The Madoff Affair: Greed's Victory Over Common Sense

The announcement last Friday of the fraud case orchestrated by Bernard Madoff is not coming as a surprise to anyone. In the light of the plethora of red flags enumerated in the press, it appears that investors all over the world have decided for years to avoid asking the right questions. The real question for the financial industry today is why due diligence and prudent investor rules have been relaxed in this particular case. The only phenomenon of surprise in this story is perhaps the size of the scheme evaluated by Mr. Madoff himself to “at least $50bl”.

A clue, that may help us understand how all this happened, is perhaps the intentional low profile of Madoff Investment Securities LLC. The company, to our knowledge, never signed an investment management agreement with the funds it managed, but rather, like in the Fairfield Sentry case, was acting as the trade execution and market timing agent of the funds. This setup makes it difficult to assess the real size of assets managed by Madoff. The unusual setup and secrecy around the failed broker/dealer is probably what made him so successful to attract assets. It was really a privilege to have an account with Bernie’s institution.

The other factor that made him so successful was that Madoff was not taking any fee to manage the accounts. According to the funds’ promoters, Madoff was remunerated through the transactions costs he was charging while implementing his investment strategy. This type of remuneration was in line with the pure execution role he was supposedly assuming in the funds. The fee schedule was therefore very attractive to the funds’ promoters since they were able to keep for themselves all the fees generated by their product. It was also very attractive to various intermediaries in the industry that made a living on the retrocession paid to them by those funds’ promoters.

Another characteristic of the scheme was that its reputation has been growing over time. It was indeed very difficult for investors to believe that such a reputable and long standing institution was able to commit a fraud for so long without being caught. The herd effect is also to blame in this case as investors believed that a manager cannot fool a large number of reputable financial institutions. Investors took comfort that amongst all the institutions exposed to Madoff probably someone had done his due diligence properly. Another factor of comfort was the fact that Madoff Investment Securities LLC was a US broker/dealer regulated by the SEC.

The sophistication of the fraud is also worth mentioning. As described before, Madoff was not the “official” investment manager of the fund but as a custodian had to provide trade tickets and financial statements to the funds' administrators/auditors to support his returns. Bernie probably had in place a sophisticated process that allowed him to simulate trades, following his declared split strike conversion strategy, that were demonstrating the type of returns expected by investors. Bernard Madoff had kept the fund returns in reasonable range probably to avoid attracting too many lights on him.

A lot of things will be learned by the different players about this sad story. For investors, the main lesson is clear: you need to have a strong due diligence process and to have a clear segregation of duty between the due diligence department and the persons taking investment decisions. If you don’t have that you are potentially exposed to new surprises down the line. The side effect of this case will certainly be a worsening of the already tainted reputation of hedge funds. However, investors should be very careful not to get to the wrong conclusion; the willing victims are sometimes not less guilty than the fraudster as they are the one that indirectly helped him to perform his crime.

Comments

[Income Tax:]

Very interesting article. If you look at top paying jobs, companies, cities on www.salarylist.com/ave... not surprisingly, you will see accountant, lawyers, portfolio manager, programmers, models, doctors.. However, when we think of 2008, all this mess are all connected to the financial systems, where we have all the smartest accountant, lawyers, and portfolio mangers. Is that ironic?

2008 Dec 16 02:43 AM

[notsosmart:]

as long as it works no one is ethical.dont ask ,dont tell, is not only for the military.without this burst the fraud would have gone on & on attracting more "sophisticated " investors.there is nothing & nobody you can trust.ceo's stare straight into the camera & lie.there is no accountability,ethics or transparency.the whol thing is a ponzi.there is more oversight to vegas than wall st.manage your own money.its the best you can do.

2008 Dec 16 12:06 PM

[secmaven:]

Human beings are by nature gullible and trusting, even the most sophisticated among them. Mr. Madoff played on these characteristics like Heifitz played on his violin.

2008 Dec 16 01:10 PM

[Josh Stern:]

A lot of detail about the Madoff case has yet to come out, but what I've heard doesn't lead me to believe that due diligence is the answer to the problem of fraud avoidance. The answer is diversification of who and what is being trusted with assets, paying particular attention to where and when the honesty of a given receiver of assets is reliably insured. Due diligence is not going to get people both access to the books and the ability to determine that the books are not cooked. Fraud will always be possible, so the correct approach has to involve spreading risk around possible sources of fraud.

2008 Dec 16 01:55 PM

[Jason Rines...:]

Here's the answers:

1) Congress issues it's own currency and goes back to greenbacks, mass default.
2) Term limits for House of Representatives (the Roman revived there rotting empire for another 200+ years by doing this)
3) Government does the only job it is supposed to do which is acting as a security guard for it's own citizenship. Increase legal immigration, no more free bennies to non-citizens.
4) Max corporate and government income tax 12% for all citizens.
5) Teach American and World History K1-12 and universities.

On Dec 16 01:55 PM Josh Stern wrote:

> A lot of detail about the Madoff case has yet to come out, but what
> I've heard doesn't lead me to believe that due diligence is the answer
> to the problem of fraud avoidance. The answer is diversification
> of who and what is being trusted with assets, paying particular attention
> to where and when the honesty of a given receiver of assets is reliably
> insured. Due diligence is not going to get people both access to
> the books and the ability to determine that the books are not cooked.
> Fraud will always be possible, so the correct approach has to involve
> spreading risk around possible sources of fraud.

2008 Dec 16 02:51 PM

[trumanburbank:]

Due diligence, and not even very concerted due diligence, apparenly kept many investors away from this toxic fund manager's clutches, so explain to us again why due diligence isn't the answer. The Mass Mutual-related hedge fund that was simply a feeder fund for Madoff just forwarded their entire $3.5 bil under managment to Madoff, charging their unsuspecting investors a 1% annual fee. I think that for $35 mil in annual fee income they could've scraped off a few dollars to look over Madoff's audits, which were apparently done by an unheard-of firm with one CPA and a calculator. Those who took the time to examine the Madoff trading strategy found that it's virtually impossible for it to have generated the reported consistent returns. To perform this due diligence one only needed access to google -- you could do it on your cell phone in a half hour. Yes, fraud will always be an element of the business world, but there is an entire mini-industry within the world of finance that is designed to evauate risk, "internal controls" and operational integrity (and even a freshly-minted junior auditor would immediatly have recognized the near-total absence of proper internal controls at Madoff). The private side of this mini risk-management industry works (or should work) hand-in-glove with their public sector counterparts in the SEC and related agencies. These mechanisms will never prevent fraud, but if properly funded and used as designed they will catch fraud quickly and consistently, with an almost mathematical certainty. Just ask your CPA.

(Disclosure: I'm not in the risk-management business, nor am I a CPA, but I do understand the fundamentals of internal controls, fraud prevention and forensic accounting.)

It ain't rocket science, but fiduciaries, managers of OPM (Other People's Money) and those who handle the public purse are responsible for understanding these tools well enough to know how and when to employ them.)

2008 Dec 16 07:04 PM

[trumanburbank:]

...Just to be clear, I agree with the author regarding due diligence, but disagree in part with prior commenter Josh Stern when he states that "...what I've heard doesn't lead me to believe that due diligence is the answer to the problem of fraud avoidance."

As I stated, due diligence doesn't always prevent fraud, but it does detect fraud, expose it and stop it with a high degree of certainty when dd tools are used appropriately. And when applied prior to investment, dd can prevent a particular investor from participating in a fraud such as the one perpetrated by Mr. Madoff. Of course, as we learned, if the police and regulators are informed and follow up appropriately, this type of dd should also bring the whole fraud to light, although it seems that unresponsive regulators failed to act on the signals in this instance.

2008 Dec 16 07:15 PM

[DegreeNodal:]

Hang Bernie on prime time television by the....you know what. Imagine the deterrence effect.

The entirety of the investment world has been exposed as possibly fraudelent, properly or not. This man was the insiders' inside man, the Chairman of the board. Yet in end, he is nothing but a cheap and clever crook. Hollow and worthless is Mr Madoff, a poster child for all the false promises made to us by the financial industry. We are the inventor and the product of the greed and deception of our own national promise.

2008 Dec 16 11:12 PM

[Josh Stern:]

The comment above seems to espouse the theory that due diligence will typically detect fraud and that the primary failure of due diligence in this case was the failure to notice that Madoff was being audited by a small accounting firm without a national reputation. I don't agree with either of those points. Another famous fraud, Enron, was audited by Arthur Anderson which was at that time one of the top 5 accounting firms in the country. Where is the evidence that fraud is much more common when the parties use small audit firms or that parties using big audit firms are unlikely to commit fraud?

In the case of every fraud there are all sorts of things to be said with 20-20 hindsight, but I guarantee that no simple prescription for fraud avoidance is going to get the job done, and most will just hurt overall returns of a well diversified portfolio.



On Dec 16 07:04 PM trumanburbank wrote:

> Due diligence, and not even very concerted due diligence, apparenly
> kept many investors away from this toxic fund manager's clutches,
> so explain to us again why due diligence isn't the answer. The Mass
> Mutual-related hedge fund that was simply a feeder fund for Madoff
> just forwarded their entire $3.5 bil under managment to Madoff, charging
> their unsuspecting investors a 1% annual fee. I think that for $35
> mil in annual fee income they could've scraped off a few dollars
> to look over Madoff's audits, which were apparently done by an unheard-of
> firm with one CPA and a calculator. Those who took the time to examine
> the Madoff trading strategy found that it's virtually impossible
> for it to have generated the reported consistent returns. To perform
> this due diligence one only needed access to google -- you could
> do it on your cell phone in a half hour. Yes, fraud will always be
> an element of the business world, but there is an entire mini-industry
> within the world of finance that is designed to evauate risk, "internal
> controls" and operational integrity (and even a freshly-minted junior
> auditor would immediatly have recognized the near-total absence of
> proper internal controls at Madoff). The private side of this mini
> risk-management industry works (or should work) hand-in-glove with
> their public sector counterparts in the SEC and related agencies.
> These mechanisms will never prevent fraud, but if properly funded
> and used as designed they will catch fraud quickly and consistently,
> with an almost mathematical certainty. Just ask your CPA.
>
> (Disclosure: I'm not in the risk-management business, nor am I a
> CPA, but I do understand the fundamentals of internal controls, fraud
> prevention and forensic accounting.)
>
> It ain't rocket science, but fiduciaries, managers of OPM (Other
> People's Money) and those who handle the public purse are responsible
> for understanding these tools well enough to know how and when to
> employ them.)

2008 Dec 17 02:58 PM