The Wizard of Lies: Bernie Madoff and the Death of Trust (9 page)

One tiny firm caught in the regulatory crunch was Gibraltar Securities, the firm Ralph Madoff formed in his wife’s name to conduct his work as a financial finder. He had never had much success with that work, and Gibraltar had been essentially dormant for several years, according to Madoff. On August 6, 1963, it was one of forty-eight firms cited for being delinquent in filing the required annual financial statements. In January 1964, the SEC dropped the proceedings after Gibraltar withdrew its registration and officially shut down. In post-2008 hindsight, there would be much speculation about this early run-in with regulators, but its primary significance within the family’s life seems to have been that it was another tacit business failure for Ralph Madoff.

Even after the hidden losses of 1962, Saul Alpern would continue to tell family members and close friends about how skillfully Bernie Madoff was playing the galloping market of the 1960s. He spoke about that prowess in quiet talks with his older brother, who used Alpern’s firm as the accountant for his jewelry store; with his younger brother, an insurance executive; and with his youngest brother, a prospering lawyer. They would all invest with Madoff and would set up funds for their children with him. They would leave their money with him for decades, in fact, living on the profits he seemed to produce so effortlessly.

In a letter from prison, Madoff described for the first time how this business relationship with Saul Alpern supposedly worked. “In the 1970s, my father-in-law put together a limited partnership comprised of some family and clients of his accounting practice,” he explained. Madoff set up an account at his firm for the partnership, and Alpern accepted checks from friends, relatives, and clients, passing the money along to Madoff to invest on their behalf—legitimately, Madoff insisted. The accounting firm received the trade confirmations and “would break up the trades into individual transactions at the identical prices and proportionate shares, according to each individual member of the partnership account,” he said. “The individuals reported this information as capital gains on their respective tax returns. My father-in-law’s firm would charge an accounting fee for providing this bookkeeping and tax service.”

He added ingenuously, “I imagine it was similar to an investment club account.”

Possibly Alpern thought he was merely introducing people to Madoff and mingling their money in his firm’s accounts just to simplify things for them and for Madoff. Unsurprisingly, Madoff himself insisted there was nothing illegal in this arrangement. As he saw it, Alpern had too few investors to require him to file with securities regulators as an investment adviser or obtain a broker’s license. But, in effect, this partnership was an informal, unlicensed mutual fund, taking in money from retail investors and handing it to Madoff to manage. Even so, nothing would ever shake the Alpern family’s faith in their belief that Saul Alpern would never have knowingly led them into his son-in-law’s fraud.

In 1958, Alpern had hired a young CPA named Frank Avellino, a graduate of City College in New York and a smart, slightly cocky young man, who was given a piece of the firm after the sudden death of Alpern’s original partner in 1967. The next year, an experienced tax accountant named Michael Bienes arrived to work for Alpern, after several years at the Internal Revenue Service. Bienes immediately formed an intense bond with Avellino. The two men, born just months apart, would remain partners for almost a lifetime.

According to Bienes, Alpern kept simple records of the individual Madoff investors in a green plastic loose-leaf notebook. It seemed casual, but everyone who knew Alpern used the word
meticulous
at least once in describing him. Using forms he designed to fit into his notebook, he entered the amount each investor paid in and sent back a simple receipt for the money, perhaps with a personal thank-you note. In Bienes’s version, Madoff initially accepted these individual accounts “from Saul’s people,” and Madoff’s small back-office staff handled the paperwork. Later, Bienes claimed, Madoff told his father-in-law that things had to change.

In an interview taped for television, Bienes played Madoff’s role in a scene that would have happened—if it happened at all—years before he even worked at the Alpern firm:

“No, I cannot handle small accounts like this. This is a pain in the neck and a pain in the butt.”

Then he spoke Alpern’s lines: “Look, open an account called A&A, and I will do the record keeping. I will handle the checks. I’ll do it all.”

“A&A” stood for “Alpern & Avellino,” the name of Alpern’s accounting practice. According to Bienes, Avellino also got “a piece” of the Madoff introduction business when he became a partner in 1970. Bienes did, too, when he became a partner a few years later. In 1974, Saul Alpern retired, and his old accounting firm was renamed Avellino & Bienes. The firm’s accounts with Madoff were renamed the “A&B accounts.”

According to Bienes, Saul Alpern insisted, “I’m taking the green book down to Florida. It’ll give me something to do. And I’ll mail the stuff up to [the firm’s secretary] and she’ll type it with the checks and send it out.”

Madoff claimed that the account set up by Saul Alpern “grew to a maximum of 50 to 75 investors” under his father-in-law’s stewardship. Bienes later estimated that this investment account was “only about 10 percent” of the accounting firm’s business, even several years after Alpern retired, although he did not estimate how many investors were involved or how much money they had invested by the mid-1970s.

Along the way, Avellino and Bienes connected Madoff to another set of accountants with whom they shared office space. That pair of CPAs set up a separate fund to invest with Madoff through the A&B accounts. Their investors paid them a fee, and they paid a fee to Avellino & Bienes, but with a steady track record like Madoff’s, nobody complained about the double-dipped expenses. Even if Madoff’s returns were no better than those of the go-go mutual funds and red-hot stock market—and, typically, they weren’t—they were a lot more predictable, a lot less volatile.

In his prison interviews and in subsequent letters, Madoff claimed that he was generating those solid, consistent profits for his father-in-law’s partnership accounts through an investment strategy that he said was his small firm’s specialty in the 1970s. It was called riskless arbitrage, and it was widely understood and accepted among the professionals on Wall Street in that era.

Riskless arbitrage is an age-old strategy for exploiting momentary price differences for the same product in different markets. It could be as simple as ordering cartons of cigarettes by telephone from a vendor in a low-cost state and simultaneously selling them over the phone at a higher price in states where they are more expensive, thereby locking in a profit. Or it could be as complex as using computer software to instantly detect a tiny price differential for a stock trading in two different currencies and execute the trades without human intervention—again, locking in the profit.

What distinguished riskless arbitrage from the more familiar “merger arbitrage” of the 1980s—which involved speculating in the securities of stocks involved in possible takeovers—was that a profit could be captured the moment it was perceived, if the trade could be executed quickly enough. A conventional trader would buy a security in hopes of selling it later at a profit; if he guessed wrong, he lost money. By contrast, an arbitrage trader would not buy a security at all unless he could almost instantly sell it, or its equivalent, at a profit; if he had to guess about whether he’d make a profit, he didn’t do the trade.

In the 1970s, riskless stock arbitrage was as basic as exploiting brief price differences for a stock trading on several regional stock exchanges. It was not unusual for a company’s shares to trade at $12 on the Pacific Stock Exchange in San Francisco at the same moment that the same shares were changing hands for $11.25 on, say, the Boston Stock Exchange. By simultaneously buying in Boston and selling in San Francisco, an alert investor could lock in that $0.75 difference as a riskless arbitrage profit.

At a more sophisticated level, a level Madoff was known to exploit, riskless arbitrage involved corporate bonds or preferred stock that could be converted into common stock. A bond that could be converted into ten shares of stock should usually trade for at least ten times the price of the stock—but it didn’t always do so. If a bond that could be converted into ten shares of a $15 stock could be bought for less than $150—for $130 per bond, let’s say—that was an opportunity for arbitrage. An investor could buy that bond for $130, simultaneously sell ten shares of the underlying common stock at $15 a share, and lock in a “riskless” arbitrage profit of $20—the difference between the $130 price he paid for the bond and the $150 he received for the ten shares he got when he converted the bond into stock.

Madoff also employed more complex strategies involving stocks that traded before they were even officially for sale, changing hands in the so-called “when issued” market at prices that sometimes offered arbitrage opportunities. Sometimes he took on more risk by not making simultaneous transactions, waiting to buy or sell in hopes that a move in the market would increase his profits. By one account, Madoff was especially active in arbitrage trades involving stocks sold in tandem with arcane securities called “warrants,” which entitled buyers to purchase more stock at a specific price. Even as late as the 1980s, the Madoff firm was supposedly one of a handful of firms actively and visibly pursuing warrant arbitrage, which some traders at the time considered “easy pickings.”

According to Madoff, arbitrage strategies like these were among the primary ways he made money for himself and his clients in the years before his Ponzi scheme began. “After the 1962 market collapse, I realized that just speculating in the market made little sense,” he wrote in a letter from prison. “I realized the market was a stacked deck and was controlled by the large firms and institutions.” The big trading firms handling orders from the giant retail houses would always have an advantage over tiny firms like his, he said, adding, “I searched for a niche for my firm and found it in market making of arbitrage securities.”

Market makers were traders who consistently and publicly maintained a ready market in specific securities, buying from other traders who wanted to sell and selling to traders who wanted to buy. Continually offering to buy and sell the arcane securities involved in riskless arbitrage strategies—convertible bonds, preferred stock, common stock units with warrants—and trading those securities for his own account and those of his clients became Madoff’s increasingly profitable market niche, he said.

According to Madoff, none of the big Wall Street firms were willing to do riskless arbitrage in small pieces for retail investors. But he was, and some of the biggest names on the Street would send him small arbitrage orders to execute for their customers, he said. “They liked to send me the business,” he recalled. “They thought I was a nice Jewish boy.”

Madoff was well positioned to earn honest arbitrage profits. Because transaction costs would wipe out most arbitrage profits, which tended to be paper-thin, arbitrage trading was usually pursued only by market insiders who could trade at far less cost than retail customers—market insiders such as Madoff.

Speed mattered in other ways, too. If it took too long to complete the paperwork involved in converting a bond into its equivalent shares of stock, the opportunity for a locked-in profit could vanish. Madoff’s firm indisputably became adept at handling the conversions quickly and efficiently. Because profits could be assured only if a trader could buy and sell almost simultaneously, Madoff—with the help, in time, of his younger brother, Peter—began to build one of the fastest trading systems on the Street.

“This type of trading had limited risk exposure, which was what I was looking for,” Madoff recalled in his letter. “I set about doing this trading for my firm’s own account as well as my few clients. In the 1970s, I traded the strategies for the [Alpern] partnership accounts as well.”

He concluded: “The combination of my market-making and arbitrage trading profits were substantial, and our capital grew nicely.” His reputation grew right along with it.

How much of Madoff’s version of his early success in riskless arbitrage trading is true? As noted, there are some indications that his firm gained a legitimate reputation on the Street for trading the warrants involved in arbitrage strategies—large-scale trading that other firms could see and participate in, not the backdated fictional trading that would become the hallmark of his Ponzi scheme. There were certainly opportunities for riskless arbitrage that could have produced sizable profits in those years. For example, between 1973 and 1992 the returns on convertible bonds were slightly higher and yet much less volatile than those on common stocks, and convertible bond arbitrage was another strategy Madoff claimed to employ.

But a subsequent lawsuit asserted that Madoff was falsifying convertible bond arbitrage profits in some customer accounts as early as August 1977. To someone familiar with riskless arbitrage, the 1977 trades cited in the lawsuit do not provide unambiguous evidence of fraud, but the case does cite later instances of obviously fictitious convertible bond arbitrage trades in customer accounts in the 1990s.