EC Amtrust Financial Services & The Karfunkle Family Foundation: An Unholy Alliance?

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Imagine you and your younger brother are poor Jewish kids in mid-1950s Hungary. Unlike so many, you managed to avoid the Holocaust only to be swept up in a bitter revolt against the cruel Soviet occupation government.

The revolt fails, and like tens of thousands of your countrymen you leave your homeland and its bloodshed, and manage to make your way to New York and a new future.

Your name is Michael Karfunkel, your younger brother is George and, fast forwarding nearly 60 years, your future is something even Horatio Alger wouldn’t have thought possible.

Quiet careers in business at the periphery of Wall Street, New York, real estate and the insurance industry, with an aversion to publicity that is rarely seen, have made both men billionaires, according to Forbes magazine.

Like so many rich people, the Karfunkels opened non-profit foundations to share their good fortune. Through the donation of large blocks of AmTrust Financial Services shares — an insurance concern they built in the 1990s — their foundations have amassed considerable size as the share price rose: by the end of 2013 Michael Karfunkel’s Hod Foundation had assets of $286 million; his brother George’s Chesed Foundation of America had assets of $293 million.

(Their foundations give almost exclusively to yeshivas and synagogues connected to Haredi Judaism, many of which are affiliated with the Belz Hasidic sect).

And this is where the story would normally end: a miraculously successful pair of brothers who, in their later years — Michael is now 71 and George is 65 — have the rare privilege of seeing their fortunes put to good use.

Except that, taking a hard look at how these foundations operate leaves a lot more questions than answers.

For three months the Southern Investigative Reporting Foundation analyzed the foundations’ publicly available documents. What we found was that all good intentions aside (Hod means “prayerful submission” in Hebrew and Chesed translates to “loving kindness”), regulatory filings indicate that the foundations, while generously supportive of the Belz Hasidic community, have become key instruments in furthering the Karfunkels' business interests.

Unfortunately for them, based on SIRF's analysis, it appears that their management of the foundations may expose them to regulatory scrutiny and possibly force them to sell a large amount of their foundation's AmTrust shares, creating a material concern for company shareholders.

What follows below is how lax regulation and imprudent management turned the capstone of the American dream into what may be the first act of an American nightmare.

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The Karfunkel brothers non-profit foundations reflect their unusual tolerance for risk.

George and Michael Karfunkel’s first attempt at making their way on Wall Street is illustrative. Employees at a mutual fund boiler room called Economic Planning Corp., their bid to diversify the firm into the capital markets ended with them in the center of a wide-ranging pump and dump scam that collapsed in 1971. Never disclosed in their AmTrust filings, the Securities and Exchange Commission injunction and suspensions they received hardly set them back.

In response to a question about the lack of disclosure surrounding their SEC sanctions, the Karfunkels' spokesman, Kekst and Company's Robert Siegfried, said the brothers have nothing to disclose, having sought and obtained a dissolution of the SEC injunction in January, 2000. (The Karfunkels' spokesman declined to provide SIRF with the motions arguing for dismissal, stating that they are a matter of public record. A search of PACER the online legal database, however, did not yield any results.)

Their next venture, American Stock Transfer & Trust, a share registry that tracked changes in holders of record in the stock and options of publicly-traded corporations, was a spectacular success and was sold to an Australian company for $1 billion in May 2008.

While managing American Stock Transfer, the brothers began cobbling together seemingly disparate insurance units in 1998, calling the collection AmTrust Financial Services. The company listed shares in 2006 with Barry Zyskind, Michael Karfunkel's son-in-law, installed as chief executive.

Unlike other medium-sized commercial insurers like W.R. Berkeley who focus on standard retail and commercial policy business, AmTrust is a publicly-traded portfolio of insurance risks, like Italian medical malpractice, manufacturer warranties and California workers' compensation.

From enough distance, there’s wisdom aplenty in seeking out niche markets as less competition in insurance can offer high returns, but those profits come with ample risk.

There is an established pattern of insurance companies that grow quickly misjudging the breadth of risk in their portfolio and facing cruel reckonings when claims begin to mount and reserves prove inadequate.

AmTrust, however, has had no reckoning despite a mounting chorus of critics who have voiced their concerns over the quality of its disclosures and accounting. The company's response to the skeptics was bolstered by the company's strong recent earnings report.

The Hod and Chesed foundation's employ risk in a fashion rarely seen in other private foundations. This is an interesting orientation for a foundation given that the IRS, the federal regulator for private foundations, has a blunt view of the role of risk in managing foundation's operations and assets — namely, to avoid it.

But in case a foundation executive didn’t get the message, the IRS released guidelines designed to prevent "a lack of reasonable business care and prudence" in the foundation's management.

Called "Jeopardizing Investments," the IRS document promises additional scrutiny of a foundation if it starts to do things like use options, employ leverage or started making swing-for-the-fences trades, where the risk/reward ration was clearly skewed towards risk.

Spending time in the Hod and Chesed filings reveals that the IRS memorandum didn't make much of an impression on the Karfunkels because much of what the IRS warned about is how their foundations have regularly done business.

For instance, they used their foundations to make aggressive, directional market bets on controversial stocks. To that end, consider Michael Karfunkel’s waltz with Fannie Mae put options in mid-2008.

According to the Hod Foundation filings, starting in June 2008 and ending a year later, Michael Karfunkel began selling put options on Fannie Mae stock, a strategy that limited his profit to the option premium (or price) on the put options he sold.

But in mid-2008, Fannie Mae, the Grand Central Terminal of mortgage risk, was the proverbial house on fire, a once high-flying company en route to a collapse into conservatorship.

The high-stakes wager on Fannie Mae’s survival cost the foundation a total of $10.5 million. The rationale for the trade aside, it is a fine example of the skewed risk/reward ratio the IRS warned about — Hod’s profits were capped at $2.6 million.

Chesed also paid dearly for George Karfunkel’s adventures with Citigroup options trading in 2008, when he sold nearly 500 put option contracts, making him effectively long the stock as the bank began to totter towards its mid-September bailout. Like his brothers bet on Fannie Mae, he was effectively betting that an institution laden with dubious mortgage-related securities would emerge essentially unscathed from the then raging crisis.

As it stands, it was a spectacularly bad bet, with the trade costing Chesed over $820,000, with potential profits capped at about $105,000. Similar bets on AIG (a loss of nearly $500,000) and Lehman Brothers (a loss of almost $250,000) also proved costly.

Another remarkable aspect of these trades is their timing, with the Lehman Brothers and AIG option positions being opened on Friday, Sept.12, with both once iconic companies promptly collapsing that weekend. The historical price action for both Lehman and AIG in the weeks leading up to that Friday is testament to the depth of investor panic. Shorting the puts of these companies wasn't so much speculation as an attempt to catch a falling knife.

Contrary to the Karfunkel's assertions below, losses from their option trading adventures — in combination with the collapse in the equity markets — had a disastrous effect on the fair market value of the foundation's portfolios, with declines of 64 percent for Hod and 43 percent for Chesed.

Through their spokesman, the Karfunkel's responded that the use of options — common among veteran market participants such as themselves — did not lead to a material decline in the size of the foundation portfolios, especially given the intensity of the 2008-2009 market collapse. A chart they provided SIRF of both foundations portrayed their book value growth as favorable to a peer group of similarly-sized family foundations. This is the full Karfunkel reply.

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During the course of reporting this story, SIRF learned that a donor, GeoInvesting LLC, had written critically about AmTrust earlier this year. By way of disclosure, GeoInvesting was not a ...

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