Bernie Madoff Fraud Case Essay Example

its principal place of business in the United States, but it also had its subsidiary – Madoff Securities International Limited (MSIL) which was incorporated in the United Kingdom. Gregoriou & Lhabitant (2009) stated in their paper that, “initially, BMIS was a pure brokerage business.

It paid brokers $0. 01 per share to execute their retail market orders; and since the NYSE was charging for order flows this convinced others to redirect a significant share of their trading volume to BMIS as well, to create what was known as “the third market. ” They further claimed that, “by 1989, BMIS was a market maker handling more than 5% of the trading volume on the NYSE. But, the brokerage business was becoming increasingly competitive and margins were shrinking.

Madoff therefore decided to create a separate investment advisory firm, which he located one floor below his brokerage business. In 2008, BMIS had $700 million of equity capital and handled approximately 10% of the NYSE trading volume. Its 200 employees (100 people in trading, fifty in technology, and fifty in the back office) were divided between New York and London, but only twelve of them were assigned to the famous split-strike conversion strategy (which will be discussed later) devised by Madoff. ” Execution of the Fraud

When news broke that Bernard Madoff – the man described as a legend and one with an impeccable character – had defrauded investors billions of dollars, one of the first questions that many asked is, how was this man able to execute such fraud; especially in the presence of the Securities Exchange Commission and all the other regulatory institutions within

the United States. To answer this, it was often written in the press that, “Madoff operated a hedge fund or a series of hedge funds. This is factually incorrect – there has never been a ‘Madoff fund’ and Madoff never claimed to be a hedge fund manager.

Madoff simply claimed that BMIS was able to execute a conservative strategy that would deliver annual returns of 10% to 12% per year by actively trading a very specific portfolio of stocks and options. But access to this coveted strategy was by invitation only – merely being rich was not in itself sufficient. ” In his criminal information issued by the Southern District Court of New York it was stated that, “Madoff marketed to clients and prospective clients an investment strategy referred to as a ‘split-strike conversion’ strategy.

Clients were promised that BLMIS would invest their funds in a basket of approximately 35-50 common stocks within the Standard & Poor's 100 Index – a collection of the 100 largest publicly traded companies in terms of their market capitalization. MADOFF claimed that he would select a basket of stocks that would closely mimic the price movements of the S&P 100. ” To add to this, in early 2008 BMIS was managing twenty-three discretionary accounts for a total of $17 billion. Most of these accounts however, belonged to feeder funds which were marketed to investors worldwide by numerous intermediaries.

This very specific structure meant that Madoff’s final investors were not direct customers of BMIS. They had to invest via one of the approved feeders which in turn had to open a brokerage account and delegate to BMIS

the full trading authority of their portfolios. Although results could vary from one feeder to another as a result of fees, leverage and other factors, all of them did in general post persistently smooth positive returns. Over his seventeen-year track record, Madoff apparently delivered an impressive total return of 557%, with no down year and almost no negative months (less than 5% of the time).

The stability of this track record, combined with its positive skewness, was one of the most compelling arguments for investing with Madoff. Returns were good but not outsized, and their consistency made it seem as if the outcome of the strategy was almost predictable. It was a perfect investment for a conservative portfolio and an even more perfect investment to leverage for an aggressive one. Not only were there feeder funds that were a part of this fraud scheme, but there were numerous other perpetrators and accomplices – whose main aim it was to benefit from the scheme and pull as much money as possible into their “coffers. In his criminal information, it was purported that, “Madoff hired numerous employees to serve as a ‘back office’ for this investment advisory business. Many of the employees hired to perform those functions had little or no prior pertinent training or experience in the securities industry. Madoff caused those BLMIS employees to, among other things, communicate with clients and generate false and fraudulent documents including, but not limited to, monthly client account statements and trade confirmations that purportedly reflected the purchases and sales of securities that Madoff claimed had been conducted on behalf of BLMIS's clients.

Madoff further caused account statements

and trade confirmation that were sent to clients to reflect fictitious returns consistent with the returns that had been promised to those clients. ” Though all of these actions were caused by Madoff – indeed he could not have done everything on his own and hence he had to have persons working in very close conjunction with him to fulfill those deeds. Another key accomplice who ought to be mentioned in this case analysis is Jeffrey Picower. Who would have thought that one of Madoff’s very own client would have been a “mastermind” behind this fraud case?

Investigations revealed that, “the biggest winner in Madoff's scheme may not have been Madoff at all, but a secretive businessman named Jeffry Picower. Between December 1995 and December 2008, Picower and his family withdrew from their various Madoff accounts $5. 1 billion more than they invested with the self-confessed swindler. ” (Bernstein, 2009) Even in recent times, and though Mr. Picower is no longer alive, it is still being alleged that Picower knew Madoff’s business was nothing more than a “ponzi scheme. ” From my point of view, it appeared as if both men were in collusion with each other to hide funds – mainly to avoid paying taxes.

Discovery of the Fraud It was in May 1999, that the most tenacious Madoff opponent Harry Markopolos started a campaign to persuade the SEC's Boston office that Madoff’s returns could not be legitimate. Carozza (2009) stated that, “Markopolos’ quest began as a simple work assignment. He was a portfolio manager for a multibillion-dollar equity derivatives asset management firm in Boston’s financial district. Frank Casey, a marketing senior

vice president for the firm, returned from New York with marketing materials for a high-performing, derivatives-based hedge fund managed by Bernard Madoff.

In early 2000, the firm’s partners asked Markopolos to reverse-engineer the strategy so that they could offer that said successful product to their firm’s customers. After he modeled the strategy, he determined that the returns could only be coming from illegal front-running of the Madoff broker/dealer arm’s client orders or from fictional returns that were the result of a Ponzi scheme. Markopolos then went to the firm’s partners and jokingly asked if they really wanted to get into that business. They hastily replied, “No way, if that’s what he’s doing then we don’t want to compete in that space. Prior to this discovery and even after, it was on several occasions that Markopolos submitted evidence to SEC offices. Much of this evidence was termed ‘red flags’ and included but were not limited to the following: Lack of segregation amongst service providers – A typical hedge fund uses a network of service providers that normally includes an investment manager to manage the assets, a broker(s) to execute trades, a fund administrator to calculate the NAV, and a custodian/prime broker to custody the positions.

These service providers work together but should normally be independent of each other and their functions segregated, as this segregation plays a major role in reducing the risk of fraud. With Madoff, all the above-mentioned functions were performed internally and with no third-party oversight. * Obscure auditors – BMIS was audited by a small accounting firm called Friehling and Horowitz. Why BMIS, with its large asset base, chose such

a small auditor should clearly have thrown up red flags.

Heavy family influence and conflict of interest heavy – Family links should also have been questioned by investors, as they compromised the independence of the functions. This is an obvious weakness of the internal controls meant to safeguard investors' assets from fraudulent activities. * No Madoff mention and extreme secrecy – At the feeder funds, several of the private placement memoranda and marketing materials never mentioned the Madoff or BMIS names. They disclosed merely that they allocated assets to “one manager who uses a “split-strike' strategy. Final investors were therefore not necessarily aware that they were investing with Madoff. * Lack of staff – In its regulatory filing, BMIS indicated that it had between one and five employees who performed investment advisory functions, including research. Simultaneously, it disclosed $17 billion of assets under management. Who could believe that such a large sum of money could really be managed by such a small group of people? Markopolos had done evidence which referred to the following ‘red flags’ in 2001, 2005, 2007, and 2008, but all submissions were to no avail.

In 2005, the SEC followed up on Markopolos’s tips and investigated BMIS and one of its feeders; but it found no evidence of a “ponzi scheme. ” In early 2008, Markopolos tried again to capture the attention of the SEC’s Washington office, but sadly he obtained no response. Resolution of the Fraud Despite numerous efforts by Harry Markopolos and other due-diligence firms to convince the SEC about the incredibility of Madoff’s Investment firm, it was Madoff himself who, on December 10, 2008, confessed to

his two sons, his brother and his wife that his investment advisory business was “a giant Ponzi scheme. It was a fraud that Madoff himself admitted could have taken as much as $50 billion from investors. On December 11, 2008, the SEC charged Madoff and BMIS with securities fraud for a multi-billion dollar Ponzi scheme that Madoff and others perpetrated on advisor clients of BMIS. Madoff and BMIS were also charged criminally for securities fraud by the U. S. Attorney's Office for the Southern District of New York. On March 12, 2009, Madoff pleaded guilty to securities fraud charges, admitting that beginning in the early 1990s, he stopped purchasing securities for his investment management clients and began operating a Ponzi scheme.

On June 29, 2009, Judge Denny Chin sentenced Madoff to 150 years in prison. A fraud case of this nature could have been avoided had the necessary rules and regulations been more strictly reinforced by regulators. The Securities Exchange Commission, only to a very small extent, played their part in protecting the interest of investors as deeper investigations should have been done into BMIS with so many ‘red flags’ highlighted.

As Gregoriou & Lhabitant (2009) stated, “these repeated failures by regulators to pursue investigations will certainly be examined and discussed extensively in the near future. ” In the mean time, while there is no way to completely eliminate fraud, Piper (2010) claims that having an effective prevention and detection programme will help to minimise the risks, which ideally should include such measures as:  A zero tolerance attitude to fraud and all types of financial crime. A system of background checks on new

employees. A whistleblower hotline for personnel to report suspicions of fraud in confidence.  A fraud investigation plan, with a commitment to investigate allegations of fraud appropriately and quickly.

A commitment from the board of directors and senior management to set the tone for fraud risk management and implement policy that encourages ethical behaviour. An independent audit committee with responsibility for monitoring financial statements, reviewing the effectiveness of internal financial controls and risk management systems, and overseeing audit arrangements. The appointment of a senior officer with oversight, and reporting responsibility for all fraud prevention and detection programmes. A fraud risk assessment to identify specific potential schemes and events (which should be repeated periodically). Specific references to fraud in the disciplinary code, with details of the sanctions for breaches of company policy. Conclusion In concluding, there are lessons to be learnt from this case analysis.

Though Bernard Madoff was considered as a man of impeccable character, there are times when we have to “look behind closed doors” in order to figure out what is there. “Madoff seems to have had an acute understanding of his targets, appealing to their desire for status by making them feel part of an exclusive secret club and burnishing that aura by turning down some potential investors. The more big names he harnessed, the easier it became to attract others, enabling him allegedly to operate one of the oldest of all financial frauds. (Sunderland, 2008) Had investors taken the time to find out more about this man, who claimed to be able to offer such extraordinary returns – then it’s quite possible many of them would not have lost so

much money. For him to have been able to pay out such high returns – there is hardly any other way he could have done so than through a ‘ponzi scheme’ – where you “take from Tom and give to Harry. ” While it’s regrettable that the SEC had not done more in its efforts to discover this fraud scheme, it is hoped that in the near future stricter regulations will be enforced by them and even other regulators.