Bernie Madoff’s $50 Billion Ponzi SchemeNamed after con man Charles Ponzi, a Ponzi scheme is a fraud of investment, which appeals to investors due to the promise of high returns with little to no risk. Investors believe they are receiving profits however they are merely receiving principal of new investors. In order to be successful, the old investors must not withdraw large sums of money at a given time, and there must constantly be an inflow of money from new investors contributing to the scheme.
Top broker, Bernie Madoff, was found guilty of this scheme, which will further be discussed below.News explaining what happened1. Background InformationFormer Nasdaq Stock Market chairman, Bernard L. Madoff was arrested back in 2008 for conducting the largest Ponzi scheme in history.
He was charged with fraud and money laundering in which he took his investors for 50 billion dollars, causing wealthy citizens, celebrities, banks, and even charities to lose money with his actions. Madoff was successful as he was a “highly respected, well-established and esteemed financial expert,” (Clark, 1) which these attributes resulted in people and organizations trusting him with their money. When investors wished to withdraw money, Madoff managed to give them their requested money within reasonable time, further confirming their trust in him. Madoff quietly managed money, in which he concentrated power into his own hand, not telling anyone about it.
He helped these people move shares around the stock market, fast and inexpensively. His early clients began with family and friends and he eventually expanded his circle larger. He was able to extend his fraud for so long due to the marketing of his investment business being by word of mouth rather than publicized. Whenever his business leaked, he would use his charm and reputation built up in the past to take back control of the situation.
2. SkepticismFairfield Sentry Ltd., a hedge fund ran by Madoff Investment Services, which invested shares in Standard & Poor’s, or S&P 100, had appeared to be up 5.6% even when S&P 500 was down 37.
65%. Returns sparked skepticism regarding Madoff’s approach. In 2000 Harry Markopolos, an executive in the securities industry reached out and discussed his complaints and findings of investigating Madoff. The Securities Exchange Commission (SEC) ignored the claims made by Markopolos in which Madoff continued to commit fraud.
Following that questioning from Markopolos, in 2001 Barrons also wrote about the potential (at the time) scheme, blaming Madoff for committing the illegal act of front-running, which is when a firm buys shares for its own account just before it fills orders for customers. Madoff deemed this allocation as “ridiculous,” and again continued to implement his scheme (Efrati, 3).3. Stress leading to failureThe decline in the market in 2008 lead to continuous high redemption requests from the contributing investors; Madoff felt the struggle to meet those requests.
People that worked with him daily even began to notice changes in his behavior and attitude. Madoff even mentioned that he wanted to pay bonuses to employees earlier than usual. When his sons questioned the bonus suggestion he left the questions unanswered and rescheduled a meeting with them in a more secluded location, his apartment. The sons met Madoff at the apartment in which, Madoff confessed to his business be a scam and that he wanted to end the whole thing.
Madoff confessed to having “absolutely nothing, that it’s all just one big lie, basically, a giant Ponzi scheme.” (Efrati, 2) The sons notified their attorney who then notified the feds, resulting in Madoff being sentenced to 150 years in prison.Concealment of the big fraud1. Reputation & the secretive businessA major reason he got away with his fraud for so long was because of his reputation.
As mentioned earlier, he ran a tight business; he was chairman of NASDAQ, participated in industry panels for the SEC and much more. He was trusted and highly respected by many. Even when people questioned how his hedge fund had such high returns, it was nothing more than just a question, due to his reputation. In 2003 when the SECMadoff had a secret business on floor 17 of his two and a half floor business, which in order to gain access on needed a special pass.
Inside this room occupied an old-fashioned IBM computer, which was stored in a locked room, various trading statements, and a staff of about 20 clerks, nothing out of the ordinary. Madoff was very detailed oriented in which everything had to be symmetrical and perfect. He diligently made sure that the fonts, texts, structures and letterheads were kept so that if investigated his paperwork would be identical to paperwork of the past, making it look more realistic and less questionable. Frank DiPascali, ran the floor of this business, in which no one really knew what his job title was, but they knew he was a big deal.
DiPascali was a huge factor in order for the scheme to go on for so long. He was loyal to Madoff and performed every task thrown at him.2. Frank DiPascali, the right-hand manDiPascali, managed to develop simple plans in order to trick investors and the SEC attorneys who were investigating Madoff from 2004-2006.
He made-up backdated and fictitious trades which resulted in the appearance of what seemed to be successful investments. As mentioned above, earlier in the scheme Madoff has very few investors involved, mostly family and friends which eventually grew to more and more investors handing him his money. People wanted to be included in this secret club of Madoff’s, by word of mouth from wealthy investors involved, more money began to generate into this system.1992 was the first incident, which sparked attention to Madoff’s plot.
TheSEC accused Avellino & Bienes, a company that contributed funds to Madoff’s scheme, of unlawfully selling promissory notes in unregistered transactions (Farrell, 1). Madoff managed to come up with the money Avellino & Bienes requested, in which DiPascali created the fictitious paper work, which supported proof to the 300 million dollar redemption. The concealment of the fraud only drew the attention of new potential clients who wanted to invest their money with Madoff, creating a multitude of new accounts, one being the investors of Avellino & Bienes himself.With the array of new accounts Frank DiPascali assisted Madoff with a “split strike” strategy.
This split strike strategy DiPascali suggested is one in which stocks would be allegedly traced in the S&P 100 index. He even had the staff who worked on the floor check trades daily to make sure the prices reported weren’t exaggerated either too high or low, no questions asked. In order to generate these false returns, Madoff’s investor accounts were recorded on the IBM computer Madoff stored away. Madoff managed to generate millions of pages of phony paperwork each year where he spent his time diligently making sure the papers looked perfect and realistic.
Madoff even kept the old letterhead from old trading records from his early years The SEC stated, “Every trade, every order ticket, every account statement, every confirmation and all other relevant records were fictitious.” (Farrell, 2) Because the business was so secretive with no questions asked, DiPascali faced challenges when he was asked questions from counterparties. A counter party is a term used in the financial services industry to describe a legal entity or collection of entities to which an exposure to financial risk might exist. Since the entire act was false and Madoff did not actually trade with his funds, auditors could have revealed this fraud by interacting with counterparties and talking to them.
In order to derail the investigators off their track, DiPascali created “trade blotters,” which is a record of trades and the details of trades made over a period of time, their purpose is to document the trades so that they can be reviewed and confirmed by the trader or firm (investopedia.com, 1). Of course these trade blotters were made up, since there really wasn’t any records to be documented. As a result of these trade blotters, when the US regulators requested information regarding counterparties, DiPascali gave them names offinancial institutions in Europe.
When auditors contacted the European investors for similar information DiPascali provided names of US counterparties, so everything matched up.Madoff, being so detailed oriented and cautious made sure he covered all his tracks, especially when it came to investors who worked for worth financial institutions. Madoff ordered DiPascali to close the accounts of those investors just in case “the compliance department of their employers” (Farrell, 2) requested account statements.3.
Depository Trust Co.In 2006 when the SEC questioned Madoff, in which he handed his account number to the Depository Trust Co willingly. The DTC is an independent clearing agency. Was Madoff already facing difficulties to produce payments? Why would he have handed his account number so willingly otherwise? That this point Madoff believed it was all over, however the SEC lacked to investigate with the DTC, which is a basic accounting mistake on the SEC’s part.
Because if they had actually investigated properly they would have seen that no trades actually took place and the whole activity was a fraud, however they did not, causing this scheme to continue for at least 2 more years.4. Role of the independent auditorMany investigators on the case believe Madoff’s independent auditor, played a major role in allowing fraud to go undetected. A small accounting firm that consisted of three men, Friehling & Horowitz, audited Madoff Securities.
David Friehling constructed “sham audits” which are fake audits, which serve no business purpose and no economic benefit but is solely created for deception (businessdictionary.com). These sham audits defied the auditor independence rules of the accounting profession as Friehling had a personal account managed by Madoff.Friehling had also violated basic rules of audit due diligence, failing tocheck for the fairness of presentation in statements, checking on assertions such as verifying the valuations of assets with specialists of independent parties requesting confirmation and documentation of trades.
Assets and balances of hedge funds should be verified with custodians and brokers/dealers. These verifications are usually performed with hedge fund administrators and custodians, brokerages with the firm who holds the account and other parties in the transaction. The assets of hedge funds are reported under the Net Asset Valuation method, which are usually reported by an independent fraud administrator. The auditor needs to verify the valuation of assets and the cash balance, which mentioned earlier, was not performed.
5. Accounting IssueMadoff had conveyed high positive returns to his investors, which never truly existed. These misrepresentations should have created a liability in the balance sheet which would have required Madoff’s company to be reported under the Statement of Financial Accounting Standards No 5: Accounting for Contingencies. However, the company never reported this liability in its audited financial statements.
Preventative controlsAU Section 316.07 lists three components of the fraud triangle which are signs that fraud exists, which include existence of an incentive or pressure to commit fraudopportunity to commit a fraud is presentthe ability to rationalize fraudulent conduct on the part of the given or potential fraudsterAll the components listed above can relate to the life of Madoff and as to why the fraud was committed. Unlike many other fraudsters where money is an issue, that was never an issue for Madoff, however his overwhelming pride was an incentive to commit fraud. He was too proud to admit his own weakness, in which failure was not an option, which lead to the birth ofthis scheme, as he always was viewed as successful even when other investors and businesses had low returns.
It was easy for him to start this fictitious scheme, as he was well respected and trusted in the industry. He was involved heavily in the finance world and people looked up to him, which gave him the opportunity to commit the fraud and continue with it. He was very intelligent and knew about finance inside and out, including how to come produce complex strategies to cover his tracks when any discrepancies arose. This was his ability to rationalize the conduct.
1. Red Flags of a Ponzi SchemeMost Ponzi schemes have many similar characteristics. Some characteristics and their relation to this case specifically include:high investment returns with little or no risk – Madoff’s scheme was constantly generating high returns which appealed to many investors interested in enhancing their wealth. They did not see the risk involved because there appeared to be none in the hands of Madoff as he was well respected and trusted financially.
overly consistent returns – when the market was falling or appearing to have low returns inversely, Madoff’s investment firm was growing and showing high returns. People were curious as to how this was possible but they trusted him as a financial genius. unregistered investments – these investments Madoff was “making” were unregistered and false. As mentioned earlier, Madoff and DiPascali created fictitious documents in order to show investigators, just in case, to cover their tracks.
All these trades on their paper work however were never registered. secretive and complex strategies – Madoff never told anyone the full details of this secretive business, people would perform tasks for him, no questions asked. When investigators questioned his tactics, he would either ignore them or give them some roundabout answer. There were also complex strategies developed such as the “trade blotter” strategy and “split strike” strategy, described above, that were detailed and so intricate it was questioned how someone could pull off such a strategy.
issues with paper work- Madoff was very detailed oriented in which he took much time making sure the font, text, letterheads and format of his old documents wereidentical to old paperwork so there were no discrepancies. He produced everything on his 1988 IBM computer, never updating the technology as time passed. The paperwork of the trades and financial audits were also all a sham. difficulty receiving payments –in order for a Ponzi scheme to continue new investors much constantly enter and contribute, in which redemptions from other investors are payments from the new investors.
Eventually the money chips away year by year causing there to be less money for redemption. When the economy began to collapse in 2008 many investors requested high redemptions in a short amount of time leading to the pressures of the outflows exceeding the inflows and the failure of the overall scheme.The outdated IBM computer was a huge red flag that no one took advantage of investigating. As technology is advancing continuously it is important to keep up to date with computer systems, however Madoff did not.
He produced everything on this computer in which it was so old that some information needed to be keyed in by hand. The fact that Madoff refused to replace it was questionable. Why wouldn’t someone so involved in the financial industry like a device that was easier to use, unless you were hiding something. The pages of statements that this computer produced showed trades that were never even made.
2. Possible controlsAs an auditor and investigator there were many red flags at hand in which this scheme could have been put to an end earlier than it was. Starting with investors just handing away their money. As an investor no matter who the investee is, or how reputable they are, if one is handing away their money, one should continuously stay on track of where their money is being invested.
One should ask continuous questions, and if they cannot be answered, especially but someone so renown in the industry, that person should be able to answer the questions brought to them. If not, take your money back in invest elsewhere.A whistleblower hotline should have been created and encouraged. There were many staff laborers that were preforming tasks for Madoff and DiPascali,with no questions asked.
At least one of them had to have felt as if something fishy was going on. If there was an anonymous hotline available, investigators could have further looked into the situation more strongly and could have even put an end to this fraud earlier.Another measure that could have taken place was a further investigation and questioning of Madoff’s company’s independent auditor David Friehling as well as KPMG who failed to properly investigate Friehling & Horowitz. In what relation did he have with Madoff as to why he produced these sham audits for him? A specific question to ask also was how such a small accounting firm can audit a company so large? This should have sparked many investigations for Madoff and firm Friehling & Horowitz.
David Friehling should have not been the sole auditor for the company, there should have been a segregation of duties or more than one person on Friehling’s team performing the audit. This would have given a higher opportunity for someone to discover fraud on the financial statements and accounts. A peer review should have also taken place in order to examine the accounting firms quality control system to make sure the firm and accounting professionals are in compliance with the requirements of that system. This system was established by the PCAOB as an inspection program to certify that auditors of public companies have established and are applying appropriate quality control policies and procedures (cengagesties.
com, 3). This peer review system would have revealed that the audits were in fact a sham.An internal control that could have benefited the SEC would have been changing the auditors of Madoff’s company. The length of relationship between Madoff and Friehling and Horowitz was lasted about 17 years, which was long enough for Friehling to have built a strong relationship with Madoff where the firm could have been colluding with Madoff in hiding the true nature of its fraud.
In relation to the information provided above, there could have also been a surprise audit conducted in order to make sure that the company is complying with rules and regulations and that no fraud or unethical conduct is occurring. The company being audited should not know when this would occur.If this had been in occurrence during the Madoff case, there is not a doubt that this scheme would have ended earlier.All downhill from hereTo this day there are still people being charged in helping with the Madoff Ponzi scheme.
Investigators are still putting facts and pieces of the puzzle together, as people who trusted Madoff are hurting financially and emotionally. A constant question asked is, where did all the money go? Some money was found in offshore accounts while there is money that will never be found because it was chipped away year by year. Madoff was sentenced to 150 years in prison while other key players such as his family and DiPascali were given smaller sentences. The SEC has developed a variety of new regulations to make sure such a huge fraud like this never happens again.
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