From the February 2009 issue of Investment Advisor • Subscribe!

The Perfect Ponzi

Bernie Madoff has given independent advisors just what they need

At the time of this writing, the Bernie Madoff story is the most popular topic in America. A quick Google search reveals countless newspaper, magazine, and on-air stories that have used his record-breaking "$50 billion" Ponzi scheme as a lead-in to what's wrong with everything from Wall Street to capitalism to Social Security to the

Bush Administration (which is a good trick, considering that Madoff is a leading New York Democrat, reportedly contributing heavily to Hillary Clinton, Charles Schumer, and Chris Dodd, among others).

First, let's talk about what we know of Madoff's crimes, which to date is very little. Apparently, in early December, he held a meeting in his New York penthouse with two "key employees" who were reportedly his sons. Madoff told them that his decades-old, highly successful investment management business was a fraud, "a Ponzi scheme" in fact, and that he couldn't keep it going any longer. The sons went directly to the FBI and ratted out the father, who, when subsequently visited by a pair of Special Agents, admitted his investment portfolio was a sham, that there were never any "returns," and that over the years, he'd lost around $50 billion of investor money.

FINRA documents show that Madoff was supposed to have $17.5 billion under management in December. Sources say that some 25 or so investors--which include some of the largest and most sophisticated institutions, hedge funds, pensions, charities, and private investors in the world--had contributed around $36 billion. Judging from Madoff's alleged (and clearly deluded) statement to his sons that he planned to distribute the remaining $200 million to $300 million to employees, family, and friends, there's little left in his investment portfolios.

How Did He Get Away With It?

To get a handle on the Madoff mess, the key question is: How did he get away with this scam for so long? One of the hedge funds with which Madoff perpetrated his alleged fraud--Fairfield Sentry Ltd--was started in 1990, "returning" an average 10.5% annually since then. (Others of his multi-billion dollar funds returned 15% a year or more.) Using Madoff's own $50 billion figure, this has been widely reported as the largest Ponzi Scheme in history, but to my mind the greater significance is that it's also probably the longest-running Ponzi, as well.

We may never know whether Madoff ran it as a scam from day one, or whether, like most Ponzis, it started as a legitimate investment fund that had some bad years, which Madoff smoothed out by using new investors' principal to pay fictitious returns to existing investors, expecting to pay the money back out of better returns in subsequent years. When those returns didn't materialize, he found more new investors whose money went to pay the older investors again, starting the downward cycle for which Charles Ponzi is known.

The problem with Ponzi schemes is that they require an ever-expanding base of new investor capital from which to pay "returns" to the growing stable of existing investors, but sooner or later, the pyramid will collapse. Unless the perpetrator plans to flee to a well-padded nest with no extradition treaty with the United States, he or she is going to get caught, and probably do some jail time. But 20 years is, as far as I can tell, a record-breaking time to keep such a fraud going.

How did Madoff pull it off? I believe he combined two elements to create the "Perfect Ponzi," if we can use that term for a guy who's probably facing prison for the rest of his life. The first factor (and you just gotta love this part) is that despite many red flags over many years, his investors didn't pull the plug because they thought his phenomenally consistent returns were coming from insider trading--AND THEY WERE OKAY WITH THAT!

What most news stories haven't reported is that the investment management business was just a sideline for Madoff, who founded and owned one of the largest investment trading and market making houses in New York, matching sellers with buyers on leading exchanges around the world. By his own account in a digitally recorded interview (http://curiouscapitalist.blogs.time.com/2008/12/15/me-and-bernie-madoff-on-video-abridged), Bernard L. Madoff Investment Securities, LLC handled $1 trillion in trades a year, and is one of the top three market makers in both NYSE and Nasdaq securities.

Is it possible that at least some of his investors believed he was using his investment funds to front-run the trades BMIS was making for other investors (that is, he'd monitor the trades for large purchases or sales, then buy or sell the securities first, locking in a sure profit when the larger transaction was executed a few seconds later)? Henry Blodgett on clusterstock.com recently reported: "For years and years I've heard people say that [Bernie's] investment performance was too good to be true... and too high given the supposed strategy. One Madoff investor, himself a legend, told me that Madoff's performance 'just doesn't make sense. The numbers can't be straight.' So why did these smart and skeptical investors keep investing? They, like many Madoff investors, assumed Madoff was somehow illegally trading on information from his market-making business for their benefit."

The Perfect Ponzi, Parts 1 & 2

So the first element in Madoff's Perfect Ponzi is that his trading business provided the perfect cover for how he was generating returns that were too high and too consistent. At least some of his investors knew he was cheating--but they were content because he was not cheating them. Madoff himself was probably too smart for the front-running scam: he'd have known the SEC computers monitor that sort of thing.

The second element of the Perfect Ponzi--and the one that holds the salvation of independent advice--is that Bernard Madoff is an NASD/FINRA/SIA insider, and therefore seemed to be off-limits to SEC investigators, despite many red flags, troubling articles, and complaints against him. According to Madoff's lawyer Dan Horwitz: "Bernard Madoff is a longstanding leader in the financial-services industry with an unblemished record." That's an understatement. Madoff served as vice chairman of the NASD, was a member of its board of governors, and chairman of its New York region. He also chaired Nasdaq's board of governors, served on its executive committee, and was chairman of its trading committee. He was also chief of the SIA's trading committee in the 1990s.

As for articles reporting red flags, you can easily find all the evidence you want with a quick Google search, including "Don't Ask, Don't Tell," which ran in Barron's on May 7, 2001. A December 22, 2008, article on Truthout.org quotes former SEC criminal investigative lawyer Gary Aguirre who explained that as an investment advisor, the SEC had regulatory authority over Madoff, yet after repeated complaints (over nine years) about a Ponzi scheme fraud, nothing was done to investigate.

But the most telling of all the Madoff stories is a 21-page report sent to the SEC on Nov. 7, 2005 by derivatives expert Harry Markopolos entitled "The World's Largest Hedge Fund is a Fraud," in which he contacted heads of Wall Street equity derivative trading desks. Markopolos said that every senior manager told him: "Bernie Madoff is a fraud."

Markopolos concluded: "I am pretty confident that BM is a Ponzi Scheme, but in the off chance he is front-running orders and his returns are real, then this case qualifies as insider trading under the SEC's bounty program. However, if BM was front-running, a highly profitable activity, then he wouldn't need to borrow funds from investors at 16% implied interest. Therefore it is far more likely that (this was) a Ponzi Scheme."

After considerable prodding, the SEC investigated Madoff, finding that he misled its examination staff, failed to inform some investors that he was in fact their investment advisor, and failed to register as an investment advisor with the SEC. The commission also apparently investigated Markopolos's charges of front-running and a Ponzi scheme but couldn't substantiate the claims and closed the case when Madoff agreed to register his investment advisory business, concluding the "violations [it uncovered] were not so serious as to warrant an enforcement action."

In a December 23, 2008, letter to the Wall Street Journal, former SEC Boston office "examiner of advisers and funds" Eric Bright wrote: "It wouldn't be the first time that something (like the Madoff case) fell through the cracks...During my time at the SEC, I heard the excuses about why cases that the examination staff uncovered failed to warrant actions by the enforcement staff: Too small...too complicated...too politically connected, don't rock the boat...It is time to rethink the structure of the regulatory system because what we have isn't working."

Which brings us to the reregulation of financial advice. As the Madoff case makes clear, despite obvious red flags, troubling articles, complaints, and even an investigation, the NASD/FINRA, NYSE, and the SEC had little interest in policing one of their own. It's time for a new sheriff in town--one who's interested in protecting financial consumers first, and in creating a level playing field for professional, client-oriented, truly independent financial advisors.

Are any of the profession's current organizations--FPA, CFP Board, NAPFA, etc.--up to that task? Hmmm. Maybe if they work together for once (and maybe their new coalition is the beginning of that cooperation; see News story on page 14) and use the stick that Madoff has provided, they could convince Washington to set up an SRO that would truly protect financial consumers by clearly separating professional advisors from those who only claim to be.


Bob Clark, former editor of this magazine, surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at rclark7000@aol.com.

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