The Danger of Madoff style “Clawbacks”

Think back to Enron. Many investors made large sums of money off Enron stock in the late 90’s, gains that in retrospect were at least partly due to fraud being committed by executives at Enron. Many investors (and employees) lost large sums of money on the same Enron stock in 2001 as the aforementioned fraud unraveled. Should those investors who sold at the peak in 2000 have to give part of their gains to investors and employees who were either unwilling or unable to sell their shares?

What about mutual funds, or pensions? Enron was held by and generated profits (and losses) for numerous mutual funds and pensions. It’s quite likely that the majority of people reading who had mutual funds, 401ks or were enrolled in pension funds in the 1999-2001 time frame either gained or lost money as a result of Enron’s dramatic fraud driven rise and fall.

If these type of after-the-fact actions become prevalent, it will have a chilling impact on our financial economy. Investors will be rightfully reluctant to redeploy gains into new investments until the statute of limitations has passed. Investors will also demand higher returns (increasing the cost of capital) to compensate for the additional risk to their returns post investment. Either of these scenarios would further slow what already promises to be a very slow economic recovery.

Why should the Madoff case be any different? Last week the court appointed trustee sent out letters requesting that anyone who withdrew money from their Madoff account in the past 6 years return it (a “clawback”), even if they had no inkling of the fraud and have already spent the money they withdrew. In addition to adding yet more financial jargon to our vocabulary, the increasing use of this type of legal remedy creates a very slippery slope which could potentially impact investors of all incomes and asset classes.

The media sympathy to the Madoff investors has been muted, as many of the “victims” appear to have spent more on their last vacation than the average American earns in year. However, it’s important to look past the class warfare and focus on the actual issue and precedent it could set. Despite all the legalese surrounding the descriptions of the case, this issue is relatively simple. On one hand you have hypothetical Madoff Investor “A” who invested $500,000 with Madoff in 1999. On the other hand you have Madoff Investor “B” who made the same $500,000 investment with Madoff also in 1999. Fast forward to 2004, both accounts have increased to $700,000 and neither investor has added or removed any money. In late 2004, Investor “A” elects to cash out his entire account ($700,000) and use a portion of the money to pay for his children’s college and uses the rest to fund expansion of his business. Investor “B” elects to keep his money at Madoff and at the start of the scandal, the account was listed as having a balance of $900,000. Now it’s April 2009 and Investor “A” does not have a Madoff account at all (having closed his account in 2004) while Investor “B” still has an account but based on the current money recovered, has a projected value of less than $20,000.

The question is – should Investor “A” have to repay some or all of the $700,000 he withdrew in 2004 to help offset the losses of Investor “B”? If the answer to this question is “yes”, and there will no doubt be legal challenges to this course of action, it is important to evaluate the impact of this scenario on other types of investments.

Currently, this style of clawback has been contained to hedge funds and Madoff style managed accounts, all of which deal only with accredited investors (defined by the SEC as having a net worth over one million dollars and income of over two hundred thousand per year for individuals, three hundred thousand for couples). What is disturbing about this trend is how easily the theory can be applied to any investment where one person wins and another loses.

As difficult as it is for many people to accept, we live in a world full of randomness and risks that we can never fully anticipate or control. While we should increase our efforts to root out and prevent Madoff and Enron style fraud, it is a mistake to try to punish investors’ whose only crime was being lucky enough to sell at the right time.

3 Comments

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  • http://s3ceojackholt.wordpress.com S3CEO_Jack_Holt

    Since nothing with tangible value was created with the Madoff investments, to whom will the proposed clawback go? Isn’t it just a big money shift?

    • http://www.johnstanderfer.com John Standerfer

      Yep. The returned money is slated to be divided among all clients with a claim against Madoff.

  • http://jamesfowlkes.com Investing Made Simple

    This is an extremely disturbing trend. I sincerely hope that this does not go through and that the investors who pulled their money out fight back against these vultures.