In a letter from prison, Madoff described for the first time how this business relationship with Saul Alpern supposedly worked. “In the 1970s, my father-in-law put together a limited partnership comprised of some family and clients of his accounting practice,” he explained. Madoff set up an account at his firm for the partnership, and Alpern accepted cheques from friends, relatives, and clients, passing the money along to Madoff to invest on their behalf—legitimately, Madoff insisted. The accounting firm received the trade confirmations and “would break up the trades into individual transactions at the identical prices and proportionate shares, according to each individual member of the partnership account,” he said. “The individuals reported this information as capital gains on their respective tax returns. My father-in-law’s firm would charge an accounting fee for providing this bookkeeping and tax service.”
He added ingenuously, “I imagine it was similar to an investment club account.”
Possibly Alpern thought he was merely introducing people to Madoff and mingling their money in his firm’s accounts just to simplify things for them and for Madoff. Unsurprisingly, Madoff himself insisted there was nothing illegal in this arrangement. As he saw it, Alpern had too few investors to require him to file with securities regulators as an investment adviser or obtain a broker’s licence. But, in effect, this partnership was an informal, unlicenced “mutual fund”, taking in money from retail investors and handing it to Madoff to manage. Even so, nothing would ever shake the Alpern family’s faith in their belief that Saul Alpern would never have knowingly led them into his son-in-law’s fraud.
In 1958, Alpern had hired a young CPA named Frank Avellino, a graduate of City College in New York and a clever, slightly cocky young man, who was given a piece of the firm after the sudden death of Alpern’s original partner in 1967. The next year, an experienced tax accountant named Michael Bienes arrived to work for Alpern, after several years at the Internal Revenue Service. Bienes immediately formed an intense bond with Avellino. The two men, born just months apart, would remain partners for almost a lifetime.
According to Bienes, Alpern kept simple records of the individual Madoff investors in a green plastic loose-leaf notebook. It seemed casual, but everyone who knew Alpern used the word meticulous at least once in describing him. Using forms he designed to fit into his notebook, he entered the amount each investor paid in and sent back a simple receipt for the money, perhaps with a personal thank-you note. In Bienes’s version, Madoff initially accepted these individual accounts “from Saul’s people”, and Madoff’s small back-office staff handled the paperwork. Later, Bienes claimed, Madoff told his father-in-law that things had to change.
In an interview taped for television, Bienes played Madoff’s role in a scene that would have happened—if it happened at all—years before he even worked at the Alpern firm:
“No, I cannot handle small accounts like this. This is a pain in the neck and a pain in the butt.”
Then he spoke Alpern’s lines: “Look, open an account called A&A, and I will do the record keeping. I will handle the cheques. I’ll do it all.”
“A&A” stood for “Alpern & Avellino”, the name of Alpern’s accounting practice. According to Bienes, Avellino also got “a piece” of the Madoff introduction business when he became a partner in 1970. Bienes did, too, when he became a partner a few years later. In 1974, Saul Alpern retired, and his old accounting firm was renamed Avellino & Bienes. The firm’s accounts with Madoff were renamed the “A&B accounts”.
According to Bienes, Saul Alpern insisted, “I’m taking the green book down to Florida. It’ll give me something to do. And I’ll mail the stuff up to [the firm’s secretary] and she’ll type it with the cheques and send it out.”
Madoff claimed that the account set up by Saul Alpern “grew to a maximum of 50 to 75 investors” under his father-in-law’s stewardship. Bienes later estimated that this investment account was “only about 10 percent” of the accounting firm’s business, even several years after Alpern retired, although he did not estimate how many investors were involved or how much money they had invested by the mid-1970s.
Along the way, Avellino and Bienes connected Madoff to another set of accountants with whom they shared office space. That pair of accountants set up a separate fund to invest with Madoff through the A&B accounts. Their investors paid them a fee, and they paid a fee to Avellino & Bienes, but with a steady track record like Madoff’s, nobody complained about the double-dipped expenses. Even if Madoff’s returns were no better than those of the go-go mutual funds and red-hot stock market—and, typically, they weren’t—they were a lot more predictable, a lot less volatile.
In his prison interviews and in subsequent letters, Madoff claimed that he was generating those solid, consistent profits for his father-in-law’s partnership accounts through an investment strategy that he said was his small firm’s specialty in the 1970s. It was called riskless arbitrage, and it was widely understood and accepted among the professionals on Wall Street in that era.
Riskless arbitrage is an age-old strategy for exploiting momentary price differences for the same product in different markets. It could be as simple as ordering cartons of cigarettes by telephone from a vendor in a low-cost state and simultaneously selling them over the phone at a higher price in states where they are more expensive, thereby locking in a profit. Or it could be as complex as using computer software to instantly detect a tiny price differential for a stock trading in two different currencies and execute the trades without human intervention—again, locking in the profit.
What distinguished riskless arbitrage from the more familiar “merger arbitrage” of the 1980s—which involved speculating in the securities of stocks involved in possible takeovers—was that a profit could be captured the moment it was perceived, if the trade could be executed quickly enough. A conventional trader would buy a security in hopes of selling it later at a profit; if he guessed wrong, he lost money. By contrast, an arbitrage trader would not buy a security at all unless he could almost instantly sell it, or its equivalent, at a profit; if he had to guess about whether he’d make a profit, he didn’t do the trade.
In the 1970s, riskless stock arbitrage was as basic as exploiting brief price differences for a stock trading on several regional stock exchanges. It was not unusual for a company’s shares to trade at $12 on the Pacific Stock Exchange in San Francisco at the same moment that the same shares were changing hands for $11.25 on, say, the Boston Stock Exchange. By simultaneously buying in Boston and selling in San Francisco, an alert investor could lock in that $0.75 difference as a riskless arbitrage profit.
At a more sophisticated level, a level Madoff was known to exploit, riskless arbitrage involved corporate bonds or preferred stock that could be converted into common stock. A bond that could be converted into ten shares of stock should usually trade for at least ten times the price of the stock—but it didn’t always do so. If a bond that could be converted into ten shares of a $15 stock could be bought for less than $150—for $130 per bond, let’s say—that was an opportunity for arbitrage. An investor could buy that bond for $130, simultaneously sell ten shares of the underlying common stock at $15 a share, and lock in a “riskless” arbitrage profit of $20—the difference between the $130 price he paid for the bond and the $150 he received for the ten shares he got when he converted the bond into stock.
Madoff also employed more complex strategies involving stocks that traded before they were even officially for sale, changing hands in the so-called “when issued” market at prices that sometimes offered arbitrage opportunities. Sometimes he took on more risk by not making simultaneous transactions, waiting to buy or sell in hopes that a move in the market would increase his profits. By one account, Madoff was especially active in arbitrage trades involving stocks sold in tandem with arcane securities called “warrants”, which entitled buyers to purchase more shares at a specific price. Even as late as the 1980s, the Madoff firm was supposedly one of a hand
ful of firms actively and visibly pursuing warrant arbitrage, which some traders at the time considered “easy pickings”.
According to Madoff, arbitrage strategies like these were among the primary ways he made money for himself and his clients in the years before his Ponzi scheme began. “After the 1962 market collapse, I realized that just speculating in the market made little sense,” he wrote in a letter from prison. “I realized the market was a stacked deck and was controlled by the large firms and institutions.” The big trading firms handling orders from the giant retail houses would always have an advantage over tiny firms like his, he said, adding, “I searched for a niche for my firm and found it in market making of arbitrage securities.”
Market makers were traders who consistently and publicly maintained a ready market in specific securities, buying from other traders who wanted to sell and selling to traders who wanted to buy. Continually offering to buy and sell the arcane securities involved in riskless arbitrage strategies—convertible bonds, preferred stock, common stock units with warrants—and trading those securities for his own account and those of his clients became Madoff’s increasingly profitable market niche, he said.
According to Madoff, none of the big Wall Street firms were willing to do riskless arbitrage in small pieces for retail investors. But he was, and some of the biggest names on the Street would send him small arbitrage orders to execute for their customers, he said. “They liked to send me the business,” he recalled. “They thought I was a nice Jewish boy.”
Madoff was well positioned to earn honest arbitrage profits. Because transaction costs would wipe out most arbitrage profits, which tended to be paper-thin, arbitrage trading was usually pursued only by market insiders who could trade at far less cost than retail customers—market insiders such as Madoff.
Speed mattered in other ways, too. If it took too long to complete the paperwork involved in converting a bond into its equivalent shares of stock, the opportunity for a locked-in profit could vanish. Madoff’s firm indisputably became adept at handling the conversions quickly and efficiently. Because profits could be assured only if a trader could buy and sell almost simultaneously, Madoff—with the help, in time, of his younger brother, Peter—began to build one of the fastest trading systems on Wall Street.
“This type of trading had limited risk exposure, which was what I was looking for,” Madoff recalled in his letter. “I set about doing this trading for my firm’s own account as well as my few clients. In the 1970s, I traded the strategies for the [Alpern] partnership accounts as well.”
He concluded: “The combination of my market-making and arbitrage trading profits were substantial, and our capital grew nicely.” His reputation grew right along with it.
How much of Madoff’s version of his early success in riskless arbitrage trading is true? As noted, there are some indications that his firm gained a legitimate reputation on the Street for trading the warrants involved in arbitrage strategies—large-scale trading that other firms could see and participate in, not the backdated fictional trading that would become the hallmark of his Ponzi scheme. There were certainly opportunities for riskless arbitrage that could have produced sizeable profits in those years. For example, between 1973 and 1992 the returns on convertible bonds were slightly higher and yet much less volatile than those on common stocks, and convertible bond arbitrage was another strategy Madoff claimed to employ.
But a subsequent lawsuit asserted that Madoff was falsifying convertible bond arbitrage profits in some customer accounts as early as August 1977. To someone familiar with riskless arbitrage, the 1977 trades cited in the lawsuit do not provide unambiguous evidence of fraud, but the case does cite later instances of obviously fictitious convertible bond arbitrage trades in customer accounts in the 1990s.
The line between true and false is very hard to draw so long after the fact, especially given Madoff’s masterful fluency in both truth and lies. There was money to be made in these exotic securities, and Madoff was known later as a big player in at least some corners of this relatively small marketplace. But he is also the man who covered up the losses he inflicted on his clients in the ruinous new-issue market in 1962.
So the possibility that he was deceptively gilding his clients’ arbitrage profits in the 1970s cannot be ruled out.
3
THE HUNGER FOR YIELD
As the 1970s began, Wall Street was changing as much on the inside as on the outside, and Bernie Madoff would ride those changes to a public leadership position that he would hold for almost forty years—a position that would reinforce his credibility with investors and regulators.
As so often happened, market regulation had grown lax during the intoxicating bull markets of the 1950s and ’60s. The 1970s sobered things up quickly as the US Securities and Exchange Commission, the principal regulator of the nation’s financial markets, struggled to catch up with the extraordinary mess that the postwar market party had left behind.
By the end of the go-go years, the manual labour required to keep track of the paperwork generated by trading in those days of paper ledgers and scribbling clerks was beyond the capacity of many Wall Street firms. As the hot mutual funds stepped up their trading pace, the volume of trading grew and the paperwork fell further behind. When the rest of the public started to get excited about stocks, too, the volume picked up even more, and the paperwork lagged disastrously as paper stock certificates had to be physically moved from one brokerage house to another. Keeping track of all this moving paper soon overwhelmed the army of clerks hired to manage it, and the consequent delays and discrepancies made it increasingly difficult for federal regulators to ensure that all this activity was aboveboard and on the level. Old Wall Street hands called it “the paper crunch”, and it bit down fiercely in 1968 and 1969, causing the ruin of a number of Big Board brokerage firms and impressing a young Bernie Madoff with the importance of automating the market’s paperwork procedures.
By then, Ruth Madoff was no longer working at the firm—she had stopped a few months before their first son, Mark, was born in 1964.
Since 1961, Madoff had shared office space at 39 Broadway with a fellow entrepreneur named Martin J. Joel Jr, who was a client of Saul Al- pern’s accounting firm. In the same month in 1960 that Madoff launched his firm, Marty Joel and a partner had opened a brokerage firm called Joel, Zuchs & Company. The partnership soon broke up, and Joel invited Madoff to share his office space and split the rent.
Marty Joel would work with and around Madoff for decades. In 1961 he was an aggressive, ambitious young man in his late twenties who was running a small and slightly raucous brokerage business, haggling with regulators, and fielding lawsuits by customers. His repeated run-ins with industry regulators during the late 1960s suggested a certain carelessness about his compliance with the market’s rule book. In 1970, the SEC suspended him from the brokerage business for seventy-five days because of repeated record-keeping and margin violations between 1966 and 1968.
While sharing the rent, Madoff also shared Joel’s office manager, Carole Lipkin, who handled the administrative chores Ruth had once done. In a few years, Madoff hired Carole’s husband, Irwin Lipkin, as his own “back-office” manager—the first outside employee of Bernard L. Madoff Investment Securities—perhaps to draw a sharper line between his firm and Joel’s. There is no sign that Madoff’s firm got tangled up in the regulatory brambles of those years, although he had been cited for minor technical violations in the early 1960s. Whatever their operational differences, Madoff and Joel socialized frequently, and their young families became friends.
Compared with the Big Board firms that served a growing army of retail investors, smaller OTC traders such as Madoff Investment Securities escaped the worst of the strangling paper crunch of the late 1960s, simply because they had fewer clients, traded largely on a wholesale basis with other traders, and were quicker to adopt labour-saving devices such as computers. Indeed, some of these firms not only survived but prospered by pro
viding better service to the mutual funds and other institutional investors who had become frustrated by the logjam at the Big Board and were demanding faster execution of their trades. But this didn’t mean it was easy; Ruth Madoff was briefly recalled from home in 1968 to help the tiny firm deal with the backlog of paperwork.
In response to the paperwork overload and the rising tide of brokerage firm failures in the late 1960s, the US Congress established the Securities Investor Protection Corporation, known as SIPC (pronounced “Sipik”), in 1970. Although its board was politically appointed, SIPC was not a government agency; it was a non-profit organization financed through annual assessments levied on Wall Street firms. Its mission was to help ease the bankruptcy process for a failed firm’s retail customers. The same law that created SIPC added elements to the American federal bankruptcy code that applied exclusively to brokerage firms. Like the other firms on Wall Street, Bernard L. Madoff Investment Securities became a member and paid its annual assessments.
In the 1970s regulators also began to lean harder on Wall Street to automate and to enable trades to be completed in a reasonable amount of time and tracked for accuracy and legitimacy. Automation would also remove the need to physically transport share certificates; stock ownership would be documented electronically. Technology—in the form of faster, cheaper computers and more sophisticated communications equipment—gradually began to replace the nearly Dickensian record-keeping process built around human clerks and paper ledgers that had failed so spectacularly in the “paper crunch” of the late 1960s.
But the same technology also started changing the very idea of what a stock market was—and this gave Bernie Madoff a legitimate opportunity to reach for greatness.
Bernie Madoff, The Wizard of Lies Page 7