Buying Madoff

“The lion cannot protect himself from traps, and the fox cannot defend himself from wolves.”

— Niccolò Machiavelli, The Prince, Chapter 18

I had enough vision to see the opportunity, enough nerve to pursue it, and enough ability to make it real. What I did not have was enough leverage to remain in control of it.

Years before Bernie Madoff became synonymous with fraud, I encountered him somewhere I had not expected.

At the time, I owned a securities business and had become involved with a fund of hedge funds originally formed by James Daehler. James had hired me to help raise capital for it.

I introduced him to Leon Cooperman, the founder of Omega Advisors and one of the best-known hedge-fund managers of his generation. Leon agreed to invest approximately $25 million, and the business was renamed Pine Street Associates. I received a minority interest in the management company for putting the relationship together.

But Leon’s investment came with another responsibility.

Pine Street would also help oversee his personal fund-of-funds portfolio—effectively a family-office portfolio containing roughly $170 million. When the portfolio was turned over, we discovered approximately $25 million of indirect exposure to Bernie Madoff through another fund.

I am not going to pretend that I had solved a mystery that later confounded much of the financial world. But by then I had spent years meeting hedge-fund managers, raising capital, and evaluating investment businesses. I had learned one rule that protected me repeatedly:

When someone refuses to permit meaningful due diligence, you have to walk away.

During my career, I encountered several managers who struck me as potential frauds. Many later proved to be exactly that. The details varied, but one characteristic appeared again and again: they resisted scrutiny.

In this case, we could not conduct meaningful due diligence on the underlying Madoff exposure.

There was another problem. The reported returns were extraordinarily smooth.

Markets are not smooth. Real investment strategies experience volatility, mistakes, changing conditions, and periods when their assumptions stop working. Yet Madoff’s reported returns appeared almost unnaturally consistent.

James and I told Leon that the position in the intermediary fund should be redeemed.

He did not initially want to do it. Madoff had stature, relationships, and a long record. But we kept returning to the same questions.

Why were the results so consistent?

And why could we not conduct the kind of due diligence we would expect before allowing that much money to remain indirectly exposed to a manager?

Eventually, Leon agreed, and the approximately $25 million position was redeemed.

That decision would later save him an enormous amount of trouble. It also placed Madoff on my radar years before his collapse—and ultimately created one of the strangest opportunities of my life.

A crisis inside the crisis

By 2008, my own securities business was in decline. The hedge-fund fundraising market had become much more difficult, and I had failed to pivot early enough. I had made substantial money, but I had not built the durable, growing institution I should have built.

I had not set clear growth objectives. I had not continually asked what the business needed to become next. Instead, I allowed the success of the existing model to persuade me that it would continue.

It did not.

As revenue weakened, I kept spending and investing as though the old economics would return. By the time the global financial crisis arrived, I was experiencing a private financial crisis of my own.

I had lost money in the market. I had burned through much of the fortune I had built. My business had only a limited amount of capital left.

Just before the crisis, I had finally begun converting my securities firm into an execution business. Instead of only helping managers raise assets, I would execute trades on behalf of clients. I secured the necessary approvals, established the infrastructure, and arranged a clearing relationship.

It was the pivot I should have made years earlier.

Through that business, I had already encountered Madoff’s market-making operation. My clearing firm had a relationship with it, and Madoff’s people had approached me about routing some of my order flow through their platform.

The operation was substantial. It made markets electronically in thousands of securities and was one of the larger automated market-making businesses in the United States.

But because I already distrusted the Madoff name, I stayed away.

Then, in December 2008, Bernie Madoff was arrested.

I immediately sent Leon a Bloomberg message.

“Look what happened,” I wrote. “Aren’t you glad we got you out?”

His reply was unforgettable.

“Yes. It was a great decision I made.”

I remember smiling at the ego of it.

But almost immediately, my attention moved somewhere else.

Everyone saw Madoff as wreckage.

I saw an asset buried beneath the wreckage.

The fraudulent investment-advisory business and the legitimate market-making operation were separate things. One had been a colossal deception. The other had employees, technology, licenses, code, customer connections, and a real operating history.

The market-making business had stopped functioning after Madoff’s arrest. Its capital had been removed. Its employees were being retained temporarily while the trustee searched for a buyer.

The longer it remained dormant, the less valuable it would become.

I believed it could be acquired for a fraction of what it had once been worth.

The problem was that I could not afford it.

Buying a business with almost no money

My broker-dealer had perhaps $100,000 of capital.

A revived market-making operation might eventually require tens of millions of dollars—possibly much more—to operate at scale.

Ordinarily, that should have ended the discussion.

But I believed the acquisition itself could be structured around contingent payments. The trustee did not merely need someone who could name the highest theoretical price. He needed a buyer capable of preserving the employees, obtaining regulatory approval, and actually closing.

I already possessed something valuable: a licensed broker-dealer and much of the regulatory foundation required to restart the operation.

I was also the first serious buyer to become involved.

I contacted the trustee and began negotiating to become the stalking-horse bidder in the bankruptcy sale.

A stalking-horse bidder makes the first binding offer. That bid establishes the structure of the transaction and creates a minimum price for the estate. Other bidders can later emerge, but the stalking horse assumes the first real risk.

That was precisely what I was doing.

To secure the position, our group had to provide a $50,000 deposit. I did not have the money readily available, so I obtained it from my friend Chris Argyrople, who had joined the acquisition group and had the financial capacity to support the bid.

The deposit was small compared with the scale of the business. To me, however, it represented real exposure.

My legal bills were approaching $100,000. The breakup fee I would receive if another bidder ultimately won was not large enough to make me whole.

If I lost the auction, I could recover something—but not enough.

Nevertheless, I signed the stalking-horse agreement.

That changed the nature of the transaction. I was no longer someone merely expressing interest in a distressed asset. I had placed money at risk, negotiated the initial purchase structure, and created the path through which the business could be sold.

We traveled to New York, met the people responsible for the sale, and met the employees who remained with the company.

The atmosphere was desperate.

The trustee was still paying salaries and rent because the operating team itself was part of the asset. But that could not continue indefinitely. If no buyer appeared, the employees would be dismissed, the infrastructure would decay, and whatever residual value remained would disappear.

The capital was gone. The business was no longer trading. Yet the technology still existed, and the direct connections to firms that had previously routed orders to Madoff were still there.

I believed the machine could be restarted.

At one point during the process, I entered the bankruptcy courthouse in Manhattan. Three of the major matters before the court during that extraordinary period involved Lehman Brothers, General Motors, and Bernie Madoff.

It was difficult not to feel the historical weight of the moment.

Some of the largest institutions in American finance and industry were being dismantled or reorganized. And I was there with a small broker-dealer trying to acquire part of what remained of Madoff’s business.

I did not possess the capital the transaction required.

What I possessed was conviction.

Conviction can take you a remarkable distance. But conviction is not the same thing as leverage.

I would learn that difference painfully.

Finding the money

John Fanning introduced me to Fairhaven Capital, a technology investment firm.

That introduction became important. Fairhaven was not ordinarily focused on market making, but people involved with the firm had a close relationship with a former chief executive of a major brokerage company.

I immediately understood that the former CEO could give the transaction credibility.

He had the industry experience, public stature, and reputation required to make Fairhaven comfortable with the deal. We brought him into the process and conducted extensive due diligence on the market-making operation.

The records suggested that the business itself had been genuine. We found no evidence that the market-making activity was fictitious. It had employees, systems, customers, trading history, and regulatory oversight.

It was also badly in need of modernization.

Its primary data center was located in the Lipstick Building, close to Madoff’s offices, rather than near the exchanges where a modern high-frequency trading operation would ordinarily place its infrastructure. Its backup arrangements were similarly inefficient.

Madoff’s technological advantage may once have been real, but the market had moved forward.

That did not discourage me. It convinced me that the operation could be improved.

The former brokerage CEO saw the potential. With his support, Fairhaven committed approximately $15 million.

It appeared that I had accomplished the impossible.

Then my lack of leverage caught up with me.

Once Fairhaven understood how financially constrained I was, the balance of the negotiation shifted sharply. The financing ultimately left Fairhaven with approximately 85% of the company and me with about 15%.

From my perspective, it was a severe cram-down.

I had identified the opportunity. I had become the stalking-horse bidder. I had placed my limited capital at risk and created the path to the transaction.

But I did not possess the money required to preserve the economics.

The first proposed documents were even more severe than the ownership split suggested. Under the terms as I understood them, I could lose the value of my interest if I were dismissed. I could lose it under circumstances over which I had very little control. As I remember the provisions, even my death could effectively have stripped the value from my estate.

I briefly walked away.

But by then, I had invested enormous time, money, and emotional energy. The acquisition appeared to be my path out of the crisis I had created in my own life. I could see what the business might become, and I could not bear to abandon it.

Eventually, I negotiated one crucial protection: if I were terminated without legitimate cause, I would have the right to require the company to purchase my interest.

Then I accepted the deal.

I told myself that 15% of something valuable was better than 100% of a struggling broker-dealer.

That may have been true.

But the negotiation had also told me something important.

From the beginning, I was convinced that Fairhaven did not see me as part of the company’s long-term future. That was not a realization I reached years afterward. It was how the documents and the relationship made me feel at the time.

My position was unmistakably fragile.

I signed anyway.

That was my decision, and I have to own it.

A contract does more than allocate economics. It reveals the relationship you are actually entering.

The auction

Once our stalking-horse bid became public, other potential buyers appeared. That was the purpose of the bankruptcy process. The trustee could use our offer to attract competition and seek improved terms for the estate.

So after months of work, we still had to go to auction and win the business again.

During the auction, I remained prepared to walk away. Walking away would have hurt. I had already incurred close to $100,000 in legal bills, and the breakup fee would not have covered everything. But I understood that the customer relationships might never return, that the economics could be far worse than they appeared, and that the desire to win could easily overwhelm sound judgment.

The senior executive who had joined our group was less willing to lose it.

In my judgment, we bid more aggressively than necessary. But much of the additional consideration was tied to future performance. If the business did not produce, much of the earn-out would never be paid.

That reduced the practical danger of overpaying.

Still, the auction taught me something that has stayed with me:

The willingness to walk away is often the final source of leverage in a negotiation.

I had very little money and very little institutional power. But I was willing to lose the deal.

The people with the capital had become determined to win it.

Ultimately, our group prevailed.

The market-making operation that had once belonged to Bernie Madoff was now ours.

Restarting the machine

Buying the operation was only the beginning.

The business had stopped trading. Its capital had been removed. Key employees were uncertain about their futures, and the person who had previously led the trading operation demanded an ownership position we could not accept.

We hired his deputy instead. We also brought in additional technical expertise, including someone from Caltech, to examine the code and determine what could be salvaged.

I became president and helped lead the effort to restart the company.

We had to preserve a team of approximately 50 people, maintain confidence, work with regulators, expand the permissions of my broker-dealer, and restore an automated trading engine that had been sitting dormant.

The licenses mattered enormously.

The operating assets alone were not enough. Without a regulated broker-dealer capable of receiving the necessary approvals, the technology and employees could not simply begin trading again.

My existing firm provided much of that foundation.

We went back to FINRA and the SEC and secured the approvals necessary to convert the business into a properly capitalized market-making operation.

We replaced our previous clearing relationship with Convergex. In return for receiving the clearing business, Convergex agreed to provide order flow, making it our first meaningful customer.

I had helped originate the transaction, preserve the team, rebuild the technical organization, obtain the regulatory path, and secure the first source of order flow.

We also added new risk protections to the trading system. One of those improvements was designed to detect unusual market activity. When the system identified conditions outside normal parameters, it could stop internalizing additional risk and route orders directly to the market.

That protection later proved valuable during an extreme market disruption.

The achievement was real.

We had taken a dormant trading operation associated with the most notorious financial fraud of the era and restarted it as a functioning market-making business.

But restarting the machine was not the same as restoring its economics.

The advantage that disappeared with Madoff

Madoff had spent decades building relationships with firms that sent him order flow. In many cases, he received that order flow without paying for it. That gave him an enormous competitive advantage.

Other market makers paid for orders. Madoff often did not. His relationships, reputation, and history allowed him to acquire the raw material of the business at little or no cost.

After his collapse, that advantage disappeared.

The direct technical connections to customers still existed, but the relationships did not automatically transfer. Someone needed to contact each firm, rebuild trust, and negotiate new arrangements.

I believed I was the person who should do it.

I had spent much of my career as an institutional salesman. I understood financial firms, decision-makers, and complex negotiations. I had enough time to focus on rebuilding the customer relationships, and I believed I could reopen many of the lines.

The new chief executive disagreed. He argued that I already had too many responsibilities.

Perhaps that was partly true. I had helped oversee the transaction, regulatory work, and operational restart. But I also believed he wanted to control what would become the company’s most commercially important function.

He hired someone else to rebuild the relationships.

It was not a successful hire. Months were lost, and the old lines were not restored. He later acknowledged to me that the decision had been a mistake.

The company continued operating, but without free order flow its economics were fundamentally different. We were not losing large amounts of money, but we were not generating the profits the old Madoff operation had once produced.

A debate developed over whether we should begin paying for order flow.

At the same time, my authority inside the company was progressively narrowed. Responsibilities were reassigned. Decisions that I believed belonged within my role were moved elsewhere. Privileges were removed. I increasingly felt isolated inside a company I had helped create.

This was not merely a feeling I reconstructed afterward. I believed at the time that the company was reducing my role step by step and creating the conditions for my eventual removal.

In the lawsuit that later followed, I described the progressive stripping away of my authority as a form of constructive termination.

The process eventually became explicit.

But I also contributed to the conflict.

The bull in the china shop

I was not easy to manage.

That is an important part of the story.

I had created the opportunity. I had assembled the pieces. I had helped preserve the team and restart the operation. I believed deeply in my judgment, and when I saw the company making mistakes, I did not respond quietly.

I was a bull in a china shop.

The chief executive had previously run a major public brokerage company. He was accomplished, experienced, and accustomed to authority.

I was entrepreneurial, impatient, and accustomed to going around obstacles.

The two of us should have been capable of working together.

We were not.

One example involved foreign-exchange trading. I saw an opportunity to pivot part of the business into foreign exchange. I went back to Lazard, which had been involved in the acquisition process, and presented the idea.

Lazard became enthusiastic and contacted the chief executive.

He was furious that I had gone around him.

From my perspective, I had identified another opportunity and was trying to move quickly.

From his perspective, I had undermined his authority.

Both interpretations contained some truth.

Not long afterward, he fired me over the telephone.

It turned out to be one of the best things that could have happened to me.

I was miserable. I had created the opportunity but no longer controlled it. I was being prevented from doing the work I believed I could do best, and the narrowing of my role had already made the direction of the relationship clear.

What the chief executive did not realize when he fired me was that I had negotiated a put right.

Once he understood the consequences, he attempted to retract the dismissal.

I refused.

Litigation followed.

The settlement

I sued the company, and the company responded with claims of its own. Eventually, we negotiated a settlement of approximately $1 million.

They wanted to pay it over an extended period. I did not trust that all the later payments would arrive, so I pushed for a shorter schedule.

My lawyer thought I was being overly suspicious.

I told him I had met the people involved and understood the situation.

I believed I would receive the first payment. I was less confident about the second, and I doubted I would ever see the last.

Then another problem appeared.

The email that returned

About a year before the Madoff acquisition, I had exchanged an email with John Fanning about a possible investment in my broker-dealer.

The proposal, as I understood it, was straightforward: John himself would invest money in my business, certain conditions would be satisfied, and in return he could receive an ownership interest.

John never made the investment, and the contemplated conditions were never completed.

Later, however, John introduced me to Fairhaven Capital.

That introduction was important. Fairhaven ultimately supplied the capital that enabled us to acquire the Madoff market-making operation.

But an introduction was not the transaction described in the earlier email.

The email concerned John personally investing his own money in my business. It did not say that he would receive equity merely by introducing someone else who later invested in a different transaction.

After I was fired and reached a settlement with the company, John argued that his introduction to Fairhaven connected the old email to the Madoff acquisition and entitled him to a substantial share of my interest or settlement proceeds.

I regarded the connection as extremely weak.

It reminded me of the sort of dispute dramatized in the Facebook story: an informal communication written early, under one set of assumptions, later becomes enormously consequential because the business has acquired value. Words that once seemed casual are examined as though they were carefully negotiated provisions in a final contract.

Fairhaven did not want the disputed email hanging over the company while it was attempting to raise additional capital. Even a weak ownership claim could complicate due diligence, frighten investors, and delay financing.

That gave John leverage.

The company valued certainty more than it valued proving that my interpretation was correct. And the simplest pool of money available to resolve the problem was my settlement.

Ultimately, approximately $400,000 of what remained was used to resolve John’s claim.

I found that deeply painful.

I never denied that John had introduced Fairhaven. But an introduction was not an investment, and in my view it did not transform the earlier email into an open-ended right to participate in every future transaction involving my broker-dealer.

Yet the strength of his legal argument was almost beside the point.

He did not need everyone to agree that he was right. He needed the dispute to become inconvenient enough that someone would pay to make it disappear.

An ambiguous agreement may be harmless when nothing is at stake. Once value appears, ambiguity becomes leverage.

My greatest success and my greatest failure

The Madoff acquisition remains one of the strangest episodes of my life.

I saw value where almost everyone else saw contamination. I recognized that the fraud and the market-making operation were separate. I pursued an acquisition I had no obvious ability to finance. I became the stalking-horse bidder. I risked capital I could barely afford to lose. I assembled the investors, industry credibility, licenses, regulators, employees, and technology needed to close the transaction.

I helped keep approximately 50 people together. I helped restart the trading engine. I obtained the regulatory path, secured the first customer relationship, and helped build protections that later benefited the business.

When I was pushed out, I had negotiated just enough protection to receive a substantial settlement.

By any reasonable standard, those were significant achievements.

And yet the experience also exposed nearly every weakness I had.

I entered the deal without enough capital. Because I lacked capital, I negotiated from weakness. Because I negotiated from weakness, I surrendered control.

I signed documents that made it clear my long-term position was fragile. I confused being essential to the creation of the transaction with being secure after the transaction closed.

I moved too aggressively inside an organization I no longer controlled.

I was strategically energetic but politically undisciplined.

And I poured nearly all of my attention, identity, and hope into a single opportunity.

The deal became my greatest success and my greatest failure at the same time.

It proved that I could recognize an extraordinary opportunity and make something nearly impossible happen.

It also proved that creating value and retaining value are entirely different skills.

The central lesson is not that you should avoid ambitious deals. It is not that you should refuse to act unless every risk has disappeared. And it is not that vision is unimportant.

The lesson is that vision without leverage can become a trap.

I had enough vision to see the opportunity, enough nerve to pursue it, and enough ability to make it real. What I did not have was enough leverage to remain in control of it.

There was one final irony.

While I was consumed by the Madoff acquisition, Paul Reeder of PAR Capital called me. PAR had historically been extremely selective about who could raise money for it. Yet in the middle of the financial crisis, Paul offered me the opportunity to receive a full share of the fees on any capital I brought into the fund.

I had the relationships. I had the experience. Even in that market, I may have been able to raise $50 million or $100 million.

Over time, that capital could have compounded into something vastly larger, generating fees for years.

But I did not pursue it.

I told Paul I did not have time.

I was too focused on Madoff.

I had convinced myself that the hardest opportunity was the most important opportunity. I had invested so much of myself in the acquisition that I could no longer see clearly beyond it.

The world had placed another path directly in front of me—simpler, cleaner, and perhaps far more valuable.

I pushed it aside.

That is another story.

And perhaps an even more important one.