Madoff Securities

Madoff Securities Case

Ponzi schemes are based on two fundamentals: trust and greed. The trust comes from building a relationship with the potential victims. Usually, in Ponzi schemes, the person perpetrating the fraud has gained trust through (a) direct, observable actions by others, (b) professional or other affiliations, or (c) through references by others. The greed comes from the investors who see an opportunity to obtain higher than usual gains, and because the trust is there, they do not perform their normal due diligence. Both trust and greed were prevalent in the Madoff scheme as described below.

In March 2009, Madoff pleaded guilty to 11 federal crimes and admitted to turning his wealth management business into a massive Ponzi scheme that defrauded thousands of investors of billions of dollars. Madoff said he began the Ponzi scheme in the early 1990s. However, federal investigators believe the fraud began as early as the 1980s, and that the investment operation may never have been legitimate. The amount missing from client accounts, including fabricated gains, was almost $65 billion. On June 29, 2009, he was sentenced to 150 years in prison, the maximum allowed.

A Ponzi scheme, named after the initial perpetrator, Charles Ponzi, who was arrested in the 1920s, is relatively simple: the perpetrator of the Ponzi scheme takes in money from investors and promises them a higher than normal rate of return. Because it is difficult to make such returns, the perpetrator needs to take in more money, and use some of that money to pay returns to the initial investors. Those investors can then “brag” about their returns to others.

Bernie Madoff built a veil of trust by running a legitimate brokerage firm, and at one time was the Chair of NASDAQ. He often appeared on CNBC talking about the securities industry. Madoff took advantage of his unique ties to the investment community to encourage further investment, but he always sold the idea of an investment into his company as one of “special privilege” (only special investors need apply.) He furthered the scheme by engaging some “finders” (other brokers) who were paid commissions to bring in more special investors. Obviously, the scheme can only work as long as the funds brought into the scheme in future years are sufficient to continue to pay all the previous investors. Ponzi schemes always become too big and collapse. However, until the collapse, Bernie Madoff led a lifestyle that can be emulated by only a very small group of the world’s richest people.

Madoff furthered the scheme by keeping all of the transactions off his formal books. He employed a CPA firm to audit the books, but the firm consisted of only one employee and there is no indication that the CPA firm ever visited Madoff’s offices or that any real audit was actually performed. However, note that the investors never asked for such audit reports. This is where the importance of greed plays a part. The investors felt they had a special thing going on (and some of the original investors did). They received significant returns for their investments. They trusted Bernie Madoff, and they let down their guard by not asking for typical due diligence information.

Trust and greed were both prevalent in the Bernie Madoff case. Ponzi schemes, when suspected, are not difficult to find. They require auditors to trace cash flows through the books. None of this took place in the case of Bernie Madoff. Although not verified, the rumor (as reported on a CNBC prime-time special) is that Madoff chose to surrender and plead guilty because one of the investors was the Russian mob and he feared for both his life as well as that of his sons. Madoff is currently serving his life sentence in federal prison, and one of his sons committed suicide two years after the fraud was revealed.

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