The Wizard of Lies: Bernie Madoff and the Death of Trust (14 page)

In 1979, Bernie Madoff also became a member of the NASD committee that helped create an electronic system linking all the regional stock exchanges (including Cincinnati) with the New York Stock Exchange, so that customer orders could be routed seamlessly among them for the best price. At his own firm and in the industry at large, Madoff was defying the conventional wisdom and betting big money on the automation of the stock market. Some had given up the market for dead in the 1970s, but it was about to experience one of the most robust growth periods in its history.

It would be a worldwide stock boom, and he would be ready for it.

Madoff opened a London office, called Madoff Securities International Ltd. The falling of regulatory barriers all across Europe made an office in London logical. The new affiliate opened for business in February 1983, in Mayfair. It existed mostly to trade foreign securities and maintain foreign currency accounts for the home office, but Madoff recruited people prominent in local stock exchange circles as his executive staff, and in time he would put his brother and sons on the board.

He opened the new affiliate with the help of an investor and friend, Paul Konigsberg, an increasingly prominent New York City accountant. Within a few years, Konigsberg had followed in Saul Alpern’s footsteps, setting up an investment account that gave clients of his accounting firm, Konigsberg Wolf, their own path to Madoff. It was a pattern that would be repeated time and again at other accounting firms in the years to come.

As the money flowed in during the 1970s and early 1980s—from wealthy individual clients, from Avellino & Bienes, from trusted professionals such as Paul Konigsberg and Mike Engler, and from the Chais feeder funds in Beverly Hills—Bernie Madoff began to live a little larger.

Around 1979, while still living in suburban Roslyn, the Madoffs bought a handsome weekend house on the water in Montauk, at the far eastern tip of Long Island. Well beyond the already-trendy Hamptons, Montauk was a quiet and almost rustic beachfront community in the late 1970s. Still, the weekend house on the ocean, with its sheltered pool and broad, sunny deck overlooking the dunes, was an impressive acquisition for a young brokerage firm owner in his early forties who had two sons to put through college.

Bernie Madoff was not a conventional financial executive—far from it. Other dads might commute to work on the Long Island railroad with briefcases balanced on their knees. But on any given morning in the 1970s, Madoff would drive from his split-level in Roslyn to Port Washington, on Long Island Sound, where a Cessna seaplane would be waiting.

He was part of a group of adventurous Wall Street executives, all living near Port Washington, who used the plane for their daily trip to Manhattan, sparing themselves the frustrations of the train (dubbed “The Silver Snail”) or the bumper-to-bumper highway traffic. It wasn’t all that uncommon in those days—the seaplane base was fairly busy—but it was a slightly swashbuckling arrangement that was sure to forge friendships among the four or five passengers who squeezed into the narrow cabin for the scenic twenty-minute trip toward the sunlit towers of Manhattan.

Besides giving Madoff an easier commute, the seaplane was good business. Some of his traveling companions on that commute became his customers, or introduced other customers to him. One of those fellows was a genial American Stock Exchange trader and Roslyn neighbor named Maurice J. Cohn, known among his friends as “Sonny,” who lived just a few doors away from the Madoffs.

Beginning in 1985, Bernie Madoff and Sonny Cohn would share far more than a seaplane.

The commuter friendship that began on the Cessna seaplane in the 1970s had ripened into a business partnership by 1985, when Sonny Cohn and Bernie Madoff formed Cohmad Securities, a name crafted from the first three letters of their last names.

An engaging wisecracker seven years older than Madoff, Cohn had been a fixture among the traders on the American Stock Exchange and the Big Board for nearly a quarter century. He began his career at Salomon Brothers but soon joined the proud and clubby fraternity of Amex floor traders, who were a little dismissive of the still-scruffy OTC market where Bernie Madoff was getting established. But as neighbors in Roslyn, the two men became close friends, indulging in goofy stunts—one friend recalled their putting a bright red phone in the rear window of the chauffeured Cadillac they briefly shared for their morning commute, to mimic the nuclear “hot line” in the White House.

Cohn used to observe that Madoff “never had a losing day” he always talked like a winner, even when his stocks were down.

In 1982, a year before Madoff opened his London office, Cohn’s floor trading firm, Cohn, Delaire & Kaufman, was bought by a big London Stock Exchange trading firm, Akroyd & Smithers. For a while, Cohn stayed on as chairman and CEO. But in 1984 a British investment bank purchased Akroyd & Smithers, and Cohn’s position began to seem largely honorary. He grew increasingly restless and wanted something new and not too demanding to do.

Madoff was already planning a big move uptown. After years at 110 Wall Street, a boxy black building near the South Street Seaport, he leased the eighteenth floor of 885 Third Avenue, the cutting-edge tower at the corner of East Fifty-third Street that quickly became known to New Yorkers as the Lipstick Building for its tubular shape. There would be space for the fifty or so employees of the Madoff firm, with room to spare. (In time, Madoff’s operation would expand to the seventeenth and nineteenth floors as well.)

Cohmad was clearly born to be Sonny Cohn’s second act. In many ways, the new brokerage firm was a throwback to the small lone-cowboy firms that galloped onto Wall Street in the early 1960s, when Madoff and Cohn were just starting out.

By the late 1980s those firms were largely extinct and their brokers had scattered—outsold and outclassed by larger firms that built retail networks across the country and knitted them together with increasingly complicated technology. Cohn’s new firm was a place where refugees from a forgotten Wall Street could roll back the clock, revel in the camaraderie of trading by telephone, and schmooze with their customers over a bountiful lunch at P. J. Clarke’s saloon or drinks at the historic Harmonie Club.

There was nothing high-tech about Cohmad; it promised “old-fashioned service” to its clientele. Within a few years, it would become a haven for older brokers looking for a place to hang their shingle; one broker was seventy-seven years old when he joined the firm in 1991.

Marcia Beth Cohn was an exception, of course. She was Sonny Cohn’s daughter and still in her late twenties when she joined Cohmad in 1988, after six years at Cowen & Company, a small brokerage firm. She owned 25 percent of Cohmad, her father owned 48 percent, and Sonny’s brother and a longtime employee each owned 1 percent.

The remaining 25 percent was lopsidedly split: 24 percent was shared by the Madoff brothers—15 percent for Bernie and 9 percent for Peter—and the final 1 percent was held by a tall, well-dressed Bostonian named Robert Martin Jaffe.

Bob Jaffe was a sociable, attractive man with a dandy’s flair for fashion. He began his Wall Street career in 1969 at E.F. Hutton & Company, and in 1980 he moved to Cowen & Company, where he worked for several years with Marcia Cohn. More significantly, he was married to Ellen Shapiro, a daughter of one of Madoff’s first and wealthiest clients, the multimillionaire Carl Shapiro. The rumor in Boston was that Shapiro had introduced Jaffe to his first client. Perhaps Bernie Madoff gave Jaffe a sliver of Cohmad in the same spirit: as a helpful gesture for an old friend’s son-in-law.

Bob Jaffe was forty-five years old in 1989, when he opened an office for Cohmad in Boston, where the Shapiro family was established in local social and philanthropic circles. Jaffe had a discerning eye, but not a perceptive one. “He is someone who identifies the best restaurants by looking at who goes there” rather than by making his own assessment of the menu, one professional acquaintance said.

Within a few months of the new office opening, state securities regulators rapped Cohmad’s knuckles for doing business in Massachusetts without being licensed there. Sonny Cohn agreed to comply with the rules and supervise his agents more carefully.

As this suggests, Cohmad was a rather casual expression of the brokerage business, a reflection of the less rigorous regulatory climate in which Sonny Cohn came of age—a time when insider trading was not yet a crime, disclosure requirements were few, and regulators were less attentive to the OTC market.

Madoff’s staff took care of most of Cohmad’s paperwork. It is not clear who made sure it complied with complex state and federal securities laws—indeed, it’s not clear that anyone did, although subsequent lawsuits would claim that the firm’s compliance officer was Peter Madoff’s daughter, Shana. The lines between Cohmad and Madoff’s much larger firm became fuzzy, in places almost invisible. Cohmad handled a small number of stock exchange orders for Madoff’s firm and had several hundred clients with traditional brokerage accounts. But most of its small corps of brokers spent their time introducing eager people to Bernie Madoff.

Cohmad offered them access to the investing genius already whispered about in affluent circles—the man Carl Shapiro and Norman Levy trusted with their own money, the man other wealthy country club members and charity dinner guests wanted to trust with their money, too. Soon the compensation that brokers got for introducing new investors to Madoff was Cohmad’s primary source of revenue, a fact that went unreported by Cohmad and unnoticed by regulators.

The compensation arrangement seemed oddly structured. Each broker’s commission was based on how much cash the investor handed over to Bernie Madoff, not how big the investor’s account balances were in future months and years. Once an investor had withdrawn all the cash originally invested, the broker’s commission stopped—even if the account still showed paper profits in the millions. Regulators would claim that this Ponzi-like accounting was evidence that Cohmad was complicit in Madoff’s fraud. But the Cohns later argued successfully in court that this arrangement simply reflected the fact that they were not managing the money and therefore did not get any credit for the profits Madoff supposedly produced.

By the time Cohmad was formed, Bernie Madoff’s reported strategy for producing those profits was changing—a shift that had begun in 1980, when his biggest clients pressed him (in his recounting) to “offer them another form of trading that would produce long-term capital gains rather than the short-term capital gains of arbitrage.” The tax shelters of the 1970s were cracking, income tax rates seemed high, and his wealthiest clients wanted to reduce their tax bills. He claimed that he offered them a new strategy: “a diversified portfolio of equities hedged as necessary” with various kinds of short sales.

In a letter from prison, Madoff insisted that he cautioned his clients that the stocks in their portfolios would have to be held long enough to qualify for the capital gains tax break and, “more importantly, that the stock market would have to go up during the holding period, which was certainly difficult to predict.” Still, he said, “a number of the wealthy clients chose to do this strategy—the Levy, Picower, Chais and Shapiro families most importantly.”

By this point, he continued, he was “doing a hedged type of portfolio trading for a French bank.” He decided that “the French institutional clients would be an excellent counterparty for this strategy as well. I was already trading with them as a counterparty for some of my arbitrage trades.”

Was any of this true? It is certainly true that, by this point, Madoff had established a trading relationship with an elite French firm called Banque Privée de Gestion Financière, or BPGF. One of its officers, Jean-Michel Cédille, had met Madoff through their mutual friend Albert Igoin. Madoff claimed to have been offered an ownership stake in the bank and to have sold it later at a substantial profit when the bank was merged into a larger French institution. With its records long dispersed and both Igoin and Cédille deceased, it is almost impossible to verify this element of Madoff’s story, but he clearly had ties to the bank; its old phone number was in his computer files at the time of his arrest. And he had French clients with long-standing accounts, who showed up as victims in bankruptcy court documents.

He also had clients who wanted to use those accounts in the 1980s to evade the higher French taxes and currency controls that were imposed after the election of François Mitterrand’s Socialist government in 1981, he said. “Everyone in France was concerned about Mitterrand,” he explained in one prison interview. “He was nationalizing banks, they were worried about outright communism…. You couldn’t take French francs out of the country—the only way to hedge the currency was to buy U.S. securities.” With the French currency losing value, Madoff’s clients wanted to move their wealth into U.S. dollars—and he helped them do that.

Some of these French clients were later caught in tax disputes with authorities in the United States and in France. But, at the time, Madoff earned their gratitude—and acquired a set of clients who were less concerned about keeping up with the market than they were about staying invested in U.S. dollars. As Madoff saw it, that made them the ideal “counterparties” for the new strategy he devised for his profit-hungry, tax-averse American investors.

Soon after Cohmad was set up in 1985, Madoff began to tell many of his investors that he was changing his investment approach in their accounts from classic riskless arbitrage trades to the complex strategy that he would still be claiming to use until the moment before his Ponzi scheme collapsed twenty years later.

His approach made even his most complicated arbitrage trades look simple. Some options traders called his new strategy a “bull spread.” Madoff came to call it his “split-strike conversion strategy.”

In its honest form, the strategy was empowered by the innovations in options trading that were pioneered in the financial markets of Chicago in the 1970s. A stock option is simply a contract that gives its buyer the right (the “option”) to buy or sell that stock at a specific price for a specific period of time. Much less expensive than the actual stocks, options gave speculators a cheaper way to bet on rising prices—an option that allowed them to buy a stock for $10 a share was a winning bet if the stock rose to $20 a share before the option expired. They could exercise the option, buying the stock for $10 and immediately selling it for twice as much. Options also provided cautious investors a hedge against declining prices—an option to sell a stock for $10 a share locked in some profits if the stock declined below that price.

Options on specific stocks began to trade freely on organized exchanges in the 1970s, but within a few years, novel option products were developed that covered entire portfolios of stocks, such as the stocks in the Standard & Poor’s 500 index. But the concept was still the same: options provided a cheaper way to profit if the index went up and could cushion losses if the index went down.

So Madoff’s new strategy was to buy a broad portfolio of stocks—one broad enough to perform roughly in step with the overall blue-chip market—and to use options to hedge against future price declines. The cost of the options would reduce his profits a bit, but the options would also reduce his losses. The strategy required a deep, liquid market for the options used to hedge the portfolio, but as options trading grew more popular in the 1980s, this did not seem to be a meaningful constraint.

Like his arbitrage strategies, this investment approach had some credibility on the Street. In December 1977 a public mutual fund called the Gateway fund was set up in Cincinnati to pursue roughly the same strategy. Its early track record was quite impressive but highly volatile. Between 1977 and the period during which Madoff supposedly adopted a similar strategy, its monthly returns bounced around from a loss of 7.7 percent in October 1978 to a gain of 7.5 percent in August 1982. Beginning in 1983, its twelve-month returns were formidable, if still unpredictable; in some twelve-month periods during the early 1980s, its gains exceeded 20 percent. This would no doubt explain why the strategy looked like a winner to Madoff, and if he achieved comparable returns he certainly would keep his investors happy.

Unfortunately, the Gateway fund remained too small and obscure to catch the attention of Madoff’s later investors, who otherwise might have noticed that his pursuit of the same strategy was producing remarkably less erratic results.

Sonny Cohn explained the new strategy to a prospective customer a half-dozen years later, calling it “a simplistic and, most important, a very conservative strategy.” After Madoff’s arrest, Cohn’s lawyers would insist that he had had complete faith in what he wrote—he was certain Madoff was pursuing a conservative strategy whose very consistency was proof that he was executing it superlatively well. After all, Cohn had bet his firm, much of his wealth, his daughter’s future career, and his long Wall Street reputation on his trust in his old friend Bernie Madoff.