Bernie Madoff’s Wealth Redistribution

Gillian Tett had a very good op ed piece in the Financial Times last December called “Let’s not forget the reality cheques in cyberspace games.” Tett speculated about whether the invisibility of money transfer (via cards, online transfers, and bill payments) makes us all less aware of what money really means.

A money transfer that’s performed at the behest of a third-party is called a wealth redistribution. “Wealth redistribution” is a straightforward term. It means just what it says. Wealth as a whole doesn’t grow when part of it is transferred; it  simply passes from one hand to another.

Wealth redistribution is what Bernie Madoff did. He took money from new clients, paid old clients, and kept a lot of their money for himself. All ponzi schemes involve illegal wealth redistribution.

But there are legal ways to redistribute wealth too.

Taxes are a common way a third-party (i.e., government) takes money from one person and transfers it to others. Then there is rent seeking. “Rent-seeking” is a more opaque term. But it also means a wealth transfer that leaves one person poorer and another richer. Like taxation, rent-seeking involves the government. “Rents,” (or above-market-rate profits) are gained through regulation and other political means. And there’s another major way wealth is redistributed: the courts.

Lawsuits as vehicles for wealth transfer and rent seeking

Being part of our government(s), courts are prime sources of wealth transfer and rent-seeking. Our legal system produces no wealth; it simply transfers wealth from one pocket to another. And most of what is transferred goes the pockets of those in the legal profession or who serve it. That’s because they do know what money means.

Wealth redistribution occurred when Bernie Madoff transferred funds from his giant investment scam. And wealth redistribution is again what is happening in the Madoff lawsuits. As a result, Bernie Madoff’s con job has left us with some really thorny questions about justice and who should get what.

Can justice be done to victims of a pure ponzi scheme?

Madoff’s scam is unique in that he earned not one penny with the money took from his “marks.” All of the money he paid out to his victims was paid to him by other victims of his scheme. This is obviously a minus-sum game, where there were bound to be losers in the end. It was an amazing juggling act while it lasted.

The question now is who are the real victims?

Irving Picard, the “trustee” i.e., attorney, in charge of overseeing reparations for Madoff’s scam has decided the victims are those who gave Mr. Madoff more money than they received. He calls other victims “net winners” and is suing them.
SOURCE: Wall Street Journal, “Madoff TRustee Files Flurry of Suits” 11/29/10 C3

This makes sense if you think the way insurance companies do. Insurance companies are supposed to see that victims of a loss are “made whole” again. If you define Madoff as a “disaster,” like fire or flood, then Mr. Picard’s approach comes the closest to approximating making the largest number of his victims “whole” again.

But obviously this definition means that a lot of Madoff’s victims are now themselves labeled “perpetrators” of the fraud, even if they knew nothing about it. Is this really “justice’?

Anatomy of a ponzi scam

Prosecutors of fraud usually begin by chasing down the “feeders” who supplied victims to the perpetrator of the scam. In large ponzi schemes there are all kinds of feeders or “helpers” who make the scam possible. These include (1) people in the know about the scam, (2) those who should know, but look the other way, and (3) those who are legitimate businesses duped by the con(s).

I had personal contact with all three of these types of feeders during a health insurance scheme I was caught in several years ago. The top con had two partners in his crime. These partners opened two other phony companies to make the con’s insurance company appear to be legitimate. He also hired a legitimate company to process “benefit” claims, and he paid a legitimate pharmacy to distribute prescriptions. Lastly, he and his partners recruited licensed health insurance brokers in all 50 states to sell his non-existent health insurance.

The scammers offered the health insurance brokers 40 percent of every monthly premium paid on each policy those brokers sold. After some state governments and the federal government closed down the fake health insurance and other phony companies, government insurance regulators sued the licensed health insurance brokers who sold the fake policies.

The three cons had spent or hidden most of the money. So the government collected money from brokers to pay back victims of the health insurance scam, who in this case were the doctors, hospitals, and labs who provided services to policyholders. Many of those licensed brokers went out of business.

The insurance brokers were legally to blame because they had a duty to do a kind of research called due diligence to make sure the insurance company really was an insurance company, and they didn’t.

My broker, for example, claimed the fraudulent company was A.M. Best top-rated company. All it took for me to discover the fraud was to sign up for a free trial at the AM Best site. The company wasn’t listed there at all. Obviously my health insurance broker didn’t bother to do even that basic research before selling phony health insurance to me.

Mr. Madoff’s “feeders”

Mr. Picard has been quite successful in getting the investment brokers directly involved with Mr. Madoff’s fraud to settle and pay up large amounts. He’s also gotten some of the wealthier victims of the fraud to pay back some of the money they got from Mr. Madoff. He even filed over 123 lawsuits against relatives, victims and others on just one day.

And Mr. Picard has been quite busy raising funds by auctioning off Mr Madoff’s property over the past two years. The auctions go from expensive mansions right down to Mr. Madoff’s boxer shorts (ie., his underwear).
SOURCE: Long Island Man Paid $1,700 For Bernie Madoff’s Boxers

Now we’re seeing another kind of redistribution of Mr. Madoff’s wealth. Two years after Mr. Madoff’s imprisonment, Mr. Picard is going after the people who were supposed to do due diligence on Madoff. Mr. Picard is seeking more than $40 billion in the 60 lawsuits he filed against dozens of banks. The complexity of such a huge fraud makes his delay in filing against the banks understandable. The banks allegedly involved in Madoff’s scheme are all over Europe as well as here in the US. And the large amount asked, of course, will be much less in actual settlements with the banks.

The banks who handled Madoff transfers of funds were supposed to perform due diligence on behalf of their clients. But large banks often pass this duty onto companies called “custodians.” It’s alleged in Picard’s lawsuits vs the banks that many of these custodians didn’t do their jobs. Moreover, some that did do their jobs had their negative reports on Madoff’s operation ignored by their banks.

Bot the custodians and big banks such as JP Morgan Chase, UBS, HSBC, UniCredit and Citgroup are being sued by Picard for billions of dollars. A couple banks have already settled for a few million dollars. Others are fighting. SOURCE: The Madoff Affair: along for the ride? and “Sloppy errors or serious omission.” Financial Times 12/17/10 p 9.

These big banks and their custodians in Picard’s lawsuits are what those in the legal profession refer to gleefully as “defendants with deep pockets.”

But will more money really bring more “justice” to victims?

As of Dec 17th, 2010 Mr. Picard had recovered $2.5. billion. He estimated that real losses from Madoff’s scheme ran around $19.6 billion. This total, however, does not include the many people who were scammed by secondary feeder funds and smaller brokers who invested with Madoff. Mr. Picard has no plans to reimburse these victims. They have to go after their own small-potatoes brokers or feeder funds on their own behalf, something that isn’t likely to be well-rewarded by the legal system.
SOURCE: FT “Real worth of investors’ lossFinancial Times Dec 11/12/10 p11.

Why? Because in lawsuits lawyers and people who work for them get most, if not all, of the money. The Financial Times reported on December 8, 2010 that a recent settlement with a Florida victim, Carl Shapiro and his family, resulted in a settlement of $645 million. This amount was to be split in the following way: “$550 million to the trustee” (Mr. Picard) and the remainder “to the Department of Justice which intends to compensate victims of Mr. Madoff.”
SOURCE: “Madoff investor agrees deal to forfeit $625m to Ponzi victims” Financial Times 12/8/10 p 1.

Rent seeking – how our legal system transfers wealth to itself

Wikipedia defines rent-seeking this way: “In economics, rent seeking occurs when an individual, organization or firm seeks to earn income by capturing economic rent through manipulation or exploitation of the economic or political environment, rather than by earning profits through economic transactions and the production of added wealth.”

Our legal system is much like the ancient cities that sprang up around pharaohs’ tombs in Egypt. All kinds of middle-class craftspersons such as sculptors, artists, embalmers, retail business persons who served their needs, and slaves were paid for from the coffers of the families of the dead pharaohs.

All kinds of people are paid when wealth is transferred from defendants to plaintiffs in lawsuits or vice versa. And much of it appears to be a form of rent-seeking

Transcribers of depositions, printers, expert witnesses, process servers, and exhibit-makers and the courts themselves all get paid off. Only in the legal system does a copy of a page cost twenty-five cents, or a transcription of a four hour conversation run $1000 a copy. And everyone involved in the case gets tons of copies, The number of trees wasted each year is mind-boggling.

Only the legal profession can afford to pay “experts” retainers of $5,000, $10,000 even $20,000 in addition to hundreds more per hour for any actual work done by those experts. A report or testimony in court from one of those experts can run even more thousands of dollars. Courts get their cut too from not only from trial expenses but also with fees levied when plaintiffs refuse to settle and then lose a case. The average costs in legal cases runs around $300,000 to pay all of these people.

Where does this money come from? Usually from people with money, organizations with money, and insurance companies. Also, during lawsuits there are often additional “countersuits” that can be used to raise even more legal fees. Many innocent people and companies get countersued during lawsuits to raise funds for the defense.

Because Mr. Picard is going after institutions with deep pockets who were supposed to do due diligence on Mr. Madoff, Mr. Picard can go after extra money for “punitive” and “compensatory” damages. Who knows? He might even get $19.6 billion dollars. But who will get to keep that money? Which pockets will it wind up in?

The final word?

I hope Mr. Picard’s efforts raise enough money to help all the people who were “net losers” in Madoff’s scam, but I’m not counting on that. I fear the best thing that will happen is, in the future, institutions who are supposed to do “due diligence” will think twice before taking that enticing 40 percent kickback, uh, I mean “fee” for their services from people like Bernie Madoff.


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