Say you were an investor in Madoff’s funds. A few years back you decided to diversify. You asked Madoff for your money back and you got it. You then invested the proceeds in an array of other assets. Madoff then goes bust in a massive fraud. One day you get a letter from a bankruptcy trustee. The letter says that you need to repay a large chunk of your original investment in order to satisfy the claims of other investors who were less fortunate (or smart) than you. Is this fair? Is this right?
The concept being applied by the Court and the bankruptcy trustee is called Fraudulent Conveyance:
The basic structure and approach of the Uniform Fraudulent Conveyance Act are preserved in the Uniform Fraudulent Transfer Act. There are two sections in the new Act delineating what transfers and obligations are fraudulent. Section 4(a) is an adaptation of three sections of the U.F.C.A.; § 5(a) is an adaptation of another section of the U.F.C.A.; and § 5(b) is new. One section of the U.F.C.A. (§ 8) is not carried forward into the new Act because deemed to be redundant in part and in part susceptible of inequitable application. Both Acts declare a transfer made or an obligation incurred with actual intent to hinder, delay, or defraud creditors to be fraudulent. Both Acts render a transfer made or obligation incurred without adequate consideration to be constructively fraudulent – i.e., without regard to the actual intent of the parties – under one of the following conditions:
(1) the debtor was left by the transfer or obligation with unreasonably small assets for a transaction or the business in which he was engaged;
(2) the debtor intended to incur, or believed that he would incur, more debts than he would be able to pay; or
(3) the debtor was insolvent at the time or as a result of the transfer or obligation.
In my career I always thought of this as being something brought about by corporations in an attempt to disadvantage certain investors, e.g. the split of Marriott International and Host Marriott, with Host Marriott bondholders getting an instant downgrade by being left with a heavily leveraged capital structure. A different example in the investment world is when hedge funds enter into “side letter” agreements with certain investors, providing them with preferential redemption rights in order that they can exit without regard to the customary lock-ups to which other investors are subject. The aggrieved parties in the Madoff case, however, are individuals and firms with no knowledge of the fraud being perpetrated and with no preferential rights. Every investors’ right to redeem (or not to invest) appeared to be just the same as any other. So why should those who got out be forced to suffer the same fate as those who didn’t, even though they were operating with exactly the same information and with the same rights?
The template for this kind of treatment was set in the Bayou case, where the fraudulent conveyance concept was used to claw back funds from investors who had exited as far back as two years prior to its implosion. It seems to me that this interpretation could have a chilling effect on asset managers in general and hedge funds specifically. I recently redeemed from a few hedge funds because, well, I wanted to. I don’t know anything special. I just want to deploy my assets elsewhere. Does this mean that I need to be worried that I might get a letter in a few years asking me to repay a portion of what I’ve redeemed because a fraud was subsequently determined to have taken place? Investors can’t place money worrying about stuff like this. If there is an even playing field, the chips have to fall where they may. It is no different than a game of musical chairs: everyone has an even chance, but when the music stops some are left without chairs. It sucks but it is what it is.
The Madoff fraud is a tragedy of epic proportions, and there is almost no punishment sufficient for the monster that caused this widespread damage. However, those who innocently exited the situation should not have their lives turned upside down on a retrospective basis due to a highly legalistic ruling with little appeal from a common sense perspective. What Madoff did was bad enough and the numbers who are suffering is massive: to enlarge the circle of damage to those who long left the fund seems neither fair nor just. Sometimes law and common sense just have to come together. This is one of those situations.