FALLOUT FROM THE BERNIE MADOFF PONZI SCHEME 18

The fallout from the Bernie Madoff Ponzi Scheme

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Abstract

Ponzi schemes are fraudulent investment scams that generate returns for earlier investors with money obtained from later investors. Bernie Madoff’s Ponzi Scheme is the largest of all schemes in history. This paper reviews Bernie Madoff’s Ponzi Scheme, the laws and regulations passed since Madoff’s fraud and explains the fraud detection tools that can be used to access the due diligence of feeder fund managers.

Table of Contents

4 1 Introduction

4 2 Madoff’s Ponzi Scheme

4 2.1 Overview

5 2.2 Bernie Madoff and Stockbroking

5 2.3 Illegal Trading

6 2.4 The Ponzi Scheme

7 2.5 The Apex of Hedge Funds

9 2.6 Casey and Markopolos Claims

9 2.7 Financial and SEC Problems

10 2.8 Reasons why SEC dismissed Markopolo’s Claims

10 2.9 SEC Rules Changes and Scared Employees

11 2.10 The Bad Ending

11 3 The Securities and Exchange Commission Post-Madoff Reforms

12 3.1 Revitalizing the Enforcement Department

12 3.2 Encouraging Cooperation

12 3.3 Enhancing Safeguards for Investor’s Assets

13 3.4 Improved Risk Assessment Capabilities

13 3.5 Conducting Risk-Based Examinations on Financial Firms

14 3.6 Improving Fraud Detection Procedures for Examiners

14 3.7 Recruiting Staff with Specialized Experience

14 3.8 Seeking more Resources

15 3.9 Expanding and Training

15 4 Conclusion

1 Introduction
Ponzi schemes are fraudulent investment scams that generate returns for earlier investors with money obtained from later investors. Most of these financial frauds lure investors under the promise of high profits (Bartoletti et al., 2020). Since the returns depend on new investors, a decline in the registration of new investors may pose the death of a Ponzi scheme. The scheme relies on a continuous and constant flow of investment to enable the facilitation of returns. Ponzi schemes are characterized by guaranteed promises of high returns with minimum risk involvement, consistent flow of returns regardless of market structures and conditions, investments are not registered with the Securities and Exchange Commission (SEC), the investment strategies are kept a secret, and investors are not allowed to view financial paperwork for the investment (Bartoletti et al., 2020). This mechanism makes it easy for scammers to lure their victims. This paper reviews Bernie Madoff’s Ponzi Scheme, illustrates the laws and regulations passed since Madoff’s fraud, and explains the fraud detection tools that can be used to access the due diligence of feeder fund managers.

2 Madoff’s Ponzi Scheme
2.1 Overview
Bernie Madoff’s Ponzi Scheme is among the largest ever mentioned in history. According to Quisenberry (2017), it made away approximately $65 billion in multiple decades, making it the largest of all ponzis ever made. Bernie Madoff started a brokerage company in 1960, which grew into an extensive firm within Wall Street. Madoff started investing money on behalf of families and friends, which generated the massive capital that initiated the Ponzi scheme. Madoff was sued and pleaded guilty, leading to his sentencing for 150 years in prison. According to Bartoletti et al. 2020), thousands of clients who invested under the scheme lost their finances after the trial in 2009. The scheme served to educate investors on the importance of planning and making documented investments through the right channels.

2.2 Bernie Madoff and Stockbroking
Madoff was the second child of Ralph and Sylvia Madoff and was born in 1938. Quisenberry (2017) asserts that Ralph Madoff had no license and worked as a plumber. Ralph and Sylvia decided to start a business in securities registered under Sylvia because Ralph did not possess a license and would help them evade IRS. Bernie studied political science at Hofstra College and had ambitions of becoming a wealthy entrepreneur in stockbroking. In 1959, Bernie Madoff married Ruth, and two days after the wedding, he registered his first stockbroking company where Ruth served s the bookkeeper. According to Bartoletti et al. (2020), the new company has $200 of assets and $5000 capital that Bernie had saved from summer jobs. This was the beginning of his entrepreneurial journey.

2.3 Illegal Trading
Bernie Madoff made significant growth in the stock business through the financial help of his father-in-law, Alpern, and Carl Shapiro. Ortner (2019) explains that Alpern, Bernie Madoff’s father-in-law played a significant role in promoting his stock business through a $50000 loan. Alpern also helped Bernie create associates, including Carl Shapiro, a wealthy merchant who invested with Bernie increasing the company’s working capital. The company had attained more than 15 clients, which according to SEC, had to acquire a trading license. However, Bernie joined the illegal unlicensed group of investors evading SEC fees, statements, and examinations. This ensured protection from scrutiny by the SEC and other government regulators (Ortner, 2019). Bernie continued violating the SEC laws and avoided submitting financial records even though his company had grown to higher heights.

Bernie had plenty of money flowing in his bank account from the illegal business advisory services he offered. He used the money to finance the company without the permission of his clients, which was illegal, which helped the company evade interests (Ortner, 2019). Bernie obtained another uplift by the inclusion of Michael Bienes as an accountant in the company. Michael Bienes encouraged his brother-in-law, Jeffrey Picower, a wealthy Wall Street investor, to invest with Bernie Madoff, which yielded Bienes huge commissions. Bernie was efficient and had speed in the company’s operations, which was remarkable and attracted significant recognition from most of his allies. Bernie acquired a computer to increase operations’ efficiency and speed, which attracted more clients, including brokerage companies, to work with them. National Association of Securities Dealers and Automated Quotations (NASDAQ) was founded in 1971 to accommodate public companies not listed in the NYSE and the AMEX, and Bernie was among the first to join (Sunarya, 2019). NASDAQ was a computerized system and was meant to reduce the monopolistic nature in stock markets provided by NYSE and AMEX.

2.4 The Ponzi Scheme
Bernie Madoff claimed to start the Ponzi scheme in 1991 during his case trials, but most financial analysts argue that he might have started earlier than that. Ortner (2019) asserts that Ponzi schemes were first mentioned in 1920 through the famous fraudster Charles Ponzi, who promised to double the money from investors in 45 or 90 days if they agreed to invest in a complex investment plan only he could manage. However, Ponzi did not invest the money but deposited it in his bank account and paid investors their agreed returns through new investor income. The scam was discovered within the year, and most of the investors who had not yet made withdrawals made huge losses (Sunarya, 2019). However, investors who made withdrawals earlier than the discovery had made huge profits from the investments.

A Ponzi’s success depends on the scammer’s ability to have a solid network of co-conspirators which was among the strong factors that made it easy for Bernie to succeed in the scheme. According to Ortner (2019), Bernie’s network included, among others, Annette Bongiorno, Frank DiPascali, and Daniel Bonventre. His brokerage firm was performing well in the stock market, and this served as an added advantage. The scheme was easy to perform since it needed a client to invest with Bernie, who would deposit the client’s money in his bank account and accumulate it with other amounts from other investors. If a client wanted to withdraw, the returns were calculated, and the co-conspirators, i.e., Annette Bongiorno, Frank DiPascali, and Daniel Bonventre, would generate a computer printout or email depicting a long list of trade that amounted to what the client would obtain (Sunarya, 2019). The printout would serve as the supporting evidence to the investments made by the client.

Investors will easily trust a successful financial manager that other investors trust, which worked well for Bernie. Henriques (2018) supports this argument by explaining that the long list of successful track records and the introduction of computerization made Bernie a trusted, successful financial manager. Other achievements included his election and service in NASDAQ and SEC, which promoted trustworthy financial managers and investors. Bernie had a positive personality that made it easy to interact with people. He was a remarkable family man, loyal and honest to his family and relatives, and never took alcohol (

Sattybayeva, 2019). He was thus treated as a brother, a friend, or even a son by the elderly investors. He opened a London office to attract European investors and promote his money laundering practices.

2.5 The Apex of Hedge Funds
The investment made a good performance and attracted many large hedge fund managers who needed to maximize their client’s investments, putting Bernie at the top of the investment pyramid. Raghuram and Dubey (2021) explain that Bernie was a reputable hedge fund manager and made significant recognition in the financial management sector with his company making consistent excellent performance. Hedge funds allow the financial manager to invest in all aspects because they are not restricted like mutual funds. According to Appel and Fos (2019), hedge funds also enjoy few regulations, charge higher management and operational costs, and have higher withdrawal fees. Hedge funds are associated with many risks involving aggressive buying and selling and more speculative positions in derivative securities. Bernie used a strategy involving marketing his investment funds in feeder hedge funds that yielded returns by investing the client’s investment into another investment fund (Appel & Fos, 2019). Bernie made consistent returns, making it easy for other financial managers to invest in his company.

Saul Alpern retired in the 1970s and handing his company to two employees who named the company after their names Avellino & Bienes. The two continued working and investing with Bernie and received their commissions as agreed (Williams, 2017). However, in 1992, a client recruited by Avellino & Bienes shared a marketing material with an investment adviser based in Seattle who reported the case to SEC, citing a Ponzi scheme. Avellino & Bienes’s documentation indicated that they invested with Bernie and had over 3200 client accounts created since 1962 with a non-registered company (Williams, 2017). Bernie accepted that he conducted business with Avellino & Bienes but claimed he assumed it was a registered company. SEC concluded that Avellino & Bienes should pay back all the clients’ money and got a ban that restricted their operation in investment advisory services. Bernie fraudulently managed to help Avellino & Bienes with finances and secretly continued to pay their commission without SEC detection. This case boosted Bernie’s reputation making highlights in Wall Street and managing to get free adverts from newspapers.

2.6 Casey and Markopolos Claims
Frank Casey sought to conduct business with Rene Thierry in 1999. Since Rene Thierry had invested with Bernie since the 1980s, Rene advised Casey that investing with Bernie would be viable (Turgeon, 2020). Casey gave Harry Markopolos the marketing materials to find and ordered Markopolos to replicate Bernie’s investment fund for Casey’s company. Markopolos was a reputable financial manager with excellent analytical skills and studied Bernie’s documents depicting Bernie’s investment as a fraud. Markopolos explained that Bernie had registered to be down only three months in a total of 87 months while the S & P 500 was down 28 months in the same period. According to Markopolos, this depicted cheating and suggested Bernie was performing a Ponzi fraud scheme or a front-running fraud (Williams, 2017). Markopolos filed a complaint to SEC to expose the findings, but SEC did not take any action.

2.7 Financial and SEC Problems
SEC obtained more complaints that Bernie was running a Ponzi scheme and decided to investigate. The investigation observed the massive billion-dollar fund and multiple contradictory statements from Bernie, which suggested he was lying (Quisenberry, 2017). However, Bernie used his computer experts to manipulate the number of clients to ensure that the list was below 15, the threshold for SEC in registration of companies. The case was closed, and Bernie escaped another capture. Bernie faced a major financial crisis in 2005, which affected the company’s liquidity position (Murdock et al., 2021). He tried to borrow hugely from European banks, and through the situation, Casey noticed and informed Markopolos, who filed another complaint to SEC. The long list made in Maropolo’s complaint was turned down by the SEC and dismissed.

2.8 Reasons why SEC dismissed Markopolo’s Claims
The SEC received many complaints from brokerage companies, yet it was understaffed. According to Quisenberry (2017), the SEO had understaffed personnel who were overworked, making it difficult to examine Bernie’s case extensively. The small number of staff was not sufficient to effectively cover all the complaints subjected to their tables. The SEO also had officers with little knowledge of Ponzi schemes. The complexity of Bernie’s operations made it hard for SEO investigators to make conclusive and substantive evidence over the claims made. Bernie also obtained the benefits of doubt from his excellent performances and the good track record depicted in Nasdaq, and the financial help he offered to SEC (Quisenberry, 2017). Bernie was brave enough to exclude lawyers in all the cases he was questioned by SEC, which suggested he had nothing to hide. Markopolos had a bad relationship with SEC managers; thus, they never followed his trails effectively. The Wall Street Journal rated Markopolos’ article low, citing other pressing economic issues, and Markopolos could not involve the FBI because the case fell under the SEC jurisdiction.

2.9 SEC Rules Changes and Scared Employees
The SEC introduced a ban to allowing entire feeder funds to act as a single client and elaborated that the number of clients in the fund was used. However, Bernie ignored the new law fearing scrutiny from SEC (Quisenberry, 2017). Further questioning led to registration in 2006 which made an end to long years of illegal practice. The continued questioning and investigations conducted by SEC investigators instilled fear in most of Bernie’s employees. The computer programmers, for instance, refused to make more programs for the company and even deleted most of the files to hide their involvement in the scheme (Quisenberry, 2017). They also made withdrawals from their accounts which affected operations in the company.

2.10 The Bad Ending
The great recession affected most companies across all industries. In August 2007, most companies recorded great losses in exemption of Bernie’s (Gertler & Gilchrist, 2018). The great recession made two significant impacts on Bernie’s investment; several wealthy investors and hedge funds were redirected to Bernie’s investment since all other companies were recording losses. On the other hand, some investors withdrew from Bernie to cover financial constraints in other sectors. More complaints were filed against Bernie; Markopolos brought up new findings, and a concerned client explained that Bernie kept two separate books. These claims were not investigated since the government was focused on stimulating economic growth (Gertler, & Gilchrist, 2018). More investors withdrew from Bernie due to the transparency issue, which tightened the problems. The scheme was exposed in November 2008 where clients’ redemption amounted to $1.45 billion, but the company had only $487 million in the investment fund account. According to Quisenberry (2017), the company made several calls to the bank to secure redemption but failed. By December 2008, Bernie declared that the company had no assets to pay all their clients’ withdrawal requests. FBI agents arrested Bernie, and his arrest information spread fast, with investors realizing their life-long pension schemes and benefits were gone.

3 The Securities and Exchange Commission Post-Madoff Reforms
The SEC took decisive and comprehensive steps to ensure they reduced the probability of such Ponzi schemes happening again. They also made measures that would help in detecting fraud to minimize the practice and avoid further economic frauds in investments. The agency made several reforms that have boosted its investigative power and mitigated fraud schemes.

3.1 Revitalizing the Enforcement Department
The enforcement department was restructured and included specialized units to help the agency in focusing on significant cases. According to Quisenberry (2017), the units focus on essential areas such as new products, market abuse, municipal securities and public pensions, asset management, and violations of the Foreign Corrupt Practices Act. The SEC has hired experts to work together with law specialists and accountants to ensure they stay at the cutting edge of the industry trends (Quisenberry, 2017). More efficient management structures have been implemented in the SEC agency to streamline its operations.

3.2 Encouraging Cooperation
The agency has encouraged cooperation from insiders by developing formal agreements with persons with information regarding fraudulent activities. The agreements promise better and reduced sanctions to individuals who cooperate and aid in investigations through testifying or offering relevant information to the SEC (Ortner, 2019). This helps to secure more witnesses and information before cases are taken to trial. Such actions provide solid evidence to fraudulent organizations making SEC more effective in dealing with fraudsters. Quisenberry (2017) explains that the cooperation helped to curb the challenges in fraud through investigating financial statement and accounting fraud, insider trading, investment adviser fraud, market manipulation, offering fraud, and FCPA violations.

3.3 Enhancing Safeguards for Investor’s Assets
The SEC introduced mechanisms to protect clients in investment advisers from abuse and theft. The formulated rules offer assurance to investors that their accounts have the indicated amount of money as depicted by their investments (Quisenberry, 2017). The rules encouraged financial advisers to place the client’s investment money with an independent body to undertake the money’s custody. The SEC also introduced mechanisms to reduce abuse and theft for investment advisers who did not use independent bodies to keep investment funds (Ortner, 2019). The mechanisms included random and surprise exams to investment advisers, third-party reviews, audit enhancements, auditor access, and custody reports analysis.

3.4 Improved Risk Assessment Capabilities
The SEC has continuously improved the risk assessment capabilities by improving procedures and techniques, which helps identify the risk areas in the markets. The agency has introduced mechanisms that facilitate the submission of information from financial firms and improved techniques to identify firms that need examination easily (Quisenberry, 2017). The information submitted helps the SEC to investigate and assess risk assessments in financial firms. Increased collaborations with third-party bodies and the government have increased the assessment capabilities (Ortner, 2019). The agency has also developed the Division of Risk, Strategy, and Financial Innovation that helps in offering expert advice to financial products, assessments, and engineering.

3.5 Conducting Risk-Based Examinations on Financial Firms
The SEC has introduced an enhanced risk assessment that helps to identify potential risk financial firms that warrant financial examination. This technique has helped the agency maximize its limited resources and effectively combat fraud (Quisenberry, 2017). The mechanism has recorded significant influence in protecting investor’s money from theft and manipulation. Risk factors considered for a financial examination include investor assets held in affiliate accounts, funds with smooth outlines on returns, and firms with disciplinary histories.

3.6 Improving Fraud Detection Procedures for Examiners
SEC has formulated measures that enhance the ability of examiners to detect financial violations and fraud. Examiners can easily reach third-party bodies, clients, and custodians during examinations to verify and collect additional information regarding the exam (Quisenberry, 2017). The access to such individuals and bodies has helped to determine the integrity of the parties concerned. The examination includes more than the general signs of fraud and undertakes investigations on the accountants used by the financial firms and a closer look into the firm’s financial structure (Ortner, 2019). The examination also takes into consideration joint broker investments and investment advisers with joint or multiple registrations.

3.7 Recruiting Staff with Specialized Experience
The agency has continuously hired new staff with specialized and diverse skills and knowledge bases. This has improved the agency’s abilities to assess risks, perform examinations, detect and investigate frauds and wrong deeds (Quisenberry, 2017). The agency has introduced senior specialized examiners who undertake more challenging aspects such as derivatives market and trade. Capital market experts have also been taken aboard to help in modern financial products and techniques (Ortner, 2019). The specialized staff offer guidance to other staff, which has generally improved the quality of services offered by SEC and minimized fraud cases.

3.8 Seeking more Resources
Congress has increased funding to SEC through the Dodd-Frank Act, which will increase the number of examiners to handle more financial firms. This ensures that the financial firms adhere to compliance protocols and laws (Quisenberry, 2017). The funds will also enable SEC to increase enforcement staff to bring more enforcement cases regarding fraud and other financial violations. Dodd-Frank Act provides a new budget for SEC which will ensure more and stable funding. The agency will also gain access to contingency funds in case it faces financial challenges.

3.9 Expanding and Training
SEC has been providing training and development programs to SEC staff to improve hedge fund knowledge and the essentials of specialized markets. The training also provides insight into derivatives markets, verification of trading, and custody practices (Quisenberry, 2017). Skills on using databases are given to staff to improve access to financial information from exchanges and clearinghouses. The training improves investigations’ quality and ensures the staff is Certified Fraud Examiners (Ortner, 2019). The SEC is also expanding the training services to ensure staff can acquire credibility to serve as Certified Financial Analysts and Chartered Alternative Investment Analysts.

4 Conclusion
In conclusion, Ponzi schemes are fraudulent investment scams that generate returns for earlier investors with money obtained from later investors. Most of these financial frauds lure investors under the promise of high profits. The scheme relies on a continuous and constant flow of investment to enable the facilitation of returns. Ponzi schemes are characterized by guaranteed promises of high returns with minimum risk involvement, consistent flow of returns regardless of market structures and conditions, investments are not registered with the Securities and Exchange Commission (SEC), the investment strategies are kept a secret, and investors are not allowed to view financial paperwork for the investment. Bernie Madoff’s Ponzi scheme has enlightened and provided insight to investors, hedge fund managers, and the federal government and has led to better laws and regulation procedures that help reduce fraud in financial and investment advisory firms.

References

Appel, I., & Fos, V. (2019). Active short selling by hedge funds. European Corporate Governance Institute (ECGI)-Finance Working Paper, (609). https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3404096

Bartoletti, M., Carta, S., Cimoli, T., & Saia, R. (2020). Dissecting Ponzi schemes on Ethereum: identification, analysis, and impact. Future Generation Computer Systems, 102, 259-277. https://www.sciencedirect.com/science/article/pii/S0167739X18301407

Henriques, D. B. (2018). A case study of a con man: Bernie Madoff and the timeless lessons of history’s biggest Ponzi scheme. Social Research: An International Quarterly, 85(4), 745-766. https://muse.jhu.edu/article/716113/summary

Murdock, M., Richie, N., Sackley, W., & White, H. (2021). Professional competence and business ethics. Journal of Financial Crime. https://www.emerald.com/insight/content/doi/10.1108/JFC-02-2021-0024/full/html

Gertler, M., & Gilchrist, S. (2018). What happened: Financial factors in the great recession. Journal of Economic Perspectives, 32(3), 3-30. https://www.aeaweb.org/doi/10.1257/jep.32.3.3

Ortner, S. B. (2019). Capitalism, Kinship, and Fraud: The Case of Bernie Madoff. Social Analysis, 63(3), 1-23. https://www.berghahnjournals.com/view/journals/social-analysis/63/3/sa630301.xml

Raghuram, V., & Dubey, M. (2021). Delving into Ponzi Schemes-Evolution Impact and Enforcement. Available at SSRN 3869793. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3869793

Sattybayeva, N. (2019). How Did the Most Sophisticated Investors Fall into Madoff’s Trap?. https://digitalcommons.pace.edu/cgi/viewcontent.cgi?article=1288&context=honorscollege_theses

Sunarya, I. W. (2019). Modeling and forecasting stock market volatility of Nasdaq composite index. Aaj (economics and accounting journal), 2(3). https://core.ac.uk/download/pdf/337610700.pdf

Turgeon, N. (2020). Money, Manipulation, & Madoff: What are Ponzi Schemes and How to Avoid Becoming a Fraud Victim. https://digitalcommons.assumption.edu/honorstheses/71/

Quisenberry, W. L. (2017). Ponzi of all Ponzis: a critical analysis of the Bernie Madoff scheme. International Journal of Econometrics and Financial Management, 5(1), 1-6. https://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.1078.8680&rep=rep1&type=pdf

Williams, D. C. (2017). A timeline and fraud triangle analysis of the sec’s Madoff Ponzi scheme investigation. International Journal of Business & Public Administration, 14(1). http://search.ebscohost.com/login.aspx?direct=true&profile=ehost&scope=site&authtype=crawler&jrnl=15474844&AN=127980565&h=EjmfTfH5Sjb3ZrNzLyKLEsRBXtAIjzBLssCU%2BYrjouTjihHsDHz%2FGObM4lzWytjRmArG3L2DKGaPFH2P097aMQ%3D%3D&crl=c

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