The Madoff Affair

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Introduction

• Bernard Lawrence "Bernie" Madoff (born April
  29, 1938) is an American former financier and
  convicted felon. Madoff, who once served as a
  non-executive chairman of the NASDAQ stock
  exchange, pled guilty to an 11-count criminal
  complaint, admitting to defrauding thousands of
  investors of billions of dollars. He was
  convicted of operating a Ponzi scheme that has
  been called the largest investor fraud ever
  committed by a single person.
• Federal prosecutors estimated client losses,
  which included fabricated gains, of almost 65
  billion. Other estimates of the fraud, excluding
  the fabricated gains, are 14-21 billion. On June
  29, 2009, he was sentenced to 150 years in
  prison, the maximum allowed

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• Madoff founded the Wall Street firm Bernard L.
  Madoff Investment Securities LLC in 1960, and was
  its chairman until his arrest on December 11,
  2008. The firm started as a penny stock trader
  with 5,000 (about 35,000 in 2008 dollars) that
  Madoff earned from working as a lifeguard and
  sprinkler installer. His business grew with the
  assistance of his father-in-law, accountant Saul
  Alpern, who referred a circle of friends and
  their families. Initially, the firm made markets
  via the National Quotation Bureau's Pink Sheets.
  In order to compete with firms that were members
  of the New York Stock Exchange trading on the
  stock exchange's floor, his firm began using
  innovative computer information technology to
  disseminate its quotes. After a trial run, the
  technology that the firm helped develop became
  the NASDAQ

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• Madoff founded the Wall Street firm Bernard L.
  Madoff Investment Securities LLC in 1960, and was
  its chairman until his arrest on December 11,
  2008. The firm was one of the top market maker
  businesses on Wall Street, which bypassed
  "specialist" firms, by directly executing orders
  over the counter from retail brokers.
• Madoff was a prominent philanthropist, who
  served on boards of nonprofit institutions many
  of which entrusted his firm with their
  endowments. The collapse and freeze of his
  personal assets and those of his firm affected
  businesses, charities, and foundations around the
  world, including the Robert I. Lappin Charitable
  Foundation, the Picower Foundation, and the JEHT
  Foundation which were forced to close.

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Ponzi Scheme

• Ponzi scheme is a scam investment designed to
  separate investors from their money. It is named
  after Charles Ponzi, who constructed one such
  scheme at the beginning of the 20th century,
  though the concept was well known prior to
  Ponzi.The scheme is designed to convince the
  public to place their money into a fraudulent
  investment. Once the scam artist feels that
  enough money has been collected, he disappears -
  taking all the money with him.

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Features of Ponzi Scheme

• The Benefit A promise that the investment will
  achieve an above normal rate of return. The rate
  of return is often specified. The promised rate
  of return has to be high enough to be worthwhile
  to the investor but not so high as to be
  unbelievable.
• The Setup A relatively plausible explanation of
  how the investment can achieve these above normal
  rates of return. One often-used explanation is
  that the investor is skilled and/or has some
  inside information. Another possible explanation
  is that the investor has access to an investment
  opportunity not otherwise available to the
  general public.

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Features of Ponzi Scheme (Contd.)

• Initial Credibility The person running the
  scheme needs to be believable enough to convince
  the initial investors to leave their money with
  him.
•  
• Initial Investors Paid Off For at least a few
  periods the investors need to make at least the
  promised rate of return - if not better.
•  
• Communicated Successes Other investors need to
  hear about the payoffs, such that their numbers
  grow exponentially. At the very least more money
  needs to be coming in than is being paid back to
  investors.

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Steps in the Ponzi Scheme

• Convince a few investors to place money into the
  investment.
• After the specified time return the investment
  money to the investors plus the specified
  interest rate or return.
• Pointing to the historical success of the
  investment, convince more investors to place
  their money into the system. Typically the vast
  majority of the earlier investors will return.
  Why would they not? The system has been providing
  them with great benefits.
• Repeat steps 1 through 3 a number of times.
  During step 2 at one of the cycles, break the
  pattern. Instead of returning the investment
  money and paying the promised return, escape with
  the money and start a new life.

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Firm
Investors

• The investors give money to the Firm
• The Firm gives back money to the investors with
  returns

Graphical Working of Ponzi Scheme
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• This way the firm makes its first set of
  customers
• These customers spread the word to other
  potential investors

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• These new investors invest in the firm and
  receive returns

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• Newer set of customers is made
• The investors again refer a newer set of
  investors
• This is how the funds of the firm increase

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• The complete events of the Company can be broken
  down into 2 main Phases,
• Phase I (1960-1992)
• Phase II (1992-2008)

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Phase I

• 1960
• Madoff started career in his father's accounting
  firm in NY as a market maker
• He Also had a side business as an investment
  advisor
• It was completely off the radar, that is it
  wasn't registered
• He basically started small, with a handful of
  closely known people, promising a return of
  around 14-20, depending on the investment

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• Brought In two accountants from his
  father-in-laws firm, Frank Avellino Michael
  Bienes
• They handled the funding part, taking small
  percentage of the total funds
• Interestingly, the firm had their name. That is
  it was called Avellino Bienes Co.
• The initial investors had not heard of Madoff at
  all
• Mid 80s
• Avellino Bienes share reached 10 million per
  year

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• 1992
• SEC (Securities and Exchange Commission )
  Launched an investigation after a complaint from
  an Investment advisor, suspecting a Ponzi scheme
• Above 3000 clients were being served
• By November 1992, SEC ordered shutting doing the
  Co.
• Avellino and Bienes paid back all the investors
  money
• End of Phase I

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Phase II

• 1992
• Madoff took over the company in public
• Michael D Sullivan took 30 accounts of Avellino
  and Bienes in the firm
• Avellino Bienes themselves invested their
  personal money with Madoff

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• Mid 90s
• By now Madoff had Bigger players in his scheme,
  Private banks had started to pool in money
• The family of the investors did the marketing
• It had started being marketed to the wealthiest
  and famous people all around the world
• Conditions implied to customers
• Funds were forbidden from Listing Madoff as
  investment advisor
• Madoffs firm was still unregistered with SEC,
  although serving thousands of investors

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• Marketing
• Madoff showed his investors his office
• The office had a nice ethical working standard
• Madoff also used his name as part of marketing as
  he was one of the most respected and influential
  people on Wall Street
• Madoff did well till 2008. In 2008, almost 1/3rd
  of all Geneva fund managers had invested with
  Madoff

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How did it collapse?

• In 2007 after the Housing bubble burst, most of
  the companies in the market allowed its
  investors to withdraw money or were simply shut
  down
• By December of the same year, There were more
  requests of withdrawals in the firm than deposits
• This was because most of the investors needed
  money to pay their own customers and/or to run
  their own business
• The firm was unable to pay the customers and the
  scheme came to light

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• The 2 main rules of Ponzi scheme are
• To have newer customers
• There is no sudden outflow of customers
• These rules are put to a shock test whenever
  there is a downfall in the market
• Finally on December 10 2008 Madoff confessed to
  his 2 sons about his funds being a Ponzi scheme
  and the next morning the FBI were at his doorstep
• He was later granted a sentencing of 150 years,
  being accused of Fraud and 8 other cases

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Catches

• Even before the SEC busted the scheme, there
  were a lot of obvious catches which, if had been
  taken into consideration at the right time by the
  SEC, could have prevented this from happening.
  They are as follows
• The company being Unregistered although serving
  thousands of customers
• There was always a steady rate of return even if
  the market goes up or down
• The statements sent to customers was always given
  in printed form and were never available online

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Catches (Contd.)

• Statements were set to customers 3-5 days AFTER a
  deal in the market was made, resulting in
  foresightedness. e.g. Betting on a horse race
  AFTER it has begun
• Statements showed names of firms whose names had
  changed and were not open to new investors
• If customers complained on any of the above
  issues, the firm would threaten to return back
  the money

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Catches (Contd.)

• The 3rd party Due Diligence (Auditor) officer had
  his office in Bermuda, a place not known for
  having such offices
• Whistle Blowers Like Marco Polo published these
  facts in 2001 but SEC did not act accordingly
• Steady flow of letters were doing the rounds to
  SEC office regarding Madoff

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• In 2006 SEC finally launched an investigation
  into the matter
• Following are SECs responsibilities which
  should have been checked
• SEC should have checked if the firm was
  registered or not
• Should have proactively taken the initiative to
  check on the firm of its funds
• Even after the warnings from whistleblowers, the
  SEC should have swiftly acted on the situation

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Sources

• Websites
• http//economics.about.com/od/financialmarkets/f/p
  onzi_scheme.htm
• http//en.wikipedia.org/wiki/Madoff
• Documentary
• PBS Frontline - The Madoff Affair

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Thank You