Wednesday, December 17, 2008

The Madoff Middlemen - Liability for Fees on Phantom Profits?

In earlier posts I referenced the potential liability of investment advisers who put their client's money into Madoff's investments, and the potential liability of investors themselves, who made a profit in Madoff's investments.

The second series of lawsuits is going to be a longer time in coming, since SIPC will first have to sort out the books and records of the firm, figure out who got money, who lost money, and a host of other facts and figures.

But the first series of lawsuits are cranking up, and being fueled by the press. The NYT has an article this morning that points out the huge sums of money the "Madoff Middlemen" made in simply investing their client's money with Madoff as part of the middleman's investment advice.

First, keep in mind that most investment advisers charge a percentage of assets under management as a fee. Something like 1% a year. Many advisers also charge a fee based on the profits in the assets. That fee varies from manager to manager, but lets call it 20%.

Now take a look at the NYT article, In Fraud Case, Middlemen in Spotlight.

The NYT sets up the article by describing the wealthy lifestyle of certain investment advisers. Its unfair because that lifestyle is presumably well earned. But then it goes into how much money investment advsiers made, for "simply" recommending another investment adviser.

Life is not so simple, and if it was that simple, we would all be doing it. Managing millions or billions of dollars is not easy, and is not something that most of us could do. Which is why some investment advisers get paid as much as they do. It is also why some investment advisers use other investment advisers to manage some of the funds - it is just impossible to manage 14 billion dollars by yourself.

While the article is not fair, it is instigating another series of lawsuits - against the Madoff Middlemen for a return of their fees.

Some investment advisers put some of their managed assets with other advisers. This is something of an oversimillification, and there are other compensation methods, but watch the money flow. The submanager, the one who got a portion of the assets, charges his 1% plus 20% of profits, on the portion of the assets he is managing for the original adviser. AND, the original adviser, the "Middleman" charges his 1% on what is left, and 20% of those profits, if any.

Again, there are other arrangements, and I am using this one to make a point, it is not an actual example. It sounds like double dipping but it is not, and it is perfectly legitimate. Of course, that arrangement only goes on a long as the fees of the submanager justify the cost, and the returns are there.

Why does the first manager get his 1% and 20%? Because he is investing the assets, conducting due diligence, monitoring the investments, etc. and therein lies the rub.

Due diligence? One will have to see how that due diligence worked, because there may be some problems there, but this whole thing gets a lot more complicated for the Middlemen. Now that Madoff's investment operation is a fraud, and one that perhaps goes back 10 years, the Middlement have a problem.

Not only do they have an issue with their investment advice and potential lawsuits, what about the 1% and 20% that they collected on the phantom profits reported by Madoff? The Middlemen are going to be totally innocent of any wrong doing in this aspect, as they have a right to report the value of investments held by other registered advisors, but they collected a fee based on profits that did not exist.

And we are not talking about chump change here. We are talking 1% a year of something like 20 BILLION dollars, or maybe 10 billion, or 50 billion, And then the 20% on profits. That is tens of millions of dollars a year in fees based on phony profits.

Are those middlemen obligated to pay those fees back to their clients?

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