The Great American Economic Meltdown (Part 2)

This article, the second of two parts, is adapted from a chapter in “Readings in White Collar Crime,” Second Edition, from David Shichor et al. (Long Grove, Ill.: Waveland Press Inc., forthcoming). Reprinted by permission of Waveland Press Inc. All rights reserved.

The 2008 corporate scandals at Bear Stearns, Countrywide, Lehman Brothers, AIG, and others that led to the American economic meltdown weren’t all based on white-collar crime. However, the study of white-collar crime should focus not only on violations of the letter of the law, but also on the acts by those in positions of power who, in their occupational roles, seriously harm others. 

This article concentrates on two Ponzi cases – the Bernard L. Madoff Investment Securities scheme and the alleged Stanford Financial Group fraud – which show the underbelly of corporate corruption during the recent economic meltdown. 

ON PONZI’S PATHWAY 

Charles Ponzi (1882-1949) unwittingly gave his name to a form of white-collar crime – the Ponzi scheme – which characterized two of the major scandals during the world’s most recent economic breakdown.  

The basic ingredients of a Ponzi scheme are very simple. You have to get enough people interested in putting money into whatever investment you’re promoting by promising them desirable profits. Then you pay off the initial investors with the funds that keep coming in as other people are attracted by the rewards reaped by the first investors. It’s likely that those original investors will be so delighted with their gains that they’ll leave the money they’ve “earned” with you to reap even greater returns. So, for a time, a great deal of money will be coming in and not much going out.  

A Ponzi scheme demonstrates the truth of one of the oldest maxims in the financial world. If something is offered that flagrantly flies in the face of common sense, it’s very likely to be nonsensical – and probably crooked.  

Italian-born Charles Ponzi had stumbled about after migrating to the United States until he hit upon the idea that he could, in theory, buy postage stamps issued internationally to facilitate commerce, and sell them at a significant profit in the United States. Investors flocked to the company he originated. He never quite got around to purchasing the stamps, which actually wouldn’t have come close to financing the scheme he advertised. When he was exposed, Ponzi received a five-year prison sentence.  

After his release, he set up another scam, this time based on Florida land sales. It ended with seven more years in prison and, thereafter, deportation to Italy, where he later died impoverished (Dunn, 2004; Zuckoff, 2006). 

BERNARD L. MADOFF INVESTMENT SECURITIES 

For 40 years, Bernie Madoff, an affable crook who mingled with the country club elite, operated a Ponzi scheme that is believed to have defrauded investors of an estimated $65 billion. Madoff enticed the careless and the gullible with a campaign that, among other enticing claims, maintained that Madoff Investments used sophisticated computer systems “to monitor prices” and to “identify trading opportunities around the world.” 

The firm generated much business through word-of-mouth endorsements from customers who were paid dividends with money invested by other customers. By the time the law caught up with Madoff, he owned apartments on New York’s Upper East Side and near Wall Street; a house in Montauk on Long Island; three properties in Palm Beach and a house in Key Largo, all in Florida; and another in Antibes, France. To gain political advantages, between 1997 and 2008 Madoff spent $590,000 on lobbying plus another quarter of a million on campaign contributions from 1991 onward. 

Madoff was arrested Dec. 11, 2008 and raised bail of $10 million that allowed him to remain under house arrest in his penthouse apartment. His sons, Andrew and Mark, who both worked for the investment company, told their attorney after their father confessed the scheme to them. The attorney informed the authorities.  

Speculation was widespread that this was a planned scenario designed to keep Madoff’s wife and his sons, both co-directors of trading, as well as his brother, Peter, the company’s chief compliance officer, from facing criminal charges. Many believe all of them must have known that the company was crooked. (According to money.cnn.com, the court-appointed trustee liquidating Madoff’s business filed a $199 million lawsuit in October of 2009 against Peter, Madoff’s two sons, and Madoff’s niece, Shana, who was a compliance director.) 

Critics were appalled that the Securities and Exchange Commission (SEC) had never thoroughly investigated Madoff, even though Harry Markopolos, CFE, had alerted the SEC several times that the “profits” heralded by Madoff were too good to be true – and, in fact, couldn’t possibly be true. Madoff’s gigantic enterprise was audited by a hole-in-the-wall, store-front accounting company, Friehling & Horowitz, that had but one active accountant, David Friehling. He had invested $14 million with Madoff, but by 2000 had withdrawn $5.5 million. Friehling would later be charged criminally for his alleged role in covering up the scheme.  

Among the gullible who were robbed by Madoff were filmmaker Stephen Spielberg; husband and wife actors Kyra Sedgwick and Kevin Bacon; Nobel Prize author Elie Wiesel; Fred Wilson, owner of the New York Mets baseball team; and media mogul Mort Zuckerman.  

Madoff also swindled a large roster of Jewish schools including Yeshiva University, which lost $110 million, as well as New York University (out $24 million) and Tufts University (out $20 million) and a host of foreign investment companies that accepted funds (often without informing their customers), charged a hefty fee, and put all of the money into Madoff’s scam operation.  

René-Thierry Magon de la Villehuchet, a co-founder of Access International Advisors, who had lost $1.4 billion of his own and his clients’ money, committed suicide two weeks after Madoff’s ruse became public knowledge. Austria’s Bank Medici had placed $2.1 billion at Madoff’s disposal. The Bank Medici had touted itself as employing “the most unusual mixture of financial strength and tradition, of sophisticated know-how and technological expertise.” In the wake of the Madoff disaster, the Austrian government took over the Bank Medici (Sander, 2009).  

As is often the case, the lawyers reaped the juiciest financial harvest. The firm appointed by the court to clean up Madoff’s business billed for $15.5 million for five months’ effort; the attorney leading the work charged $700 for each hour he said he put in on the job. 

Madoff pleaded guilty on March 3, 2009, to 11 criminal charges. His lawyer noted that at age 71 his client had a life expectancy of 13 years and asked the judge to impose a 12-year sentence. Ignoring the defense recommendation, on June 29, 2009, federal district court judge Denny Chin imposed the maximum possible sentence of 150 years on Madoff, declaring that the defendant was “extraordinarily evil.”  

The judge granted that the overkill sentence was symbolic, according to the June 30, 2009, article in The Wall Street Journal, “‘Evil’ Madoff Gets 150 Years in Epic Fraud,” by Robert Frank and Amir Efrati. But he said he considered it a lesson to actual or potential white-collar criminals. The sentence wasn’t a record for a financial fraud perpetrator. In the past decade, there have been sentences as high as 350 and 845 years, according to Frank and Efrati.  

Madoff is in the medium-security section of the federal correctional complex in Butner, N.C. There, he can enjoy the company of a coterie of other white-collar crooks including Franklin C. Brown, former vice chairman of Rite-Aid, and Al Parrish, who also was convicted of operating a Ponzi scheme. 

Some thought Madoff’s sentence would nullify any attempt by the authorities to gain his cooperation in locating moneys that he might have hidden away and could be used to repay victims. They believed Madoff would be more inclined to offer that possible information if he knew he possibly might be granted some clemency and be set free before he died.  

Victims of his nefarious acts gave wrenching testimony during Madoff’s sentencing session. One victim said he had planned to use the funds he deposited with Madoff for the care of his mentally disabled brother, according to the June 30 article in The Wall Street Journal, “Victims’ Speeches in Court Influence Verdict,” by Peter Lattman and Annelena Lobb. “I hope Madoff’s sentence is long enough so that his jail cell will become his coffin,” the victim declared. One woman told the judge, “I now live on food stamps. I scavenger in Dumpsters at the end of the month.” Others labeled Madoff a “monster” and a “low life,” according to Lattman and Lobb. 

Debora and Gerald Strober, a writing team who interviewed numerous victims of the Madoff rip-off, asked but never answered a trio of interpretive questions: 1) Is Bernie Madoff mentally disturbed? 2) Is he a sociopath? 3) Is he completely rational but totally amoral? (Strober and Strober, 2009). The Strobers stressed that what differentiated Madoff from other white-collar malefactors was that he cold-bloodedly betrayed and fleeced intimates, including relatives and his closest friends.  

The hammer also fell in June 2009 on persons who had steered billions of dollars into the Madoff scam – so-called “feeders” – when the SEC filed a civil fraud suit against Stanley Chais, a prominent money manager for some 40 years with an office in Beverly Hills, Calif. Chais was charged with a breach of fiduciary duty by deceiving his investors and ignoring obvious signs of fraud.  

The other SEC case was against three executives of the Cohnad Securities Corporation, a small brokerage firm housed in the same building as the Madoff enterprise. Unbeknownst to their clients, they had turned over the clients’ money to Madoff, according to the June 23 article in The New York Times, “Madoff Suits Add Details About Fraud,” by Diana B. Henriques.  

The SEC said the Cohnad executives never took their rewards from the clients’ allegedly accrued amounts, which indicates that the executives knew these profits were fictitious. The executives’ attorneys claimed their clients had also been victims and had lost large amounts of their money in the Madoff swindle, according to Henriques. Also, New York State Attorney General Andrew Cuomo filed a civil suit against J. Ezra Merkin, who ran a Madoff feeder firm, while Massachusetts went after Fairfield Greenwich on the same grounds. 

There was scant satisfaction in seeing Madoff get his due while those who directly contributed to the economic meltdown not only escaped untouched by the criminal justice system but were raking in even more exorbitant incomes. At the firm of Goldman Sachs, the average employee salary had risen to $700,000 a year – higher than before the meltdown. For Frank Rich, a columnist for The New York Times, Madoff’s offenses were small potatoes compared to “the esoteric (and often legal) heists by banks and bankers.” Rich wrote in his July 5 Times column, “Bernie Madoff is No John Dillinger,” that “they gamed the entire system, then took the money and ran before the bubble burst, sticking the rest of us with that fear, panic and loss.”  

On Nov. 3, 2009, David G. Friehling, who was Madoff’s independent auditor from 1991 until the fraud collapsed in December 2008, pleaded guilty to nine criminal charges. He admitted he had never adequately audited Madoff’s business, but he said he never knew Madoff was engaged in a Ponzi scheme. Friehling was to have been sentenced Feb. 26. He faced a potential term of 114 years. 

On Aug. 11, 2009, top Madoff aide Frank DiPascali, pleaded guilty to 10 counts including securities fraud, investment adviser fraud, and falsifying books and records of a broker dealer. He faces 125 years in prison. As of press time, DiPascalli was held without bail in a Manhattan jail while he awaited sentencing. 

STANFORD FINANCIAL GROUP 

The Madoff case was instrumental in leading law enforcement authorities to the Stanford Financial Group (SFG). The SEC went on alert when SFG lied to it by declaring it had no exposure to Madoff’s schemes. However, Stanford International Bank had $400,000 in “indirect investment” in the Madoff enterprise. Earlier, U.S. enforcement agencies had ignored financial analyst Alex Dalmady’s scathing denunciation of SFG in an article he wrote for a Venezuelan magazine, and they hadn’t responded to a 2008 discrimination lawsuit filed by two SFG employees who cited the firm’s “various unethical and illegal business practices.”  

Finally, in June 2009, the U.S. Department of Justice filed a 21-count criminal indictment against financier Sir R. Allen Stanford, a 59-year-old Texas billionaire, and five others. Stanford was accused of masterminding a Ponzi scheme that bilked some 30,000 investors – many of them from Latin American countries – out of an estimated $7 billion.  

As is common in prosecutions that involve co-defendants, the government convinced one of the secondary participants, James M. Davis, SFC’s chief financial officer, to plead guilty to charges of fraud and conspiracy and testify against Stanford in return for a lesser sentence. Davis and Stanford had been close; they first met as college roommates at Baylor University in Waco, Texas. 

SFC had its headquarters on the Caribbean island-nation of Antigua and Barbuda with investment offices in Venezuela, Houston, Panama, and Miami. Forbes magazine had listed Stanford as the 250th wealthiest person in the United States. In 2006, he had been the first American to be knighted in Antigua.  

The head of the Antiguan Financial Services Authority, Larry King, indicted with Stanford, allegedly was paid more than $100,000 to abstain from auditing SFG and for supplying confidential business information to the company, according to the June 20 article in The New York Times, “How Stanford Financial Dodged Regulators,” by Clifford Krauss. Stanford and King, in a melodramatic move, had cut their wrists and mixed their blood in a “brotherhood ceremony.” 

When SEC investigators asked King to supply reports about Stanford’s operation, he told the company about the agency’s inquiry and helped craft a response that said that SFG was “in compliance with all areas of depositor safety and solvency, as well as all other applicable laws and regulations.” The SEC’s enforcement head used a football analogy to convey the character of the Stanford-King relationship: “While Stanford quarterbacked his massive Ponzi scheme, he paid the referee to spy on the huddles and provide an insider’s play-by-play of the SEC investigation.” Earlier, in February 2009, the SEC had filed a civil suit that charged Stanford and Laura Pendergest-Holt, the company’s chief investment officer, with two instances of obstruction of a federal investigation and with complicity in the Ponzi scheme that netted $7 billion, much of which can’t be accounted for.  

In its heyday, SFC offered certificates of deposit paying 10 percent interest, according to the June 19 article in The Wall Street Journal, “Stanford is Indicted in Fraud, Surrenders,” by Evan Perez. Among its other scams, the company allegedly had engaged in “round-trip” real estate transactions by buying undeveloped Antiguan real estate for $63.5 million and then “selling” the property to its own subsidiaries for $2 billion and allowing that sum to be carried on its books as an asset.  

In the company’s magazine, Stanford made a declaration that an SEC spokeswoman said was “improbable, if not impossible.” Stanford said: “Our world is far different than the world my grandfather lived in when the first Stanford company was founded. … As a company founded in the midst of the Great Depression – an environment of despair – we have a long-proven record of how even the most severe downcycles can bring opportunities that yield significant benefits in the long run.”  

Instead, in the words of the SEC spokeswoman, Stanford had operated “a fraud of shocking magnitude that has spread its tentacles throughout the world.” Unlike Madoff, Stanford was denied bail on the grounds that he posed a serious risk of fleeing the country because he had high-placed connections in foreign lands.  

At the bail hearing a pilot testified that he had recently flown Stanford to Libya and Switzerland and an auditor told the court that $100 million had been withdrawn from a Swiss bank that Stanford controlled. And Stanford had recently requested a friend retrieve his Antigua passport.  

The denial of bail indicated, at least in this instance, the judicial system can hit a noted alleged white-collar offender harder than street criminals. Courts often allow street criminals to bail themselves out of holding facilities; Stanford must remain in custody for a considerable period until the attorneys are prepared to go to trial.  

As of press time, Stanford, who apparently has undiagnosed health problems, was awaiting trial in solitary confinement in the Houston Federal Detention Center. 

ABUSES OF POWER 

As Gillian Tett observes in her 2009 book, “Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan was Corrupted by Wall Street Greed and Unleashed a Catastrophe,” the economic meltdown that began in the fall of 2007 “was not triggered by a war, a widespread recession, or any external shock.” It was self-inflicted. She notes that “the entire financial system was wrong as a result of flawed incentives within banks and investment funds, as well as the rating agencies; warped regulatory structures; and a lack of oversight.”  

These allegations are true, but they don’t go far enough. They imply that structural conditions inevitably allowed – indeed, encouraged – many to take advantage of these economic fault lines. White-collar crime research over the years has documented in great detail the greed and rapaciousness of many of those in power or clawing their way up the ladder to financial wealth.  

There is no denying the general truth of Lord Acton’s famous maxim that “power tends to corrupt and absolute power corrupts absolutely” (Creighton, 1904). We can also note the written observation of novelist Isaac Beshevis Singer: “Power kills all ideals.” (Singer, 2008). And considerably more pungent is the observation of Francis Bacon, a 16th century English philosopher and statesman. “He who rides without a lid,” Bacon said, apparently referring to self-control and self-discipline, “doth like the ape, the higher he climbs the more he shows his ars” (quoted in Pope, 1975). Power must be held in check by restraining mechanisms, diligent oversight, and tough responses to its abuse. 

The economic meltdown proved something more than the failure of unbridled and under-regulated capitalism. It revealed the failure of a social system to have taught enough of its citizens – most notably those in the top echelons – principles of honesty and transparency in their dealings and to have inculcated them with a goodly dosage of selflessness.  

“The scent of money deadens all other sensory and ethical organs,” Charles R. Morris noted in his book, “The Two Trillion Dollar Meltdown.” He added that “the securities laws assume that lawyers, accountants, and credit raters will not allow monetary incentives to override their professional ethics – an assumption that draws little support from the abysmal recent record.”  

That record offered a backdrop for author Elliot J. Gorn, who sought to understand the public support accorded John Dillinger, a bank robber at work during the Great Depression of the 1930s, in Gorn’s book, “Dillinger’s Wild Ride.”  

“As our own day’s story of stupid policies and lax regulations, of great moneymen, free-market hucksters, white-collar thieves, and self-serving politicians unfolds and banks foreclose on millions of families’ homes, workers lose their jobs, and life savings disappear,” Gorn writes, “it becomes clear” why an outlaw who could be said to rob those who became rich by robbing the poor might channel “a people’s sense of rage at a system that had failed them.”  

The study of white-collar crime alerts us to the flaws in human beings and in social systems that permit – even encourage – abuses of power. We can only hope that we might finally learn some lessons that might avert, or at least ameliorate, the next economic disaster. 

Gilbert T. Geis, Ph.D., CFE, is President Emeritus of the ACFE. A pillar of the ACFE, he was one of the earliest advisors to Joseph T. Wells, CFE, CPA, founder and Chairman. An expert in white-collar crime, Geis is professor emeritus in the Department of Criminology, Law & Society at the University of California-Irvine. 

REFERENCES 

Creighton, Louise (1904). Life and Letters of Mandell Creighton. London: Longmans Green, vol. 1, p.37. 

Dunn, Donald H. (2004). The Incredible Story of the King of Financial Con. New York: Broadway Books. 

Frank, Robert & Efrati, Amir (2009, June 30). “ ‘Evil’ Madoff Gets 150 Years in Epic Fraud.” The Wall Street Journal, pp. A1, A12. 

Gorn, Elliott J. (2009). Dillinger’s Wild Ride: The Year That Made America’s Public Enemy Number One. New York: Oxford University Press, p. 213. 

Henriques, Diana B. (2009, June 23). “Madoff Suits Add Details about Fraud.” The New York Times, pp. B1, B4.  

Krauss, Clifford (2009, June 20). “How Stanford Financial Dodged Regulators.” The New York Times, pp. B1, B6. 

Lattman, Peter & Lobb, Annelena (2009), June 30). “Victims’ Speeches in Court Influence Verdict.” The Wall Street Journal, p. A12. 

Morris, Charles R. (2008). The Two Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crunch. (Rev. ed.). New York: Public Affairs, pp. 31, 150. 

Perez, Evan (2009, June 19). “Stanford is Indicted in Fraud, Surrenders.” The Wall Street Journal, p. C1. 

Pope, Alexander (1975/1728). Dunciad I, 1728. New York: Garland. 

Rich, Frank (2009, July 5). “Bernie Madoff is No John Dillinger.” The New York Times, Week in Review, p. 8. 

Sander, Peter (2009). Madoff: Corruption, Deceit, and the Making of the World’s Most Notorious Ponzi Scheme. New York: Lyon Press, p. 7. 

Singer, Isaac Bashevis (2008). Shadows on the Hudson. Translated by Joseph Sherman. New York; Farrar, Straus Giroux, p. 54. 

Strober, Debora and Strober, Gerald. (2009). Catastrophe: The Story of Bernard L. Madoff, the Man Who Swindled the World. Beverly Hills, Calif.; Phoenix Books, p. 47. 

Tett, Gillian (2009). Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan was Corrupted by Wall Street Greed and Unleashed a Catastrophe. New York: Free Press. 

Zuckoff, Mitchell (2005). Ponzi’s Scheme: The True Story of a Financial Legend. New York: Random House.

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