New York – Ezra Merkin’s Investments In Madoff Scheme, And The Halachah Of Responsiblity

New York – Most of the yeshivas that lost money in the Madoff scandal did not lose it by in­vest­ing directly with Bernard Madoff. Instead, they invested with Ezra Merkin’s Ascot Partners Fund, who, unbeknownst to them, invested it in Madoff’s “fund.”

The question is, according to halachah, did Merkin misrepresent what he was doing to his investors, and would he be at all liable to repay any of the funds that the yeshivas invested with him? Also, how would halachah look at Merkin’s fund? Is it a loan, or is it a shutfus (a halachically valid partnership)? If it is a shutfus, is the general partner (Merkin) obligated to look into the investment? How might a beis din look at the issue?

Any analysis of this sort, of course, must take a look at the initial offering memorandum. In Merkin’s case, the latest “offering memorandum” (henceforth OM) for the “C class” members was written in November 2006. The OM clearly shows that the investment must be looked at as a partnership, where Merkin is responsible for managing the shutfus.

If one reads the memorandum carefully, one can tell that Merkin was planning all along to place any moneys solicited into the Madoff fund. Since he also assessed a fee (1.5%) for his services, it seems that he did try to obscure the fact that he was investing completely in Madoff. Nonetheless, this is neither illegal nor is it in technical violation of any halachah.

Merkin’s offering memorandum stated: “The Partnership’s investment objective is to provide limited partners with a total return on their investment consisting of capital appreciation and income by investing in a diverse portfolio of securities. Generally, the Partnership engages primarily in the practice of index arbitrage and options arbitrage, in which individual or baskets of securities are purchased and/or sold against related securities such as index options or individual stock options. These strategies are used to take advantage of price disparities among related securities.”

Merkin could easily make an argument that he liked Madoff’s strategy of supposedly engaging in index and options arbitrage, and therefore chose that investment objective in his offering memorandum. Since he did plan to invest it in third-party funds, it was probably not deceptive to state that this was his investment objective.

Since he was a partner and it seems that he was not acting deceptively—even though he did obscure who he was doing the investing with, and that he was investing only with that party—he would not be considered like a partner who placed the money in investments not agreed upon. According to the Shulchan Aruch (Choshen Mishpat, 176:11) the halachah of a partner who uses the moneys given to him in a manner not agreed upon is as follows: All profits from these moneys would be split between the partners. All losses entailed must be borne solely by the partner who misappropriated the money. Since it seems that Merkin did not misappropriate these funds, according to the halachah the losses would be split amongst all the partners, not just him. Merkin would be a victim just like anyone else and would not be held responsible for the losses.

We did, however, say that it was “probably” not deceptive. An argument might be made that Merkin’s memorandum was slightly misleading. It did seem to imply that Merkin himself was implementing the general strategy himself, and that he meant to do this by investing with third-party managers. He obscured the fact that he was relying on the third-party manager to implement the strategy in its entirety. There are three paragraphs that strongly give this misimpression.

Here are the paragraphs in question (the numbering is our own):

1. “The Partnership primarily follows a strategy in which the Partnership purchases a portfolio of large-cap U.S. equities drawn from the S&P 100. In order to hedge its exposure to these securities, the Partnership simultaneously purchases a put option and sells a call option on the S&P 100, each with a notional value that approximates the value of the Partnership’s long portfolio. The purchase of the put option allows the Partnership to partially hedge its portfolio against downward movement in the S&P 100. The sale of the call option allows the Partnership to partially finance the purchase of the put option while at the same time partially hedging the Partnership’s portfolio against any downward movement in the S&P 100.

2. “The Partnership will make investments through third-party managers, using managed accounts, mutual funds, private investment partnerships, closed-end funds and other pooled investment vehicles (including special purpose vehicles), each of which is intended to engage in investment strategies similar to the Partnership’s (collectively, “Other Investment Entities”).

3. “The General Partner intends, to the extent circumstances permit, to adopt a selective approach in evaluating potential investment situations, generally concentrating on relatively fewer transactions that he can follow more closely. The General Partner is expected to engage in hedging and short sales. There can be no assurance that any of the hoped-for benefits of the foregoing approach will be realized.”

Merkin did, however, cover himself by adding the following sentences and caveats:

1. “Moreover, the General Partner reserves the right to deviate from the foregoing approach to the extent he deems appropriate. To the extent that the Partnership trades in commodities and futures and related options, the Partnership will incur additional risks…

2. “The General Partner reserves the right to alter or modify some or all of the Partnership’s investment strategies in light of available investment opportunities to take advantage of changing market conditions, where the General Partner, in his sole discretion, concludes that such alterations or modifications are consistent with the goal of maximizing returns to investors, subject to what the General Partner, in his sole discretion, considers an acceptable level of risk.

3. “The descriptions contained herein of specific strategies that the Partnership may engage in should not be understood as in any way limiting the Partnership’s investment activities. The Partnership may engage in investment strategies that are not described herein, but that the General Partner considers appropriate. The Partner­ship’s investment program is speculative and may entail substantial risks. Since market risks are inherent in all investments to varying degrees, there can be no assurance that the Partnership’s investment objectives will be achieved. In fact, certain investment practices described above can, in some circumstances, substantially increase the adverse impact on the Partnership’s investment portfolios. (See “Certain Risk Factors.”)

4. “Independent Money Managers. The General Partner may delegate investment discretion for all or a portion of the Partnership’s funds to money managers, other than the General Partner, or make investments with Other Investment Entities. Consequently, the success of the Partnership may also be dependent upon other money managers or investment advisors to Other Investment Entities.”

A beis din would probably view the four caveats above as clearly stating that Merkin would not be violating the terms of the shutfus as originally agreed.

Another argument could be made that Merkin promised to look after the third-party investments as much as possible but did not actually do so. Generally speaking, partners are supposed to look after the items of the partnership, according to the Shulchan Aruch (Choshen Mishpat 176:8). They have the halachic status of a paid watchman, a shomer sachar. Since he took responsibility for doing so, and got paid to do it, he might have some liability. He does, however, specifically exclude such responsibility, which might be sufficient to get him off the hook. Indeed, the Rama (C.M. 176:8) rules that he only has the status of a shomer chinam, an unpaid watchman. If we look carefully at the wording, however, he only writes that he will take care in selecting the manager and monitoring the results—not in the means by which the third-party manager makes the money. He takes on this promise in the following paragraph:

“Although the General Partner will exercise reasonable care in selecting such independent money managers or Other Investment Entities and will monitor the results of those money managers and Other Investment Entities, the General Partner may not have custody over the funds invested with the other money managers or with Other Investment Entities. Hence, the actions or inactions on the part of other money managers or the investment advisors to Other Investment Entities may affect the profitability of the Partnership. The risk of loss of the funds invested with other money managers or with Other Investment Entities may not be insured by any insurance company, bonding company, governmental agency, or other entity and the General Partner is not liable for any such loss.”

Finally, we have the opinion of the Shach (C.M. 176 on the Rama) who disagrees with the aforementioned Rama and states that he does not even have the status of a paid watchman. Merkin would be able to use the argument of “Kim li k’hani poskim” to state that in his view the opinion is like the aforementioned Shach. “Kim li” is a legal argument that can be used to allow an aggressive legal position to be taken when the status of the money is not in the possession of the other litigant. Since the money is no longer in the hands of the investors, this argument might have validity to exempt Merkin from any violation of a fiduciary responsibility to look into what Madoff was doing.

In short, the investors’ option would be to focus their efforts on seeing what they can get from Madoff as well as the moneys paid to the other investors above and beyond their initial investments, as we discussed in last week’s article.