Madoff Fund-Brokerage Link Questioned for Years

Chidem Kurdas, Dec 14, 2008

A hedge fund manager who was under investigation for defrauding his investors and who hoped to negotiate a no-prison deal with the prosecutor in return for providing information told government officials that there was big trouble at Bernard Madoff’s firm. Regulators did not take legal action, as far as can be determined. That was about nine years ago.

Those allegations in early 2000 were at least in part about an abuse of the relationship between the brokerage arm of Mr. Madoff’s business and the hedge funds he managed. At the time technology stocks were still riding high and Bernard L. Madoff Investment Securities was a major market maker on the Nasdaq, executing a great number of trades.

One rumor going around financial circles was that Mr. Madoff made his amazingly stable returns for the hedge funds by front running the brokerage trades—that is, taking investment cues from trades executed by the brokerage. In this telling, it was the brokerage customers, not the hedge fund investors, who were being harmed.

If anything, the fund investors benefited from this trading strategy, which worked in all markets because it was based on inside information. Since the strategy is almost certainly illegal, it would be no surprise that Mr. Madoff did not explain it to his clients and made a show of keeping the investment management separate from the market making.

An interesting part of the arrangement was that the investors did not have to pay the usual hedge fund fees. Instead, Mr. Madoff made money from the brokerage commissions on the trades his firm executed for the hedge funds. So the brokerage was pivotal for both the returns he made for the hedge funds and for the profits he took himself. Perhaps not having to pay the usual 2% and 20% attracted investors.

But this arrangement may have broken down or become too risky to continue in recent years. Without the inside information, the strategy would of course no longer work. It is also possible that some part of the $50 billion loss Mr. Madoff says he made is related to the brokerage. In so far as he engaged in a so-called Ponzi scheme of paying some clients with others’ money, that was likely a result of losses rather than a long-time tactic.

The issue of how intertwined the Madoff broker-dealer was with the Madoff hedge funds and the Madoff family’s hold on key positions in the firm attracted public attention. For instance, an article in The Globe and Mail discussed the Madoff business as a contrast to large financial companies’ new rules against hiring family members (“For Wall Street firms it’s no longer a family affair,” May 29, 2002.)

The various anomalies of the Madoff firm were thus highlighted in the early 2000s. Investors may have thought that regulators looked into the situation and found nothing amiss. The brokerage was always overseen by the Securities and Exchange Commission, which has extensive authority over broker-dealers.

As for the fund manager who tried to trade the information for leniency in his own fraud case, he was disappointed. For unknown reasons the various government agencies he told the story to, in particular the prosecutor’s office, did not give him the deal he wanted. He’s Michael Berger, the manager of Manhattan Capital. Facing prison, he escaped from the US after a lengthy legal battle and in 2007 was apprehended in his native Austria.

Copyright 2008 Chidem Kurdas. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.