The hedge fund industry has been shaken by volatile financial markets and the Madoff investment scandal of December 2008. While the hedge fund and investment management industries are changing because of these twin forces, many people are looking back to try to piece together what has happened and more importantly why it happened. One primary source will definitely be “The World’s Largest Hedge Fund is a Fraud” – a whistleblower manifesto provided to the SEC on November 7, 2005 by Harry Markopolos. This article provides a link to the manifesto (Madoff Whistleblower Report), and discusses the observations and predictions therein.
Overview
Mr. Markopolos has been highly profiled and written about since the report came to light. In the report he describes himself as a derivatives expert who has significant experience trading options strategies in the U.S. Mr. Markopolos starts the report by providing details on the Madoff trading firm and the arrangements with various fund of funds and other investors. According to Mr. Markopolos these uncommon arrangements were entered into in order to evade regulatory requirements. Madoff’s investment returns are summarized (through the lens of the Fairfield Greenwhich fund).
From the very beginning Mr. Markopolos lays out his fundamental beliefs about the Madoff trading program and gives two potential scenarios for the incredible Madoff returns. The potential scenarios are (1) that Madoff was front running customer orders through his executing broker dealer or (2) he was operating a massive Ponzi scheme. Both scenarios would present problems for Madoff as front running is illegal under the securities laws and running a Ponzi scheme is nothing more than outright fraud and stealing.
The report runs through 25 different points (many of which have sub-points) and 29 “Red Flags” were found. While many of the red flags relate to one another, it becomes very clear very fast that there is something wrong and that an investigation should be in order. The report ends with a 6 point conclusion.
The Predictions
Mr. Markopolos made a series of predictions about what would happen once the scheme was discovered. One prediction was that Congress would be up in arms and pissed that something like this could happen. In fact, members of Congress are pissed and there have been numerous stories castigating the SEC for not investigating Madoff. Mr. Markopolos also predicted that those people who have been calling for less hedge fund regulation would be silenced. On the contrary these people seem to be even more adamant that hedge funds should not be regulated. The argument goes something like – Madoff was not a hedge fund….
Another prediction from the fallout was that the SEC would receive increased funding and would also garner more political clout. It remains to be seen whether this is the case, but with a shaky economy and pressing bailout concerns, it may be politically inconvenient for either Chairman Cox or incoming Chairman Shapiro to press this issue with Congress or the incoming President.
Legal/ Due Diligence Notes for Managers
There are a couple of important notes for hedge fund managers. First, as Mr. Markopolos points out when discussing the Fairfield performance results, a hedge fund’s results should always be compared against an appropriate index. In Madoff’s case, the performance of his split-strike conversion program was compared to the S&P 500 when it should have been compared to the S&P 100’s OEX performance. While this is not a red flag, it is important for hedge fund managers to remember that performance results should always be compared to an appropriate index. Please see Hedge Fund Performance Advertising.
Another item which is discussed was the use of a non-independent audit firm. According to the report Madoff’s organization was audited by a firm his brother owned
Conclusion
It is clear from the report that the SEC had a guidebook for taking down Madoff years ago and failed to act. Even the most junior or new SEC attorney could have seen the red flags deserved to be checked into. The fallout for the hedge fund manager is likely to be increased requests for due diligence and less blind investing by investors. As Mr. Markopolos noted, hedge funds will face increased due diligence from regulators, investors, prime broker, and counter-parties – and that is a good thing.
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