The Fraudulent Scheme Of Madoff: A Deep Dive Into The Ponzi Scheme

How Madoff Lured Investors

Discuss about the Fraudulent Scheme of Madoff.

Bernie Madoff adopted the Ponzi scheme concept to lure investors into his company, Bernard L. Madoff Investment Securities LLC (BLMIS), by promising an unusually high return on their investments. Madoff acquired his clients’ assets, then transferred the money into his accounts and mailed fictitious statements to his clients to hide his subterfuge (Rimkus 2017). When Madoff’s clients withdraw their funds, he uses the capital obtained from new investors to pay out the redemptions and the cycle continues. Arguing from a marketing standpoint as noted by Arvelund (2009) and Campos (2009), Madoff sold his financial product to customers as in the form of a hedge fund with promises of consistently good performance irrespective of the prevailing market conditions. He used a business strategy that included both long and short positions thereby making his claim to be plausible (Kirtzman 2010; Bernard and Boyle 2009). The scheme also managed to operate for decades based on the fact that Madoff rarely met with his investors and he did not divulge any form of information that regards the organization’s business transactions. In this sense, he used split-strike conversion investment strategy (Pozza Jr, Cox and Morad 2009). 

The fear for the 2008 global financial crisis resulted in financial panic among most investors, and this made most of Madoff’s investors to request for their redemptions. The company received a high number of redemption requests amounting to $7 billion, and Madoff could not successfully pay these redemptions as he could not bring in additional funds from new investors.

The U.S Securities and Exchange Commission (SEC) carries out its operations in a three-part mission; and these are protecting investors, maintaining a fair, orderly and efficient financial market and also facilitating capital formation (US SEC 2009). From another article by Fishman (2011), the author provides that one of the primary responsibilities of SEC is to ensure the legality and transparency of business practices with regards to their accessibility to their stockholders and the public. This organization, therefore, police how businesses conduct their transactions and how they regulate themselves in the market; focussing primarily on the irregularities in their stock transactions to expose any operation that is financially improper according to market regulations (Poser 2008; Fisch 2009). In general, this organization was created to protect consumers from corporate malfeasance and industrial greed. 

With regards to Madoff’s fraud case, SEC is accused of negligence to take action on the several initial warnings that were brought to its attention by both internal and external individuals who detected illegal dealings at the company.  The organization’s Chairman, Cox, indicated that there were massive failures within the agency in investigating what is regarded as one of the largest Ponzi schemes in America history (Chung 2008). One of the allegations brought against SEC was the fact that the commission received numerous credible and specific allegations against Madoff’s financial crimes from as early as 1999, but there was no recommendation for action. This indicates a sense of negligence on the part of the commission for failure to fully carry out their mandate. Also, the failure of the Agency to seek formal authority to investigate Madoff’s company shows a failure on its part to use the subpoena power to gather information on Madoff (Markopolos 2011). However, as indicated by SEC’s chairman, the agency entirely relied on the voluntary information that was produced by Mr. Madoff and his organization; and these were heavily falsified to hide the ruse that the firm was a Ponzi scheme.

Exposure of the Ponzi Scheme

Another accusation against SEC’s failure to investigate Madoff’s financial crimes was levied by an external individual, senior fellow at the Millstein Center for Corporate Governance, who indicated that the investors’ advocate missed the signs provided on Madoff. Mr. Davis indicated that some of the warnings that SEC would have based their investigations included the company’s caginess about the information it was disclosing to authorities and the claim that it was a small auditor firm (Markopolos 2009; Pickhardt and Prinz 2012).

In an article by Taibbi (2013), the author notes that SEC also failed to grant permission to their officials to pursue investigations against Madoff’s firm. Kathleen, who was an official at SEC tried to press for an investigation against the Ponzi scheme, but her superiors repeatedly thwarted her efforts with claim’s that the organization are not to investigate investment management companies (Taibbi 2013).  Miss Kathleen’s allegations against the company provided shed light on SEC’s snubbing the efforts of Harry Markopolos who provided incontrovertible evidence accusing the company of their financial wrongdoings. The financial regulatory role of SEC is pegged on four primary roles among which are the Investment Advisers Act of 1940 and the Investment Company Act of 1940. These laws are tools that the agency uses to prosecute those involved in fraud and malfeasance when managing other people’s money in the form of hedge funds, mutual funds and even investment managers (Taibbi 2013; Fingleton 2013). Despite the presence of these securities laws, the superiors at SEC refused to take actions on the allegations brought to their attention regarding any investment company. The agency was to use these laws as the tool to initiate an investigation into Madoff’s affairs and regulate his financial activities to prevent fraudulently stealing money from his customers.

SEC has strict rules that prohibit any staff from participating in those matters that the staff has a personal interest (Chung 2008). However, it is noted that Mr. Erick Swanson, Mr. Madoff’s niece took part in the examination that looked into the dealings of Madoff between 1999 and 2004 and this might have contributed to non-disclosure and transparency within the company. Additionally, Madoff was believed to keep numerous books of accounts with false documents which provided misleading information to both regulators and investors, and this, therefore, duped the authorities into believing that the company was legal.  In the article by Chung (2008), the author provides that between 2005 and 2007, SEC conducted an intensive inquiry into Madoff’s firm which revealed three financial violations, however, upon completion of the probe in 2007, the team failed to refer the findings to the SEC commissioners for action. This act, therefore, indicated a significant failure on the part of the organization in being unable to carry out its responsibilities effectively as provided by law.

Role of SEC and Allegations Against SEC

The events on 2008 which were instigated by the fear for the global financial crisis subjected Madoff’s organization into looming financial bankruptcy as many investors withdrew their funds from the company more than Mr. Madoff could afford since the money was not invested anywhere. Upon his confession to sons and wife, Mr. Madoff was arrested on suspicion that he operated a Ponzi scheme which duped investors and stole their money (Maglich 2013; Stolowy et al. 2014). The company’s assets were then frozen to help recover the amount that the firm stole from a vast number of investors with promises of constant high returns and low risks on their investments. A federal court further orders the freezing of Madoff’s assets and appointment of a receiver to take control of his company. After an investigation, Madoff is charged with eleven accounts of felony cases which included perjury, money laundering, fraud and false filings with the SEC; he was sentenced to 150 years upon pleading guilty and indicating that he was acting alone and therefore was responsible.  

The discovery of Madoff’s Ponzi scheme further initiated other investigations and lawsuits on some of the financial institutions who conducted businesses with Madoff and these included banks and behemoths such as HSBC, UBS and JP (Maglich 2013). These institutions were accused of being willfully blind to the firm’s fraud practices irrespective of the several red flags that were produced by different whistle-blowers.

Despite the magnitude of their crime of negligence with regards to Madoff’s case, SEC did not fire its employers who were either directly or indirectly involved in the Ponzi scheme. In an article by Ackerman (2011), it is pointed out that the organization disciplined its workers who participated in handling the $50 billion Madoff’s fraud. This repercussion is quite minimal as compared to the effects that the scheme had on Mr. Madoff and his family whose assets were liquidated. This point is emphasized by O’Toole (2011) who noted that the agency disciplined eight of its workers for negligent failure to detect the fraudulent activities at Madoff’s Ponzi scheme. This incident subjected SEC to public embarrassment for failure to carry out their activities effectively as mandated by law and letting the Ponzi scheme operated for over three decades. Some of the punishments that SEC workers were subjected to range from; pay reductions, suspensions, and counseling after analysis of each of the individual roles in the saga.

Consequences Faced by Madoff Compared to SEC Employees

SEC also suffered from the legal lawsuit as noted in an article by Dealbook (2009) where it is noted that two victims of the Madoff’s Ponzi scheme sued SEC for failure to detect the fraud and illegal financial dealings by Madoff several years before the investors incurred the huge losses on their investments.  Most of the victims pointed out that they would not have fallen victims of the scheme if the agency had effectively done its regulatory and investigative role (Dealbook 2009). Despite the magnitude of the effects on SEC, they were less severe as compared to the repercussions that befallen Mr. Madoff as no employee of SEC was either fired or jailed with regards to the case.

References

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Arvelund, E., 2009. Too Good to Be True: The Rise and Fall of Bernie Madoff. New York: Portfolio.

Bernard, C. and Boyle, P.P., 2009. Mr. Madoff's amazing returns: An analysis of the split-strike conversion strategy. Journal of Derivatives, 17 (1): pp. 62–76.

Campos, J.J., 2009. Avoiding the Discretionary Function Rule in the Madoff Case. Loy. L. Rev., 55, p.587.

Chung, J., 2008. SEC chief admits to failures in Madoff case. Financial Times. https://www.ft.com/content/92bd4c68-cbd7-11dd-ba02-000077b07658. (Accessed May 22, 2018).

Dealbook, 2009. S.E.C Sued Over Madoff Fraud. The Year York Times https://dealbook.nytimes.com/2009/10/14/suit-accuses-sec-of-failing-to-detect-madoff-scheme/ (Accessed May 22, 2018)

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Fisch, J.E., 2009. Top Cop or Regulatory Flop? The SEC at 75. Virginia Law Review, pp.785-823.

Fishman, S., 2011. The Madoff Tapes. New York Magazine. https://nymag.com/news/features/berniemadoff-2011-3/. (Accessed May 22, 2018).

Kirtzman, A., 2010. Betrayal: The life and lies of Bernie Madoff. Harper Collins.

Maglich, J., 2013. Madoff Ponzi Scheme, Five Years Later. Forbes. https://www.forbes.com/sites/jordanmaglich/2013/12/09/madoff-ponzi-scheme-five-years-later/#6e06b8ff1b76. (Accessed May 22, 2018).

Markopolos, H., 2009. FDCH congressional testimony: Madoff Ponzi scheme and regulatory failures. https://www.gpo.gov/fdsys/pkg/CHRG-111hhrg48673/pdf/CHRG-111hhrg48673.pdf. (Accessed May 22, 2018).

Markopolos, H., 2011. No one would listen: a true financial thriller. Hoboken, NJ: John Wiley & Sons.

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Pozza Jr, C.L., Cox, T.R. and Morad, R.J., 2009. A Review of Recent Investor Issues in the Madoff, Standford and Forte Ponzi Scheme Cases. J. Bus. & Sec. L., 10, p.113.

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Stolowy, H., Messner, M., Jeanjean, T. and Richard Baker, C., 2014. The construction of a trustworthy investment opportunity: Insights from the Madoff fraud. Contemporary Accounting Research, 31(2), pp.354-397.

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