The Affluentialist: The Next Case of Madoff Disease

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.”