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Legal Commentary

: Adam Smith, Esq.

If You're So Smart, Why Aren't You Rich?


Actually, the formulation of that headline that I prefer these days is the famous inversion by the Nobel economist Paul Samuelson: "If you're so rich how come you're so dumb?"

And yes, that brings us promptly to the Bernard Madoff scandal.

Among the multitude of "we should have seen it coming" stories:

  • the SEC was alerted to irregularities as early as 1994 [by putative competitors, to be sure, but where do you think "competitive intelligence" comes from?],
  • the shockingly consistent monthly returns were suspicious on their face,
  • Madoff in person was apparently something of a social misfit, whose primary technique for dealing with unwanted questions was to clam up and/or bluster,
  • the investment strategy was a black box,
  • and the auditing firm was a joke--a three-man firm operating out of a strip-mall office of about 125 square feet, whose principal and senior member was 80 years old and living in Florida.

Nevertheless, there have been surprisingly few first-person accounts of someone who encountered Madoff and said no.

But this week Barron's brings us one: "Living to Tell About Madoff," an interview with James Hedges (not, I assume, a stage name, although in the circumstances it ought to be), "president and founder of LJH Global Investments in Naples, Fla., who has invested billions in hedge funds and private equity since 1990 through relationships with numerous hedge funds."

Eleven years ago, Hedges spent two hours meeting with Madoff in his New York office planning to invest a few billion dollars of his clients' money. He walked out without a deal.

Here are some of the reasons why. If you read to the end, I promise I'll tell you why this is germane to what you do.

  • "I was told it was unusual for him to meet with anyone for that length of time, and that he was perturbed with the process. His whole tone during the meeting was curt, truncated, and he volunteered nothing. It was an extraction process to get him to answer anything. He was distracted the whole time, looking at people out on the trading floor through the glass wall of his office. Mind you, I was coming in to potentially invest billions of dollars for prominent families and institutions, representing extraordinarily well-known clientele. I couldn't be more the type of person for whom you would open up the kimono. And what it told me was that it was a fraud, full-stop. It was wildly impressionable on me [I'm just the messenger--that's the word he used. Bruce]. I have said over the years to many people: Do not touch Madoff with a barge pole."

  • "We have a due-diligence questionnaire that we use as a template for any investment. It's substantial, about 40 pages of factors we have to get comfortable with. It covers management's trading strategy, the back office, the pricing mechanism for the portfolio, how the manager is compensated, the checks and balances, and governance issues, and a whole host of other factors. We could barely get past page one with Madoff before alarm bells were going off. On the strategy itself, when I asked him to explain his investing strategy, it didn't line up. His strategy was like [defunct hedge fund] Long Term Capital Management, where you're saying you're going to sweep up pennies and nickels around the globe via arbitrage opportunities. His representation that he was going to get free money gains from the marketplace, without a principal risk, didn't make sense."

  • "I literally remember waving my arms in the meeting and saying -- I'm going to guess -- there were, like, 50 to 75 guys trading [stuff] behind his glass wall, out on the trading floor.

    "So what do these guys do? I asked. Because when you're investing with anyone, you want to meet the chef, and the sous chef, see who's preparing the dish. That request was turned down.

    "We don't ever allow investors to meet our team, is what Madoff said. I said, Let's go into pricing. Who holds the securities?

    "He said, We hold the securities. There was no global custodian, no prime broker. That never happens in a real business.

    "I said that what we do is look at three to five years of audited financials on funds.

    "He said, We're not going to provide audits. I was there representing a billionaire family, and to be told I couldn't gain access to an absolutely correct and appropriate thing to ask for, was amazing to me.

And now, the "payoff question" from the interview. Hedges is asked how it was possible that "reputable" hedge fund consultants could have placed billions with Madoff? "What could Tremont and others have possibly been thinking?", the Barron's reporter asks (emphasis in what follows mine)

  • "I was far from the only person to draw the conclusions that I drew about Madoff. Madoff was the fraud that happened in full view, with lots of complicit partners. This kind of thing requires complicit behavior. I believe the due diligence conducted by investors who were there was faulty, or possibly they were lied to, or it was not even done at all, perhaps put aside in deference to a relationship with a con man. Fairfield Greenwich allegedly derived some $300 million per year from their Madoff product -- that's the rumor. When someone is paying you or me or anybody that much per year to go to polo matches with high-net-worth investors and tell them about their portfolio, or on their boat in the south of France, it's hard to imagine [that] one's vision doesn't get skewed."

Here are the questions the Madoff saga should pose for you, managing your firm:

  • What's going on that we're not asking enough questions about? Where are we following the herd because it's socially convenient, socially comfortable, and all of the "in crowd" is doing it (don't kid yourself that the "in crowd" phenomenon expires on high school graduation).

  • Who are the 800# gorillas we're not scrutinizing as we should?

  • Who is getting paid so much, or helping to get you paid so much, that "it's hard to imagine one's vision doesn't get skewed"?

  • Is there a practice group that's throwing its weight around and trying to drive the firm's strategy? Are they getting away with it because they're the most profitable group going? Ask yourself how long that may last, and if you haven't read Clayton Christensen's The Innovator's Dilemma, about how companies at the top of their game can suffer fatal attacks from seemingly unworthy upstarts, it's high time you do. (Andy Grove said of it: "This book addresses a tough problem that most successful companies will face eventually. It's lucid, analytical-and scary.")

The real issue is this: How critical a thinker are you?

This is not a facetious, flip, or insulting question.

The fact is, none of us can rest on our laurels on this score. We can always improve.

I say this from personal experience.

Had you asked me, five years ago as I was about to start "Adam Smith, Esq.," whether I thought I was a critical thinker, I would surely and, resentfully and somewhat with hackles raised, have answered that of course I consider myself so. After all, I can imagine myself saying back then something embarrassing along the lines of, "I've gone to a college and law school you've heard of; I've worked in some fairly demanding environments, and so, yes, I consider myself a 'critical thinker,' thank you very much."

But that was before I started "Adam Smith, Esq."--the single most unexpected and salutary intellectual result of which is that it has made me a much more critical thinker. How so? Today, in a way that wasn't the case five years ago, I can scarcely read anything--from an article in The McKinsey Quarterly to a simple reportial story in The Economist, without asking myself questions like:

  • What are the unspoken assumptions behind this piece?;

  • If what the author is saying is correct, what happens next?;

  • Does this align with most things we read in the past few months or is it squarely at odds with the consensus--and then who's right?;

  • What are the author's presumed biases, predilections, and hobbyhorses?; and

  • Last and most important--but hardest!--of all, does it spark any new ideas in your mind? What have you been taking for granted that might be due for a challenge or an update or a revisionist note?

This is all hard intellectual work. The reason most people who invested with Madoff did so is because they avoided the hard intellectual work. They, tragically, relied on friends at the country club, friends at the synagogue, friends in the boardroom, friends in the supposed insiders' group of insiders.

If you are an insider, or if you aspire to be one, don't fall prey to the seductive, salacious, and sleepy temptations of turning off your critical thinking.


Complete with serene, almost beatific smile

Full post as published by Adam Smith, Esq. on December 27, 2008 (boomark / email).

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