff’s promises as verifiable estimates of value.
But as taxpayers and observers, we really don’t know how much these tax exempt entities might have lost either -- and we couldn’t. These foundations file Form 990PF with the IRS which list their investments, but the public would be stymied to figure out how much the nonprofit and foundation sectors actually had invested in Madoff. The data isn’t digitized and easily searchable by normal investigators.
Even if you put scores of researchers to work reading the pdfs of 90,000 foundations, you might not spot “Madoff” as the investment vehicle as opposed to the names of intermediary hedge funds or “feeder funds” like Ascot and Tremont, so watchdogs and regulators would have been hard pressed to determine how much tax exempt money had been placed at risk by these foundations’ primary and secondary relationships with Madoff.
The end result? The American public entrusted some millions and billions with investor-philanthropists who turned a nearly blind eye to their investments inside Bernie Madoff’s pyramid.
But some charities seemed to escape the scam even though they had some tangential connection to Madoff. As has been widely reported, Madoff’s children have vocally professed that they had no knowledge of dad’s financial shenanigans, despite being financial wizards themselves, and were shocked, shocked! when they learned. Believable? The authorities are still looking at how much the Madoff kids, as well as Bernie’s brother and spouse, knew about the systematic scam the firm pitched to investors.
Bernie’s son Andy, a director of proprietary trading at dad’s firm after graduating Wharton, began serving as chairman and CEO of the Lymphoma Research Foundation (LRF) as of January 2008 in addition to his Madoff Securities work. But since becoming involved with LRF as far back as 2003, LRF somehow never invested a nickel of its resources in Madoff’s hedge fund. A check of the young man’s personal foundation (the Deborah and Andrew Madoff Foundation), the latest 990PF being from 2004, also reveals no investments through Madoff’s firm or the other hedge funds that invested through Madoff, preferring equity investments and bonds through Lehman Brothers and Goldman Sachs. Deborah’s own family-related foundation, the Fran-Man Foundation, also seems to have steered clear of putting its resources in Bernie’s hands. Brother Mark Madoff, on the board of Lincoln Center’s Vivian Beaumont Theater, has resigned from that post, but there’s no evidence or word that the Theater’s $90 million in assets were lost in Madoff investments.
Even as they worked for the firm, the children seemed to avoid, at a minimum, the conflict of interest of investing their foundations’ tax-exempt dollars in the family investment scam, or at best knew that the hedge fund of hedge funds concept was no better than the investment scams John Kenneth Galbraith described in “The Great Crash.” Unlike some of the charities and foundations that lost their endowments, the sons seemed to grasp some concepts of due diligence, prudent investment, and conflicts of interest.
Remedies? Not in the offing. The Web site of Madoff’s firm (Bernard Madoff Investment Securities) announced the liquidation and receivership status of both BMIS and Madoff Securities International, pursuant to the Securities Investor Protection Act (SIPA).
These foundations and other private investors might be out $50 billion, but the Securities Investor Protection Corporation (SIPC) can help investors recover some of their investments out of what might be left in the fraudulent fund up to a total of $500,000 per investor. The SIPC is notoriously tight on payouts and resistant on payouts to people defrauded by hedge funds. Even if it paid out $500,000 per investor, that wouldn’t make multi-million dollar philanthropic endowments whole by a long shot.
Over its history since being established in 1970, the SIPC has paid out $508 million to 625,000 investors; do the math, that’s a compensation of $812.80 per investor.
Reportedly, the SIPC has sent out 8,000 claims forms to potentially aggrieved Madoff investors. The taxpayers who made their investments by entrusting tax exempt funds, that is, foregone tax revenues, to the foundations in the Madoff scam won’t receive claims forms. Maybe something will come from New York State AG Andrew Cuomo’s reported inquiry into frauds that might have been perpetrated on charities as a result of this scam, though reportedly not probing Madoff himself. Among public and charitable investors in Madoff, fingers are increasingly being aimed at their investment advisors for allegedly not providing sufficient warning, information, and due diligence. But advisors are only advisors; the people with the investment decisions have to own up to their responsibilities for playing fast and loose with taxpayers’ moneys.
The Bernie Madoff scandal is a shot across the bow of Wall Street and the SEC, no question about that. But it’s also a red flag that the era of family philanthropy that plays a bit too fast and loose with taxpayers’ tax-exempt charitable dollars might be coming to an end.
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Rick Cohen is the former executive director of the National Committee For Responsive Philanthropy in Washington, D.C. His email address is cohenreport@npqmag.org and the Web site for the Cohen Report e-newsletter is http://www.nonprofitquarterly.org/cohenreport/
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