From the January 2010 issue of Investment Advisor • Subscribe!

The Affluentialist: The Next Case of Madoff Disease

The illness can affect smart, affluent clients, overwhelming logic

Even shrewd clients and professionals are susceptible to Madoff disease--that seemingly inexplicable investment flu that stuns its victims into becoming non-questioning believers despite the warning signs. To spread, a victim doesn't even need to touch a Madoff directly, just one of his surrogate carriers.

When clients rely on just the word-of-mouth reputations of investment professionals within their social groups, they miss out on the healthy skepticism and due diligence exercised by an advanced planning group. A referral from a successful friend may be a great place to start, but it's only a start. The next Madoff may offer different trinkets, but the same seductive allure will still infect some with short memories and weak immune systems.

How One smart Client Lost $30 Million

Morton Zuckerman knows something about financial matters and analysis. He holds substantial real estate (in Boston, New York, Washington, and San Francisco), owns media companies (notably The New York Daily News, where he is also co-publisher, and U.S. News & World Report, where he is also editor-in-chief), and pursues large philanthropic endeavors. After receiving an MBA from the Wharton School, he attended Harvard for his LL.M, and stayed on to teach for nine years at the Harvard Business School as an associate professor. By any account, he would be considered a financially sophisticated client, even if he weren't familiar with particular investment strategies.

In court papers, Zuckerman said his Charitable Remainder Trust invested $25 million in the Ascot fund run by Ezra Merkin, a very-well connected money manager and financier, who also became chairman of GMAC about the same time. According to the offering documents, Ascot was to take a value investing strategy adopting "a selective approach in evaluating potential investment situations, generally concentrating on relatively fewer transactions that he can follow more closely. [Merkin] is expected to engage in hedging and short sales." The trust paid an annual fee of 1.5%, while Merkin also required strong lock-up restrictions on redemptions. The developer and publisher also invested $15 million of personal money with Merkin's Gabriel Capital fund. In all, he had given $100 million to various Merkin ventures, since he considered him a "trusted advisor."

On December 12, 2008, Zuckerman received two faxes from Merkin. The first one informed him that substantially all of the $1.8 billion Ascot fund was invested with Madoff's company and likely gone. The Trust was out $30 million. The second revealed that 30% of Gabriel Capital was also gone. Between September 2005 and December 2008, Zuckerman and Merkin had spoken several times. "Never once during their numerous meetings and calls did Merkin mention to Zuckerman the name Madoff," states the complaint.

Zuckerman is not the only experienced investor to be shocked by Merkin's activities. As it turned out, Merkin was completely entwined with Madoff. New York University has sued Merkin, claiming $24 million in losses, which occurred when he invested the school's funds with Madoff without prior discussion and even after officials objected. A separate class action suit brought by a group including professional investors claims that Merkin misled them by stating that Ascot invested in a diverse portfolio of securities.

As chairman of the investment committee of Yeshiva University, Merkin was even able to place $15 million with Ascot--while taking a 1.5% annual fee--and at the same time he made charitable contributions to the school. In fact, the school could have invested directly with Madoff without paying the fee. Interestingly, Madoff later served on the board as treasurer.

"There are dozens and dozens of people who...thought they were investing in a multiple and diverse group of funds," Zuckerman told BusinessWeek soon after he received the two faxes from Merkin. He expected Merkin to inform investors about such a substantial investment in a single fund. "This is somebody whom I had known who had managed money, particularly for philanthropic funds," stated Zuckerman. "I wasn't looking for this charitable fund to make a lot of money. I wanted it to make some money, of course, but most of all, to preserve the principal. It wasn't to be a high-risk investment."

When asked about how very successful people could get burned by such a scam, Zuckerman provided an interesting answer that showed the reliance on reputation, not the more rigorous due diligence with which advanced planning teams more typically engage before agreeing to investments. "When you have a [successful] principal occupation, and my principal occupation is not the management of money...," stated Zuckerman, "What you do is you try to find somebody who will manage the money for you. . . You do a certain amount of due diligence, you think you have the ability to rely on somebody based on his general community reputation, and you find out you can't. . . It's not that I didn't check [Merkin] out, but look at all the people at philanthropic organizations that used him as the chairman of their investment committees, and they were all wrong."

Skeptics Spoke Out

If an investment strategy is brilliantly successful, you would expect others to jump at the opportunity to borrow that brilliance and offer it to their clients. In 2000, Harry Markopolos, CFA, was working at Rampart Investment Management in Boston, and his bosses saw the huge returns Madoff was getting with his hedge fund. They asked Markopolos to reverse-engineer the strategy so Ramparts could market its own high-return product. Markopolos took a look at the hedge fund's performance and immediately became suspicious. "Only 4% of the [fund's] months were down months," the reclusive Markopolos told 60 Minutes in one of his rare interviews. "That would be equivalent to a baseball player in the major leagues batting .960 for a year. . . No one's that good."

Jack Nash, the former chairman of Oppenheimer & Co. and one of the fathers of the hedge fund, was another early skeptic. In the early 1990s, he had given Madoff money to invest but soon pulled back his investment. He and his son became alarmed after Madoff couldn't satisfactorily explain his investment strategy and when they learned he relied on a one-person accounting firm for auditing. Later however, Nash and his son invested with Merkin's Gabriel Capital. They didn't know about the Madoff connection although they told Merkin about their lack of confidence in Madoff, according to the New York State Attorney General's case against Merkin.

The fact that Markopolos contacted the SEC on five separate occasions isn't as important to advance planning advisors as the giant blinking detour signs that sophisticated and professional investors and mangers of feeder funds ignored. He calculated that Madoff would have needed to purchase more options on the CBOE to execute his trading strategy than actually existed. As a trustee overseeing the liquidation of Madoff's assets confirmed many years later in 2009, Madoff's funds hadn't made any real trades since at least since 1993.

"[The SEC comes] in after the crime has been committed," observed Markopolos. "They toe-tag the victims, count the bodies, and try to figure out who the crooks were after the fact, which does none of us any good."

Madoff and Merkin's Special Charms

Both Madoff and Merkin took advantage of their considerable skills of persuasion and suggestion that made smart people want to invest with them, even if logic suggested otherwise. Merkin's talent wasn't managing money but gathering it for others to invest. As one money manager who worked with him for many years told New York Magazine, Merkin's gift was that he "was a world-class salesman. . . He recognized that many people didn't have confidence [to make investment decisions]. He recognized that if people had confidence in him, then he could give them confidence."

Clients, for example, respond more positively and with satisfaction when conversing with an advisor who mirrors their statements and gestures. This technique has been taught in many training programs for financial advisors as a means of building rapport. In the hands of someone with evil intentions and more polished technical skill, that persuasion can be powerful. Putting aside the SEC's blunders in monitoring their investment activities, Merkin and Madoff were able to succeed because the psychological tools they applied may have been just too powerful for many talented and smart people to resist. Robert Cialdini, a social psychologist at Arizona State University, has identified six weapons of influence:

Reciprocation. By emphasizing the exclusive nature of his client list and by focusing in the early years on the interconnected HNW and UHNW Jewish community based in New York and Palm Beach, Madoff quickly built up his business with clients so grateful they gave him very large sums to invest.

Confirmation Bias. Once committed to an idea that seems to be working (annual statements indicating what purportedly represents a healthy 12% return, e.g.), it's hard to stop. Confirmation that continues unbeneficial behavior comes in many forms. During the mid-80s, certain media, publishing, and financial executives tried plowing through stacks of work on their desks with temporary "super powers of concentration," which were actually fueled by cocaine. They gave themselves temporary illusions of productivity, even if long-term effectiveness suffered. "With Madoff, the more that people originally invested, the more they continued to invest and the more they invited theirs friends to invest," observes Mark Goulston, a business consultant and a clinical psychiatrist, who writes and lectures about communication skills. "This all served to reinforce their believing they had made the best decision to begin with. Finally, this also caused people to overlook or negate any facts to the contrary."

Social Proof. Madoff had two drivers working for him with this type of influence, which depends on people emulating what others are doing. Since he concentrated on a small universe of clients and advisors who to a large extent knew each other, what appeared as successful investing was visible to many. If smart investors found success with Madoff, natural skepticism would recede. Before he purchased a house in Palm Beach and joined a country club there, people had heard of Madoff, reports New York. One early Madoff investor reported the feeling at the time: "Everybody said, 'You got to go with Bernie.'"

Authority. As the former chairman of Nasdaq and a well known philanthropist with interests similar to many of his clients' charitable intentions, Madoff embodied authority and apparent understanding of arcane investments and small-company potential.

Liking. One of the essential talents of most successful salespeople is likeability--whether it's based on an ability to connect with customers or massage their egos so they feel good about a transaction they shouldn't.

Scarcity. Madoff emphasized the exclusive nature of his services to a small group of connected clients, advisors, and feeder funds. Even if his intention was to keep the investor group limited to provide better control and reduce the chance of troublemakers from entering, the effect was the same.


Lewis Schiff is the principal of Advanced Planning Group, a private wealth specialist for advisors and their clients and the author of The Middle-Class Millionaire. He can be reached at lewisschiff@advancedplanning.org.
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