Jan. 13 (Bloomberg) -- U.S. prosecutors said they will appeal a ruling allowing Bernard Madoff, the accused mastermind of the biggest Ponzi scheme in history, to remain free on bail while he decides how to plead to a securities fraud charge.

U.S. Magistrate Judge Ronald Ellis in Manhattan denied a government request that Madoff, charged last month with securities fraud in the alleged $50 billion scam, be jailed instead of remaining under house arrest in his apartment on Manhattan’s Upper East Side. The judge imposed new conditions to his $10 million bond, ordering Madoff to compile an inventory of all items in his home and barring him from transferring property.

“The government has failed to articulate any flaw in the current conditions of release,” Ellis wrote in his ruling yesterday. Prosecutors said in court papers that they will appeal to the U.S. district court. Ellis granted a 48-hour stay of his decision while the government prepares its challenge.

The case may now go before U.S. District Judge Colleen McMahon in Manhattan, who is assigned this week to hear appeals of magistrate judge orders. Among the cases McMahon presides over is that of Samuel Israel, the convicted founder of hedge-fund firm Bayou Group LLC who was later charged with bail jumping.

Madoff, who hasn’t formally responded to the fraud charge, is scheduled to appear in court Feb. 11 for an evidentiary hearing. If indicted before then, he’ll be brought before another judge to answer the charges, at which time prosecutors may ask again for him to be jailed. The investment adviser faces as much as 20 years in prison and a $5 million fine if convicted.

Diamond Bracelet

Ellis’s ruling came a week after prosecutors sought to jail Madoff because he mailed items including a diamond bracelet and watches to relatives in violation of a court-ordered asset freeze in a lawsuit by the Securities and Exchange Commission. Madoff’s defense lawyer, Ira Sorkin, said his client didn’t know the order from the SEC lawsuit applied to personal items.

“We intend to comply with the judge’s order,” Sorkin said. Prosecutors said the defense consented to a delay of Ellis’s order. “They have a right to an appeal,” the attorney said.

Yusill Scribner, a spokeswoman for Acting U.S. Attorney Lev Dassin in New York, declined to comment on the court’s ruling or the grounds for appeal. A spokeswoman for Ellis declined comment.

Madoff, 70, was arrested Dec. 11 and charged with using billions of dollars from new investors to pay off older ones. He told authorities that investors may have lost $50 billion, prosecutors said. With government consent, he was released on bail and restricted to his Manhattan home, under guard and subject to electronic monitoring. He surrendered his passport.

Alleged Fraud

Although many victims of the alleged fraud consider Madoff a “scoundrel,” they need to separate the emotional aspect of his case because he “hasn’t been tried and convicted,” said Frank Candia, managing partner of accounting firm Holtz Rubenstein Reminick in New York.

“It’s not a popular decision by any means, especially to the victims of Madoff,” said Candia, who is hosting a town-hall style meeting for Madoff victims in New York this month. “They really do have to be patient and let the legal system take its course.”

New Yorkers walking by Madoff’s East 64th Street home yesterday were of a different mind, criticizing the judge for not putting Madoff behind bars.

Dawn Pohl, a real estate broker who said she lives on 72nd Street, said Madoff deserves to be imprisoned.

“Other people go to jail for much less severe offenses, while he is sitting in the lap of luxury,” Pohl said. “It’s almost as if he’s being rewarded for what he’s done. I think it’s a disgrace.”

‘Deserves Jail’

Risa Pilicer of Great Neck, New York, agreed.

“He deserves jail,” she said. “Three hots and a cot.”

The trustee unwinding Madoff’s investment firm, Bernard L. Madoff Investment Securities LLC, won approval from a federal bankruptcy judge in Manhattan yesterday to issue subpoenas as part of a broad probe of the company’s assets and conduct.

Irving Picard, the trustee appointed by Securities Investor Protection Corp., is working to collect as much cash as possible for the creditors of the trading firm.

Last week, an evidentiary hearing in Madoff’s prosecution was postponed, giving the government another month to indict him. In a Jan. 9 postponement request, Assistant U.S. Attorney Marc Litt said prosecutors and Sorkin “have had discussions with respect to a possible disposition” the case. “The parties plan to continue those discussions,” Litt said.

Declined to Comment

Sorkin and Scribner both declined to comment. Such language is routinely included in postponement requests and may not mean plea talks are under way. Similar language was included last week in the postponement of the unrelated fraud case of Marc Dreier. Dreier’s defense attorney, Gerald Shargel, said resolution wasn’t imminent.

On Jan. 5, prosecutors said Madoff violated a court order in the SEC case and obstructed justice by mailing Cartier and Tiffany watches, a ring, a diamond necklace and other jewelry in an effort to “dissipate” his assets. They said his violation of the order indicated he might flee the country. The property was worth more than $1 million, they said.

Sorkin told Ellis last week that the mailings started Dec. 24 as Madoff and his wife Ruth began to “reach out” to immediate family and friends by giving them a few “sentimental personal items.” That evening, Ruth Madoff set aside items accumulated over 49 years of marriage and Madoff gathered watches he’d collected over the years.

Mailed Items

The couple, Sorkin said, mailed the items to their sons Andrew and Mark; to their daughters-in-law; to Ruth Madoff’s sister, Joan Roman; and to an unnamed married couple with whom they were close friends. It wasn’t until after Ruth Madoff met with lawyers on Dec. 30 that she realized they shouldn’t have done so, and the Madoffs began retrieving them, the lawyer said.

Ellis said an asset transfer may warrant jailing a criminal defendant, though it wasn’t called for in this case. Even for the most serious offenses, more than half of all defendants are released on bail, including 73 percent of those charged with fraud, he said in the ruling.

“The issue at this stage of the criminal proceeding is not whether Madoff has been charged in perhaps the largest Ponzi scheme ever, nor whether Madoff’s actions should result in his widespread disapprobation by the public,” Ellis said. At issue is “whether the government has carried its burden of demonstrating that no condition or combination of conditions can be set that will reasonably assure Madoff’s appearance and protect the community from danger.”

He ruled the government didn’t meet that burden.

The case is U.S. v. Madoff, 08-mag-2735, U.S. District Court, Southern District of New York (Manhattan).

To contact the reporters on this story: David Glovin in New York federal court at dglovin@bloomberg.net and; Erik Larson in New York federal court at elarson4@bloomberg.net.

Last Updated: January 13, 2009 00:01 EST