Madoff Enablers?Madoff Enablers?

David T. Leibell & Daniel L. Daniels, partners in the Stamford, Conn. office of Wiggin and Dana LLP

Charities may not only have been Bernard Madoff's victims but also his enablers, most probably unknowingly — but some, possibly, knowingly.

Mitchell Zuckoff of Fortune magazine, in an article on CNNMoney.com dated Jan. 5, 2009, “Charities: The Foundation of Madoff's Scheme?” hypothesized that it was money from the charitable foundations and endowments that helped Madoff continue his Ponzi scheme for decades, when most Ponzi schemes typically fail within a year or two as withdrawals exceed deposits. According to Zuckoff, Madoff used the stability of the billions of dollars invested in his funds by these foundations and endowments (which typically withdraw between 4 percent and 6 percent a year to satisfy grantmaking requirements) to build up a rainy day fund available to pay off withdrawals from less predictable non-charitable investors.

Because Madoff provided steady returns of between 10 percent and 12 percent for decades, it's hard to blame the charities for investing with Madoff. Unlike the general markets, there was never a down year with Madoff. Charities could generate 5 percent to 7 percent returns each year above and beyond what they paid out for charitable programs.

Madoff's house of cards appears to have fallen apart only in the last quarter of 2008, when, investors seeking cash in a brutal market went to the source they could always rely on: Madoff. This run on the bank allegedly forced Madoff to make a poignant confession to his sons that his life had been a sham. After this touching family moment, the boys turned dear old dad over to the proper authorities.

Shortly after the news of Madoff's scheme hit the front page, one charity after another began announcing massive losses in his funds. Several have since closed, including the $1 billion Picower Foundation, in Palm Beach, Fla.

Although charities were victims, it did not take long for the press to question whether charitable boards had breached certain fiduciary duties by investing with Madoff. And not without good reason. Madoff and friends (those who ran so-called “feeder funds”) had used not only social and business connections, but also their positions on charitable boards and investment committees to prey upon charitable investors. It certainly begs the question of whether there were some serious conflicts of interest.

Perhaps the best example is J. Ezra Merkin, who ran investment funds that fed billions of dollars to Madoff. Merkin sat on the boards of numerous charities and on the investment committee of several others; including acting chairman of the investment committee at Yeshiva University (where Madoff was also a director). Yeshiva, along with more than a dozen other charities, gave Merkin money that ultimately was invested with Madoff. According to Leslie Wayne, in “Inquiry Started of Financier Who Invested With Madoff,” (The New York Times, Jan. 15, 2009) Merkin's investment funds (including both charitable and non-charitable investors) placed more than $2 billion with Madoff, collecting more than $40 million in fees annually from investors.

There are no accusations that Merkin (or any other manager of feeder funds) had any knowledge of Madoff's Ponzi scheme. But the fact that Merkin and others invested money for a fee for charities where they sat on the board or investment committee has caught the attention of both New York Attorney General Andrew Cuomo and Connecticut Attorney General Richard Blumenthal.

In early January 2009, Cuomo issued subpoenas to 15 charities that gave money to Merkin to manage, including several, like Yeshiva, where Merkin also served on the board. Although it appears that Cuomo is looking into Merkin's behavior rather than the victim charities, it's clear that it will be necessary to focus on the process and procedures each charity had in place (including investment policy statements and conflict of interest policies) to determine how each board chose to invest with Merkin.

Blumenthal, in Connecticut, seems to be casting a broader net. In late December 2008, Blumenthal wrote to Irving H. Picard, the court-appointed trustee overseeing the liquidation of Madoff's firm, and asked for a list of the charities in Connecticut that invested with Madoff. His concerns are two-fold. First, Blumenthal wants to help Connecticut charity victims to recover as much from the fraud as possible. This is the job of each state's attorney general as the legal protector of charitable funds. Second, he wants to know whether some charity directors should be held accountable for breaching their fiduciary duties by investing with Madoff. “The standard is that the director or fiduciary at any nonprofit has to exercise due diligence and the care and caution of an ordinary prudent investor,” Blumenthal wrote in his letter to the trustee. According to Blumenthal, if there was a reckless failure on the part of the directors to do the necessary due diligence, his office would investigate and take action, and such directors “could be held personally and financially responsible.”

This focus on the behavior of non-profit directors in exercising their fiduciary duty regarding charitable investments is probably long overdue. Many boards fail to follow the requirements set forth under relevant state law, and in the case of private foundations, under relevant state law and federal tax laws. In fact, many directors don't even know the laws exist.

The laws not only exist but also are quite well developed. Non-profit directors would be well-advised to have an independent audit of their charity's corporate governance procedures regarding choosing and monitoring charitable investments and investment advisors. The key factor under the prudent investor standard is the process, not the result. If the process of selecting and monitoring investments and investment advisors is prudent, the directors should be protected.

In addition to legal standards, directors should consider whether certain behavior, such as having a board member invest for the charity for a fee, while perhaps legal and permissible under the charity's conflict of interest policy, may not pass the “smell test” with donors. In particular, charities should be extra careful about how they handle endowment assets, which are subject to the greatest protections under state law with respect to investing, expenditure and administration.

It is in the area of abuse of endowment funds that donors are most likely to get angry and state attorneys general to file suit.

Investing charitable assets is a sacred trust. Those who rely on the good works of a charity are particularly dependent on the proper stewardship of a charity's assets by the board. As such, charity directors should and are held to stringent fiduciary standards under both the Uniform Management of Institutional Funds Act (UMIFA) and particularly UPMIFA with regard to the proper investment of assets held in donor restricted and board restricted endowments. Unfortunately, many board members are not aware of the rules and procedures associated with investing charitable assets prudently. If one good thing can come out of the Madoff mess, hopefully it will be that publicity of attorney general action against charitable boards acts as a wake-up call for boards to establish proper policies and procedures for investing charitable assets.