Investors Forced To Give Madoff 'Profits' Back?

Imagine this scenario; You are an honest fund manager who has returned pretty good profits to your investors and you are just beginning to think that you might scrape through the credit crunch with a fund, happy clients and a future. Then you get a letter from lawyers saying that one of the investments you made, and then withdrew from, wants the profits back.

Nightmare right?

Looks like this is what is befalling a number of investment managers and charities in the Bernie Madoff case.

The bottom line is that investors who withdrew funds in the last 4 years may be sued for those profits, and perhaps, some principal. The problem for the bankruptcy trustee, Irbing Picard, is that those who have to pay back withrawn funds will then have a claim for losses from the scandal. These claims have to be submitted before July 2nd, only issue is that the trustee hasn’t told investors how clawback claims would be handled.

This means that people who withdrew money before the firm imploded may be compelled to file documents before the July 2 deadline to preserve their claim. If they do, they may lose the right to a jury trial if Picard sues seeking return of the money.

Confused? Me too.

Picard said Feb. 4 he has recovered about $946.4 million in cash and securities for customers of the bankrupt New York company, allegedly at the center of a $50 billion Ponzi scheme. Picard, appointed as part of the Securities Investor Protection Corp.’s supervision of the advisory firm, declined to comment when asked by reporters.

Bernard Madoff was arrested by FBI agents in December and charged with securities fraud. Madoff, 70, hasn’t formally responded to the criminal charge, though on Feb. 9 he partially settled a parallel suit by the U.S. Securities and Exchange Commission. He said he wouldn’t challenge the SEC allegations when the judge in that case determines the penalty. Madoff didn’t admit or deny any wrongdoing in the settlement.

Creditors of his firm may file claims until July 2, though customers should submit their forms before March 4 to be paid “out of customer property,” according to Picard’s Web site.

Any way you look at it, the only certainties will be time, litigation -- and pain. "It's hard to have a rule of thumb on this," says Robb Evans of Robb Evans & Associates. Evans was the receiver -- the person appointed by authorities to oversee the company while it's in government control -- for the Bank of Credit and Commerce International after it collapsed in a multibillion-dollar fraud and has also served as receiver in dozens of Ponzi schemes. "But the longer the Ponzi scheme has run, the less money is going to be available. Because the only way a long-running Ponzi scheme can keep going is by paying off early investors."

As Evans puts it, "The sad part of it is that it usually works out that your primary source of recovery is innocent people who put in their money early and got their money out -- and are asked to return it."

This is the legal notion known as "fraudulent conveyance," and it's a concept whose interpretation has recently gotten much more onerous for investors.

The basic notion is ancient, says Philip Bentley of New York-based law firm Kramer, Levin, Naftalis & Frankel. "It's an old concept going all the way back to back to Elizabethan times," he says. "The first case involved a man who transferred all his sheep to his wife to keep them out of the hands of people who were suing him. Nowadays, the classic case of a fraudulent transfer is a man who is being sued who transfers his house or his investment assets to his wife."

According to Bentley, it is long-settled law that some investors might have to give back some or all of their investment gains. But what has changed as a result of a federal court ruling in 2007 -- stemming from the faked results and misappropriation by the now-convicted managers of the $450 million Bayou hedge funds -- is that some investors might have to return some of their principal, too.

In the abstract, there's some logic here. Here's how Bentley, who represented 70 clients who had invested in, and then exited, the Bayou fund before its collapse, explains it: "The court ruled that because there was clearly a fraud going on at Bayou, and because arguably the redemption payment to investors furthered the fraud by fostering the illusion of profitability, the investors who took out their money were liable if they knew of the fraud or if they should've known of the fraud."

As Bentley puts it, "the first part -- having to give money back if they knew of the fraud -- is uncontroversial. Because if they were in on the fraud or had inside information, not many people would quarrel with the view that they should give money back. But what's problematic about the Bayou decision is holding them liable if they should've known; in other words, if they saw enough red flags that they should've investigated further."

"There's going to be a very big policy issue at stake," Bentley argues. "You're penalizing the investors who were savvy enough to see the warning signs that others overlooked... And the question is, especially in today's world, when you've got a financial crisis caused by people being blind to risk, do you really want to put in place a legal rule that penalizes investors who were savvy about risk and did something about it?"

Apparently, this is going to take years to resolve and with all the convoluted legal issues here I doubt any investor will get back much. I do know one thing though, this is going to soften the recessionary blow for many a lawyer, and the trustee? He wants $28 million for salaries and expenses.

So investors have paid their taxes for the SEC to protect them, which they didn't and now they are going to pay money out of potential settlements to trsutees and lawyers to sort the mess out.

Is it just me, or is something very wrong here....