​Stakeholders in the Madoff Scandal and Their Need to Act Promptly and Proactively – Installment 4

February 9, 2009Articles White Collar Compliance & Defense Blog

This is the fourth in a series of Installments on this blog 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 the discussion of charitable entities and foundations that invested with Madoff. This series has already discussed in Installment 3 some generally accepted accounting principles specific to 501(c)(3) Entities that aided Madoff in extending the life and increasing greatly the scope of his operation. Hand in hand with the GAAP principles for 501(c)(3) Entities that assisted Madoff are federal income tax rules that are applicable to 501(c)(3) Entities.

Direct Entity Investors (“DEI”) that are charitable entities and foundations (“501(c)(3) Entities”)

Certain Income Tax Rules Applicable to 501(c)(3) Entities that Inured to the Benefit of Madoff

The most important tax principle for 501(c)(3) Entities that benefited Madoff is that their investment income is exempt from federal and state income taxes. Charities can therefore stay fully invested and roll over investment income into further investments. This was a powerful tool for Madoff. Because of the apparent safety, consistency and stability of his relatively high “returns,” Boards and Investment Committees of 501(c)(3) Entities would be disinclined to redeem either principal or “returns” in accounts with Madoff because they did not even have to pay taxes on their reported returns from Madoff. Such 501(c)(3) Entities would seek to use funds from other areas of their endowment funds to remain as fully invested as practicable with Madoff.

Madoff preyed upon the various business and tax advantages that many 501(c)(3) Entities saw in an investment with him. As a result Madoff was able to count on the fact that charities would be resistant to request redemptions of principal and would even reinvest their reported “returns” for a long period of time. It was only when the rest of the financial markets collapsed that 501(c)(3) Entities began to demand large distributions that Madoff could not meet. Then the 501(c)(3) Entities became subject to the glare of adverse publicity and embarrassing questions as to how and why the staggering losses that they suffered had taken place.

Summary of the benefits for Madoff’s operations of the credibility and stability that he projected to 501(c)(3) Entities

The next discussion in this series will focus on the proactive review and responses that 501(c)(3) Entities should be considering in governance and investment policies to the shocking losses and other harmful aftermath of investing with Madoff. Such a proactive review makes good sense for all 501(c)(3) Entities, irrespective of whether or not they were investors with Madoff. The increased regulatory scrutiny under which charities will be operating in the future makes “best practices” a necessity.

As a prelude to that discussion, it should again be observed that 501(c)(3) Entities have been on the lookout for many years for investment vehicles in which to place their endowment funds that appear to have a high degree of safety and stability and provide a consistent and relatively high rate of return. An investment with Madoff appeared to be ideal to many 501(c)(3) Entities on all of these levels, especially with his track record of 12% average annual returns over decades, combined with the added credibility flowing from the fact that many other highly respected 501(c)(3) Entities were also long time investors. Moreover, for 50 years Madoff had been a leader and innovator in the investment industry and had been Chairman of the NASDAQ Stock Market. This prominence enhanced his stature and trustworthiness as an investment advisor. Therefore, Boards and Investment Committees of many 501(c)(3) Entities felt comfortable with entrusting millions of their endowment dollars with Madoff for extended periods.

Such comfort was heightened by the fact that Madoff appeared to be one with them, that is, he was the epitome of the famous “Three W’s” that are the most desirable attributes for Board members of 501(c)(3) Entities: Wealth, Wisdom and Work. Madoff evidenced personal wealth and largesse in personally contributing large sums to numerous charities; he appeared to unselfishly share his wisdom, experience and business acumen with those 501(c)(3) Entities in which he was interested; and finally he was deeply involved in rising to leadership roles in charities because of his work effort and apparent wealth and wisdom. All of these factors, combined with the apparent business and tax benefits of an investment with Madoff for 501(c)(3) Entities, enhanced the scope and longevity of his enterprise.

The next Installment will continue the discussion of the aftermath of the Madoff scandal for 501(c)(3) Entities with an emphasis on the review and analysis on governance and investment policies that charitable organizations should be conducting to repair and/or enhance their standing among their peers and competitors for contributions.

[To be continued in Installment 5]