Charities, Financial Institutions and the Public Trust

The revelation in December 2009 that New York financier Bernard Madoff was running for years a giant Ponzi scheme which is shaping up to be the biggest swindle in world history displays a frightening array of ethical failures – a veritable perfect storm of misconduct.

Madoff invested money on behalf of individuals and institutions, and showed a steady stream of market-beating profits month after month, year after year. It is now known that the trades investors saw were largely fictional, and that investors who cashed out were paid with funds of other investors coming in, but there was no lack of warning signals. Many people shunned Madoff’s firm when they noticed the bizarre lack of electronic account access, the unnatural lack of losing months (72 consecutive plus months), the fact that each investor saw trades that while individually plausible could not have been duplicated on anywhere near the known scale of his total business, and the tell-tale use of a tiny obscure accounting firm with a single active accountant to audit a financial empire managing tens of billions of dollars – an obviously impossible task. Almost ten years ago competitor Harry Markopolos connected the dots and wrote regulators that “Madoff Securities is the world’s largest Ponzi scheme.”

One of the most worrisome aspects of the case is the involvement of institutional funds. While private investors are free to risk their money as they see fit, institutions – who have lost hundreds of millions of dollars in the Madoff meltdown – are obligated to high standards of prudence in order to ensure that they are able to carry out the mandate of their donors.

It is true that institutional investing has progressed a long way from the old common-law “prudent man rule” which forbade the administrator of a trust from investing in any risky asset, even if the portfolio as a whole was diversified. Today we have moved towards a “prudent investor” standard which enables a more growth-oriented strategy, which advances the mandate of the donors while still maintaining safety. It is also true that the idea of having endowment investors actively seek above-market routines by skillful trading is not new. While in the public consciousness the high-flying endowment is often identified with the incredible returns achieved by Jack Meyer’s management of Harvard’s endowment, Meyer’s approach and performance were actually anticipated by over 60 years. John Maynard Keynes, besides being the world’s most famous economist, was also the investment manager for a large fraction of the Cambridge University endowment. During his fifteen years as portfolio manager, from 1928 to 1943, he outperformed the stock market by a substantial margin.

Even so, the investments many charities made through Madoff securities went way beyond prudent investing. Both Keynes and Meyer emphasized thorough research, solid assets, and adequate diversification. Madoff Securities was a black box, with inadequate oversight, and had nothing going for it except for a track record – which was itself a prime basis for suspicion. (Keynes in particular had some awful years.) As the saying goes, “Past returns are no guarantee of future performance.” Furthermore, some charities had so much invested through this single firm that its collapse has crippled their ability to carry out their mandates. Even a good, solid transparent investment can sometimes go bad, and no charity should have all its eggs in few baskets.

An additional shirking of responsibility by Jewish charities involved governance failures – conflicts of interest between personal and institutional interest. The most salient of these is Yeshiva University. Bernard Madoff was Treasurer of the university’s Board of Trustees, while Ezra Merkin served on their Investment Committee. Yet YU invested endowment funds in an investment fund Merkin ran, and which in turn “invested” its own money through Madoff. The conflict of interest is obvious, and in has been a long-term source of controversy at the university.

A good example of prudent financial management would be the UJA-Federation of New York. This organization has three distinct safeguards in place, each of which protected them from exposure to the Madoff debacle:

1. According to their statement, “UJA-Federation does not make any new investment without the manager meeting with, and responding to questions from members of the Investment Committee to give them an understanding of the manager’s strategy and execution.” Madoff consistently refused to provide this kind of information to investors.

2. The statement continues: “In the case of managed accounts (such as we understand Madoff ran), UJA-Federation would insist that securities be held by our independent custodian (JPMorgan).” This would have disclosed Madoff’s fraud from the very first month of operation.

3. News reports state that the UJA Federation of New York has a conflict-of-interest policy which forbids investing in a fund run by a member of their investment committee. So Ezra Merkin, who sits on their investment committee as well, would have been unable to direct their endowment funds to his management.

I believe every investor should manage his or her money prudently. But a charity fund, entrusted with using donor money for a defined public interest, must commit itself to the highest standards of financial prudence. Many Jewish charities knew this before the Madoff scandal; let us hope that the others internalize this lesson now in its aftermath.