The Wizard of Lies: Bernie Madoff and the Death of Trust (36 page)

Fires, earthquakes, and hurricanes were readily recognized as events that required an emergency response to alleviate human suffering; the Madoff fraud was not. Few people even wondered at first if there were victims who had been totally wiped out overnight by this crime, victims in need of immediate help who could not turn to their relatives because they, too, were suddenly destitute.

So the public imagination focused on the sequined names of the wealthiest victims, people who would suffer no more than embarrassment from their Madoff losses. Madoff’s crime thus came across as just another overdue comeuppance for the rich and greedy people who had helped drive the nation into a ditch in 2008. Politicians were wary of leaping to the defense of beleaguered victims they suspected were just hapless hedge fund managers and Madoff’s country club cronies.

Instead of focusing on how to help the neediest victims, they focused on where to put the blame.

On the day of Bernie Madoff’s arrest, the veteran bankruptcy lawyer Irving H. Picard was in his Manhattan office, located in a gray-trimmed Midtown tower above Madison Square Garden, when he got a call from a senior attorney at the Securities Investor Protection Corporation in Washington, the safety net organization for brokerage customers.

“Could you be the Madoff trustee if we needed you?” the attorney asked.

Picard was the obvious choice: he had handled more SIPC bankruptcy liquidations than any lawyer in the country. He promised to check immediately to see if his law firm had any conflicts that would prevent him from taking the assignment.

The timing was not ideal. At sixty-seven, Picard had one foot out the door of his old law firm, based in Newark, New Jersey, with a branch office in Manhattan. He was seriously considering a move to the Rockefeller Center offices of Baker & Hostetler, a giant Cleveland law firm expanding its New York presence. His friend and former law partner David J. Sheehan, also in his mid-sixties, was already at Baker and wanted him to come aboard. But nothing had been formalized, and the two men planned to discuss the matter further after the first of the year.

Soon after Picard hung up from the SIPC call, he found a snag: his firm had long represented U.S. senator Frank Lautenberg of New Jersey, and the senator’s children and family foundation were Madoff investors—now Madoff victims. He discussed the potential conflict with his partners in Newark and thought they had agreed the firm would not handle the Lautenbergs’ claims so that Picard would be free to take on the SIPC case.

That evening, as Picard and his wife were leaving a diner on West Fifty-seventh Street to attend a Boston Symphony concert at Carnegie Hall, he noticed a phone message from a partner saying that reporters were asking about Lautenberg. Ducking out of the rain, he called back, reminding the partner about the conflict this would pose for the SIPC case.

In the next morning’s papers, his partner was quoted speaking on the Lautenbergs’ behalf. Picard clearly had to choose: his current law firm, which was growing less congenial, or the Madoff case. Sheehan, who had already been asked by SIPC to be counsel to whoever became the trustee, discussed the move with Picard that night over dinner with their wives at a sleek Belgian bistro near Central Park.

By Sunday afternoon Sheehan had gathered a team of Baker & Hostetler partners to interview Picard. He was offered a job and was assured that the offer stood regardless of whether he landed the SIPC assignment. Early Monday morning, December 15, he called his law firm to tender his immediate resignation and called Sheehan to accept the Baker & Hostetler offer.

When SIPC’s lawyers went into federal court that afternoon to seek Picard’s appointment as the Madoff trustee, he was in a short stretch of no-man’s-land between his former job and his future job. More than a year later, his new ninth-floor office in Rockefeller Center—with its astonishing close-up view of the rose window of Saint Patrick’s Cathedral, just across the street—looked as if he had just arrived and had yet to unpack.

Picard and Sheehan had teamed up on nearly a dozen brokerage firm liquidations over the years, but their personal styles were dramatically different.

A trim six-footer with thinning hair and a wide smile, Picard was methodical and even-tempered, carefully (perhaps overly) legalistic in his conversations and quietly corporate in his conservative wardrobe. He’d been raised in Fall River, Massachusetts, the son of a well-to-do dermatologist and the grandson of affluent German-Jewish immigrants. He had gone into the law after changing his mind about an accounting career.

After several years as an in-house lawyer on Wall Street and five years at the SEC, he was appointed in 1979 as the first U.S. trustee for the federal bankruptcy courts in New York, a new position Congress had created in the Justice Department to address rising concern about bankruptcy fraud. He then went into private practice and, in 1984, was hired to handle his first SIPC liquidation. Over the years, this became one of his specialties.

The other half of this odd couple was David J. Sheehan—small and shaggy, a mercurial, combative litigator with a biting wit, a grizzled beard, a messenger bag to throw over his parka, and impishly chic black-framed glasses.

Sheehan was the son of a janitor in the urban New Jersey town of Kearny. He worked his way through college and law school. In the face of the Vietnam draft, he enlisted as a lieutenant in the Navy Judge Advocate General’s Corps and spent his tour of duty handling legal matters at the Brooklyn Navy Yard.

His civilian law practice was eclectic—everything from product liability cases to trademark battles to pro bono work on death penalty cases. The unifying theme was courtroom work. While Picard seemed more at ease in conference rooms, negotiating the out-of-court settlements and litigation strategies that were a staple of his work, Sheehan relished courtroom combat and enjoyed the intellectual and administrative challenges of a complicated trial. He was regularly recognized as one of the top litigators in the city.

On the other hand, SIPC, the agency Picard and Sheehan would work for during the contentious years of the Madoff liquidation, was a frail and poorly equipped vessel to trust in the rough seas they were sailing into.

SIPC’s job, defined by the federal statute that created the agency in 1970, had been to make sure customer claims came first in bankruptcy court—ahead of general creditors such as the landlord and the cleaning service—and to maintain a fund to pay cash advances to customers waiting for the court to process their claims. Although SIPC’s procedures were better than the old approach (which treated all claims alike and provided no cash advances), they essentially just moved investors to the front of the line in bankruptcy court. SIPC did little, however, to speed up the tempo at which that line moved through the court system—and this was going to become an enormous problem for the Madoff victims, some of whom did not even have a cushion of cash for daily expenses.

The Madoff case also would drive home the fact that SIPC provided a far less extensive safety net than the deposit insurance programs created for banks and savings and loans after the Great Depression. (It would have been strange if Congress, in 1970, had intended to make investing in stocks as safe as putting money in the bank. Stocks paid higher returns than banks precisely because they involved greater risk.) Despite the comments of a few legislators at the time, few people in Washington considered SIPC as “insurance” against wall-to-wall fraud inside a brokerage house—until Madoff’s victims came along.

By 2008, SIPC had been shaped by its own courtroom history in ways that would compound its difficulties in handling the Madoff mess. If a brokerage firm failed for financial reasons, everyone agreed that SIPC’s role was to oversee the transfer of customer accounts to a healthier brokerage firm. If assets were stolen from customers by some rogue broker, clearly the customer’s first line of defense was always the broker’s employer.

But what if the brokerage firm failed because of a systemic fraud—for example, a Ponzi scheme such as Madoff’s? Unfortunately, SIPC’s court battles in fraud cases over the years had left a trail of limited and occasionally inconsistent decisions that would become a churned-up battlefield before the Madoff case was over. Most, if not all, of those court challenges arose from the liquidation of two-bit brokerage firms selling penny stocks—firms whose customers either had relatively small claims or, in some cases, were not entirely innocent bystanders. That experience, too, was going to be singularly unhelpful in preparing SIPC to deal with the Madoff liquidation.

Then there was SIPC’s reputation for customer service, which was spotty, to say the least. As early as 1992, the General Accounting Office urged the agency to explain more clearly to investors what it did and did not cover. A dozen years later, the GAO was still critical of how SIPC handled its public relations duties. SIPC did not even have an office of public affairs to ensure that the public got accurate, timely information about what was going on in high-profile cases. Instead, it left most of the public relations chores to whichever lawyer it hired to handle each case—a witless approach, since lawyers were typically trained not to talk at all about their cases outside the courtroom or the judge’s chambers.

Fundamentally, SIPC—like so many people in Washington, on Wall Street, and along all the Main Streets across America—had simply scaled back its vision of what could go wrong in the financial markets. As firms became more professional and better capitalized, the risk of a huge failure began to seem remote. By 1996, SIPC’s emergency fund to cover cash advances to defrauded customers had grown to more than $1 billion—far more than the organization ever expected to need, given that it was handling only a few small cases a year. So that year, it cut its member assessment from a percentage of each firm’s revenues to a flat fee of $150 a year.

As early as 1992, the GAO warned that SIPC was not really prepared for a titanic failure. But the warning was not taken seriously by Congress, Wall Street, the SEC, the investing public, or SIPC itself.

Despite its flaws, SIPC attracted little public or congressional attention after the 1970s simply because it became increasingly marginal to the world of Wall Street. Strong markets and targeted regulations sharply reduced the number of brokerage firm failures. In its first four years of existence in the early 1970s, SIPC liquidated 109 firms, some of them well known. Since then, its busiest year had been 1992, when it had thirteen open cases. In the four years before 2008, there were just five; there were none at all in 2007. Three small firms failed early in 2008, but they certainly did not put SIPC on the public’s radar.

This changed a bit on September 15, when Lehman Brothers filed for bankruptcy, the largest brokerage firm failure in history. But with Lehman’s customer service and accounting infrastructure still in place, things went smoothly. More than 135,000 customer accounts with more than $140 billion in assets were seamlessly moved into the hands of two other brokerage firms within weeks. While the legal battles among Lehman’s giant Wall Street counterparties would continue for years, Lehman’s retail customers were barely inconvenienced by the massive bankruptcy.

Then came the Madoff case. Bernard L. Madoff Investment Securities had been a charter member of SIPC, but this did not automatically mean that the Madoff fraud was a SIPC case or that its victims would be eligible for the limited cash advances the organization offered.

The victims clearly were not the kind of customers served by Madoff’s legitimate wholesale brokerage business. The customers of that business were the likes of Fidelity and Merrill Lynch, whose traders made their own decisions about what and when to buy and sell.

Moreover, Madoff had been registered with the SEC as an investment adviser since 2006. Although his customers opened their accounts with standard brokerage firm paperwork, they clearly had relied entirely on Madoff to pursue his own investment strategy on their behalf. This was one reason the SEC had forced him to register as an investment adviser in the first place.

And if one thing was crystal clear in the murky law governing brokerage bankruptcies, it was that SIPC did not cover a member’s investment advisory business.

In the days since Madoff’s arrest, the small SIPC staff in Washington had been wrestling with its responsibilities. Before anyone knew what had actually happened, a decision had to be made. The SIPC board and staff apparently concluded quickly that refusing to take responsibility for the Madoff fraud claims, while possibly defensible in a court of law, would be politically suicidal.

The only formal business Madoff had was his SIPC-protected brokerage firm. Even after he registered as an investment adviser, he did not incorporate a separate unit for his advisory clients. All the customer account statements were on the brokerage firm’s letterhead. And there on that letterhead, tiny as a ladybug, was the logo announcing that Madoff’s firm was a member of SIPC.

With the firestorm brewing in the weeks after Madoff’s arrest, it was simply impossible for this Wall Street–financed organization to walk away from this gigantic Wall Street swindle. So the SIPC board and staff stretched their definitions a little and took on the Madoff fraud claims.