Bernard Madoff’s Fraud Case
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 several decades, Madoff was a favorite choice in the last three decades. The popularity of Madoff led to the 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 the 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 a great financial reputation as one of the founders of the NASDAQ stock exchange. Madoff even served the NASDAQ as its chair for one full term.
The ineffectiveness of the SEC (Securities and Exchange Commission) was one of the reasons why Bernard was able to operate a pyramid scheme for so long. The SEC had reasons to investigate Madoff but, like the client market, they seemed to have been blinded by Madoff’s reputation. Additionally, Madoff’s firm seems to have influenced its independent auditor, an accountant working with a small firm. This led to sham audits for which the accountant was arrested.
As stated, the fact that Madoff was an established financial advisor and the fact that he had his legitimate firm also fueled the fraud. By his 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. 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 a 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. Recruited investors were advised to keep Madoff’s investments secret.
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 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 the 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 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 1990s, Harry Markopolos reported to the SEC that Bernard was operating a Ponzi scheme. His research had shown that, based on the strategy used by Madoff to invest, it was not possible to realize the returns that Bernard’s firm was boasting. Markopolos concluded that Madoff was involved in an illegitimate business that could only be a Ponzi scheme. The commission subsequently investigated Bernard’s investments and was not able to unearth evidence pointing to fraudulent activities.
The discovery of Bernard’s Ponzi scheme took place in the year 2008. During that year, there was 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: 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).
When Madoff realized that he would be caught, he wrote several cheques amounting to $ 137 million to friends and family and confessed to his sons that he had been running a pyramid scheme since the year 2005 (Quinn, 2009, p. 1). This led to events that culminated in his confession of the fraud to the FBI, his arrest, and his indictment. Madoff got the maximum sentence of 150 years in prison.
Lessons learned
The Madoff business had been put in the spotlight for close to a decade before it was completely unearthed. In 2001, two articles were published on the possible misconduct of Madoff in the trade business. According to one of the articles, Madoff’s assets “made it the largest or the second-largest hedge fund in the world at the time. Yet it was unknown” (Bandler & Varchaver, 2009, p. 1). 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 minimal commissions. Even after these articles were published, and were in the public domain, nothing was done to prove or disapprove their assertions.
One of the most important lessons learned 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 SEC has also proposed conducting surprise audits on investment advisers to ensure that malpractices are detected early.
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 and exposed itself.
Reference List
Bandler, J. & Varchaver, N. (2009). How Bernie did it. Web.
Clark, J. & McGrath, J. (2012). How Ponzi Schemes Work. Web.
Quinn, J. (2009). Bernard Madoff: How the scandal worked. Web.