Lessons for Charities and Foundations from Bernie Madoff

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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 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 in 2009, that’s what we’ll be doing no matter how much happy talk about the strength of our economy 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 “The Great Crash: 1929” book 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.

But 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 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, Tom Petters focusing on evangelistic Christian investors in contrast to Madoff’s emphasis on his Jewish peers.  Petters, Madoff, and there will be successors.

So, a bevy of foundations, their donors, 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), and so were a lot of other rich people.  Isn’t this simply the story of a hugely successful crook who happened to swindle gullible foundations among his willing victims?

Hardly.  Most commentators on Madoff’s thievery looting of as much as $50 billion focus on the swindle, but that’s hardly the only story.  The Madoff story looks so much like the investment trusts of the 1920s, funds that look a lot like Madoff’s promising huge returns, the diversification of their investments hidden behind the financial genius of Bernie Madoff much like the deification of the investment trust wizards before they and their investors lost everything in the great crash.  Madoff might have been a thief of the highest order, but he was playing the game of promising returns, asking investors (friends, associates, socio-economic peers) to trust his genius, and no one looked 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 vehicle.

These foundations of various political and programmatic hues invested so much of their corpus in Madoff’s investment vehicles that when he was exposed, they went out of business overnight.  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, 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 ones 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, such as Ascot Partnership and Tremont Group Holdings, 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 those 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 appetite for digging into this is limited, as evidenced by the less aggressive approach of Massachusetts AG Martha Coakley, who said that “we”, meaning the AG’s office representing the taxpayers of Massachusetts (where some foundations have completely shut down due to Madoff), “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!  They 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 investment dollars, but these big money people and their investment advisors should have and could have known. The issue, according to NYU 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 Madoff, whose operations were generally termed “black box” investments, there was plenty to raise due diligence questions.  How about Madoff’s questionable audits done by a relatively unknown 3-person firm (one of the 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 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 in order 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.

The third lesson is 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, 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 onshore 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, in putting money in off-shore entities created to avoid U.S. tax laws, and other “alternative” investment vehicles, they will reap what they sow.

It’s high time for the AGs to do what the 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 many of these foundations in the Madoff vortex that they were, as Brandeis professor Jonathan Sarna described them, ” cowboy mega-donors” , the philanthropic equivalent to the “cowboy economy” of plentiful resources, extreme individualism, no regulation, and, as Louisville law school dean Jim Chen notes, 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 may 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 that the foundations made perfect fodder for Madoff.  Since his pyramid scheme required taking in new money to pay off claimants looking 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 may 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.

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, according to these early publicized estimates (this list doesn’t include nonprofits that will suffer because of the grants they will lost from these shrunken or closed foundations):

  • The JEHT Foundation (closed)
  • The Robert I. Lappin Charitable Foundation (closed)
  • The Chais Family Foundation (closed)
  • The Los Angeles Jewish Community Fund (out $25.5m)
  • Fairfield Town Employees Board and Police and Fire Board (out $41.9m)
  • The Carl and Ruth Shapiro Family Foundation (out $145m)
  • The Technion-Israel Institute of Technology ($6m)
  • The UJA Federation of New York (“significant hit”)
  • The North Shore-Long Island Jewish Health System Foundation (out $5.7m)
  • Yeshiva University (out $110m, 10% of its endowment; Madoff was a trustee there, and the money was invested with Madoff through a hedge fund controlled by another Yeshiva trustee)
  • Tufts University ($20m)
  • Gottesman Family Foundation
  • Betty and Norman F. Levy Foundation
  • Picower Foundation (closed, out $955m)
  • The Fair Food Foundation
  • New York Law School ($3m through Ascot partners, being sued for “wrongful conduct”)
  • Elie Wiesel’s Foundation for Humanity ($15.2m)
  • The Ramaz School (out $6m)
  • Children of Chernobyl
  • Charles and Candice Nadler Family Foundation
  • Phileona Foundation
  • Robert M. Beren Foundation
  • the foundation of New York Daily News and US News and World Report owner Mort umer Zuckerman ($30m)
  • Julian J. Levitt Foundation ($6m)
  • family foundation of Senator Frank Lautenberg (D-NJ)
  • Stephen Spielberg’s Wunderkinder Foundation
  • family foundations of Fred Wilpon (New York Mets owner)
  • Massachusetts state pension fund (out $12m)
  • the charitable trusts of Avram and Carol Goldberg (money from the Stop & Shop supermarket chain)
  • The Bernard L and Ruth Madoff Foundation (presumably its $19m is also gone)

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.

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 990PF forms 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, so for 90,000 foundations, we can only wait and see which fly the flag of Madoff-victim over time.  Moreover, some would have likely invested in intermediary hedge funds like Ascot and Tremont which then invested for leverage in Madoff, so the actual proportion of foundation assets sunk into this scam wouldn’t be apparent even if the data were searchable.

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 ponzi 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?

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 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.

Bernie apparently confessed to his sons, they consulted a lawyer, and it is unclear somewhat as to whether the lawyer went to the authorities to report a crime that was likely to be committed or the sons went to the authorities directly after the legal consultation.  But the FBI complaint reports on conversations with two “senior employees” of Madoff’s firm, presumably the sons, who had enough knowledge of the situation to question the father’s idea of distributing employee bonuses earlier than scheduled.  Somehow, it all doesn’t ring totally true.  Did they all figure out, based on unscheduled employee bonuses, that “MADOFF stated that he was ‘finished’, that he had ‘absolutely nothing’, that ‘it’s all just one big lie,'” as the FBI complaint noted?  Or might this have been the general awareness that the scheme was about to collapse, and that to pick the dad to take the fall for the family was the simplest and easiest out?  (The kids and other family members are still being investigated by the authorities).

But 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 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 website 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 may be out $50 billion, but the Securities Investor Protection Corporation can help investors recover some of their investments out of what may 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.

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.