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One of the many repercussions of the Madoff fraud is how
to treat investors who had money in his Ponzi scheme.
There has been plenty written about how the trustee is
treating the direct investors. He is only treating net cash. If you took out
more cash than you put in, you are on the hook. That is regardless of how
massive your paper losses may be. This clearly hurts the early investors with
The other aspect is how the feeder funds or other
investment funds treat the losses and pass them through to their investors. The
case of Beacon Associates caught my eye when it popped up. (There
is no connection to my employer.)
Beacon Associates had placed a big chunk of its assets
with Mr. Madoff. That has lead to a class actions suit by its investors and ERISA lawsuits.
The losses have also left the fund in the lurch as to how
to treat the losses and which period to attribute the losses. Between 1995 and
December 2008, Beacon issued monthly financial statements reporting substantial
gains on Beacon's investments. Beacon allocated those gains to its members in
proportion to each member's interest in Beacon and reflected those gains in its
financial statements. As we have now discovered, Madoff never invested the
capital and those gains allocated by Beacon never existed.
As a result, Beacon ended up commencing liquidation and
needed to figure out how to distribute its remaining assets to its investors.
Beacon lost approximately $358,000,000 through investments with Madoff and had
just $113,283,785 of remaining assets.
One way to treat the loss is the valuation method. You
treat the losses to have occurred on December 2008 when the Madoff fraud was
uncovered. Any investor who was fully redeemed before then would not be
allocated any loss.
An alternative treatment would be the restatement method.
They would treat the losses to have occurred when Beacon made each of its
investments with Madoff. That would allocate the Madoff losses over a much
longer period of time.
Not surprisingly, the different methodologies "provided
dramatically different results." While the capital account of one member was
calculated at $4,750,866 using the Valuation method, it had a balance of
$2,735,636 under a Restatement method. Another member's capital account was
valued at $1,815,576 under the Valuation method, but exceeded $3,000,000 under
a Restatement method. Beacon polled its investors. Eight-two percent preferred
the Valuation Method, 10% preferred a Restatement Method, and twenty-five (8%)
did not make a selection.
The court ended up ruling:
"Because Beacon's Operating Agreement requires that
capital accounts be maintained in accordance with Federal Treasury rules, and
because the IRS has ruled that losses attributable to Ponzi schemes be reported
in the year they are discovered, Beacon's Operating Agreement must be read as
requiring that Madoff theft losses, including those losses owing to "fictitious
profits," be allocated among its members' capital accounts in proportion to
their interest in Beacon as recorded in December 2008, when Madoff's fraud was
The net investment method is similar to the one being
used by the Madoff and is appropriate for Ponzi scheme cases. Here, the court
points out that Beacon itself was not a Ponzi scheme. The valuation method is
the proper choice.
For additional commentary on developments in
compliance and ethics, visit Compliance Building, a blog hosted by Doug Cornelius.