Just over a week ago, Geneva Partners, a small wealth manager in Switzerland has taken Santander and Optimal to court in a criminal action. They argue that Optimal lied to its clients about the due diligence it was supposedly performing – something that is obvious to all observers, but will take time to prove. They are encouraging other interested parties to contact them with regard to this action.

Additionally, there is an increasing number of other Swiss law firms keen to pursue action against Santander. Swiss law is actually quite strict with regard to investor protection and requirements for due care and disclosure in client relationships. It also does not allow banks to bankrupt their subsidiary in order to absolve themselves of all guilt. This blog has details of such firms and will forward them to interested parties – contact details on the About page.

Naturally the investigation process will take time, but it is heavily in the interest of Swiss authorities to demonstrate that they will not tolerate lying and stealing from clients of Swiss regulated institutions. If they fail to punish Santander and compensate its victims, the already shaken aura of Swiss dependability will take a further blow by putting the protection of its legal system into doubt.

Fairfield and its owners have had assets frozen, while Santander is quietly winding down Optimal, its own feeder fund. Clearly the bank will continue pretending it has no liability, but as the legal moves progress, this is looking increasingly shaky.

Apparently the bank will lend selected clients up to 85% of the value of their preference shares at 3%. Assuming you had $1,000 originally invested, you get your hands on $850 and pay the bank $25.5 annually for the privilege. Of course the preference shares are paying you $20, so your net cost is $5.5, effectively you have been given a loan for $850 at an admittedly low interest rate of 0.6%. Assuming you are not forced to repay this loan before the preference shares redeem, and that the interest rate is fixed (both pretty hopeful assumptions), this is like getting 85% of your original investment back (in return for promising not to sue and relinquishing all claims on any money Santander recovers). So why not just offer all  its clients 85% of their original investment back instead of this farce?

At the same time Santander apparently argues that the original offer might be worth as much as 40% of what they claim it’s worth. So why did they claim it’s a 100% refund in the first place? Furthermore, the bank claims that 75% of its clients have accepted the offer. If this is really the case, they must be particularly concerned about the damage from lawsuits if they are sweetening the terms. What is worrying is that the bank is being selective about the initial offer, and even more so about the subsequent sweetener. Effectively it is bullying people into accepting the worst they think they can get away with and hope to smother any legal action before it takes off. Those that give in too early, get a really bad deal, while the tougher ones get some improvement.

What emerges from this is that the bank is willing to play as dirty as it needs to with its customers, but is genuinely afraid of the repercussions. Overall it does not help Santander’s image and is unlikely to prevent legal action gathering pace unless its offer is broadened and made clearer.

By signing, the clients are obliged to keep their assets with the bank (and are prevented from selling the preferred shares, meaning they don’t see any cash). They are giving up the right to sue Santander and any further claims on the losses from Optimal. This implies that any money that Santander/Optimal manages to recover goes into Santanders pockets.

So far, liquidators have listed some $1bn in Madoff assets. These will be available as compensation. It seems the $50bn total loss figure was exaggerated – the numbers are probably more like $30bn according to Harry Markopolos, meaning there is cover for around 3% of the final value of funds (contrast to Santader offering 20% of funds originally invested). Additionally there are a number of legal actions against the fund custodians (HSBC, UBS) and auditors (Ernst & Young and others). These could be liable to significant damage payments and have deep pockets. It is therefore not implausible that Santander could recover a larger cash amount than the value of securities it has offered its clients. It would then make a profit on the compensation scheme.

The current injunction to prevent Santander using its pressure tactics is in US courts. Deadlines given to clients range from 5th -15th of Feb. The bank wants to get as many people to sign up as possible as it is a fantastic deal from its point of view. Of course for the victims it feels like a case of a bird in the hand versus two in the bush. The problem is that Santander wants you to think you’re getting a healthy chicken, while giving you a dead sparrow.

The results coincide with Harry Markopolos’ testimony to the US congress. He successfully highlights how totally inept the SEC was in dealing with the Madoff fraud. Of course Santander and other feeder funds will jump on this as an excuse for their own failings – they were relying on the SEC. Unfortunately, this is no excuse whatsoever as they sold their products to investors on the basis of the sophisticated due dilligence they were supposedly doing themselves. As Markopolos says, the SEC was run by lawyers with no clue about finance – this cannot be said of Santander’s Optimal Investment Services  which boasted of its research capability and sophistication.

To quote Markopolos (p16), “…ask yourself what the managers of these feeder funds were thinking as they performed due diligence or even if they were thinking while they performed due diligence. Yes, BM [Bernie Madoff] was a “no-brainer” investment but only in the sense that you had to have no brains whatsoever to invest into such an unbelievable performance record that bears no resemblance to any other investment managers’ track record throughout human history“.

It took him less than four hours to mathematically prove that Madoff was a fraud. How could Santander’s Optimal take over 10 years of due diligence, which included access to Madoff that Markopolos did not have, to not discover anything might be wrong?

If feeder funds had disclosed that their due diligence consisted of verifying whether the SEC thought a manager was a fraud and nothing else, they would have a defence. As it was, they claimed to do far more for the millions they took in fees and they have to be held accountable. For investors in these vehicles, the choice they now face is which lawsuits to join. There are new ones springing up each day and ultimately a lot depends on individual circumstances of the investors. What is consistent accross all of them, is the clear culpability of the feeder funds, whose deceitful marketing and total negligence made Madoff possible.

The contrast is sharp with Santander’s pretend offer to reimburse retail investors the principal they had originally put in, in return for losing all rights to sue them and being obliged to keep their assets with Santander. As discussed previously, the offer is only worth a fraction of what Santander claims.

The bank is using high-pressure tactics on its own clients to force them to accept the derisory offer, hoping to pick off as many potential litigants as it can. A US court has been asked to prevent Santander from doing this. It has been highlighted that Santander has never lost a court case in Spain and that people should take what they can get. However Santander has never been accessory to and beneficiary of stealing $3bn from its own clients until now, meaning its legal track record is unlikely to hold up!

Clients have very little to lose by turning down the Santander offer and plenty to gain by opting for legal action.

Optimal said Riskdata’s FOFiX product was key to “quantitative risk analysis” for hedge fund investments in a 30-page due-diligence questionnaire filed last April with the Alternative Investment Management Association.
“Risk profiles are calculated for each hedge fund in order to estimate the systematic factors influencing the returns of the fund,” Optimal said in the document, which was reviewed by Bloomberg News. “Deviation from expected risk profiles need to be explained.”
“Potential breaches of the risk parameters would be immediately notified to the chief operating officer and if appropriate the chief executive officer,” Optimal said in the document. AIMA, based in London, is the hedge fund industry’s largest trade organization, with more than 1,280 members.

The Bias Ratio, a quantitative technique analyzing returns will have highlighted to Optimal management that Madoff and other Madoff feeder funds were extreme outliers, along with identified frauds Beacon Hill (2002) and Bayou (2006). Additionally, the software allowed a simulation of Madoff’s strategy with various parameters and showed that his returns were impossible and inconsistent with the factors he should have been sensitive to.

Optimal’s management chose to ignore this information, which was on top of the dozens of other red flags. They absolutely cannot plead ignorance in this case, as they wilfully risked investors money in order to take in fees. In that light, the derisory offer to investors (see last post in this blog, referred to in the Finanacial Times) looks even more of a joke.

At a closer look, Santander is once again trying to scam its clients. What it actually proposes to do is to give them “preferred securities to be issued by the Group in the referred amount  of 1,380  million euros.  These preferred  securities will have an annual coupon of 2% and a Santander Group call from year 10. “

Preferred securities are a half way house between equity and bonds. If a company goes bust, the bond holders have first claim on the assets. If anything is left over (in the case of a bank, very unlikely), preferred shareholders get something back. If anything else is still left, equity holders might get something. So what are these 2% preferred shares worth?

Santander has the option to call the securities in 10 years time (ie repay the full amount). It does not have to do this and in fact is unlikely to, as funding at 2% is very attractive for the bank. If the securities were to be repaid in 2019, they should yield more than a 10 year bond (as they are riskier). Santander bonds maturing in May 2019 yield 8.8%. Santander equity has a dividend yield of 10.6%. So the preferred shares would need to have a yield of around 10% to be in line with the market, meaning they would need to trade at 50% of their face value (the amount Santander claims to be paying out) today.

In fact, Santander has plenty of preferred securities outstanding and they are only repayable in 2049 (as is fairly standard in the banking world). It is very likely that these would take the same form. There is no active market for them, although occasionally someone makes an indication in prices. The latest indications seen in the market imply yields to maturity of around 14% (based on 7.35% prefs maturing in 2049). On that basis, the 2% preferreds should be worth just under 15% of their face value. This is the most that an investor could hope to realise today from a sale of such securities, assuming he even found a buyer (very unlikely if you are a private client). Given you cannot sell them, you have to be a very patient (and young) investor to wait 40 years for redemption.

When we read on, Santander admits that “the pre-tax  cost for  the  Group of  this  transaction would  be  500 million euros, which has been fully-booked against the accounts for 2008“. So while Santander claims to be offering clients E1,380m in compensation, it is in fact only taking a charge of 36% of that amount (roughly in the middle of the market-derived 15-50% range). Although we have yet to see the exact terms of these prefered securities, I suspect the 36% is a conservative writedown for Santander, which they expect to reverse over time given the very low value of the securities they are proposing to issue (around E200m based on 15%). It is also almost certainly less than they have taken in fees from their Madoff victims over the last 10 years.

Many investors may be relieved that they are being offered something back. If they are not financially sophisticated, they might even believe they are getting a full refund. However I suspect most will correctly understand this offer as adding insult to injury by Santander. In that light, the lawsuit launched yesterday in Florida looks like a far more attractive option. Anyone who accepts the near worthless preferred securities loses the right to sue – be warned!

The purported mission of such feeder funds was to vet hedge funds for wealthy clients. Instead, the line between victim and perpetrator was blurred. Middlemen like Littaye funneled billions of dollars to Madoff, even, in some cases, when they suspected he was engaged in questionable trading practices. In return, they reaped hundreds of millions of dollars in client fees.

Wolfer says he heard of traders trying to replicate the split-strike conversion strategy Madoff told investors he used — buying shares of large U.S. companies and entering into options contracts to limit the risk — and getting far lower returns. He also says he heard Littaye and other middlemen talk about how Madoff may have used the knowledge he gained from his market- making firm, New York-based Bernard L. Madoff Investment Securities LLC, to get in and out of stocks ahead of market swings.
That’s front-running, a term usually applied to brokers’ trading for their own account — and profit — ahead of clients. It’s also applicable to Madoff’s purported practice, says Peter Henning, a law professor at Wayne State University in Detroit and a former federal prosecutor.
“Front-running isn’t who’s getting the benefit; it’s who’s paying the price,” says Henning, noting that Madoff’s market- making customers expected the firm to obtain the best price available when buying or selling stocks. Instead, their interests were apparently subordinated to those of Madoff’s investment clients.
While front-running is illegal, it didn’t horrify Madoff’s champions.

So as I have pointed out previously, whether they suspected fraud or not, feeder funds would have been knowingly part of an illegal activity – it’s just that they may have mistaken the type of crime they were getting involved in. As the article points out:

The alleged crime couldn’t have been pulled off without the participation of dozens of enablers. It was a Ponzi scheme built on the respectability of others.

None of the “others” would have had quite as much respectability to offer Madoff as Santander, one of the worlds biggest banks. Another of the world’s biggest banks refused to sell its respectability in return for easy client money:

A delegation from Credit Suisse Group AG, led by Oswald Gruebel, then head of private banking, had a similar experience in 2000. Gruebel, whose bank had about $500 million invested in Madoff funds at the time, wanted to know why the firm had an obscure auditor, why Madoff didn’t have a ­third-party custodian hold his clients’ assets and how much money he was running.
After the fifth or sixth query, people who were at the meeting say, Madoff ended the session.
“You guys, if you are not happy with the returns you are getting,” he said, “you can take your money.”

Credit Suisse did and advised its clients to pull out of Madoff (and did not run its own feeder funds). Finally, the article comes to the obvious conclusion:

The feeder funds became Madoff’s ad hoc sales force. The payoff was the steady flow of fees. Every billion dollars invested in Madoff generated $150 million in paper profits a year for clients, based on a 15 percent return.
If a fund charged its clients 1 percent of the assets under management and 20 percent of the gains, as the largest one did, that translated into $41 million in annual fees.
Assuming Madoff didn’t do any investing on behalf of his clients, as investigators now suspect, the feeder funds were, in effect, being paid out of principal, which would have been depleted after 15 years.
In other words, much of the money invested in Madoff through feeder funds wound up in the pockets of fund managers.

In the case of Santander’s Optimal, the fee was 2.15% of assets – the maths is identical. A client who put $100 in with Santander would have paid the bank $99 in cash fees over 15 years, based on Madoff’s 15% headline returns (12.85% to the client). So essentially Santander has taken the investors money and, well, kept it. Madoff goes to prison, Santander walks away with its client’s money.

The bottom line is that Santander and others that try to present themselves as victims were complicit and beneficiaries of Madoff’s illegal activities. They cannot be allowed to walk away from their responsibilites.