February 21, 2012

Baseball ProGUESTus

What Wilpon Knew

by Howard Megdal

Believe it or not, most of our writers didn't enter the world sporting an @baseballprospectus.com address; with a few exceptions, they started out somewhere else. In an effort to up your reading pleasure while tipping our caps to some of the most illuminating work being done elsewhere on the internet, we'll be yielding the stage once a week to the best and brightest baseball writers, researchers and thinkers from outside of the BP umbrella. If you'd like to nominate a guest contributor (including yourself), please drop us a line.

Howard Megdal is the Lead Writer for the LoHud Mets Blog and Writer At Large for Capital New York. He covers baseball, basketball, and soccer for these and numerous other publications. His new book, Wilpon's Folly, from which much of the following text was drawn, is available as an e-book at Amazon.com and Barnes and Noble. Follow the LoHud Mets Blog on Twitter @lohudmets. Follow Howard on Twitter @HowardMegdal.
 

When Bernie Madoff was arrested for financial fraud on December 11, 2008, there were astonishingly far-reaching consequences. Madoff was emblematic of the sudden recession that had struck a few months before; he was a man people wanted urgently to punish. But no one was more affected by his fall than his clients. Some of these folks clicked open their portfolios to discover that thousands or even millions of dollars they thought were there had never existed. Others had a different problem, one that would take longer to fully manifest itself: not only had they lost what money Madoff still had of theirs, but they also would soon owe their Madoff profits to Madoff’s victims. Fred Wilpon, principal owner of the New York Mets, was one of these people.

In the final six years of Madoff’s Ponzi scheme, Bernard L. Madoff Investment Securities brought in $17.3 billion in principal. Because Wilpon profited handsomely from the scheme, some have assumed—falsely—that Wilpon was somehow in on it. The truth is that Wilpon was among the many Madoff investors who profited, and so he is partially responsible for paying back those who lost money to him. What he knew or didn’t know is a separate issue. And there are many other questions yet to be resolved. What was the nature of the relationship between Wilpon and Madoff? Exactly how much money does Wilpon have, and how much does he owe to Madoff’s victims? Will the losses sustained in the process of resolving Madoff’s debts force Wilpon to sell his beloved team?

Irving Picard, a bankruptcy trustee brought on by the Securities Investor Protection Corporation (and paid by them) to recover as much of that $17.3 billion as he can from the people to whom it was paid out as “fictitious profits” from investments that never took place, is tasked with answering many of these questions. Picard is working to determine where all that money went and using existing law to recover it. To date, he's already recovered $9.067 billion for the victims, and lawsuits are moving forward to collect far more than that. The purpose of this book is to sort through Picard’s findings, the lawsuits, and the facts, and to spell out what happened to the hundreds of millions of dollars that Fred Wilpon made from his Madoff investments, the hundreds of millions Wilpon had with Madoff that he lost, and what effect both those losses and the legal proceedings will have on Wilpon and the New York Mets, the team he’s owned since 1980.

It is a complex case. But contrary to conspiracy theories and rumor, Madoff's money–rather, the money that Madoff took and pretended to invest—didn’t go to buy diamonds that he has stashed secretly all over the world or get buried in some secret account. Those who lost money with Madoff lost it to those who made money with Madoff. And in the overwhelming majority of those cases, even the trustee Picard acknowledges it happened without anyone’s knowledge, save that of Madoff himself. Despite the innocence of the winners, the law in Ponzi schemes has been clear: those who profited need to make those who lost whole again.

Fred Wilpon was a “net winner” in the Ponzi scheme, as the phrase goes. So why would he be in financial trouble? The answer lies in Wilpon’s impressively heavy reliance on money he made from Madoff, both as a source of funds for his businesses and as collateral for loans made against that money.

***

Note: in the months since the publication of Wilpon's Folly, a significant piece of additional information has come to light that comports with the evidence below. I have written about Noreen Harrington's testimony here; she brings together knowledge that Bernie Madoff's activities provided ample indications of fraud with a first-person account of telling her concerns to Saul Katz. She also has contemporary emails supporting these claims; the trustee is presenting these as evidence in a trial on March 19.

This section presents the summary of the other key evidence in the case and the standard it needs to meet. None of this evidence is conjecture; it has been presented with physical proof, examined by both sides, added in sworn depositions with cross-examination, and entered into the public record. (A fuller examination of the evidence, with complete sourcing, is available in the book.)

How a jury will respond to it is to be determined, but the evidence record they will consider is already in existence. Pretending otherwise is like pretending that a bottle of milk that's been pasteurized, packaged, sent to a store, and sold isn't really milk because no one's consumed it yet.

Known? No. Should Have Known.

Using 20-20 hindsight, it is tempting to argue that the Sterling partners (the company founded by Fred Wilpon and Saul Katz that owns the Mets, the sports network SNY, and other real estate interests) would have withdrawn their funds from Madoff if they had so much as suspected that he was running a Ponzi scheme. But this supposition bypasses a crucial detail: even if they did think he might be running a Ponzi scheme, they had no way of knowing that he’d be arrested for it. After all, if there had been reason to believe that such a thing would happen, Madoff himself might have shuttered his own business, or at least taken measures to protect himself.

And that is applying the facts of what we know now, since when we think of the case, we aren’t merely thinking of a Ponzi scheme, but a different question: How could the Sterling partners have kept so much money in Bernie Madoff’s hands, when he was running a Ponzi scheme that would come to an end on December 11, 2008? Of course, no one knew that as the 2000s dragged on. No one could.

Let’s say you apply this logic to Bernie Madoff himself. Madoff actually knew he was running a Ponzi scheme, since he was the one running it. Given that he had to know that eventually he’d either run out of money or get caught, there’s no logical reason he would have put his entire life and finances at risk. Therefore, Bernie Madoff couldn’t have run the Ponzi scheme he ran.

Logic doesn’t lead to Ponzi schemes, nor does it guide those who participate in them, nor to those who turn a blind eye to indications that they may be happening. Greed is the driver.

But even if the Sterling partners believed Madoff was running a Ponzi scheme—and that is neither suggested by the trustee, nor is it the level of proof he needs to reach—what they saw, over a period of 23 years, was an investment that somehow provided positive returns—always. In good markets, in bad markets—consistency, not huge profits, was what Bernie Madoff provided to Fred Wilpon and Saul Katz.

This represented a huge operating advantage to the businesses they ran. Not because they were making so much more money than various businesses were making one year or another year through investments, but because they were making a little more, and they were always making a little more. As a result, by the time the red flags really started flapping, all of their businesses were reliant on that steady income to operate effectively.

So the question isn’t why they continued to invest with Bernie Madoff. The question is, just how many indications of fraud were they willing to ignore to keep investing with him? And, more important, does their willful ignorance meet the trustee’s standard of inquiry notice, or the current judge’s standard of willful blindness?

Again, the issue here isn’t whether they received information that should have alerted them to this particular fraud, which was a Ponzi scheme. Certainly, they received plenty of that, from a trusted business partner urging them to buy one-of-a-kind fraud insurance to cover their Madoff accounts to a mini-Madoff Ponzi scheme that they exited prematurely due to the very same concerns that existed for Bernie Madoff’s enterprise.

But these responses, or lack of response, constitute an incomplete record of the Sterling partners’ thinking. Every other indication of fraud they failed to see, misread, or disregarded also impacts the court’s standard. And it is the total set of actions that may ultimately be evaluated by a jury:

• March 2000: Chuck Klein purchases fraud insurance to cover his holdings with Bernie Madoff purchased through Sterling Equities and holds it through 2004 while he is a business partner of Sterling Equities.
• 2000: David Katz, a Sterling partner since 1987, begins “screaming” for diversification from Bernie Madoff.
• August 2000: Wilpon and Katz sign letters prepared by and on the authority of Madoff that hide their Madoff connection from the New York attorney general.
• No later than February 2001: Chuck Klein advises Katz to purchase fraud insurance for his Madoff holdings.
• June 2001: The Sterling partners look into fraud insurance, specifically its cost; determining that it is insufficient to cover even a portion of their Madoff holdings, they decline to purchase it.
• 2002: Sterling Stamos, an investment fund created expressly for Sterling Equities to diversify away from Bernie Madoff, is created, with Chuck Klein serving on the investment committee.
• October 2003–June 2005: At Madoff's request, Saul Katz and Sterling Stamos work to create a firewall between Katz and Madoff for the express purpose of keeping Sterling Stamos’s investments with Madoff secret from the SEC.
• October 2003–March 2005: Sterling Stamos’s due diligence reveals a high probability of fraud in Bayou Superfund, identifying the exact same types of problems that exist with Bernie Madoff. Sterling Stamos, acting on these red flags, redeems its entire investment and eventually settles with the bankruptcy trustee for 100 percent of profit and 44 percent of principal in a suit alleging Sterling Stamos had sufficient red flags to reach the “inquiry notice” threshold.
• May 2004: To secure a $54 million loan from Madoff, Katz and Wilpon sign a document falsely characterizing the money as an investment by Madoff's wife, Ruth.
• 2007–2008: In the wake of the financial crisis, Saul Katz asks Sterling Stamos to invest with Madoff, whose “investment” returns are still positive; he is denied. In December 2008, Katz informs Peter Stamos that Sterling Equities intends to withdraw most or all money from its funds from Sterling Stamos and invest with Madoff instead.
• December 11, 2008: Bernie Madoff arrested on suspicion of fraud.

Consider these events in light of the issue that the compliance officer for Merrill Lynch, along with Peter Stamos and others, raised in connection with Bernie Madoff: a practice called front-running, which means making trades based on information about movement within the market before the movement actually occurs.

Here’s how front-running would have worked in the Madoff case. Madoff’s Ponzi scheme operation existed in the shadows of his well-known legitimate business. And that business consisted of executing trades for others. His ability to do so quickly, thanks to trading software whose use he helped pioneer, made it valuable for other traders to use him for this purpose. He’d get a small fee for each trade and made his money through the volume of trades he executed.

Because of his success and his large client base, Madoff received a substantial portion of the trade orders on Wall Street each day. This means that simply by checking his inbox, he could see—in fact, know with certainty—how some of the market’s trends were shaping up. Merely by putting his own preferred money management clients, such as the Sterling partners, at the head of the line, he could make these clients function ahead of the market and thereby profit from the actions of the other trades he made. Not by a lot, mind you—but consistent, positive returns. Sound familiar?

That Madoff was front-running is the conclusion that most doubters of Madoff’s methods reached. If it is the conclusion reached by Saul Katz—who certainly had the expertise to understand both how Madoff’s front-running scheme could work and that the profits it would likely generate would match the ones he was getting as an investment client of Madoff’s—then his continued confidence in Madoff starts to make a lot more sense.

If Madoff was making his returns for clients from front-running, and if this is what Fred Wilpon and Saul Katz believed, then they had little reason to worry about diversification; the advantage of getting ahead of the market at all times canceled out the risk normally reduced by having a position in a range of financial vehicles. And there was no danger that their money would disappear: if, or when, Madoff got busted for front-running, they’d at least get their initial investment back. In the meantime, they’d continue to profit.

As Arthur Friedman said, they liked their investment.

Wouldn’t you?