Executive Summary
People who work at managerial levels may commit fraud. Such people have interests in the operations of organizations. They anticipate increased earnings and personal gains with time. They engage in fraud to secure financial resources at the expense of other organizational stakeholders such as the owners who also anticipate that the organization will record increased returns on their investments. Considering the implications of engaging in fraud, is it then ethically right for securities investment managers to jeopardize the interest of other people at the expense of advancing their personal interests? As the paper reveals, for Bernard L. Mandoff, jeopardizing these interests is just right if one gains optimal returns through false or deceptive business ideologies such as the Ponzi Scheme.
Bernard L. Mandoff was the mastermind of the Ponzi Scheme that led to the loss of investors’ money amounting to about 50 billion USD. SEC failed to identify the basic tenets of Mandoff business model as Ponzi Scheme, despite scholarly findings that had identified it as such. Mandoff used money collected through new investors to fund the huge returns of older investors to the extent that the whole investment business gained trust that aided to attract more investors. Through the illegitimate operations masqueraded as the best investment opportunity available in the US, many people lost their money. For example, Fairfield Greenwich Advisors lost about 7.5 billion. Banco Santander, the largest bank in Spain, lost approximately 2.87 billion.
Ponzi Schemes arise partly due to a lack of elaborate rules and regulations that can ensure that corporations and investment entities behave ethically. Ethics refers to standards of behaviors or conducts. It involves the evaluation of individual values, possession of knowledge on communal principles, and individual standards. It also entails the development of the capacity to make well-informed choices, including the realization of the impacts of the choices made on a short and long-term basis. Where the choices result in undue repercussion that may impair an organization or individual’s achievement of the pre-set standards of conduct, codes of ethics demand that such persons take responsibility for the aftermaths of their choices.
In the case of the Ponzi Scheme masterminded by Mandoff, social responsibility ethical concerns could have prevented the crime. Such a fraud robs some stakeholders of their interests via reaping benefits from their hard-earned money. Mandoff’s Ponzi fraud raises concerns on how the current investment corporations and business entities can develop strong trust in investors who they claim to invest money on their behalf. These concerns can be fully analyzed when the contexts and nature of major frauds are examined in terms of the causes and factors that lead to their propagation.
This paper deploys up-to-date journal articles to conduct an analysis of Mandoff scandal. It is concerned with investigating circumstances that surrounded Mandoff investment securities. It identifies parties that suffered from the scandal. It then discusses how the fraud arose, including how people and institutions were lured to invest in the scheme, which Mandoff later revealed to his family that it was a Ponzi Scheme. The paper concludes that the scheme escalated due to the failure of the regulatory authority (SEC) to execute its mandates. Both investors and SEC should take note of red flags, which are likely to indicate that a new entrepreneurial investment opportunity amounts to a Ponzi Scheme.
Purpose Statement
The purpose of this report is to investigate the fraud surrounding Madoff Investment securities. This report will answer the questions that were requested by the CEO. First, this report will analyze how the fraud occurred, and provide investors with steps to detect and avoid this type of fraud.
Problem Statement (Draft)
Starting with $5000 in 1960, Bernard Madoff formed his securities firm using his own name: Bernard L. Madoff Investment Securities LLC (BMIS). In 2001, BMIS became one of the three market makers in NASDAQ, as well as the third-largest securities firm on the New York Stock Exchange. In 2006, BMIS applied to U.S. Securities and Exchange Commission (SEC) to become a registered investment adviser.
In the US nowadays, a lot of securities firms also perform as money managers for clients, for which clients can authorize the security firm to invest for them. Madoff did the same thing. However, for the past many years before 2008, no matter how fluctuated the stock market was, Madoff’s return rate still surprisingly remained very stable, which was too good to be true as questioned by some scholars and investors. His explanation was that he simply used an investment strategy called split-strike conversion, which basically consisted of buying shares at market price, selling call options and buying put options.
Why this abnormal phenomenon could happen for almost twenty years; in a certain extent it could make known that the government supervision was not strong and complete enough. In fact, even today the Financial Industry Regulatory Authority (FINRA) and U.S. Securities and Exchange Commission (SEC) are still passing the responsibilities to each other. This report not only will discuss the fraud, but also the possible causes and effects of it.
Background / Overview (Draft)
At the end of the year 2008, the biggest fraud in Wall Street’s history erupted together with the global financial crisis. Bernard Madoff, former chairman of NASDAQ and founder of BMIS was charged by the SEC with accounting fraud of 50 billion USD using the Ponzi scheme.
A Ponzi Scheme is a type of investment fraud in which the perpetrator(s) of the scheme promise(s) investors a high percentage return on their investment, however, returns to existing investors are actually paid out using the money pulled in from new investors. Ponzi schemes usually do not have legitimate investment operations taking place and rely on a continual influx of investors in order to continue (Lewis, 2011). The scheme is named after Charles Ponzi, who in the 1920s was able to lure in thousands of investors, promising a 50% return by investing in his operation of arbitrage of International Reply Coupons. His scheme eventually collapsed under its own weight when new investments were not enough to cover redemptions, resulting in over $10 million dollars in losses and affecting over 30,000 individuals (Robb, 2012).
Methodology
The report uses three standards to evaluate the sources: Credibility, Currency and Objectivity.
Credibility
In order to maintain a high level of credibility, most of the articles used are selected from major financial journals, and the data used all come from the SEC website. Although some of the press releases might have biases, they are only used for conducting debates and representing arguments.
Currency
To ensure freshness and currency on the topic, only articles written after 2009 were adapted.
Objectivity
Pros and cons like Yin and Yang, and they always coexist. There are thousands of articles in the databases, and they all have a different perspective on the Madoff case. The authors read and analyzed articles from various sources, and then finalized their opinions. To maintain objectivity, the information used is mostly facts like historical data and descriptions of what happened, rather than personal opinions or judgments.
Facts
On December 10th, 2008, Bernard Madoff confessed to his family that his whole business was basically just a Ponzi scheme scandal, and from that moment, another huge wave of the financial crisis was set off to the world.
Estimates of the total losses from this giant scandal were about to be 50 billion USD, and victims were from all over the world, all different social classes and industries. (Chung, Mackintosh and Sender, 2008) Examples of victims include Fairfield Greenwich Advisors (a New York-based hedge fund with a loss of about 7.5 billion in this fraud), Banco Santander (the largest bank in Spain with a loss of about 2.87 billion), HSBC (the largest bank in Britain with a loss of about 1 billion), Nomura Holdings (a Japanese brokerage firm with a loss of about 358 million) and Jewish Community Foundation of Los Angeles (the largest manager of charitable gift assets for Los Angeles Jewish philanthropists with a loss of about 18 million). (The Wall Street Journal, 2009)
Another suspectable fact was Madoff’s 13F filing to the SEC. According to law, all US registered investment managers who manages investment of more than 100 million USD, have to report their holdings to the SEC on a 13F filing form quarterly. (SEC, 2015) By the fourth quarter of 2008, the total holdings BMIS listed on its 13F was about 323 million USD, which is just about 2% from its total managed assets of 17 billion USD. (Gregoriou and Lhabitant, 2009) This percentage of holdings from total managed assets was extremely low when compared with other investment firms such as Bridgewater with 57%, Paulson & Co with 39% and Morgan Stanley with 36%. A detailed computation table is shown in Table 1.
Table 1: Assets listed on 13F as a percentage of total assets managed.
Causes
Ponzi schemes are caused by the willingness of perpetrators to cheat investors out of money. Ponzi Schemes take advantage of the regulatory environment and use several tactics to achieve their objectives including offering high returns on investments, providing regular investment returns, establishing trust and reputation, targeting affinity groups, and maintaining obscurity of the operation (Benson, 2009, p. 24).
High-interest rates to attract investors. Charles Ponzi promised 50% returns to investors within 45 days; at a time when the average return rate offered by banks was 5%, it is easy to understand why investors were eager to give them their money (https://www.sec.gov/answers/ponzi.htm). Once the initial investments have been made, M.K.Lewis states that perpetrators must fulfill their promises. Establishing trust is a critical component of the scheme because it will allow the operation to grow and attract new investors. To confirm their legitimacy and gain trust from investors, Ponzi schemes must perform regular payouts to earlier investors and provide them the option to reinvest their earnings. Performing regular payouts of returns will establish the legitimacy and reputation of the operation. As soon as the scheme has gained a loyal following and reputation, word of mouth from early investors will help to grow and extend the life of the operation. Lewis refers to these early investors as “songbirds”; they perpetuate the scheme by becoming the salespeople for the scheme and bringing in new investors (Lewis, 2012, p. 303)
Ponzi Schemes also prey upon affinity groups to raise capital. Perpetrators target specific groups to which they are connected; the logic behind this is that individuals are more likely to trust someone who is a member of their own group (Business Wire, 2004, Investor Alert: Department of Corporations Warns Californians to Beware of Ponzi Schemes and Affinity Fraud). In 2010, investment adviser Kenneth McLeod admitted to using his business relationship with law enforcement agencies to convince FBI, DEA, Immigration, and IRS agents to invest a total of $34 million into his obscure bond fund, which was later revealed to be a Ponzi scheme. In the same vein, Australian accountant Allan McFarlane defrauded over 80 members of his township between $AUD30-$40 million before killing himself (Lewis, 2012, p.298-307).
Madoff’s Promised Returns
Madoff’s scheme was different from most Ponzi schemes in the fact that it did not promise outrageous returns; rather it provided modest but consistent annual returns (10%-12%) in both up and down markets (Ragothaman, 2014. p. 273). The modest returns helped deter suspicion of fraudulent activity from investors, enabling BMIS to stay under the radar as much as possible. Satisfied with the returns on their initial investment, many investors reinvested their earnings into the scheme and were provided with phony account statements detailing the “growing” balance in their account (http://www.cbsnews.com/news/how-madoff-pulled-it-off/). This aided Madoff’s investment scheme by minimizing the frequency of payouts while inspiring investor trust. The reduced frequency of payouts is likely to have prolonged the life of the scheme because it provided BMIS more time to attract new investors between payout dates. For investors that requested payouts, their requests were handled promptly, adding to the illusion that BMIS was a legitimate operation (Lewis, 2012, p. 297).
Secrecy
BLMIS used Feeder funds to bring in a large number of investors without their knowledge. A Feeder fund is a third-party fund that pools money from investors and “feeds” that money into a larger “master fund”. In many cases, the investor may be unaware that they are indirectly investing in the master fund due to limited transparency (http://www.investopedia.com/terms/f/feederfund.asp). Such was the case with feeder funds that invested with Bernie Madoff; many funds expressed that they were prohibited by contract to disclose Madoff as the actual investment manager (Gregoriou&Lhabitant, 2009, p. 89).
Targeting Affinity Groups
Madoff initially targeted members of the Jewish Community. After obtaining membership of elite Jewish clubs, Madoff would develop relationships with members and encourage them to invest in his funds (Blois & Ryan, 2013, p. 193). Madoff also used his status to target several charities and non-profit foundations, forcing them to close in the aftermath (http://s.wsj.net/public/resources/documents/st_madoff_victims_20081215.html).
Regulatory Failure
In October 2005, Harry Markopolos, a renowned derivatives expert at _ with more than _ years experience, submitted a 19-page memo to the SEC-Boston titled “The World’s Largest Hedgefund is a Fraud”. In his report, Markopolos identified 29 red flags indicating that BMIS was conducting a massive Ponzi Scheme and provided mathematical proofs to demonstrate that it was impossible to achieve 16% annual returns using the Split-Strike Conversion strategy that Madoff claimed. Given the estimated $20 Billion of assets that Madoff was managing, Markopolos demonstrated that using this type of strategy was likely to result in annual losses. Moreover, this report also identified inconsistencies in Madoff’s business model that he recommended required immediate investigation. The report prompted an investigation into BMIS and was assigned to the SEC’s Northeast Regional Office (NERO) (financial expertise). NERO dismissed the report’s content, concluding there was no evidence indicating the likelihood of a Ponzi Scheme.
This was not the first time BMIS was the focus of the investigation. From 1992 to 2006, the SEC conducted 5 investigations of Bernard Madoff Investment Securities in response to concerns of the legitimacy of its operations. SEC regulators were given 5 opportunities to uncover the massive fraud Madoff was conducting and managed to fail everyone. In the aftermath, investors questioned how was it possible that the regulators overseeing financial markets failed to discover this fraud not once or twice, but five times? Was it due to carelessness, incompetence, or merely lack of experience? The SEC concluded that the regulators’ lack of financial expertise was to blame.
In its 2009 “Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme”, the Securities and Exchange Commission (SEC) concluded that enforcement staff at its Northeast Regional Office (NERO) failed to recognize the significance of the red flags identified by Markopolos (most notably his demonstration that it was mathematically impossible to achieve Madoff’s returns using the Split-Strike Conversion strategy) because they lacked a fundamental understanding of equity and options trading markets (SEC, 2009). Simona Suh, an Enforcement Staff Attorney at NERO who worked on the 2006 Madoff investigation, later testified that she did not know enough about the financial market industry to determine how likely or unlikely it would have been to achieve the consistent returns that Madoff claimed (SEC, 2009). Assistant Director DoriaBachenheimer and Branch Chief Meaghan Cheung, also assigned to the 2006 investigation, questioned Madoff on his success using the split-strike conversion strategy and took his explanation at face value. Their satisfaction with his explanation demonstrated their lack of understanding of equity and options trading; as a former Madoff investor quoted in a May 2011 Barron article, “Anybody who’s a seasoned hedge-fund investor knows the split-strike conversion is not the whole story. To take it at face value is a bit naïve” (SEC, 2009). Due to their ignorance of financial markets, NERO investigators dismissed Markopolos’ assertion that Madoff was operating a Ponzi Scheme and instead shifted the focus of their investigation to whether Madoff should register as an Investment Adviser. Had the regulators at the SEC been educated in equity markets the same way Markopolos and other derivatives experts had, they would have realized achieving 16% returns using a Split-Strike Conversion strategy was virtually impossible.
Lewis and Rhee also agree that because most regulators at the SEC did not come from quantitative backgrounds, they failed to recognize the significance of Markopolos’ statistical modeling. Rhee (2009) also argues that incompetent regulators at the SEC failed to detect the Madoff fraud even with though it was laid out in front of them in “explicit terms”. In his 2005 submission to the SEC, “The Worlds Largest Hedgefund is a Fraud”, derivatives expert Harry Markopolos explained that it was highly likely that Madoff Securities was a large Ponzi scheme. The 19-page memo identified over 29 red flags pertaining to Madoff’s operation, and anyone with a basic understanding of financial markets should have been able to appreciate the significance of the findings (Rhee, 2009). The memo addressed three areas of concern: Madoff’s secrecy; low volatility and impossible returns; and unrealistic options trading volumes (SEC, 2009). Unfortunately, the investigators at the SEC consisted of lawyers who lacked a basic education in financial markets (Rhee, 2009).
Effects
Will be about people losing their retirement savings and charities and donation having to close down.
Summary
Mandoff developed the world’s largest hedge fund. The fund turned out to be a Ponzi Scheme. While corporate ethics suggests that Mandoff could have acted in the best interest of the investors to ensure that their investments were secure, this case may not be evident in all situations. As evidenced by the case of Mandoff security investments, some people may divert from ethical standards. A mechanism for dealing with such situations should call for regulatory action. SEC would have taken such an action. Based on the increasing concerns that Mandoff security investments could have been a Ponzi Scheme, NERO SEC investigators were assigned the responsibility of justifying the claims. Besides the mathematical modeling done by Markopolos demonstrating that Mandoff Split-Strike Conversion strategy was impossible, NERO investigators dismissed the possibility of Mandoff’s hedge funds being a Ponzi scandal. This situation marked an immense failure of SEC since it made its conclusions, despite the evidence of secrecy, low volatility, and impractical returns in Mandoff’s business model.
Recommendations
Considering Mandoff’s hedge funds scheme, investors should investigate whether the profits are assured since such a manager may be driven by deception to entice to invest. Secondly, investors should first examine whether the opportunity promises above-market guaranteed returns on investments since this case is indicative of a Ponzi Scheme (Benson, 2009). The red flag is that such promises are too attractive to have truth in them. Thirdly, any lack of work division may be a warning that investors should look out for when making investment decisions. In this case, investors should be informed that fraud-driven administrators want to be the only caretakers of finances. Investors should also request financial documents to verify whether they are valid and updated for the respective company (Benson, 2009). By checking these warnings, Ponzi investors can circumvent all established safeguards for protecting investors’ financial resources. Therefore, Baucus and Mitteness (2016) advise that people should inform SEC on any entrepreneurial investment opportunity that appears too good. Hence, the organization can identify the Ponzi entrepreneurs before the venture collapses.
Reference List
Baucus, M., & Mitteness, C. (2016). Crowdfrauding: Avoiding Ponzi entrepreneurs when investing in new ventures. Business Horizons, 59(1), 37-50
Benson, S. (2009). Recognizing the Red Flags of a Ponzi Scheme: Will You Be Blamed for Not Heeding the Warning Signs? The CPA Journal, 1(1), 18-25.