Madoff's legacy: What have we learned from the debacle?

“What’s your number?” asks a young trader to a veteran market maker in the movie, “Wall Street – Money Never Sleeps” — meaning the amount of money that will bring contentment and enable an escape from fevered Wall Street. “See, I find everybody has a number, and it’s usually an exact number. So, what’s yours?” The other trader pauses and then says with a smirk, “More."

Bernie Madoff didn’t have a number either. What he did have was hubris and greed that drove him to grab “more” and mastermind the largest-ever Ponzi scheme that cruelly stole the retirement savings of hundreds of victims, caused suicides and decimated charitable efforts around the globe.

Court-appointed trustee Irving Picard has relentlessly recovered billions for Madoff’s victims. That’s solace for some but not for those who lost all and died destitute before they could benefit from Picard’s efforts. Regardless of the avarice of Madoff — who succumbed to kidney disease at the Federal Medical Center in Butner, North Carolina, on April 14 — what has the fraud examiner community learned from the colossal fiasco?

Fraud Magazine recently posed that question and others to Diana Henriques, the first reporter to interview Madoff in prison, and four anti-fraud professionals — including the original Madoff whistleblower plus an expert witness in the “Madoff 5” trials — to see how the case has changed the anti-fraud profession. The experts’ answers provide insights far beyond the scheme that redefined “Ponzi.”

Revisiting the long con

On Christmas Eve of 1997, 30 trusted brokerage firms, including Merrill Lynch, Goldman Sachs and Morgan Stanley, agreed to pay about $900 million to end a civil suit that said they schemed to fix prices for years on the Nasdaq stock market.

The plaintiffs said that between 1989 and 1994 brokers manipulated a large portion of stock trading on Nasdaq by inflating the bid-offer spreads — the difference between the price at which stocks are bought and sold — to acquire higher trading profits. (See 30 Firms to Pay $900 Million in Investor Suit, by David Barboza, The New York Times, Dec. 25, 1997.)

What made the case even more interesting was the omission of a big player among the culprits: Madoff Securities, one of the largest Nasdaq market makers. “Conspicuous by his absence was Bernie,” says Henriques, a former New York Times business reporter and author of “Wizard of Lies.” (See ‘The Wizard of Lies’ describes a tragedy of Shakespearean proportions, by Dick Carozza, CFE, Fraud Magazine, September/October 2012.)

“I called one of the class-action lawyers who had filed the lawsuits the Department of Justice had taken over,” Henriques says. “I asked if they just didn’t have quite enough on Bernie. Completely the opposite. They didn’t have any evidence on him.” She says he couldn’t risk any regulator investigating his legitimate trading business on the 18th and 19th floors of New York’s Lipstick Building because he was secretly running a huge, back-office Ponzi scheme on the 17th floor. “No doubt, he kept his traders on a very tight leash.”

Madoff had kept everyone in the dark on his deliberate, colossal rob-Peter-to-pay-Paul scheme since at least the 1990s (and some say the 1970s) with his front as an urbane, dignified Wall Street statesman.

“Many of my perceptions about Ponzi schemers were like most [before Madoff],” Henriques says. “That Ponzis involve sky-high profits, outrageous returns, get-rich-quick schemes, heavy pressure to invest ‘right this minute before this opportunity goes away,’ ” she says. “That’s the stereotype. But that didn’t match Bernie at all. Not remotely. He turned possible investors away. The velvet-rope syndrome. He cultivated this idea that you had to be very, very special for him to manage your money."

Regent Emeritus Bruce Dubinsky, CFE, senior advisor in the governance, risk, investigations & disputes practice of Duff & Phelps LLC, says that Madoff actually began his fraud similarly to Charles Ponzi by actively recruiting investors. “Ponzi schemers are actors. Not much different than the Three-card Monte guy on the New York corner. …

It wasn’t until much later that he cultivated the ‘I’ll see if I can accept you into the club attitude’ ” when he had plenty of would-be victims to make the illusion work, he says.

Dubinsky was the U.S. government’s expert witness at the criminal trial in which five of Madoff’s closest employees were convicted for securities fraud in their participation in the fraud. Dubinsky also is the bankruptcy trustee — Picard’s expert witness on the Ponzi scheme in the civil cases recouping money for the victims of Madoff’s scheme.

“Bernie had so many more years than Charles Ponzi to perpetrate and refine his act,” Dubinsky says. David Kugel, a former trader in Madoff’s legitimate proprietary trading unit, described in court that from the 1970s he provided historical market data from The Wall Street Journal to portfolio managers Annette Bongiorno and Joann Crupi, Dubinsky says. Kugel said the two women then used the information to manufacture fake, backdated trades in clients’ investment accounts. (See Ex-Madoff trader turned prosecution witness avoids prison time, by Joseph Ax, Reuters, May 27, 2015.)

“We have evidence in the computer programs that go back that far [showing] that stuff was just key punched into a giant typewriter system that Madoff used,” Dubinsky says. Madoff used a rare IBM AS/400, which helped investigators find evidence of wrongdoing. “When our team was investigating, we found only two of these systems left in the country,” Dubinsky says. “We stripped one down, restored the Madoff backup tapes and proved that the system didn’t have the ability to even communicate with the trading markets to conduct real trades, and therefore proved it couldn’t have executed the purported automated trades that Madoff was saying he was doing. ... it was all faked.”

Henriques says she was surprised when she heard of Madoff’s arrest because of his credibility on the Street and demonstrated honesty through a major market scandal. She’d known Madoff since the early 1990s when he was member of a panel of esteemed financial experts at a Pace University conference. And he and his managers were sources when she was a reporter at Barron’s and then The Times.

The victims never knew that Madoff had sole custody of their money and was stealing every dime as soon as it came in.

Why the scheme continued for decades

Many Ponzi schemes can’t last long because fraudsters run out of money to transfer from one area to another. Harry Markopolos, CFE, who tried three times (in 2000, 2001 and 2005) to alert the U.S. Securities and Exchange Commission (SEC) about Madoff’s fraud, says the scheme endured for many reasons.

“Money-center banks and investment advisors marketed Madoff to their clients and fed billions into the scheme without conducting any of the due-diligence procedures printed on their standard checklists,” Markopolos says.

He says Madoff also offered much higher payouts to institutions marketing him than competing money managers. “They got paid outsized fees to look the other way and not ask questions,” he says.

And big institutional players all assumed that the other firms must have conducted due diligence so there was no need to worry that anything was amiss, Markopolos says.

Madoff acted as an undisclosed sub-custodian of the assets, Markopolos says. “Big banks would receive Madoff’s bogus performance statements, reprint them on their letterheads and mail them to the victims,” he says. “The victims never knew that Madoff had sole custody of their money and was stealing every dime as soon as it came in."

Markopolos says Madoff  would routinely threaten his institutional investors and tell them they weren’t allowed to provide information about Madoff’s firm or investment process, or he’d give all their money back. “One time Bernie was in Switzerland meeting with a large group of his Swiss banking institutional clients,” Markopolos says. “He stood up in front of this esteemed audience and told them they were all stupid and didn’t know anything about finance.” (See Chasing Madoff – An Interview with Harry Markopolos, by Dick Carozza, CFE, Fraud Magazine, May/June 2009.)

Regulatory improvements

On Feb. 4, 2009, Markopolos told Congress' House Financial Services Committee’s capital markets panel that U.S. regulatory agencies had failed in the Madoff case to be watchdogs. Twelve years later, his opinion has moderated. “The only positive result from this case is that my congressional testimony led to the establishment of both the SEC and Commodity Futures Trading Commission whistleblower programs,” he says.

“Those two programs result in tips, complaints and referrals that lead these agencies’ enforcement staff right to the heart of new Ponzi schemes, securities frauds and public company accounting frauds, and stop them before they grow too large. Both agencies now have better trained staff — many with the CFE credential — and well-developed procedures to effectively investigate Ponzi schemes.

“The SEC adopted all 65 of the SEC inspector general’s recommendations that resulted from the Madoff case,” he says. “As a result, the SEC now has highly effective procedures to detect and shut down Ponzi schemes.”

Jane Norberg helped organize the SEC’s Office of the Whistleblower, a part of the Division of Enforcement, first as deputy chief in 2012 — a year after the office’s inception — and then as chief, beginning in 2016. (She left the office in April and is now a partner at law firm Arnold & Porter in its Washington, D.C. offices, specializing in counseling companies regarding whistleblowing issues and best practices.) The U.S. Dodd-Frank Wall Street Reform and Consumer Exchange Act, passed in the wake of the Great Recession, mandated the creation of the office by adding Section 21F to the Securities Exchange Act of 1934.

“The overarching goal of the program is to encourage the submission of specific, timely, credible information about possible securities laws violations,” Norberg says. “To really achieve this goal and foster public interest, we established a public hotline where people could call and talk to an attorney on the team. We publicly promoted the program;  the main message being that the Office of the Whistleblower is open for business and wants to talk to you.”

Norberg says that eligible whistleblowers who voluntarily provide the SEC with original information about a violation of the federal securities laws that leads to the successful enforcement of a covered judicial or administrative action, and any related action, will be awarded an aggregate amount — determined by the SEC — that’s equal to not less than 10%, and not more than 30%, of monetary sanctions that have been collected in the actions. The SEC presents awards from its Investor Protection Fund, which is replenished with fines from wrongdoers.

In my experience, the SEC recognizes the courage and potential sacrifices of whistleblowers and treats them with respect.

The Office of the Whistleblower funnels tips to the SEC’s Office of Market Intelligence, which begins a 10-step process from analysis and investigation to final orders issued and resolution of appeals.

Norberg advises ACFE members who are considering blowing the whistle to do their research before contacting the SEC or another regulator to understand the process. For example, working with an attorney is a stipulation for retaining anonymity through the SEC process. “The Office of the Whistleblower has information on their website and a public hotline that allows possible whistleblowers to make fully informed decisions and to go into the process with their eyes wide open,” she says. “In my experience, the SEC recognizes the courage and potential sacrifices of whistleblowers and treats them with respect.”

Internal reporting

Norberg thinks that the SEC’s whistleblower program has likely caused companies to review their internal-reporting structures. “Companies need to take steps to ensure that they have internal reporting processes that truly encourage and support employees’ claims of suspected fraud or other wrongdoing, whether it is to middle managers or through more formal mechanisms,” she says.

Norberg says that many whistleblowers report to the SEC because they don’t think the company responded adequately, or at all.

“The Office of the Whistleblower’s last annual report to Congress reported that 81% of insiders who received awards in fiscal year 2020 raised concerns internally before or at the same time as reporting to the SEC, which is an incredibly high number,” she says. “That means in 81% of those reports to the SEC, someone at a company already knew about the problem. It’s incredibly important that companies not only cultivate a culture that is welcoming to employee’s internal reports, but that they also have a process in place to take appropriate steps when they do receive those internal reports."

She says employees at organizations that don’t have adequate reporting processes like anonymous hotlines are hesitant to report problems to their bosses. And then middle management often doesn’t know what to do with tips. Whistleblowers and their supervisors always fear company reprimands or termination.

The Office of the Whistleblower has placed public and regulated entities, at least, on notice that it’s a clear channel for their employees to blow the whistle if internal reporting mechanisms are inadequate, Norberg says. That’s a definite plus for fraud examiners who are struggling to convince management to encourage employees to report anomalies.

Clawing back millions

On Dec. 15, 2008, Federal Judge Louis L. Stanton, in accordance with the U.S. Securities Investor Protection Act, appointed attorney Irving Picard to be the Madoff trustee.

As of publication, of the estimated $17.5 billion Madoff stole, Picard and his team had recovered $14.42 billion and distributed $13.562 billion to Madoff victims, and they’re still working to reclaim funds.

In August 2011, the Second Circuit  Court of Appeals upheld the method Picard and his team use to determine how to handle claims. Madoff investors have no claim if they took out more money from the fund than they had deposited and have to return their Ponzi-inflated gains. (See The Amazing Madoff Clawback, by Tunku Varadarajan, The Wall Street Journal, Nov. 30, 2018.)

“The pain experienced by the victims of Mr. Madoff’s fraud is not diminished by his death, nor is our work on behalf of his victims finished,” Picard said in a public statement. “My legal team and I are committed to continuing to identify and recover Mr. Madoff’s stolen funds and return them to their rightful owners.”

In a 2010 Fraud Magazine interview, Picard said, “A real challenge is to balance my duties as the trustee in seeking to recover funds for the victims against needing to be compassionate with the plight of individuals from who we might seek to recover fictitious profits and who now face significant financial, medical or other difficulties.” (See Balancing Act, by Dick Carozza, CFE, Fraud Magazine, July/August 2010.)

“Irving Picard has done a tremendous job with a recovery rate at almost 70%, so far,” says Peter S. Davis, CFE, CPA, CFF, senior managing director, restructuring, turnaround and receivership at J.S. Held. Davis has served as a receiver in regulatory matters brought by the SEC, Federal Trade Commission and other agencies.

“His recoveries are stunning. He’s extremely methodical, thoughtful, careful, kind and humble. Trustees in other high-profile cases can be blunt forces. Being a good receiver is keeping our egos in check and being a good human being.”

Davis says Picard’s efforts have changed how recoveries are done and opened opportunities for CFEs to become receivers or assist trustees as investigators. Davis is on the board of the National Association of Federal Equity Receivers, whose members work in the areas of receivership, insolvency, bankruptcy, restructuring and international asset recovery.

The story is the victims

Markopolos says extreme sadness is his strongest emotion from this case. “I’ve met too many victims who suffered extreme anguish, and I’ve met families whose loved ones committed suicide in the wake of their Madoff losses,” he says.

“Madoff’s legacy is the loss of his two sons, one from suicide and the other from reoccurring cancer that he said was brought back by his dad’s crimes,” Dubinsky says. “But the most important part of this story is the victims. I’ve met so many who had to file bankruptcy and then have to live with their children.”

Henriques writes in “Wizard of Lies” that a common thread in the hundreds of stories about Madoff’s victims at every socioeconomic level is their generosity. “A typical example is Gordon Bennett, the natural foods entrepreneur who retired on his Madoff savings; with his modest nest egg generating a comfortable income, he was able to devote the second half of his life to conservation causes and making a notable difference in his community,” she writes.

What have we learned

Lessons from this Shakespearean morality tale? Norberg says frustrated employees will continue to seek out possible remedies such as the SEC’s Office of the Whistleblower if organizations don’t seriously emphasize internal reporting and quash any hint of retaliation for honesty. “It may sound cliché, but companies still need to have good tone at the top and communicate that any retaliation to whistleblowers is just unacceptable,” she says.

Henriques writes in “Wizard of Lies” that one of the problems in trying to prevent a Madoff-like Ponzi scheme is that while regulators want to investigate someone claiming to have a safe, high-yield investment that always goes up — even when everything else goes down — investors just want to take him or her to dinner.

Henriques writes that the Madoff scandal prompted almost everyone in Washington to ask the wrong questions: “How can we improve the world that regulators live in? How can we make a regulatory regime based on fine print work better?”

She suggests that maybe they should’ve asked: “How can we improve the world that investors live in? What kind of regime will work in a world where nobody reads the fine print, where investing is almost always a blind leap of faith?”

What was wrong, she writes, was investors’ rejection of basic bedrock principles in investing:

• High returns are leg-shackled to high risks.
• Never put all your eggs in one basket.
• Never invest in something  you can’t understand.
• Don’t hand all your money to someone because you admire or trust them.

Regulatory clamps have tightened in the U.S., but not necessarily elsewhere on the globe. “Overseas the rest of the world’s financial markets regulators are underfunded, understaffed and not particularly well-trained,” Markopolos says. “With the advent of social media, it is now possible to scam victims remotely from lawless, safe-haven nations and have literally zero risk of being brought to justice. Even worse, we now have nation-state actors engaged in financial frauds, particularly in the digital currency space. I’d judge the risks to be much higher today than in 2008 for anyone investing outside of the U.S.”

Henriques writes that more rules and fine print won’t stop the next Bernie Madoff. But, perhaps, borrowing a lesson from the medical world, regulators could develop a “formulary” — a list of safe investments that the public must buy from, such as mutual funds, annuities, bank CDs, real estate investment trusts — and then watch those categories like hawks to ensure that no con artists slip in.

Or governments could require individual investors to be licensed, Henriques writes, testing them on how to recognize a fraud, how to choose the best investment, and how to spot the Ponzi schemer.

Markopolos says post-Madoff vigilance was short-lived. “Now, that over a decade has passed, investors have forgotten all of the lessons learned from the Madoff case and are willingly investing in Ponzi schemes and other ill-considered investments.

“I’ve been working in the financial services industry since 1987, and there’s more speculation, gambling and irrational behavior in the capital markets today than I’ve seen in the past 34 years,” Markopolos says. “No doubt this speculative bubble will end badly, and when it does CFEs, CPAs, attorneys and prosecutors will be quite busy sorting out who did what, to whom, for how much."

See sidebar: Markopolos’ 15 tips for aspiring fraud examiners.

Dick Carozza, CFE, is editor-in-chief emeritus of Fraud Magazine. Contact him at dcarozza@ACFE.com.

How Markopolos quickly spotted Madoff’s Ponzi scheme

The title of Harry Markopolos’ 2010 book is “No One Would Listen: A True Financial Thriller.” But many now listen to Markopolos, especially when he explains his Madoff investigation. Markopolos recently spoke to Fraud Magazine on some of the ways he knew Madoff was running a major Ponzi.

“Madoff’s name was never on the marketing materials. That was clue No. 1,” Markopolos says. “I’ve never seen a product offering where the manager’s name wasn’t listed up front. Securities fraudsters’ product offerings almost always look quite different than legitimate money managers. Keying on all of Madoff’s many differences solved the case.”

He says it took five minutes after reading Madoff’s strategy to determine that he wasn’t really using it to earn the returns he said he was.

“Under existing securities law, if you tell clients that you are using Strategy A to invest their money but, in fact, you use an undisclosed Strategy B to really invest their money, you’ve committed fraud,” Markopolos says.

The other dead giveaway, he says, was that Madoff’s strategy was supposed to be coming from the U.S. stock market. “But when I ran a regression analysis of his returns versus U.S. stocks, surprisingly, he only looked like the U.S. stock market 6% of the time. In other words, mathematically his returns could not possibly have been coming from the U.S. stock market.”

Madoff’s returns went up in a straight-line at a 45-degree angle, Markopolos says. Meanwhile, the U.S. stock market went up and down like a roller coaster.

“Those returns were too consistent, too steady, and with too few down months,” he says. “He had no down quarters and no down years.”

Most telling, Markopolos says, is that Madoff never had back-to-back losing months. Madoff’s returns were like a baseball player batting .960 for the year but hitting only doubles and never singles, triples or home runs,  Markopolis says.

He says that Madoff said he purchased insurance contracts known as Standard & Poor’s 100 index put options to protect his stock portfolios against market downdrafts.

“However, there were never more than $1.5 billion of these contracts in existence at any point in time,” Markopolos says. “Madoff was running no less than $3 billion when we first spotted him in late 1999, and he ended up managing — or so he said — $64.8 billion when his scheme finally collapsed on Dec. 11, 2008. So, there were never enough of these insurance contracts/put options in existence for him to be doing what he said he was.”

Markopolos says fraudsters’ numbers are almost always too good to be true. “Fraudsters lie all the time, but the math never does."

He asks, “How many red flags are enough to walk away from an investment?”

Markopolos answers his own question. “One should be enough; anything past one is overkill. By the end of our case, my team and I had developed 30 red flags. What does this say about the quality of due diligence in finance? I’d say it tells you there’s a lot of opportunity for CFEs with good math, finance and accounting skills."

Markopolos’ 15 tips for aspiring fraud examiners