Far from the Madoff crowd

Mon Feb 2, 2009

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By Neil Wilson

The brouhaha surrounding the huge fraud perpetrated by Bernie Madoff could hardly have come at a worse time for hedge funds. Performance in general was deeply disappointing in 2008. Even if the industry did, on average, beat returns in most asset classes, the fact is that a significant majority of hedge funds were negative on the year. And with an increasing number imposing "gate" provisions or suspending redemptions, all too many managers have also gotten themselves into highly fractious relationships either with their investors or with their prime brokers, or both.

Two key questions will dominate the debate about Madoff for the foreseeable future. One: how did he do it? And two: how did get away with it - how come the extensive due diligence supposedly conducted failed to discover that the Emperor had no clothes? There will be a lot of further investigation and research before final conclusions are reached on those questions.

Nevertheless, some key points can already be made - even at this relatively early stage - about some of the lessons for the industry.

Yet again, this is a fraud that occurred in the United States - as have almost all the scandals since the industry began. And the U.S. remains one of the few jurisdictions where it is still possible to run a hedge fund without having to be registered with a regulator. The U.S. also remains one of the few jurisdictions where it is still commonplace to run a fund without an independent administrator.

From the very first edition of Absolute Return back in 2003, we have argued strongly in favor of registration and of independent administration. To me, the Madoff case seems to demonstrate yet again how important it is for the industry to have more checks and balances - as it already has in most other parts of the world.

Of course, there are arguments against registration, as well as against independent administration. Those who oppose such developments will not be slow to point out that the SEC hardly covered itself in glory in its regulation of Madoff as a broker/dealer - within which this fraud was perpetrated; and secondly, that various of the Madoff feeder funds, such as Kingate and Fairfield Greenwich, did retain independent administrators - who were seemingly ineffective at helping investors detect the fraud.

There are various reasons, however, why I think Madoff presented a highly special case - and hence why it does not invalidate the need for more industry oversight.

The Madoff funds were run within an exceptionally unusual - probably unique - structure, in which Madoff himself was not the "manager" but merely a kind of subadviser who charged commissions to the feeder funds. This should of course have served as a major red flag to potential investors - as to why he would willingly forgo the 20% performance fees picked up by a normal manager and allow those to be picked up instead by the feeder funds.

A second major difference was that - unlike most hedge funds - Madoff did not use any independent prime broker. Hence, any administrator that checked the trades claimed during a reporting period could check the audit trail with only one source - Madoff Securities.

The administrators may or may not have done their jobs properly - they certainly have some tough questions to answer, and that will only be established in time. But the problem was arguably more with the absence of independent prime brokers. And this again, of course, should have served as a red flag for investors.

The fact that Madoff itself did not possess a credible auditor is something else that should of course have been noted by investors, or those doing due diligence on their behalf.

To us, it seemed for quite a long time that something was suspicious - if not about the size of the returns reported by Madoff, then the unbelievably smooth return pattern. For it to be possible, I felt Madoff must have discovered some new and undetectable way of "front running" customer orders - or that he was a fraud.

We now know, of course, that the SEC was approached by at least one party who argued forcefully it should investigate. Not for the first time, the SEC was not up to the task.

Nevertheless, it does not seem right that the SEC should be excluded from the industry, and even less likely to occur. A better solution is surely for the SEC to improve its game. If it can do that, with a system of registration and sensible (not heavy-handed) oversight - which I admit is a big "if" - then it may be possible both to deter future fraudsters and to encourage a healthier, more robust industry in the future.

ISSN: 2151-1845 / CDC10004H

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