Question: Bernie Madoff perpetrated the world’s largest

Bernie Madoff perpetrated the world’s largest Ponzi scheme,1 in which investors were initially estimated to have lost up to $65 billion. Essentially, investors were promised—and some received—returns of at least 1% per month. However, beginning in the early 1990s, these payments came from funds invested by new investors, not from returns on invested funds. Consequently, when new investor contributions slowed due to the subprime lending crisis in 2008, Madoff ran out of funds to pay redemptions and returns, and the entire scheme unraveled. As Warren Buffet has said, “You only learn who has been swimming naked when the tide goes out.”2 Bernie Madoff certainly was, much to the chagrin of some supposedly very savvy investors who were attracted by seemingly constant returns of about 1% per month in up as well as down markets. Among those who invested sizable sums3 were the actors Kevin Bacon and Kyra Sedgwick as well as Jeffrey Katzenberg, the CEO of Dream- Works Animation. Others are listed here.

Ultimately, Madoff pleaded guilty to 11 charges by the SEC, confessed, and was sentenced to 150 years in the penitentiary. The story of how Madoff began his scheme, what he actually did, who suspected he was a fraudster and warned the SEC, why the SEC failed to find wrongdoing, who knew, and who did nothing is a fascinating story of ethical misbehavior, greed, innocence, incompetence, and misunderstanding of duty. How Did Madoff Do It? In his plea elocution4 on March 12, 2009, Madoff told the court, The essence of my scheme was that I represented to clients and prospective clients who wished to open investment advisory and investment trading accounts with me that I would invest their money in shares of com- mon stock, options and other securities of large well-known corporations, and upon request, would return to them their profits and principal.… [F] or many years up until I was arrested … I never invested those funds in the securities, as I had promised. Instead, those funds were deposited in a bank account at Chase Manhattan Bank. When clients wished to receive the profits they believed they had earned with me or to redeem their principal, I used the money in the Chase Manhattan bank account that belonged to them or other clients to pay the requested funds.5 Of course, in reality, Madoff ’s scheme was more complex and went undiscovered for a very long time. Over the years, Madoff became involved in two major activities as (1) a market maker or broker and (2) an investment adviser or manager. The first, which he began in 1960 as Bernard L. Madoff Securities, matched, by phone, buyers and sellers of stocks of smaller companies that were not traded on large recognized stock exchanges, such as the NYSE. Initially, he made a commission on each over-the- counter trade, but soon he was buying or selling on his own account, thereby taking the risk of not being able to find a matched buyer or seller and not making a profit on the spread. In time, this form of trading became more regulated, and the spread between the buying and selling prices for shares became restricted to one-eighth of a dollar, or 12.5 cents, per share. In order to maximize his volume of orders, Madoff would “pay for order flow” a sum of 1 to 2 cents per share of the 12.5-cent spread to the referring broker. Later, computerized trading6 allowed share prices to be denominated in cents rather than one-eighth of a dollar, and the spreads shrunk to 1 cent or so by 2001.7 Consequently, Madoff ’s profit on this type of trading activity dwindled, and he had to be creative to make any significant profit. It is speculated8 that he did so by “front running,” a variation on insider trading. Using advance knowledge of a large buy transaction garnered through his “pay for order flow” process, Madoff could buy the stock for his own account at the current price and then sell the stock moments later to fulfill the large buy order at an increased price. The trading part of Madoff ’s activity was properly registered with authorities and was not the source of Madoff ’s Ponzi scheme. The second activity—that of investment advisor—which Madoff began as early as 1962, was the source. Interestingly, he did not register as an investment advisor until he was forced to do so by the SEC in 2006 in reaction to a very public and now famous whistleblower’s report by Harry Markopolos.9 In fact, Madoff is said to have asked his clients not to divulge his investment services to them, perhaps in an effort to keep the service below the level of recognition by authorities. In any event, as Madoff states in his plea elocution, his fraud began in the early 1990s: Your Honor, for many years up until my arrest on December 11, 2008, I operated a Ponzi scheme through the investment advisory side of my business, Bernard L. Madoff Securities LLC, which was located here in Manhattan, New York at 885 Third Avenue. To the best of my recollection, my fraud began in the early 1990s. At that time, the country was in a recession and this posed a problem for investments in the securities markets. Nevertheless, I had received investment commitments from certain institutional clients and understood that those clients, like all professional investors, expected to see their investments out-perform the market. While I never promised a specific rate of return to any client, I felt compelled to satisfy my clients’ expectations, at any cost. I therefore claimed that I employed an investment strategy I had developed, called a “split strike conversion strategy,” to falsely give the appearance to clients that I had achieved the results I believed they expected. Through the split-strike conversion strategy, I promised to clients and prospective clients that client funds would be invested in a basket of common stocks within the Standard & Poor’s 100 Index, a col- lection of the 100 largest publicly traded companies in terms of their market capitalization. I promised that I would select a basket of stocks that would closely mimic the price movements of the Standard & Poor’s 100 Index. I promised that I would opportunistically time these purchases and would be out of the market intermittently, investing client funds during these periods in United States Government-issued securities such as United States Treasury bills. In addition, I promised that as part of the split strike conversion strategy, I would hedge the investments I made in the basket of common stocks by using client funds to buy and sell option contracts related to those stocks, thereby limiting potential client losses caused by unpredictable changes in stock prices. In fact, I never made the investments I promised clients, who believed they were invested with me in the split strike conversion strategy. To conceal my fraud, I misrepresented to clients, employees and others, that I purchased securities for clients in overseas markets. Indeed, when the United States Securities and Exchange Commission asked me to testify as part of an investigation they were conducting about my investment advisory business, I knowingly gave false testimony under oath to the staff of the SEC on May 19, 2006 that I executed trades of common stock on behalf of my investment advisory clients and that I purchased and sold the equities that were part of my investment strategy in European markets. In that session with the SEC, which took place here in Manhattan, New York, I also knowingly gave false testimony under oath that I had executed options contracts on behalf of my investment advisory clients and that my firm had custody of the assets managed on behalf of my investment advisory clients. To further cover-up the fact that I had not executed trades on behalf of my investment advisory clients, I knowingly caused false trading confirmations and client account statements that reflected the bogus transactions and positions to be created and sent to clients purportedly involved in the split strike con- version strategy, as well as other individual clients I defrauded who believed they had invested in securities through me. The clients receiving trade confirmations and account statements had no way of knowing by reviewing these documents that I had never engaged in the transactions represented on the statements and confirmations. I knew those false confirmations and account statements would be and were sent to clients through the U.S. mails from my office here in Manhattan. Another way that I concealed my fraud was through the filing of false and misleading certified audit reports and financial statements with the SEC. I knew that these audit reports and financial statements were false and that they would also be sent to clients. These reports, which were prepared here in the Southern District of New York, among things, falsely reflected my firm’s liabilities as a result of my intentional failure to purchase securities on behalf of my advisory clients. Similarly, when I recently caused my firm in 2006 to register as an investment advisor with the SEC, I subsequently filed with the SEC a document called a Form ADV Uniform Application for Investment Adviser Registration. On this form, I intentionally and falsely certified under penalty of perjury that Bernard L. Madoff Investment and Securities had custody of my advisory clients’ securities. That was not true and I knew it when I completed and filed the form with the SEC, which I did from my office on the 17th floor of 855 Third Avenue, here in Manhattan. In more recent years, I used yet another method to conceal my fraud. I wired money between the United States and the United Kingdom to make it appear as though there were actual securities transactions executed on behalf of my investment advisory clients. Specifically, I had money transferred from the U.S. bank account of my investment advisory business to the London bank account of Madoff Securities International Ltd., a United Kingdom corporation that was an affiliate of my business in New York. Mad- off Securities International Ltd. was principally engaged in proprietary trading and was a legitimate, honestly run and operated business. Nevertheless, to support my false claim that I purchased and sold securities for my investment advisory clients in European markets, I caused money from the bank account of my fraudulent advisory business, located here in Manhattan, to be wire transferred to the London bank account of Madoff Securities International Limited. There were also times in recent years when I had money, which had originated in the New York Chase Manhattan bank account of my investment advisory business, transferred from the London bank account of Madoff Securities Inter- national Ltd. to the Bank of New York operating bank account of my firm’s legitimate proprietary and market making business. That Bank of New York account was located in New York. I did this as a way of ensuring that the expenses associated with the operation of the fraudulent investment advisory business would not be paid from the operations of the legitimate proprietary trading and market making businesses. In connection with the purported trades, I caused the fraudulent investment advisory side of my business to charge the investment clients $0.04 per share as a commission. At times in the last few years, these commissions were transferred from Chase Manhattan bank account of the fraudulent advisory side of my firm to the account at the Bank of New York, which was the operating account for the legitimate side of Bernard L. Madoff Investment Securities—the proprietary trading and market making side of my firm. I did this to ensure that the expenses associated with the operation of my fraudulent investment advisory business would not be paid from the operations of the legitimate proprietary trading and market making businesses. It is my belief that the salaries and bonuses of the personnel involved in the operation of the legitimate side of Bernard L. Madoff Investment Securities were funded by the operations of the firm’s successful proprietary trading and market making businesses.10 Who Knew or Suspected the Fraud, and What Did They Do? According to Madoff, his family—his sons, his wife, and his brother—knew nothing of his fraudulent behavior until he revealed it to them—first to his brother on December 9, 2009, and a day later to his sons and wife. On December 10, his sons wanted to know why he would pay out millions of dollars in bonuses several months early and how he would do so when he was complaining that he was having difficulty paying off investment withdrawals and returns. After shifting the meeting to his apartment, he confessed to his sons that he is “finished,” that he has “absolutely nothing,” and that the operation was basically a giant Ponzi scheme.… Madoff also tells his sons that he plans to surrender to authorities in a week but he wants to use the $200–300 million he has left to make payments to selected employees, family and friends. After speaking to his sons, the FBI knocks on Madoff ’s door on the morning of Dec. 11 and asks if there is an innocent explanation. Madoff says no, it was “one big lie.”11 According to many reports, several senior members of the financial community questioned how Madoff ’s investment business could earn such consistent, positive returns. Some thought he had to be running some type of fraudulent scheme and refused to deal with him. Others thought he was a genius, but they failed to look very deeply into his investment strategy and how he made his money. In 1999, Harry Markopolos, a finance expert, was asked by his employer, who was a competitor of Madoff, to investigate Mad- off ’s strategy. After four hours of analysis, Markopolos appeared in his boss’s office to declare that it was extremely unlikely that Madoff could generate the consistent positive returns he paid by legal means. In his opinion, it was much more likely that Madoff was operating a Ponzi scheme or that he was front running orders through his broker/ dealer operation with “the split-strike con- version strategy” as mere “front” or “cover.”12 Markopolos even went so far as to contact the SEC with an eight-page submission in 2000 with his concerns, but no investigation was launched, and no significant action was taken. Later, the alleged front running operation was proven to be “unworkable.” Markopolos, however, did not give up. He resubmitted his information several times between 2000 and 2008, usually with little effect. He attributed this to the fact that some of the key SEC representatives had insufficient financial background in derivatives to understand his submissions until he met Mike Garrity, the branch chief of the SEC’s Boston Regional Office in late October 2005. Garrity understood the significance of Markopolos’s analysis and referred it on to the SEC’s New York Region Branch Office. Markopolos quickly submitted a 21-page report to Meaghan Cheung, the branch chief, on November 7, 2005, but she failed to understand it or its significance and concentrated on the Adelphia case that she was handling. In his November 7, 2005, letter,13 Mar- kopolos identifies a series of 29 red flags and provides analyses supporting the following (greatly distilled) summary of the salient points he made at the time about Bernard Madoff’s (BM’s) activities: • BM chose an unusual broker-dealer structure that costs 4% of annual fee revenue more than necessary. Why would he do this unless it was a Ponzi scheme? • BM pays an average of 16% to fund its operations although cheaper money is readily available. • Third-party hedge funds and funds of funds are not allowed to name BM as the actual fund manager. Shouldn’t he want publicity for his wonderful returns? • The split-strike conversion investment strategy is incapable of generating returns that beat the U.S. Treasury Bill rates and are nowhere near the rates required to sustain the rates of return paid to BM’s clients. • The total OEX options14 outstanding are not enough to generate BM’s stated month or 12% per year. Actually BM would have to earn 16% to net 12%. • Over the last 14 years, BM has had only 7 monthly losses, and a 4% loss percent- age is too unbelievably good to be true. • There are not enough OEX index put option contracts in existence to hedge the way BM says he is hedging. • The counter-party credit exposures for UBS and Merrill Lynch are too large for these firm’s credit departments to approve. • The customization and secrecy required for BM’s options is beyond market volume limits and would be too costly to permit a profit. • The paperwork would be voluminous to keep track of all required Over-The- Counter (OTC) trades. • It is mathematically impossible to use a strategy involving index options (i.e., baskets of stocks representative of the market), and not produce returns that track the overall market. Hence, the consistency of positive returns (96% of the time) is much too good to be true. • Over a comparable period, a fund using a strategy more sound than the split-strike approach had losses 30% of the time. Return percentages were similarly worse. • Articles have appeared that question BM’s legitimacy and raise numerous red flags. • BM’s returns could only be real if he uses the knowledge of trades from his trading arm to front-run customer orders, which is a form of insider trading and illegal. In addition, it is not the strategy he is telling hedge fund investors he is using. • However, this access to inside knowledge only became available in 1998, so front running could not have generated the high profits BM reported before that date. • If BM is front running, he could earn very high profits and therefore would not need to pay 16% to fund his operations. Since he is paying 16%, he is probably not front running, but is very probably involved in a Ponzi scheme. • To achieve the 4% loss rate, BM must be subsidizing returns during down- market months, which is a misstatement of results or the volatility of those results and therefore constitutes securities fraud. • BM reportedly has perfect market- timing ability. Why not check this to trading slips? • BM does not allow outside performance audits. • BM is suspected of being a fraud by several senior finance people including: • a managing director at Goldman, Sachs; so they don’t deal with him • an official from a Top 5 money center bank; so they don’t deal with him • several equity derivatives profession- als believe that the split-strike con- version strategy that BM runs is an outright fraud and cannot achieve the consistent levels of returns declared, including: • Leon Gross, Managing Director of Citigroup’s equity derivatives unit • Walter Haslett, Write Capital Management, LLC • Joanne Hill, V.P., Goldman, Sachs • Why does BM allow third-party hedge funds and funds of funds to pocket excess returns of up to 10% beyond what is needed? • Why are only Madoff family members privy to the investment strategy? • BM’s Sharpe Ratio15 is at 2.55. This is too outstanding to be true. • BM has announced that he has too much money under management and is closing his strategy to new investments. Why wouldn’t he want to continue to grow? • BM is really running the world’s largest hedge fund. But it is an unregistered hedge fund for other funds that are registered with the SEC. Even though the SEC is slated to begin oversight of hedge funds in 2006, BM operates behind third-party shields and so the chances of BM escaping scrutiny are very high. Although Markopolos continued to call, Ms. Cheung was not responsive. As a result, he pursued other avenues, and when he uncovered leads to people who suspected that Madoff was a fraudster, he passed the names on to the SEC. Unfortunately, no action was taken. If it had been, Markopolos believes that Madoff “could have been stopped in 2006.”16 Markopolos continued to try to influence the SEC orally and in writing as late as March or early April 2008 with no apparent response. On February 4, 2009, he testified before the U.S. House of Representatives Committee on Financial Services about his concerns. During that testimony, he was asked why he and three other concerned associates had not turned Madoff in to the Federal Bureau of Investigation (FBI) or the Federal Industry Regulatory Authority (FINRA)17 and responded as follows: For those who ask why we did not go to FINRA and turn in Madoff, the answer is simple: Bernie Mad- off was Chairman of their predecessor organization and his brother Peter was former Vice-Chairman. We were concerned we would have tipped off the target too directly and exposed ourselves to great harm. To those who ask why we did not turn in Madoff to the FBI, we believed the FBI would have rejected us because they would have expected the SEC to bring the case as subject matter expert on securities fraud. Given our treatment at the hands of the SEC, we doubted we would have been credible to the FBI.18 Markopolos goes on to lament that dozens of highly knowledgeable men and women also knew that BM was a fraud and walked away silently, saying nothing and doing nothing.… How can we go forward without assurance that others will not shirk their civic duty? We can ask our- selves would the result have been different if those others had raised their voices and what does that say about self-regulated markets?19 Harry Markopolos is tough on the SEC in his February 2009 oral testimony. The YouTube video of his testimony is available at http://www.youtube.com/watch?v=uw_ Tgu0txS0 and is well worth viewing. For example, he states the following: • “I gift wrapped and delivered to the SEC the largest Ponzi scheme in history, and they were too busy to investigate.” • “I handed them … on a silver platter.” • “The SEC roars like a mouse and bites like a flea.” During, and at the end of his verbal testimony, Markopolos points out why the SEC has a lot to answer for, repeatedly letting down investors, U.S. taxpayers, and citizens around the world. Why Didn’t the SEC Catch Madoff Earlier? According to Markopolos, SEC investiga- tors and their bosses were both incompe- tent and unwilling to believe that people as well respected in the investment com- munity as Madoff and his brother Peter Madoff could be involved in illicit activ- ities. According to the Madoff ’s own website,20 Bernard L. Madoff was one of the five broker-dealers most closely involved in developing the NASDAQ Stock Market. He has been chairman of the board of directors of the NAS- DAQ Stock Market as well as a mem- ber of the board of governors of the NASD and a member of numerous NASD committees. Bernard Madoff was also a founding member of the International Securities Clearing Corporation in London. His brother, Peter B. Mad- off has served as vice chairman of the NASD, a member of its board of governors, and chairman of its New York region. He also has been actively involved in the NASDAQ Stock Market as a member of its board of governors and its executive committee and as chairman of its trading committee. He also has been a member of the board of directors of the Security Traders Association of New York. He is a member of the board of directors of the Depository Trust Corporation. In order to find out why the SEC did not catch Madoff earlier, an internal review was undertaken by the SEC’s Office of Inspector General. The resulting report by H. David Kotz, the inspector general, on the Investigation of the Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme— Public Version (OIG-509),21 dated August 31, 2009, is a ringing condemnation of SEC investigative and decision-making activities. Although the SEC was approached by several individuals with concerns, tips, and/or analyses, including Markopolos several times, the red flags raised were ignored or not understood, or, when investigated the so-called investigations failed to identify the Ponzi scheme. According to the report, the investigations failed for the following reasons: • Investigators were inexperienced, usually fresh from law school. • Investigators were untrained in forensic work: • Their practice during the few investigations undertaken was usually to interview Madoff himself and then write their report without further action even though Madoff had been caught in contradictions during the interview. • Their work was poorly planned at best and poorly led, although work ratings were exemplary and promotion followed for some. • Investigators did not have sufficient knowledge of capital markets, derivatives, and investment strategies to understand the following: • The fundamentals underlying the marketplace and the fraud. • What was a red flag or a red flag worthy of following up? • How to check the red flags raised by others. • That external third-party verification of Madoff ’s verbal or fabricated written claims was necessary and would have revealed the Ponzi scheme. • What the correct scope of the investigation should have been. • Investigators were biased in favor of Madoff and against Markopolos. • Investigators were frequently delayed by other SEC priorities or by inter-SEC rivalry and bureaucratic practices. H. David Kotz is to be commended for his report and his related recommendations for the improvement of SEC person- nel and practices. Anyone who reads the Kotz Report will conclude that the SEC’s performance in the Madoff scandal was serially and ridiculously incompetent. TYPE OF FRAUD THE MAXIMUM It is interesting to note that although there were repeated indications to the SEC that Madoff ’s company auditor was allegedly a related party to Madoff, SEC agents never checked. It was finally checked by the New York Division of Enforcement after Madoff confessed. “Within a few hours of obtaining the working papers, the New York Staff Attorney determined Securities 20 Investment advisor 5 Mail 20 Wire 20 International money 20 laundering related to transfer of funds International money 20 Laundering that no audit work had been done.”22 Apparently, there had been no external or independent verification of trades or of securities held. The so-called auditor was David Friehling, Madoff ’s brother-in- law,23 who headed up a sole practitioner, three-person accounting firm known as Friehling & Horowitz. Friehling has since been charged with fraud.24 He had been Madoff ’s auditor from 1991 through 2008. A Happy Ending? Fortunately, Madoff confessed on December 11, 2008, and the SEC subsequently charged him with 11 counts of fraud. In fact, Madoff thought that the jig was up in 200625 when he had fabricated a story to support his claim of placing orders to hedge his portfolio, but the SEC investigators failed to check the trades externally. If they had, they would have found that there were essentially no trades even though his claim placed him as running the world’s largest hedge fund. On March 12, 2009, Madoff appeared in court and pleaded guilty to 11 charges.26 On June 29, 2009, he returned to court. where he was sentenced for “extraordinary evil” to the maximum sentence of 150 years in penitentiary27 for the following

Madoff was 71 years old when he was sentenced, so he will spend the rest of his life in prison. His friends did not make out well either. Over the years, however, some friends who were also investors made considerable profits on their investments with Madoff. One of these, Jeffry Picower—a sophisticated investor and friend of Mad- off ’s and a noted philanthropist—was found drowned at the bottom of his Palm Beach pool when a trustee attempted to claw back the $7 million Jeffry and his wife made in Madoff-related profit.28 It remains to be seen how much will be recovered by court-appointed trustees to be ultimately distributed to investors who lost money investing with Madoff. Questions 1. Was Madoff’s sentence too long? 2. Some SEC personnel were derelict in their duty. What should happen to them? 3. Are the reforms undertaken by the SEC (see http://www.sec.gov/ spotlight/ sec-post madoffreforms. htm) tough enough and sufficiently encompassing? 4. Does it matter that Madoff ’s auditor, Friehling, was his brother-in-law? 5. Does it matter that Friehling did no audit work? 6. Comment on the efficacy of self- regulation in the form of FINRA and in respect to the audit profession. What are the possible solutions to this? 7. Answer Markopolos’ questions: “How can we go forward without assurance that others will not shirk their civic duty? We can ask ourselves would the result have been different if those others had raised their voices and what does that say about self-regulated markets?” 8. How could Markopolos and the other whistleblowers have gotten action on their concerns earlier than they did? 9. Did Markopolos act ethically at all times? 10. What were the most surprising aspects of Markopolos’ verbal testimony on YouTube at http://www.youtube.com/ watch?v=uw_Tgu0txS0? 11. Did those who invested with Madoff have a responsibility to ensure that he was a legitimate and registered investment advisor? If not, what did they base their investment decision on? 12. Should investors who make a lot of money (1% per month while markets are falling) say, “Thank you very much,” or should they query the unusually large rate of return they are receiving? 13. Should investors who made money from “investing” with Madoff be forced to give up their gains to compensate those who lost monies? 14. Is this simply a case of “buyer beware”?