Tuesday, December 16, 2008

Madoff, Ponzi Schemes and The Excise Tax on Jeopardizing Investments

When I was a young ROTC "cadidiot" somebody was always yelling at me or my fellow cadets to "get your head out your ass!"  In hindsight, it was a crude but effective admonition.  Many foundation managers probably should have been subjected to the same advice.  The advice is implicit, in more detail and legalese, in some of the private foundation excise taxes (such as IRC 4944, regarding jeopardizing investments).  Somehow, I find it hard to feel sorry for the large wealthy foundations and other investors who appear to have lost billions in the "ponzi" scheme allegedly perpetrated by Bernard Madoff.  As more and more information becomes available, it appears that the returns the Madoff firm was paying were always "too good to be true" and yet the uber rich foundations, university endowment funds, and individuals continued to pour money into what they "might shoulda known" was fishy!  The harm, unfortunately, will no doubt be felt by the ordinary charities struggling on a daily basis to achieve extraordinary returns on a different level.  So now is definitely not the time for righteous indignation.   Funding for bone marrow transplant research, the innoccence project, death penalty appeals and a whole host of other important causes is apparently hanging in the balance. 

As the press and government investigators begin to unravel it all, I can't help but wonder whether the case will serve as a teaching tool for the jeopardizing investment tax imposed under IRC 4944.  The Wall Street Journal has published several articles, all of which suggest that the warning signs were all over the place but ignored because the "too good to be true" returns caused a bad case of "head in the sand (or other parts) amongst foundation managers.  According to one such article:

Mr. Madoff was a central player in Manhattan's close-knit world of Jewish charities, serving both as a direct contributor and portfolio manager for individual foundations. Many of his clients are also a main funding source for charities, acting as the key donors who provide large checks necessary to keep them running.  Officials in the charity world said the effects would be felt for years, as donors curtail both current contributions and future commitments.  "In the Jewish world, we've just taken a major, central player, and introduced fear and uncertainty all over the system. It's like finding out your brother is a murderer" said Gary Tobin, president of the Institute for Jewish and Community Research, which studies Jewish philanthropy. Dr. Tobin estimated the total amount of such giving in the U.S. to be as much as $5 billion annually. . . Two philanthropic trends over recent years made the fund-raising world -- both Jewish and non-Jewish -- particularly vulnerable to an investment scam. One is the rise in charitable endowments, as institutions moved away from the practice of distributing all the money they raised each year to beneficiaries and began to invest a portion of it. The second is the huge rise in family foundations, which typically have smaller advisory boards than larger charities and therefore may not get the same level of investing advice, philanthropic experts say.

To see all of the Wall Street articles to date on the topic, go here.  One article states that investment managers were simply dumb:  "Here we have the biggest dirty secret of the "sophisticated investor": Due diligence often goes undone."  I used to rail in my tax exempt organizations class against the "over legislation" I thought was so thoroughly exemplified by the private foundation excise tax statutes and regulations but this and other cases in both the profit and nonprofit worlds has pulled the rug out from under my righteous indignation.  Now, unfortunately, I will have a pretty good case, setting aside the tragic consequences that will follow, to explain to my suffering students why the seemingly ridiculous detail of the excise taxes exist. 

dkj

http://lawprofessors.typepad.com/nonprofit/2008/12/madoff-ponzi-sc.html

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Comments

Those were my thoughts, as well, Darryll, although you expressed it far more colorfully than I could have. Sad for charities, but, on the up side, good for those of us who have to write future exam questions. For example, some reports seemed to suggest that Cardozo's investment advisor was also a Cardozo insider, which gives us a nice tie to _Diamondopolous_.

Posted by: BDG | Jan 7, 2009 6:28:21 AM

I was just thinking the same thing about Section 4944 - it seems like the IRS also missed the boat on the regulatory/enforcement side if so many foundations (JEHT, Picower, the Elie Wiesel Foundation for Humanity) were all so sadly affected by Madoff...

Posted by: Archana | Jan 7, 2009 6:29:19 AM

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