One of the many repercussions of the Madoff fraud is how to treat investors who had money in his Ponzi scheme.
There has been plenty written about how the trustee is treating the direct investors. He is only treating net cash. If you took out more cash than you put in, you are on the hook. That is regardless of how massive your paper losses may be. This clearly hurts the early investors with Madoff.
The other aspect is how the feeder funds or other investment funds treat the losses and pass them through to their investors. The case of Beacon Associates caught my eye when it popped up. (There is no connection to my employer.)
The losses have also left the fund in the lurch as to how to treat the losses and which period to attribute the losses. Between 1995 and December 2008, Beacon issued monthly financial statements reporting substantial gains on Beacon’s investments. Beacon allocated those gains to its members in proportion to each member’s interest in Beacon and reflected those gains in its financial statements. As we have now discovered, Madoff never invested the capital and those gains allocated by Beacon never existed.
As a result, Beacon ended up commencing liquidation and needed to figure out how to distribute its remaining assets to its investors. Beacon lost approximately $358,000,000 through investments with Madoff and had just $113,283,785 of remaining assets.
One way to treat the loss is the valuation method. You treat the losses to have occurred on December 2008 when the Madoff fraud was uncovered. Any investor who was fully redeemed before then would not be allocated any loss.
An alternative treatment would be the restatement method. They would treat the losses to have occurred when Beacon made each of its investments with Madoff. That would allocate the Madoff losses over a much longer period of time.
Not surprisingly, the different methodologies “provided dramatically different results.” While the capital account of one member was calculated at $4,750,866 using the Valuation method, it had a balance of $2,735,636 under a Restatement method. Another member’s capital account was valued at $1,815,576 under the Valuation method, but exceeded $3,000,000 under a Restatement method. Beacon polled its investors. Eight-two percent preferred the Valuation Method, 10% preferred a Restatement Method, and twenty-five (8%) did not make a selection.
The court ended up ruling:
“Because Beacon’s Operating Agreement requires that capital accounts be maintained in accordance with Federal Treasury rules, and because the IRS has ruled that losses attributable to Ponzi schemes be reported in the year they are discovered, Beacon’s Operating Agreement must be read as requiring that Madoff theft losses, including those losses owing to “fictitious profits,” be allocated among its members’ capital accounts in proportion to their interest in Beacon as recorded in December 2008, when Madoff’s fraud was discovered.”
The net investment method is similar to the one being used by the Madoff and is appropriate for Ponzi scheme cases. Here, the court points out that Beacon itself was not a Ponzi scheme. The valuation method is the proper choice.