By Mark Gimein

Let’s say, just for the sake of argument, that you invested your life savings in a fund run by a Wall Street legend named Mr. Made Up. For 15 years, your investment in the Made Up Fund has risen a nice 10 percent a year, and now the $1 million you put in is worth about $4 million. Then you get a tip from a friend out on the golf course that the Made Up Fund is … well, just what its name suggests.

Do you:

a) Take your money out the next morning, then go to the police
b) Take your money out the next morning and say nothing
c) Do nothing with your money and go to the cops the next morning
d) Do nothing, say nothing, and hope that no one else notices

The ordinary human impulse on finding out that you’ve given your money to someone who’s unlikely to return it is to ask for it back immediately. The ordinary moral impulse is to let other people know. And the one choice that you’d think any reasonable person would avoid is (d). That seems completely obvious, right?

Unless, that is, you have any familiarity with the terrifying labyrinth of the law on investment frauds. Once you do, you’ll see why even the investors who got suspicious of what Bernard Madoff was up to might have been very, very wary of going public—and why the Madoff implosion will probably lead to an even longer, uglier unraveling than the sheer numbers suggest.

A hedge-fund manager friend called last night to talk about Madoff. He wanted to talk about just how ugly the unraveling of the Madoff saga was likely to get. And if the first name on his lips was (obviously) Madoff, the second was Bayou. Bayou was a fund that blew up and was revealed in 2005 to be a fraud with some $450 million in investor losses. Bayou is memorable for two reasons. One is founder Samuel Israel III’s staged suicide. (He eventually rose from the dead and turned himself in after prosecutors went after the girlfriend who helped him disappear.) The other is a legal precedent set in the Bayou case that should scare the heck out of anyone who once invested with Madoff but who managed to get out safely in the last few years: Any investors who managed to take out profits from a fund like Bayou before the fraud was revealed had to give the money back.
On the face of it, the Bayou ruling (which stories in the Wall Street Journal and Forbes have, to their credit, noted) seems reasonable: If some early investors made outsized gains, doesn’t it make sense for them to pay back the money to those who lost everything? But, as this fund-manager friend pointed out, it has some pretty extreme implications.

The obvious consequence of Bayou is that a country-club friend who’d given his money to Madoff and then gotten suspicious can’t just take his money out and then go to the cops. If he reports his suspicions, he’s likely to be asked to repay any of those 10-percent-a-year “profits” he’d accumulated for a decade. This is bad enough. But there’s more to it here.

Much of the money that Madoff managed came from people who’d written a check not to Madoff directly but to so-called “funds-of-funds”: hedge funds that had raised money from investors. A few of these funds-of-funds, such as Fairfield Sentry and Tremont Group’s Rye Investment, had billions of dollars invested with Madoff and teams of auditors to track it. These companies should have wised up to what was going on much earlier.

Thanks to the Bayou court decisions, however, the moment Madoff was revealed as a fraud, any money that these funds-of-funds would have managed to take back would become gains that have to be given back to be redistributed among all the losers in the Madoff scheme. Now, this sounds bad enough, but … again, there’s more. There’s no time limit on the gains they’d have to give back, so any fund that outed Madoff could be on the hook for any profits it had gained from its Madoff investments for years back. So, as my fund-manager friend puts it, “The question people have to ask is not, ‘Do I have money in a fund that has exposure to Madoff now?’ but, ‘Do I have money in a fund that that has ever invested with Madoff?’ ”
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