Former Madoff Market Maker Yields Trickle for Victims

A year ago, Irving Picard put in place an idea to get back some of the money Bernard Madoff stole from his customers: Sell the con man’s legitimate market-making business, including his old software and computers.

Castor Pollux Securities Inc. got Fairhaven Capital Partners to provide the financing and bought the unit in a bankruptcy auction, agreeing to pay as much as $24.5 million to Madoff’s victims out of future revenue. It hired some of Madoff’s old employees and gave the business a new name: Surge Trading Inc.

So far, Surge has produced barely a trickle. Picard said in court papers that the unit has handed over just $3,386, a fraction of the $1 million spent marketing its sale.

“They went for a quick and dirty deal, and that’s exactly what they got,” said Erin Arvedlund, author of the book “Too Good to Be True: The Rise and Fall of Bernie Madoff.”

Arvedlund called the market-maker sale a “public relations stunt” to make it look as if Picard was making progress liquidating Madoff’s former businesses for the benefit of creditors.

The company’s former founding president sued in New York federal court in May, claiming Surge forced him out and failed to pay him everything he’s owed for his share of the company, which was formerly run by Madoff’s sons, Mark and Andrew.

Four Hours Work

The formula under which the payouts to the bankruptcy estate are made suggests that in Surge’s first nine months, its total trading revenue has been about $22,571, less than the Madoff firm typically made in about four hours, according to marketing materials prepared by Lazard Ltd., which was hired to find a buyer for the business.

Picard, who has so far recovered $1.5 billion for Madoff’s victims and other creditors, declined to comment. Paul Ciriello, founder and managing partner of Cambridge, Massachusetts-based Fairhaven Capital, didn’t return phone messages seeking an interview.

Madoff, 72, is serving a 150-year sentence in federal prison in Butner, North Carolina, after pleading guilty to orchestrating the biggest Ponzi scheme in history.

Surge, which characterizes itself as a start-up company, says it spent the past year putting its leadership team in place, updating its technology and starting to trade for customers.

“We’re feeling very good about what’s happening,” Joseph Marinaro, Surge’s chief business development and strategy officer, said in an interview. “As we become more successful, we’ll be able to pay off the bankruptcy trustee.”

Market-Maker

A market-maker acts as middleman between buyers and sellers of stocks, providing liquidity to the market. Surge said in a regulatory filing that it handles trading in 2,200 stocks listed by Nasdaq OMX Group Inc. and NYSE Euronext.

Castor Pollux outbid one other firm in an April 27, 2009, auction of the unit’s assets, agreeing to pay $1 million in cash, or $50,000 less than Lazard’s bill for putting the sale together. In addition, Castor Pollux agreed to pay 15 percent of its trading revenue, after transaction and regulatory fees, up to $24.5 million in so-called “earn-out payments.”

To reach that total, Surge is going to have to overcome several challenges, including the “Madoff taint,” said Larry Tabb, founder and chief executive officer of the Westborough, Massachusetts-based research firm Tabb Group LLC.

“Do they want to send flow over the same lines that used to go to Madoff?” Tabb asked, referring to customer orders.

Customers Signed Up

Surge executive Marinaro said the firm has signed up 25 customers since it began trading Sept. 3. A dozen more are in the process of connecting to Surge, and 15 prospects are completing due diligence, he said. Marinaro said Surge is concentrating on the quality of its trade execution to attract clients and build market share.

“We’re realistic,” he said. “It’s all about connectivity first and the rest will follow.”

Surge got through the so-called “flash crash” of May 6, when the markets plunged, without requiring any clients to route orders away from the firm, according to Marinaro. Since then, the firm’s biggest trading-volume day, clients have increased their order flow, he said.

In April, the firm executed trades on about 80 million shares, according to Thomson Reuters Corp. That’s a little more than the Madoff firm used to execute in a day, according to a marketing document prepared by Lazard.

Biggest Market Makers

The three biggest market makers in April, by volume, were Direct Edge Holdings LLC, with 6.5 billion shares executed; Citadel Derivatives Group LLC, with 5.5 billion; and Knight Capital Group Inc., with 5 billion, according to Thomson Reuters. Direct Edge, whose owners include the International Securities Exchange, Knight Capital, Citadel, and Goldman Sachs Group Inc., received approval in March to convert its EDGX and EDGA markets into exchange platforms. Direct Edge spokesman Erik Milster said the firm isn’t a market maker and doesn’t belong on the list.

Surge asked Picard in March to restructure the deal, claiming it otherwise might be forced to halt operations within two weeks, Picard said in court papers supporting the request.

According to Picard, Surge failed to account for the future earn-outs as a contingent liability on its books. Once on the balance sheet, the liability -- about $16 million, according to an April 30 Ernst & Young LLP audit filed with the Securities and Exchange Commission -- put the company in violation of net- capital requirements for market makers.

U.S. Bankruptcy Judge Burton Lifland in Manhattan agreed on April 13 to amend the sale agreement. Under the amendment, Surge Trading carries on the market-making business. A new holding company, Surge Trading Group Inc., will be responsible for paying the earn-outs.

Increased Risk

In exchange for the increased risk to Picard’s ability to collect as a result of the deal, Surge agreed to extend the $24.5 million payout period one year, through 2014, to pay $50,000 per quarter to the estate as a “monitoring fee” and to provide additional assurances that the estate will be paid.

Former Surge president Darin Oliver claimed in a federal suit filed in New York May 4 that Surge forced him out in January and hasn’t fully paid him for the 14 percent equity stake he held in the company.

According to Oliver’s complaint, Surge agreed in January to pay him $878,000, in three equal payments, for his shares.

Oliver, the founder and former chief executive officer of Castor Pollux, said Surge withheld the second and third payments, citing the need to defend against a potential legal claim by John Fanning, an Oliver associate.

Equity Interest

Fanning, the former founding chairman and CEO of the online music file-sharing service Napster LLC, sent an e-mail to Surge CEO Petrilli in February claiming an equity interest in Surge, based on an agreement with Oliver, according to Oliver’s complaint. Oliver sued to collect the remaining $585,333. Fanning hasn’t sued.

Surge replied in court papers that Oliver signed an agreement that made him responsible for paying Surge’s expenses to defend any claim by Fanning.

“You would think that both sides would have learned from Madoff that it’s important to be honest, upfront and trustworthy in your business relationships,” said Fanning. He declined to address specifics of Oliver’s and Surge’s claims.

The Madoff bankruptcy case is In re Bernard L. Madoff Investment Securities LLC, 09-11893, U.S. Bankruptcy Court, Southern District of New York (Manhattan).

To contact the reporter on this story: Bob Van Voris in New York at rvanvoris@bloomberg.net.