Here is a deceptively complex and subtle legal question involving Ponzi schemes and fraud: What are “losses” in the legal sense of the word? The question arises in the case of Bernie Madoff, whose offices cranked out account statements like they were junk mail.

As it turns out after the fact, that was all they were — merely junk mail. And that key fact is the major determinant of what the actual losses were.

By the end of his multi-decade fraudulent run, the final account statements (November 30 2008) issued to all his “clients” totalled the sum of $73.1 billion dollars. The people conned by Madoff believed they were worth a collective $65 billion dollars more than their accounts were worth.

The initial amount of cash put up: ~$20 billion dollars, beginning in the early 1960s and continuously from there forward.

The bankruptcy court in this case made the basic determination that the losses were ONLY the cash that was initially given to Madoff & Co. The extra $45-50 billion was a fictitious part of Madoff’s fraud. Therefore, it represents funds that were not actual investment losses, and are not covered by SIPIC insurance:

The key passage the bankruptcy judge issued was:

“Given that in Madoff’s fictional world no trades were actually executed, customer funds were never exposed to the uncertainties of price fluctuation, and account statements bore no relation to the United States securities market at any time. As such, the only verifiable transactions were the customers’ cash deposits into, and cash withdrawals out of, their particular accounts. Ultimately, customer requests for payments exceeded the inflow of new investments, resulting in the Ponzi scheme’s inevitable collapse.” . . . At bottom, the BLMIS customer statements were bogus and reflected Madoff’s fantasy world of trading activity, replete with fraud and devoid of any connection to market prices, volumes, or other realities.”

Here’s the New York TImes:

“Losses should be defined as the difference between the cash paid into a Madoff account and the amount withdrawn before the fraud collapsed in mid-December 2008 . . . The total of those account balances — the wealth investors believed they had saved — was nearly $65 billion, by far the largest financial fraud loss in history. But those statements “were bogus and reflected Madoff’s fantasy world of trading activity,” Judge Lifland wrote in his opinion. As such, they cannot reflect legitimate “securities positions” on which claims can be based, he said. As such, they cannot reflect legitimate “securities positions” on which claims can be based, he said. Judge Lifland endorsed the approach of the Madoff trustee, Irving H. Picard. The differences between how much investors put into their accounts and the amount they took out are “the only verifiable amounts” reflected in the Madoff firm’s records, Judge Lifland said of that method.”

This approach makes sense.

Consider for a moment if some future Madoff wannabe had a Ponzi scheme even bolder, and their final statements were trillions of dollars, on returns of 100% a year — not 12%. The final amount is merely a fantasy number, how much the victim of the fraud erroneously believed they had. Their expectations of riches were the product of the scam, not based on real securities.

Any other decision leads to potential absurdities created by the reliance on entirely fabricated accounting entries. The number based on accounting fraud does not represent an actual loss — only the amount the victim was scammed into believing they actually had.

Its sad, but true . . . The judge seems to have made the difficult — but correct — call here.

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Source:

In re: BERNARD L. MADOFF INVESTMENT SECURITIES LLC

SIPA LIQUIDATION (PDF)

No. 08-01789 (BRL)

UNITED STATES BANKRUPTCY COURT SOUTHERN DISTRICT OF NEW YORK

Madoff Judge Endorses Trustee’s Rule on Losses

DIANA B. HENRIQUES

NYT, March 1, 2010

http://www.nytimes.com/2010/03/02/business/02madoff.html