Bernie Madoff - How To Avoid A Ponzi Scheme
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. The $50 Billion Bernard Madoff Ponzi Scheme
2. Bernard Madoff’s Career History
3. The Money Management Arm Of Madoff
5. How Could Regulators Have Missed This One?
By now I suspect that virtually everyone reading this has heard of Bernard Madoff, the New York broker-dealer owner/investment manager who was arrested by the FBI on December 11 and charged with securities fraud and allegedly losing and/or absconding with an estimated $50 billion in investor monies. Madoff reportedly told FBI investigators that his money management business was essentially a Ponzi Scheme and that the money is all gone.
If the Madoff number is remotely in the neighborhood of $50 billion, or even $30-$40 billion, it will be the largest Ponzi Scheme in history. Most investors are at least somewhat familiar with the term Ponzi Scheme, yet some of the largest investors in the world bit on this one despite numerous warning signs and red flags that were largely ignored.
This week, we will look into the Bernie Madoff debacle with the express purpose of pointing out how the colossal swindle took place. While I assume that none of our clients were caught up in the Madoff scandal, it nevertheless serves as a good example of how to spot investment schemes and fraud.
Most importantly, the Madoff scandal emphasizes how important it is to have an independent, experienced third-party Advisor on your side of the table, doing the thorough due diligence for you when it comes to selecting where to place your hard-earned money.
In the pages that follow, I will outline the Madoff scandal, how it came to pass despite the usual regulatory scrutiny, and finally point out the warning signs you should always look for. Let’s get started, and I suggest you read this carefully.
The $50 Billion Bernard Madoff Ponzi Scheme
To begin this sad and pathetic story, let’s start with a brief explanation of a Ponzi Scheme. Such scams date back hundreds of years, though they derived their current name from a swindler named Charles Ponzi in the early 1900s. The basic premise is one of raising lots of money based on the promise of high returns. But the promoters simply use money coming in from new investors to pay older investors who want or need their money back. Typically, the promoters siphon off the money and create ficticious account statements showing impressive returns. In such schemes, there is often no real investment strategy, or “black box” trading system.
Invariably, some problem always arises – usually a bear market as in this latest case, along with the global credit crisis. At some point, investors want their money back, even if the supposed returns still look good. As a result of the latest financial crisis, investors in Bernie Madoff’s funds reportedly sent in redemption requests of over $7 billion in the fall of 2008. And that is when Madoff’s giant Ponzi Scheme came to a screeching halt.
Let’s go through the background, and then highlight the warning signs we should all keep in mind, especially when the investment returns appear too good to be true.
Bernard Lawrence Madoff (age 70) is a businessman and former chairman of the NASDAQ stock market. He started the Wall Street firm Bernard L. Madoff Investment Securities LLC in 1960 and was its chairman until December 11, 2008, when he was arrested and charged with securities fraud.
Bernard L. Madoff Investment Securities, which is in the process of liquidation, was one of the top “market maker” businesses on Wall Street (reportedly the sixth-largest in 2008), often functioning as a “third-market” provider that bypassed normal specialist firms and directly executed orders over-the-counter from retail brokers. Madoff’s company also included an investment management and advisory division that is now the focus of the fraud investigation.
On December 11, 2008, FBI agents arrested Madoff on a tip-off from his sons, Andrew and Mark Madoff, and charged him with one count of securities fraud. On the day prior to his arrest, Madoff reportedly told his senior executives at the firm, including his two sons, that the money management and advisory division of the business was “basically, a giant Ponzi scheme.” Five days after his arrest, Madoff’s assets and those of the firm were frozen and a receiver was appointed to handle the case. Madoff’s alleged fraud is estimated at a loss of up to $50 billion in cash and securities. Several large banks outside the US have reportedly announced that they have lost billions as a result of the Madoff scam. To date, it is the largest investor fraud ever attributed to a single individual.
Bernard Madoff’s Career History
According to various sources, Bernard Madoff started his firm in 1960 with an initial investment of $5,000 that he said was earned from working as a lifeguard and installing sprinkler systems. At first, the firm made markets (quoted bid-ask prices) via the National Quotation Bureau’s “Pink Sheets.” In order to compete with firms that were members of the New York Stock Exchange, Madoff’s firm began to use computers and information technology to electronically disseminate its quotes and set itself apart from competitors.
Over time, the technology Madoff’s firm helped develop essentially became the NASDAQ stock exchange. These technologies allowed the advent of online trading and online brokers, such as Ameritrade and Charles Schwab. At one point, Madoff Securities was reportedly the largest “market maker” at the NASDAQ, both buying and selling.
Madoff was active in the National Association of Securities Dealers (NASD), a self-regulatory organization for the US securities industry. (The NASD recently changed its name to the Financial Industry Regulatory Authority, or FINRA.) Madoff’s company was one of the most active firms in the development of the NASDAQ exchange, and he served as its chairman of the board of directors, and on its board of governors for several years in the 1990s.
The brokerage/market maker side of Madoff Securities reportedly flourished in the 1980s and 1990s. The firm, which eventually occupied three floors in the ManhattanLipstickBuilding, was considered to be one of the top traders of securities in the nation during the 1990s. As far as we can tell, Madoff’s market making and brokerage activities were legitimate, and proved to be a source of wealth for him. Thus, it’s even harder to understand why someone who enjoyed such success on Wall Street felt it necessary to swindle others out of their hard-earned savings.
The Investment/Money Management Arm Of Madoff
Details are still a bit sketchy but it appears that, in addition to brokerage/market maker activities, Madoff began to act as a money manager in the early 1970s, reportedly specializing in “convertible arbitrage” and related option strategies in large-cap stocks. At some point, Madoff moved his money management operation to a separate floor in the LipstickBuilding, with a separate staff from the brokerage arm. In the early years, Madoff reportedly promised returns of 18-20% per annum. It has been reported that Madoff’s money management business started mainly with investments from family and close friends.
In the 1980s and 1990s, however, Madoff solicited investments from supposedly sophisticated investors around the world, including investment banks, trust managers, hedge funds and even large charities. Madoff also raised billions in the New York Jewish community, of which he was a member, as well as in several prominent East Coast country clubs.
Madoff also solicited investments from other high profile Jews around the country. His Jewish clients included film producer Jeffrey Katzenberg, Former New York State Governor Eliot Spitzer, Hollywood film director Steven Spielberg, well-known publisher Mort Zuckerman and J. Ezra Merkin, whose fund Ascot Partners steered $1.8 billion USD towards Madoff's firm – just to name a few.
Madoff also solicited investments from Jewish institutions including YeshivaUniversity, the Elie Wiesel Foundation, and various other Jewish charities. A scheme like this that targets members of a particular religious or ethnic community is a type of “affinity fraud,” which I have written about often in the past.
Madoff’s allure was his promise of steady positive monthly returns and his reports of annual returns in the 10-12% range, even in the bear market which unfolded in 2000. Federal investigators now claim that those reports to investors and prospective investors were fraudulent.
It is not yet clear exactly when Madoff began the Ponzi Scheme. What appears to be clear is that at some point, Madoff either lost the clients’ money in the markets, or absconded with it, or some combination of both. A Wall Street Journal article published in late December concluded that Madoff’s Ponzi Scheme had been going on for at least 17 years. Over that period of time, it is alledged that Madoff falsified customer account statements with phoney numbers that indicated steady positive returns. But since Madoff was both the investment manager and broker-dealer, there was virtually no way for investors to verify that their statements were accurate.
When Madoff supposedly confessed to his two sons about the giant Ponzi Scheme, he reportedly told them that at least $50 billion was lost. Some of the investigators now think the number may be closer to $30 billion, with the other apprx. $20 billion representing fake profits that never existed. Again, it remains to be seen if the money was lost in the markets, or if Madoff has much of it stashed away in offshore accounts. If convicted, Madoff likely faces up to 20 years in prison (effectively a life sentence at his age) and fines of $5 million or more.
Investigators are also looking into whether Madoff’s brother Peter and his two sons, all of which worked in the brokerage/market making division of Madoff Securities, had any prior knowledge of the massive Ponzi Scheme. In order to invest with Madoff in more recent years, clients had to invest in one of the many feeder funds managed by Madoff or open managed accounts with Madoff Securities, which has reportedly been largely managed by Peter Madoff and Bernie Madoff’s two sons.
It is hard to fathom how the principals of the brokerage arm could not know that Madoff was alledgedly draining tens of billions of dollars out of customer accounts for years and creating falsified account statements showing that, not only was the clients’ money there, but also that it was gaining 10-12% or more year after year with no losses. Yet the two sons who tipped off federal investors claimed that they had no knowledge of their father’s giant Ponzi Scheme until he admitted it to them earlier this month.
Madoff’s Supposed Investment Strategy
Since Madoff’s investment management started back in the 1970s, there is little doubt that his investment strategies have changed and evolved over the years. The advent of stock index futures and options in the early 1980s brought more changes to Madoff’s strategy. Since then, Madoff has represented that he invests in a stock and option strategy known as “split-strike conversion,” a strategy that is well-known to most professional options traders.
In 2001, the Offering Memorandum (prospectus) for a Madoff-managed feeder fund described his investment strategy as follows: “Typically, a position will consist of the ownership of 30–35 S&P 100 stocks, most correlated to that index, the sale of out-of-the-money calls [options] on the index and the purchase of out-of-the-money puts on the index. The sale of the calls is designed to increase the rate of return, while allowing upward movement of the stock portfolio to the strike price of the calls. The puts, funded in large part by the sale of the calls, limit the portfolio’s downside.”
However, Madoff’s split-strike conversion, or “collar trade,” strategy as described above is not a perfect hedge since options are purchased/sold on an index which contains a much larger basket of stocks than the 30–35 purchased to hold. In any event, Madoff’s strategy was well-known in the industry, especially among professional options traders. However, reportedly no one else in the industry could consistently generate the kind of returns Madoff claimed.
Over the years, several analysts performing due diligence on Madoff did raise alarms because they were unable to replicate Madoff’s past returns using historic price data for US stocks and options on the indexes. Of course, there is no credible evidence that Madoff actually made all the required trades dictated by this particular strategy, and Madoff refused to discuss his actual investment strategies in detail other than as described above.
Financial analyst Harry Markopolos complained to the SEC’s Boston office in May 1999, telling the SEC staff they should investigate Madoff because it was impossible to legally make the profits Madoff reported using the investment strategies that he claimed to use. In 2005, Markopolos reportedly sent a detailed 17-page memo directly to the SEC, entitled “The World's Largest Hedge Fund is a Fraud.”
There were other warning signs that many investors ignored. For one thing, Madoff's company avoided filing required disclosures of its holdings with the SEC; it did so by selling all of its holdings for cash at the end of each reporting period. Such a tactic is highly unusual, and one would think the SEC would have questioned this practice.
Also, Madoff’s use of a small accounting firm, Friehling & Horowitz, which has only one active accountant, is also highly unusual. Friehling & Horowitz claims that it never did any audits for Madoff and that it doesn’t conduct audits for anyone. So here you had one of the largest investment programs in the world, yet it was not audited, and reportedly no audits were ever issued to clients or prospective clients. Yet billions and billions flowed to Madoff. Given the size and sophistication of Madoff’s larger clients, their failure to demand annual audits from a nationally recognized accounting firm simply baffles me!
How Could Regulators Have Missed This One?
Oddly, Madoff appears to have operated below the radar screens of the SEC and various other regulatory agencies for many years. Perhaps this was because of Madoff’s very high Wall Street profile and his service as co-founder, board chairman and governor of the NASDAQ for several years in the late 1980s and early 1990s.
In 1992, the SEC reportedly investigated one of Madoff’s feeder funds, Avellino & Bienes, which invested solely with Madoff. Avellino & Bienes was accused of selling unregistered securities, and in its report the SEC mentioned the fund’s “curiously steady” reported yearly returns to investors; however, the SEC apparently did not look any more deeply into the matter. Avellino shut down in 1993, with investors receiving their money back. At the time, Madoff said that he didn’t realize the feeder fund was operating illegally. In that investigation, the SEC did not publicly name Madoff because he was not accused of wrongdoing.
The SEC said it conducted two inquiries of Madoff in the last several years and did not find major problems. An SEC statement detailed that inspectors examined Madoff’s brokerage operation in 2005, finding only three violations of rules requiring brokers to obtain the best possible price for customer orders. In 2007, SEC enforcement staff reportedly completed another examination of Madoff Securities and found no serious violations and thus did not refer the matter to the SEC commissioners for legal action.
I find this baffling! My company, Halbert Wealth Management, is a Registered Investment Advisor with the SEC. We have been through a routine examination by the SEC. Our broker-dealer firm, ProFutures Financial Group, has been through multiple routine examinations by the National Association of Securities Dealers (NASD), and more recently FINRA, the successor to the NASD – both of which are/were regulatory agencies chartered specifically to enforce SEC rules and regulations governing the securities markets.
I can tell you that these routine regulatory examinations – at least among smaller firms like mine – are rigorous. They typically have 2-3 examiners in our offices for up to two weeks at a time looking at all of our books, records, bank accounts, brokerage accounts, client files and correspondence, marketing materials, etc., etc. If my company was running a Ponzi Scheme, or stealing customer monies, I feel confident that the regulators would have caught us upon the next regularly scheduled examination.
So why not Madoff? My company is a relatively small SEC regulated firm. Our client assets under management pale in comparison to Madoff Securities which had tens of billions under management. Frankly, I have NO CLUE how the SEC failed to discover Madoff’s giant Ponzi Scheme in its various examinations.
BusinessWeek magazine had the following to say in an article published on December 18:
Interestingly, in the wake of the Madoff scandal most of the attention has been focused on the SEC and how this federal agency failed to detect the giant Madoff Ponzi Scheme. I find it interesting, however, that very little has been said about the failure of the National Association of Securities Dealers (NASD) to detect Madoff’s huge scandal. The NASD and its successor the Financial Industry Regulatory Authority (FINRA) also failed to detect the huge Madoff fraud.
This is most surprising since the NASD/FINRA is a securities industry “self-regulatory” agency that conducts more frequent examinations of securities firms and broker-dealers. As noted above, my firm has been examined several times by these self-regulatory agencies, and our experience is that they are very thorough, especially when it comes to accounting for all the client monies. So I remain very surprised that the NASD didn’t catch on to Madoff years ago.
Lessons To Be Learned From The Madoff Fiasco
Where to begin? A lot of very smart and very rich people were duped by Bernie Madoff, along with lots of other investors who were not wealthy or sophisticated. Investors like Steven Spielberg and Jeffery Katzenberg won’t likely see their lavish lifestyles change dramatically as a result of the Madoff swindle. Others, however, invested all or most of their retirement savings with Madoff, and their world has been turned upside down. They are now in panic mode.
So, the first lesson to be learned from the Madoff fiasco takes us to the old adage: If something sounds too good to be true, it probably is. At the risk of oversimplication, a stock market investment program that claimed no losing years for at least 17 years, and only 4-5 losing months during that same long period of time, should have made people wonder if it could be true. At the least, investors should have demanded more documentation from Madoff.
At Halbert Wealth Management, we are in the business of finding and evaluating profesional money managers. I have been evaluating money managers for over 25 years. What follows is a brief review of our “due diligence” process when we consider a money manager.
1. We never settle for published or advertised track records. Performance must either be verified by a reputable third party performance reporting entity, or if not, we insist on sampling actual account statements from a third-party custodian or brokerage firm to verify the numbers.
2. Double check account statements provided by the Advisor. We insist that any statements from the Advisor are also supplemented with statements from a third-party custodian, mutual fund company or brokerage firm. Advisor statements can sometimes provide clarification, but should never be the only source of performance and trading information in the program.
3. The manager must have his/her own money in the program. We require our third-party money managers to disclose how much of their own money they have in the investment programs they manage. If they don’t manage some of their own money, why should we trust them to invest our clients’ money?
4. The custodian or brokerage firm must not be affiliated with the Advisor. This is a big part of why Bernie Madoff was able to get away with so much, since he wore all of the hats in the transactions.
5. Conduct an on-site due diligence visit in the Advisor’s office. We physically visit most Advisor candidates to see their operation, meet their staff members, gauge their backup plans, etc., etc. If an Advisor is a one-man shop, we may have them come to Austin to meet with our staff. These on-site trips are very expensive, especially since we usually send two members of my staff, but they are well worth it. We have had instances when the due diligence trip revealed problems that would not have been discovered otherwise.
6. Question the Advisor about affiliated business relationships and personal issues. Unrelated business issues as well as personal issues may affect an Advisor’s ability to manage money effectively. (Hint: We ask some tough questions and demand answers.)
7. Understand as much as you can about the investment strategy. Advisors may understandably be reluctant to discuss the details of their proprietary system. However, they should be able to divulge enough information so that you can understand generally how the system works without giving away the “black box.”
8. Open a test account with real money to monitor the program. Whenever possible, we open a trading account prior to making a final decision and recommendation to our clients. This allows us to monitor trading activity and compare our results to the Advisor’s published performance information on a “real-time” basis.
9. Finally, we never perform a lesser amount of due diligence on a money manager simply because they are large and successful. There’s little doubt that Madoff’s “rock star” status on Wall Street allowed him to attract investors, and possibly even minimize due diligence scrutiny. After all, who would dare question the great Bernie Madoff? We would.
In fact, we just recently did a follow-up due diligence trip to an Advisor we have recommended for years, even though they manage over $1 billion in client assets and have a very good reputation in the marketplace. We do these follow-up trips with our Advisors on a periodic basis, just to make sure that we are familiar with any changes that may have been made since our last on-site visit.
Be sure to keep in mind that a due diligence review is simply a snapshot of the Advisor’s situation at a given point in time. There is never any guarantee that the favorable business practices discovered in a due diligence review will continue into the future. Thus, we also monitor performance and trading on a daily basis for every program we recommend in order to determine if the Advisor is performing per our expectations and understanding of the strategy employed.
We do all the above, plus we also remain in frequent contact with each Advisor via e-mail and telephone discussions and conduct periodic follow-up due diligence reviews to update our files.
Unfortunately Most Investors Can’t Do All Of This
Most investors do not have the time, money, knowledge and experience to conduct the level of due diligence described above, which is probably why many of Madoff’s clients relied on word of mouth or reputation to make a decision. It is also precisely why it is wise to have an independent third party on your side of the table.
Not only do we perform the extensive due diligence noted above, and monitor each Advisor on a daily basis, but we also will not hesitate to “unrecommend” a money manager if the performance does not live up to expectations or other troubling developments occur. This is very important. Why? Because most money managers would never tell you to fire them. We will!
I hope this discussion on due diligence has been helpful to you, especially in light of the Bernie Madoff disaster. You can never be too careful! Since I began writing this E-Letter over six years ago, I have stressed the need for actively managed strategies in your portfolio – strategies that can move to cash or “hedge” positions with the goal of reducing losses in bear markets.
At times like this, I think it’s also important to stress the due diligence process Advisors go through before we ever introduce them to you. As we enter 2009, there will be many money managers claiming to have beaten the market in 2008. Some will be legitimate, and others will not, so it’s important to have someone on your team who can help separate the wheat from the chaff.
In light of the major bear market we are now in, maybe it’s time to consider the actively managed programs I recommend. If you agree, give us a call at 800-348-3601 or visit us at www.halbertwealth.com.
Wishing you profits,
Gary D. Halbert
Business Week – “Madoff – What a Week”
Q&A Overview of the Madoff Scandal
Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.