A New York hedge fund manager who funneled billions of dollars to Bernard Madoff's massive Ponzi scheme has agreed to a settlement with the New York Attorney General's Office that will return more than $400 million to investors of those funds. J. Ezra Merkin ("Merkin"), a noted financier, operated four funds that lost approximately $1.2 billion when Madoff's scheme collapsed in December 2008. Investors in those funds now stand to receive roughly a third of their initial investment assuming the settlement stands, but uncertainty remains as the trustee appointed to liquidate Mr. Madoff's brokerage firm is expected to object to the arrangement as it will essentially 'leapfrog' Madoff's direct victims.
Shortly after Madoff's scheme collapsed in December 2008 erasing billions of dollars in paper wealth for thousands of investors, the New York attorney general's office filed a civil fraud case charging Mr. Merkin with breach of fiduciary duty, claiming he hoodwinked investors by misrepresenting that he would be managing their funds himself, when in reality he was simply handing the money over to Madoff. Merkin had operated four private funds: Ariel Fund Ltd., Gabriel Capital L.P., Ascot Fund Ltd., and Ascot Partners (the "Funds"). Over the life of the Funds' relationship with Madoff, more than $2 billion was ultimately invested. When Madoff's fraud was uncovered, over $1.2 billion of the Funds' investment was lost.
New York State Attorney General Eric Schneiderman, who announced the settlement, revealed that Fund victims would receive $405 million in payouts over the next three years, with the remaining $5 million being paid to the city of New York. However, the formula for determining the payout due to investors will not be calculated by simply distributing a pro rata amount of each investor's losses; rather, Schneiderman's plan seeks to distribute a larger portion to investors who were unaware of Merkin's plans to act as a feeder fund to Madoff. While further details were not available, the process will likely be a time-consuming affair, as it would appear that an individualized inquiry would be required to determine each investor's knowledge.
The settlement is also likely to draw the ire of Irving Picard, the bankruptcy trustee appointed by a federal bankruptcy court in the wake of Madoff's scheme. Not only does Mr. Picard share a different view as to the entitlement of Merkin's investors to any funds, but he also has how own lawsuit pending seeking to recover $500 million from Mr. Merkin and is likely to assert that his efforts should receive priority from all other recovery efforts - including the government. Mr. Picard's view, which was recently upheld by United States Bankruptcy Judge Burton Lifland, is that those who invested not with Madoff himself but through various feeder funds, were not eligible to receive the proceeds of any assets recovered by Picard and his team. Rather, those indirect investors must seek redress from the fund they originally invested in.
At first glance, Schneiderman's settlement with Merkin may comport with this view. However, under the schematics of a Ponzi scheme, Picard is likely to argue that Mr. Merkin's management fees were paid not by his investors, but by Madoff's use of funds from existing investors that falsely masqueraded as returns on Madoff's investments. Thus, returns paid to Merkin, who in turn redistributed those returns to the Funds' investors, consisted solely of other direct investors' funds. Additionally, federal bankruptcy laws allow the recovery of "preference" payments made to investors within specific time periods before a bankruptcy filing. These "clawback" actions, as they have become known, have largely been pursued only against investors for any funds withdrawn in excess of their original investment, but Picard has indicated his intention to pursue both the return of principal and interest from sophisticated investors, including his much-publicized suit against New York Mets owners Katz and Wilpon. That case was ultimately settled out of court.
Picard's spokeswoman, Amanda Remus, indicated that the trustee and his team were still reviewing the settlement, but reiterated that the "trustee's claims, by law, take precedence."