A Clamoring for registration of feeder funds - Challenges to Fund of Fund Business Model

Bernie Madoff's Victims: Why Some Have No Recourse
By Robert Chew Monday, Jan. 12, 2009
Lucas Jackson / Reuters

While the Securities Investor Protection Corp. (SIPC) is helping Bernie's closest friends and investors with recovery of up to $500,000, the unregistered feeder-fund victims are likely to get little. Here's why: As it stands, the SIPC's charter helps investors recover monies only from registered brokers and firms engaged in fraud. This is all good for the 8,000 who had registered or direct accounts with Bernard Madoff Investment Securities, a broker/dealer. In fact, right now, most are busy filling out their just arrived SIPC claim-recovery forms in hopes of getting back half a mil. See a brief history of Ponzi schemes.

The others devastated by Madoff's $50 billion global Ponzi — people like me, who collectively may have contributed 30% to 50% of Madoff's billions under management and never heard of Madoff until a month ago — are wondering what to do and whom to sue. Currently there are 17 legal cases filed against Madoff or his feeder-fund managers, according to the D&O Diary, a legal blog following the case. Some of these suits are akin to grasping at straws. For example, my feeder-fund manager, Stanley Chais, has already said he's broke because of losses suffered with Madoff.

How did Bernie Madoff come to have two classes of investors — the first-class crowd enjoying SIPC support, and the rest of us in coach? The Securities and Exchange Commission (SEC) encouraged the growth of unlicensed, unregistered feeder funds when it liberalized investing rules in the 1996 National Securities Markets Improvement Act, now part of the Investment Company Act of 1940. As a result, anyone managing pooled investments held by fewer than 100 people, or managing monies for an unlimited number of "qualified purchasers" (investors with more than $5 million or institutions with more than $25 million), need not worry about SEC registration.

Some experts, prior to the Madoff mega-swindle, were all for lesser regulation. But now they are rethinking this idea. "Registration of these funds might have helped prevent this," says Barry Barbash, a Washington-based securities lawyer with Wilkie Farr & Gallagher. Barbash was the SEC director of investment management from 1993 to 1998, the time the liberalization took place.

A 1992 study showed Barbash and others in the Clinton Administration that there was a need for liberalization for hedge funds. "There was a greater appetite for them, and the 100-person rule was too narrow," says Barbash. "The philosophy was that we needed to cut regulation for larger, more sophisticated investors."

Madoff, the "sophisticated swindler," couldn't have agreed more. Some unregistered feeder funds, like the one I and others invested in, had $500 million or more in them and were the early engines of Madoff's dubious success.

"I'm not sure it would have helped stop this crime, but earlier transparency, or registration for the sponsor group [feeder fund] has a logic to it now," says Barbash. "Certainly, I think greater protection would have come if Madoff was forced to register."

Up until 2006, Madoff was not even registered as an investment adviser. When he did register as an adviser, the SEC checked him out and gave the thumbs up. No Ponzi here.

But who checks on these now very large "small funds"? Who blows the whistle when there are more than 100 investors or when each investor truly has the deep pockets to invest? "Either the manager of the fund has to regulate this, or someone in the fund has to raise a red flag," says John Heine, deputy director of the SEC's Office of Public Affairs.

In effect, the unregulated funds have to regulate themselves, and if there is fraud, the only recourse is to sue the unlicensed fund manager. Those investing under the SEC's amended rules have no recourse for recovery from the system that fathered them.

Generally, hedge-fund managers are loath to endorse more regulation, but even Chris Kundro, co–chief executive officer at New York City-based LaCrosse Global Fund Services, which manages $13 billion in assets for its clients, believes the Madoff case "has changed things." Kundro told Bloomberg TV last week that the Madoff fraud was a unique situation that added to the overall crisis in investor confidence. Since Madoff, Kundro said, there is "now a fundamental shift in thinking that some regulation may be needed for feeder funds."

Better late than never.