Critical Analysis of Bernie Madoff's Ponzi Scheme: Case Study

Abstract

Bernie Madoff, who began his brokerage firm in 1960, was the mastermind who executed a historical the world’s largest and longest-lasting Ponzi scheme fraud of $50 billion through his investment company, Bernard L Madoff Investment Securities LLC, shocked the global economy. As per his modality of fraud, Madoff used investments to pay off his first investors, creating the appearance of a return and prompting more people to invest with him. In reality, the company had no income and no way to pay off later investors. Madoff created falsified accounts and statements to win the trust of the investors. The Ponzi scheme consisted of tens of thousands of falsified balance sheets and client statements (Collins, n.d.). The rise of Madoff started from very small investment and family members, business friends, and acquaintances as customers. However, it grew leaps and bounds, when the business grew Madoff used the path of illegal unlicensed investment advisors to escape the scrutiny of the SEC and state securities regulators. In this way, the way followed to fraud this case was absolutely planned and calculated. Meantime, there were many people involved with the scandal, from family members put in positions of power, to SEC agents to corrupt auditors and accountants. Ultimately it took several whistle-blowing attempts to bring down the corrupt company. The handling of the audits, and whistle-blowing allowed Madoff to continue his scheme for much longer than it should have been possible. Madoff ran an intentionally corrupt business in order to profit himself and was able to go unchecked, instead, the SEC encouraged him to create a “third market”. His business creates a negative image for investment companies and accounting as a whole. This is a classic case of ambition, trust, efficiency and betrayal.

Data visualization techniques that could have detected Madoff's Ponzi scheme

Data visualization is an analytic tool that can allow auditors to rapidly interrogate an entire transaction history or database to identify the most suspicious transactions to investigate (Mar, 2015). Analysis of data to detect transaction anomalies is an important fraud detection procedure. Interactive data visualization tools that allow the investigator to change the representation of data from text to graphics and filter out subsets of transactions for further investigation have substantial potential for making the detection of fraudulent transactions more efficient and effective (Dilla & Raschke, 2015). The fraudsters manufacture and modify data to create a realistic scene which are almost impossible to segregate from real data during normal course of audit. Since fraudulent actions are deliberate and non-random, traditional audit methods involving the use of statistical sampling are often ineffective for discovering fraud (Dilla & Raschke, 2015). In such a scenario, data visualization techniques are more supportive to detect such fraudulent data. If we closely look into Madoff fraud case, he explained about his investment strategy as he invested client money using a complicated three-part “split strike conversion” investment strategy. He told clients that first he purchased common stock from a pool of 35 to 50 Standard & Poor’s 100 Index companies whose performance paralleled overall market performance. The S&P 100 Index represents the 100 largest publicly traded companies based on market capitalization, and represented a very sound investment. Second, he bought and sold option contracts as a hedge to limit losses during sudden market downturns. Third, he left the market and purchased U.S. Treasury Bills when the market was declining, and then sold the U.S. Treasury Bills and reentered when the market was rising (Collins, n.d.), which, prime facie, seems very convincing explanation. Meantime, in the initial phase, all investors who invested in Madoff plan or gave money to Madoff to invest, got return as promised. Bernie told his father-in-law to do him a favor by collecting money from various investors and then give the total amount to Bernie as one account to invest. This also made it appear to the SEC as though he had fewer clients (Collins, n.d.). These arrangements are something that would never come into light in traditional auditing.

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Cressey's fraud triangle, Bernie and his co-conspirator's rationalization

Much of our contemporary understanding of preventative measures of fraud center

around the Fraud Triangle in which the three must-have elements of fraud engagement are incentives, opportunities and rationalizations (Azim & Azam, 2016). Cressey’s fraud triangle is based on the hypothesis that corporate frauds are more likely to occur when a person possesses three key factors of fraud triangle namely motivation or pressure to commit fraud, opportunities to implement it and rationalizations to excuse the fraud. The presence of all three elements will stimulate people to engage in fraudulent acts in which each element plays an equally important role. (Horacek,2019)

If we analyze Madoff personal life, correlating with Cressey's fraud triangle, he had all three components available. When comes the motivation element, the motivation is based on personal status and those needs could be determined by either the hunger to achieve or the fear of losing it (Azim & Azam, 2016). Madoff, at the age of 21 years before registering Bernard L. Madoff Investment Securities Company, decided that he, too, wanted to become rich working as a stockbroker (Collins, n.d.). This is clear indication that he had the hunger to achieve wealth at any cost. He had a pressure to earn a huge amount of money. On the other hand, Madoff faced the pressure of maintaining the reputation and profit of the firm so that the current investors continue with him as well as he can attract new investors. Similarly, the second element of the fraud triangle is opportunity, which is a perceived chance that fraud could be committed without being caught (Azim & Azam, 2016). Madoff was the head of the company, hence, had enough management power and authority to design the level of internal control and corporate governance. On the other hand, the corporate governance of the Madoff organization was compromised by having all the key players be members of Madoff’s family. His brother was the chief compliance officer. His nephew was the director of administration. His sons were directors. His niece was the general counsel and rules compliance attorney (Fuerman, 2009). Similarly, Madoff was appointed a non-executive chairman of NASDAQ and this position brought him considerable respect and trust from both investors and regulators (Azim & Azam, 2016). In this context, he could execute any plan without being questioned. When he won the trust of investors and they were investing or providing funds, Madoff was in better position (had opportunity) to use all these funds as per his decision

Now coming to the third element; rationalization. Rationalization is established to make an excuse for the fraudulent act (Azim & Azam, 2016). First of all, I think Bernie and his co-conspirators rationalized the fraud by putting a warning signs to potential investors who pursued him to invest their money. The warnings, that investing is risky and could lead to losses, were enough of a disclosure to get permission to take more money into the scheme (Pavlo, 2011). The other aspect is Madoff’s ultimate goal was to achieve his financial goal and he rationalized all his activities by acting in favor of him and his family, no matter who was paying (definitely, the investors). Further, Madoff rationalized that “it was their fault for trusting me” because not everyone was trapped by Madoff’s hedge fund and the investors who lost were the players joining the game at the very last second. Similarly, Madoff tried to justify his fraudulent engagement by persuading himself that the market was rigged anyway so if he had not done that, others would (Azim & Azam, 2016).

Probable SEC role to avoid (reduce or eliminate) financial and nonfinancial losses

Truly speaking, there was no actual investment in securities market and customer funds were never exposed to the uncertainties of price fluctuation, and account statements bore no relation to the United States securities market at any time. Bernie Madoff’s fraud resulted $65 billion financial loss which definitely paid for the perpetrators, their families, and their friends as well as a lot of people got rich during his long-running scam. Pension funds, retirement accounts, and children’s trust funds were worthless because of this scam. Philanthropic organizations had to cancel millions of dollars in promised or ongoing donations (Collins, n.d.). Many employees lost their jobs and trust of millions broken. It is also a fact that Madoff ended up in prison. In this context, if the Securities and Exchange Commission (SEC) had listened and taken necessary actions both financial and nonfinancial losses could have been avoided (reduced or eliminated, but the understaffed and underfunded SEC, which received a record 13,599 complaints in 2000, decided not to initiate an investigation of his complaint (Collins, n.d.). Markopolos explained his analysis presented in the 2000 complaint at a meeting at the SEC's Boston office and encouraged the SEC to investigate Madoff. After the meeting, both Markopolos and an SEC staff accountant testified that it was clear that the SEC's Boston District Office – BOD’s Assistant District Administrator did not understand the information presented. Our investigation found that this was likely the reason that the BDO decided not to pursue Markopolos' complaint or even refer it to the SEC's Northeast Regional Office (NERO) (Kotz, 2009). The other interesting part is most of SEC investigations, the company sent junior agents to corroborate Madoff’s earnings and verify the legitimacy of his operations (Howell, 2017) and senior officials at the SEC did not directly attempt to influence examinations or investigations of Madoff or the Madoff firm, nor was there evidence any senior SEC official interfered with the staffs’ ability to perform its work. This shows SEC did not play any role to uncover Bernard Madoff's Ponzi Scheme. If SEC had listened to Harry Markopolis the first time he informed them of his suspicions. The activities of Madoff would stop and what he did over a period of four years, like he deposited $21 million in Ruth’s account to pay for her Paris shopping sprees and a $2.8 million yacht. Bernie’s brother, Peter, purchased an expensive weekend home in the Hamptons for his daughter, and Bernie’s sons acquired a manufacturer of fly-fishing equipment, a sport they both enjoyed (Collins, n.d.), would never happened and the investors would never lose their future.

Madoff's Ponzi scheme vis-à-vis Mr. Ponzi's Ponzi scheme

Charles Ponzi was the originator of Ponzi scheme. Coalition of international postal services had begun selling postal reply coupons after World War I ended. Each coupon was good for one stamp in any of the affiliated countries; this allowed the mail services to continue operations smoothly despite the instability of most European currencies at the time. Ponzi reasoned that he could persuade investors to capitalize on the fluctuating currency prices by using the postal reply coupons in a series of exchanges. Instead of making legitimate trades, Charles Ponzi used money from his latest round of investors to pay those who’d purchased his ‘securities’ earlier. By convincing people to reinvest their funds he was able to postpone his financial obligations even longer (Patterson, 2009). Bernie Madoff followed almost same scheme but in different way. He deposited the client’s money in his own bank account. As more clients invested over the course of the year, the amount in Bernie’s bank account grew. If the client decided to redeem the entire investment on December 31, Bernie wrote the client a check for $1.2 million from the company’s bank account (Collins, n.d.). In this way, both Ponzi and Madoff used the same strategy, they never invested anything in real market but they used investment from later investors to pay earlier investor pretending they are earning.

If we see the differences between Mr. Ponzi and Madoff scheme, there are many differences. Madoff's Scheme occurred right under the Securities and Exchange Commission's nose. On multiple occasions they missed their chance to nab Madoff, even blatantly ignoring informants like Harry Markopolos. In contrast, Ponzi operated in a highly unregulated era, more than a decade before the SEC's formation in 1934. Madoff was private about his scam, preferring to target high net worth people/institutions and to use word of mouth via a tight network of financial intermediaries to gather money. In contrast, Ponzi took money from average people and just about anyone willing to give him a chance (DeLegge, 2012). Madoff’s scheme was very secret and his methods were 'proprietary', he never disclosed his investment strategy. On the other hand, Ponzi was very public about his scam and even bought newspaper ads promoting it. If we talk about return on investment, Charles Ponzi promised clients a 50% profit within 45 days, or 100% profit within 90 days. On the other hand, Madoff promised modest but steady returns through up and down markets. It is true that the modus operandi of Madoff was quite different. Bernie owned a successful and legitimate brokerage firm. He used the activities of his booming brokerage business to shield his fraudulent activities. Bernie’s auditor created fraudulent records to verify trades that never occurred. The most important fact here was, Madoff was an ex-Chairman of the NASDAQ and the CEO of a successful investing company, he was the ultimate Wall Street insider whereas Charles Ponzi was never in such position.

The accounting profession failed to learn lessons from Ponzi scheme

Many Ponzi schemes rarely start as a registered business, hence avoiding detection by regulators. Consequently, it is unlikely that regulators are able to stop Ponzi schemes in their early stages. Ponzi promoters take several steps to ensure information about their scheme is not leaked to the SEC. First of all, they keep their operations small in terms of human resources. They employ people they can trust who are unlikely to denounce them even after leaving. Second, Ponzi promoters publish little information about their operations. This lack of information makes it hard to uncover their fraudulent activities. They also ask their investors not to reveal anything to regulators as the promised high returns will be impossible to achieve under a regulatory watchdog (Jory & Perry, n.d.). The investors, who agree to take risk for a higher return, as well agree to conduct their business outside the shadow of regulatory bodies. On the other hand, those schemes are conducted preparing full documentation. Coming to Charles Ponzi’s Ponzi scheme, which was operated more than a decade before the SEC's formation in 1934, so we can say SEC never decided to implement any regulatory environment to protect from any such fraud by studying and learning from the history. SEC this attitude was also shown in Madoff’s Ponzi scheme where they never took initiations to investigate even after receiving complaints. On the other hand, other accounting bodies also might not went beyond their comfort zone to circle out how the fraudsters are using the loopholes to implement their fraud and misappropriate public money. I think this is the major reason, all regulatory bodies including accounting professional bodies waited another scam to complete.

Measures implemented to thwart financial schemes like Madoff’s Ponzi scheme

Madoff’s Ponzi scam taught many lessons to all regulatory entities. The major regulatory body who could play the major role to avoid the Ponzi scheme or might lower the losses if they would take proper steps, SEC, who ignore various complaints against Madoff and inspired Madoff dream big, definitely learnt the great lesson from this scheme. Post Madoff, they revamped the handling of complaints and tips. SEC implemented a centralized information technology system for tracking, analyzing, and reporting on the handling of the tips and complaints. In addition, the agency is working on a future system to apply data analytics to this information so the agency can be more proactive in detecting fraud. They restructured their organization to include national specialized units, focus on the key areas of Structured and New Products, Market Abuse, Municipal Securities and Public Pensions, Asset Management, and violations of the Foreign Corrupt Practices Act. In December 2009, the SEC adopted rules to better protect clients of investment advisers from theft and abuse by conducting surprise exam, third part reviews as well as encouraging registered investment advisers to place their clients' assets in the custody of an independent firm, unlike Bernard Madoff did.

References

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