Introduction
Wealthy families usually place their money with private banks, wealth managers, and hedge funds. This move is meant to ensure that the wealth of these families keep on multiplying through the investments done by the private banks, wealth managers and hedge funds. Once the money has been placed with these professionals, they choose experienced and successful fund managers. Due to good performance for a number of decades, Madoff was a favorite choice in the last three decades. The popularity of Madoff led to formation of feeder funds that were collecting money from clients to be managed by his firm. The feeder funds were benefiting from this arrangement by getting a fee for their services. Although the understanding was that Madoff was investing the money he was getting, he was instead using new inflows to pay old profits. In the year 2008, when the financial crisis occurred, there were no inflows and most Madoff clients wanted to be paid. This led to exposure of the fraud because Bernard had no money to pay out to clients. This paper investigates the conditions that led to the success of the Madoff pyramid scheme over a period spanning decades and recommends steps for preventing such a scheme from occurring in the future.
Environmental factors that supported the fraud
One of the factors that led to a successful Ponzi scheme by Bernard is the fact that as an individual, Madoff was an established, esteemed, and respected financial expert. He had great financial reputation as one of the founders of NASDAQ stock exchange. Madoff served the NASDAQ as its chair for one full term.
Among the greatest environmental factors that fuelled the fraud was the federal 5% payout rule. With this rule, Madoff could run his fraud for quite a long time without detection. The rule provides that foundations that are private in nature have to pay out at least 5% of the funds they hold annually. Much of Bernard’s inflow was from organizations that are non-profit in nature and thus it was unlikely for them to withdraw suddenly. With a huge investment running into billions of dollars, he could survive for decades, paying the 5% federal requirement per annum (Zarrabi & Lundberg, 2012).
Madoff family’s influence was another reason why the fraud ran for so many years without detection. Members of the family had direct access to regulators and lawmakers. “Madoff himself was the chairman of the board of the Securities Industry Association, later merged into SIFMA where his brother Peter Madoff sat as a member of the board” (Zarrabi & Lundberg, 2012, p. 4). Additionally, the Madoff’s were in-laws to the compliance official in the SEC. The official, Eric Swanson, was married to Shana Madoff, Bernard’s niece. The investment company owned by Bernard spent at least $400,000 on the Board Market Association and the SIFMA, which made the firm commendably influential (Zarrabi & Lundberg, 2012). It is therefore clear that Madoff had connections that could help him diffuse suspicion.
The ineffectiveness of the SEC (Securities and Exchange Commission) was another reason why Bernard was able to operate a pyramid scheme for so long. Actually, the SEC was one of “the biggest reasons for Madoff’s ability to avoid problems for such a long time” (Zarrabi & Lundberg, 2012, p. 5). Three years after the discovery of the pyramid scheme, it became public knowledge that the commission had taken disciplinary action over eight employees in relation to the fraud. The disciplinary was occasioned by an investigation that revealed that SEC officials had ignored six warnings about the suspicious activities of Madoff over a period of sixteen years. The investigation resulted in a report that suggested that SEC’s failure to detect the fraud was because of delayed examinations and inexperienced officers (Zarrabi & Lundberg, 2012). Critics have expressed fears that the SEC has always been understaffed and thus there is still a risk that such frauds can occur in the future.
Madoff’s firm had influenced its independent auditor, Firehling, an accountant working with a small firm. This led to sham audits for which the accountant was arrested. He was accused that he had approved reports that were sent to the SEC alleging that Bernard’s firms had $1.09 billion worth of assets and owed $425 million to other people. These figures were later established to be phony. It is therefore clear that the firm’s independent auditor was compromised.
As stated, the fact that Madoff was an established financial advisor and the fact that he had his own legitimate firm also fueled the fraud. By his own confession, Madoff told his sons that he was not always running a Ponzi scheme. He told his sons that he had started the pyramid scheme under the cover of his legitimate firm in the year 2005. From this confession, it is apparent that the existence of a legitimate firm owned by Bernard helped him to cover his misconduct. In fact, Madoff subsequently used the fraud to subsidize the operations of the legitimate firm.
How Bernard accomplished the fraud
One of the reasons why the Madoff fraud went undetected for long is because he conducted his advertising “by word of mouth” (Bandler & Varchaver, 2009, p. 1). Until the last years of the fraud, Bernard’s customers brought friends and family members as prospective clients. The firm attracted more customers due to Madoff’s popularity and the fact that he used to reject some clients. Actually, Madoff Investment Securities was more or less a clan-run business in that its management was composed of few individuals, who included several members of Madoff’s family. It is also important to note that Bernard was commendably influential and thus his firm was regarded highly.
Madoff knew that he could easily be caught by wise investors or regulators who cared to find details of his investment ventures. He therefore set up an investment operation complete with fake terminals and hired traders. The traders were supposed to pretend to be engaged in trading of stocks, and they kept fake accounting reports and fictitious transaction documentations (Ahamed, 2011). One was required to have a special pass to get into the pyramid-scheme office that was located on the 17th floor. However, on gaining access to the office, it would take a skilled investigator to know what was going on in that office. The office had “an antiquated IBM computer server kept in a locked room, piles of trading statements, and about twenty paper pushers and clerks” (Bandler & Varchaver, 2009, p. 1). Looking back however, there were numerous indications of fraud at the aforementioned office. The IBM machine was too old for such an office that it would have been replaced if Bernard cared about operational efficiency. Actually, some of the data required was typed by hand because the machine was too old. The reason why Bernard kept it is that the IBM server formed the nucleus of the fraud by printing fictitious statements, which showed transactions that were actually never made (Bandler & Varchaver, 2009). The people who worked in this office were mysterious to the extent that nobody knew what they did or what their titles were. This was despite the fact that all investors knew them and regarded them highly as top Madoff employees. He was appointed by the SEC to industry panels, he was the chair to the NASDAQ, and he was friends with the Senator of New York, who once dropped by his offices (Bandler & Varchaver, 2009).
Madoff was the ultimate schemer. The scheme would have ideally been exposed in 1987 when the United State’s stock market collapsed. However, Madoff knew that the only way he could keep the scheme secret was by getting more money. He therefore always found new investors with high amounts of money during hard financial times to keep the scheme going. After surviving the collapse of the U.S. stock market in the 1980s, he also applied the same principle to survive the early 1990s recession and the bubble burst in technology that occurred in the year 2000 (Ahamed, 2011). Most of Bernie’s investors were brought to his firm by other firms, which were feeding into Madoff’s firm, the so-called feeder funds. Therefore, most of Madoff’s investors did not know that Bernard was managing their hard-earned savings.
Madoff’s success at running the Ponzi scheme can also be attributed to the fact that he was also running a parallel legitimate business. He was therefore able to earn his clients’ trust because he would pay withdrawals requested by his customers promptly. Madoff was a smart manipulator. He did not promise his investors unbelievable returns. “He reported moderate (albeit, suspiciously consistent) returns to his investors” (Clark & McGrath, 2012, p. 1). He was also able to launder money from his illegal business to his legal business. For instance, there was a transfer of $250 million from the London asset management office of the firm to the legal business in America. Madoff’s admission after the discovery of the fraud was that the money was laundered from the illegitimate firm’s London office to the legal business in the U.S. (Bandler & Varchaver, 2009, p. 1). Madoff’s illegal business was actually subsidizing his legal investment. In March 2009, Bernard pleaded guilty to money laundering. The charges involved the aforementioned transfer of $250 from London to his business in New York.
His asset management business, the name with which the Ponzi scheme was known, was located on the seventeenth floor of his office. The legitimate business was on eighteenth floor and physical access to the asset management wing was restricted. He only had a few employees in the asset management business and they were all non-professionals. Most or all of them were high school graduates. Having people who were not professionals managing the business was meant to ensure that his unconventional transactions would not be discovered. For instance, Mr. DiPascali, a Madoff employee, who was a high school graduate, has admitted to manipulating client returns depending on the needs of the clients. The clients would request an increase in returns or a decrease in returns depending on whether they had made high profits in other investments. The adjustment of their returns from Madoff would therefore help them to manage the size of their tax bill (Bandler & Varchaver, 2009, p. 1).
How the fraud was discovered
In the year 1992, Madoff was almost caught when one of his firm’s feeder funds was suspected of being a pyramid scheme. Avellino & Bienes had invested all of their clients’ money in Bernard’s firm despite the fact that their securities firm was not registered with the authorities. When investigators established that the firm had promised investors unrealistic returns of up to twenty percent, they began investigating the possibility that the firm was a pyramid scheme. After the discovery, Madoff returned the money the firm had invested with him in one week (Bandler & Varchaver, 2009). Instead of proceeding with the investigation, the SEC simply closed the case when the money was given back. All along, Madoff was acting the model citizen. Records show that Bernard conversed on several occasions with a trustee and an official from Price Waterhouse, who were working on the case.
In 1999, while working in Boston for a firm as an investment officer, Harry Markopolos’ boss tasked him to undertake a case study of the Bernard Madoff firm with an aim of establishing why Madoff’s firm was consistently making positive returns in a tough trading environment. After analyzing Bernie’s investment strategy and figures for an approximate four hours, Harry noticed that it was impossible for Madoff to make the reported returns legitimately. Markopolos however took nine years together with his coworkers convincing the SEC that it should have Bernie investigated. Despite an uncooperative commission, Harry continued studying and investigating Madoff’s investment until he was fully convinced that the investment was no more than a large pyramid scheme.”In 2008, he filed his last report and decided to give up trying to get the government to do the right thing” (Rasor, 2011, p. 1).
Coincidentally, during the same year that Markopolos was on the verge of giving up on Bernard’s investment, the recession kicked in. This led to an accelerating decline in markets, which made investors lose much of the money they had invested in other firms. This meant that Madoff’s clients had to turn to the one investment that “they thought was their most solid holding, and thus they began requesting withdrawals from Madoff’s fund” (Bandler & Varchaver, 2009, p. 1). For some time, Bernard’s firm seemed defiant to the depression. Most firms were reporting monthly drops reaching double digits, while Bernard’s firm “was somehow eking out a heroic positive return, ostensibly 4.5% through October” (Bandler & Varchaver, 2009, p. 1).
Madoff’s savings were diminishing by the day because investors were making massive withdrawals that he could not sustain because the recession meant that it was quite difficult to get new investors. During the first days of December 2008, Madoff knew that he would soon be caught because he could not pay all his client’s withdrawals. After some time, he summoned his sons and expressed his intentions to reward clients with bonuses. His sons could not understand why their father would give bonuses at a time when all firms were struggling to survive the recession. They demanded their father to give a logical explanation and Madoff confessed that he was running a giant pyramid scheme (Quinn, 2009, p. 1).
After the confession, Bernie’s sons talked to their lawyer. This started a chain of events, which culminated in Madoff’s confession to the FBI, and his subsequent arrest. In his confession to the FBI and his sons, Bernard said that he had operated a pyramid scheme or ponzi scheme from at least the year 2005. The scheme operates in such a way that money given by new investors is used to pay withdrawals and profits made by earlier investors. The year following his confession, Madoff made a full confession before a court of law and he got the maximum sentence of 150 years in prison. The investors who had not made withdrawals before the recession lost the money they had invested with Madoff. The list of victims includes billionaires, celebrities, individuals, charities, banks, and so forth.
Lessons learnt
Ignorant and erroneous investigations conducted by the SEC have been proved the greatest variable that created an environment conducive for Madoff to run his fraud for a period spanning a decade. However, many factors aided Madoff in his scheme. Some of these factors include loopholes in regulatory institutions, corruption, and so forth. It is therefore imperative that the SEC deals with the investigative loopholes to ensure that no frauds go undetected in the future. The SEC should also deal with corruption by perhaps developing a stringent ant-corruption policy that will deter its officers from engaging in corrupt practices. It is however important to note that much more changes need to be done to the commission to enable it to deal with future fraud cases.
The Madoff business had been put in the spotlight for close to a decade before it was completely unearthed. In 1992, SEC officials were convinced that one of Bernard’s feeder funds was a pyramid scheme. However, the investigations that followed can only be described as shoddy because after discovering that the aforementioned firm had all its money invested with Bernard, it never occurred to the investigators that they should look into Bernie’s investments. Madoff was always acting like the Good Samaritan during the investigation. Phone records have proved that he was always in touch with the investigators, ensuring that everything was okay. He eventually paid the entire firm’s money without being investigated. It is therefore vital that future investigations by the SEC in suspected fraud cases be thorough to avoid repeating the same mistake.
In 2001, two articles were published on the possible misconduct of Madoff in the trade business. It was reported that Bernard’s investment put it among the largest world over despite the fact that it was not that popular (Bandler & Varchaver, 2009). It was also noted in the articles that Bernard’s returns were steady and smooth at 15% per annum, which was almost impossible in the trading environment that Madoff was operating. Also noted in the articles was the fact that Madoff did not charge fees in running his investment operation. They noted that Madoff only accepted commissions, which were minimal. Even after these articles were published, and they were in the public domain, nothing was done to prove or disapprove their assertions.
One of the most important lessons learnt in the Madoff fraud case is perhaps that government agencies like the SEC should never ignore the assertions of independent investigators like individuals and publications. As stated above, the SEC had received a report in the 1990s from an investigator named Markopolos on the irregularities practiced by Madoff. The SEC must have been aware of the assertions made by the aforementioned two publications. It was therefore negligence for the SEC to fail to conduct a credible investigation on Madoff after these tip-offs.
Given that the SEC had conducted several audits of Madoff’s businesses and failed to unearth any anomaly, it is imperative that the fraud detection measures employed by the SEC be stepped up. The SEC should also employ preventive measures to ensure that it is nearly impossible to run a Ponzi scheme of the magnitude planned by Bernard. The SEC should particularly perfect its investment regulation and ensure that all businesses abide by the provisions of the investment regulation. The commission has also proposed conducting of surprise audits on investment advisers in order to ensure that malpractices are detected early.
Notably, after Bernard’s fraud was discovered, the SEC reformed its enforcement division, which was highly responsible for the negligence that resulted in the running of the pyramid scheme for decades. The division “focuses on significant cases that will have a meaningful impact” (Zarrabi & Lundberg, 2012, p. 8). A number of initiatives have also been started to ensure that the commission is fed with insider information regarding firms that can potentially run frauds of Madoff’s magnitude. The SEC also learnt that inexperienced staff was one of the reasons why Bernard was able to run his pyramid scheme for so long. The commission has therefore invested heavily in recruitment of experienced personnel.
The private investigator who single-handedly discovered the Madoff fraud suggested that the SEC puts up a whistleblower program to increase its effectiveness in detecting and dealing with fraud. Markopolos campaigned for the program until it was set up. Therefore, whistleblowers can now contact the SEC through the program and give their fraud knowledge for further investigations by the SEC. This is especially helpful considering that Markopolos pleaded with the SEC to investigate Bernard for almost a decade until the schemer confessed that he was running a pyramid scheme.
Conclusion
Investigators are continually trying to find the assets acquired by Madoff during his fraudulent activities. Over a billion dollars worth of assets has been recovered and investigators are looking in offshore locations for more assets. Some assets are being recovered by lawyers hired by the trustee appointed by the court in locations around the world. Experts however warn that there will never be a discovery of large sums of money or assets worth the amount that Madoff fleeced his customers. According to experts, the sum of $ 65 billion, often quoted as the amount that Madoff fleeced his customers, is exaggerated. Experts also argue that the amount that Madoff received from his clients is close to $ 20 billion (Bandler & Varchaver, 2009, p. 1). Even this relatively modest sum can never be found because it was used with time. That is how a pyramid scheme operates. Money inflow from new clients is used to settle sums owed to old clients. If Madoff had access to huge amounts of money, he would have paid the investors demanding payment and continued his pyramid scheme. That is why he was approaching wealthy individuals like Ken Langone to invest with him shortly before his downfall. It is however important to note that the scheme would have ultimately collapsed.
References
Ahamed, L. (2011). How Bernard Madoff Did It. Web.
Bandler, J. & Varchaver, N. (2009). How Bernie did it. Web.
Clark, J. & McGrath, J. (2012). How Ponzi Schemes Work. Web.
Rasor, D. (2011). The Whistleblower From the Madoff Scandal Tells How to Reform the SEC. Web.
Quinn, J. (2009). Bernard Madoff: How the scandal worked. Web.
Zarrabi, S. & Lundberg, L. (2012). MVE220 Financial Risk: The Madoff Fraud. Web.