Stakeholders in the Madoff Scandal and Their Need to Act Promptly and Proactively – Installment 3January 27, 2009 – Articles White Collar Compliance & Defense Blog
This is the third in a series of Installments that will discuss some of the threshold issues that face the manifold stakeholders who have been materially affected by the Bernard L. Madoff scandal, allegedly the longest, most widespread and financially devastating Ponzi scheme on record. All potential stakeholders should consult professional advisors promptly to have their positions evaluated.
We will continue by discussing Direct Entity Investors.
Direct Entity Investors (“DEI”) that are charitable entities and foundations (“501(c)(3) Entities”)
Perhaps the most perplexing and concerning group of Madoff victims is the long list of charitable organizations that have reportedly lost many millions of dollars in their endowment funds through investments with Madoff. A number of 501(c)(3) Entities have even been forced to abruptly cease their operations.
There are a number of reasons that Madoff may have targeted 501(c)(3) Entities as potential investors, some of which will be discussed in these Installments. The harm that has been inflicted upon many charities, with respect to finances and image, requires discussion beyond the level of other classes of Madoff victims. 501(c)(3) Entities occupy a unique position in society, as tax exempt organizations to which contributions are deductible, thereby imposing on their governing boards a higher standard for operating and investing. These boards have the responsibility for overseeing, protecting and dealing with contributions of others to serve charitable missions that society deems to be of high value. There are important principles on governance and compliance that may be drawn from the Madoff scandal, which should be considered by all 501(c)(3) Entities and their governing boards, whether or not they were direct or indirect investors with Madoff.
In recent years, legislators like Senator Charles Grassley (R-Iowa), the Ranking Member of the Senate Finance Committee, have been questioning whether charities, especially hospitals and colleges and universities are adequately carrying out their charitable missions at a sufficiently high level to warrant their continued favored tax exempt status. One of his principal criticisms is that these institutions are more interested in enhancing their endowment funds than spending such funds on the charitable missions that qualify them for tax-exempt status. The losses to charities with Madoff investments, some of which had appurtenant overtones of conflicts of interest, are almost certain to raise further calls for greater controls on tax exempt organizations and how they use and invest their endowment funds to achieve their charitable missions. The Madoff scandal greatly exacerbated the massive endowment losses in 2008 of 501(c)(3) Entities.
Charitable Involvements of Madoff
Madoff enhanced his reputation and standing in the community of wealthy potential investors by being a leader of and heavy contributor to highly visible charitable organizations. Such organizations included those with humanitarian, educational and religious missions. By identifying himself with such charities, Madoff was able to associate with wealthy individuals and leaders involved in foundations, business entities and government. This enabled him to get access to a diverse group of investors, including the charities themselves.
The investment by charitable organization with Madoff held certain advantages for Madoff in furtherance of his alleged Ponzi scheme. These include certain accounting rules and tax laws that are specific to public charities and private foundations.
Certain Accounting Rules Applicable to 501(c)(3) Entities that Inured to the Benefit of Madoff
The first accounting principle that is worthy of note in the Madoff context is the requirement under generally accepted accounting principles for 501(c)(3) Entities (“GAAP”) that 501(c)(3) Entities “mark investments to market.” Therefore, under this GAAP principle, unrealized gains and losses on investments by 501(c)(3) Entities are recognized on the income statement and the current value of investments is reflected on the balance sheet. This principle inured to the benefit of Madoff, because his reporting of consistently high, stable “returns” over years would encourage 501(c)(3) Entities to simply reinvesting and rolling over their Madoff “returns.” It became clear to Madoff than 501(c)(3) Entities would predictably seek to maintain the Madoff investments intact to get the maximum benefit for revenues on their income statements and balance sheet values. To the extent that a 501(c)(3) Entity needed endowment funds or returns, it would be inclined to draw upon assets other than Madoff investments. This in turn enhanced the ability of Madoff to extend the life of his enterprise by avoiding redemptions and even distribution of current “returns.”
Another GAAP principle that would inure to the benefit of Madoff is the requirement that financially credible pledges to 501(c)(3) Entities of multi-year gifts are all recognized as revenues in the year the pledge is first made. To the extent that donors or even Madoff himself expected to use Madoff investments to satisfy such multi-year pledges, the 501(c)(3) Entities would recognize the full amount of the gift in the year of the pledge and then receive interests in Madoff investments over a number of years to satisfy the pledges. Madoff would again benefit by the stability of the investment that would stay in place over years from the donor to the receiving 501(c)(3) Entity, which would be inclined to keep the investment in place for the reasons set forth in the immediately preceding paragraph.
The next Installment will continue the discussion of the aftermath of the Madoff scandal for 501(c)(3) Entities.
[To be continued in Installment 4]