With Madoff, even winners may lose out

By Alex Berenson

Published: December 19, 2008

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Amid the thousands of people caught up in the alleged multibillion-dollar fraud of Bernard Madoff, some investors stand out.

They made money.

One client said he invested more than $1 million with Madoff over a decade ago. As his portfolio rose in value, he took out several million dollars. While his statements showed several million dollars in his Madoff account when the fund collapsed last week, the client still ended up ahead.

How many clients of Bernard L. Madoff Investment Securities profited unwittingly on what Madoff described as a big Ponzi scheme. But given the structure of Ponzi schemes, which use money from later investors to pay early investors, many longtime clients may actually have wound up ahead.

"In a Ponzi scheme, not all investors lose," said Tamar Frankel, a law professor at Boston University who has written on Ponzi schemes. "Those who manage to get out in time retain their investments and some of their gains."

But previous court rulings regarding financial frauds suggest the winners could be forced to give up some of their gains to losers.

One of the unanswered questions so far is precisely how much investors lost over all.

When Madoff confessed and was arrested last week, he told FBI agents that the losses might be $50 billion, according to court filings. Various institutions and individuals so far have reported losses totaling more than $20 billion, but it is unclear how much of that is cash they actually invested and how much represents paper profits based on the falsified returns Madoff said investors were earning.

Madoff regularly delivered returns of 10 to 17 percent to investors, a very good year-in, year-out return but on the low end of the 10 to 100 percent a year typically dangled by promoters of Ponzi schemes.

But assets that can guarantee those returns year after year without risk simply do not exist. Instead of profitable investments, Ponzi schemes repay initial investors by raising more money from new investors. The schemes typically collapse when the promoter cannot bring in enough money to pay existing investors seeking redemptions.

Joel Cohen, the deputy head of litigation for the Clifford Chance law firm and a former federal prosecutor who specialized in business and securities fraud, said that payments to early investors are an integral part of any Ponzi scheme.

"You need to deliver returns in the range that you promised to attract investors," Cohen said.

Yet even Madoff's most fortunate clients may wind up having to give back some of their gains, as investors might have to do in another recent financial fraud, the collapse of the hedge fund Bayou Group in 2005.

In the Bayou case, in which investors lost $400 million, a bankruptcy judge ruled that investors who withdrew money even before Bayou collapsed might have to return their profits, and possibly some of the initial investments, to the bankruptcy trustee overseeing the unwinding of Bayou.

The returned money is to be distributed among all investors, who are expected to receive only about 20 to 40 percent of their original investments.

Madoff's winning clients are likely to face similar legal challenges. In fact, the Madoff client who profited from his investment spoke on the condition that he not be identified, out of concern that he might be sought out to repay some of his gains to the receiver or bankruptcy trustee for Madoff.

Jay Gould, a former lawyer at the Securities and Exchange Commission who now runs the hedge funds practice at Pillsbury Winthrop Shaw Pittman, said the client was correct to be concerned. New York State law may allow the receiver or bankruptcy trustee to demand that Madoff's investors return money they received from the scheme anytime in the last six years, Gould said.

Such so-called clawbacks may occur even if the client had no idea that the gains were fraudulent, he said.

"The idea is that the whole thing was a fraudulent undertaking, so nobody should profit from it, and everybody should be put on equitable footing," Gould said.

But in a sign of the complexity of securities law, Cohen said he did not agree with Gould's interpretation.

"I don't think it's that easy to claw back money from something that happened six years ago," Cohen said. "There's no level of fiduciary duty between investors. If someone put in a million dollars five years ago, and made 11 percent, and took their money out after one year, are they required to give back the 11 percent? I think that's inaccurate."

Even determining which investors made money will be enormously complicated.