Masters of Fraud Bernie MadoffOur Masters of Fraud series profiles the biggest Wall Street criminal of them all, Bernie Madoff. The finance world was shocked in 2008 when it was revealed that Madoff’s exclusive hedge fund was a complete fraud. Even getting into the fund became a bragging point in the South Florida social scene. Unfortunately, it was the largest securities fraud ever discovered.

Everything seemed pretty straightforward for investors. They sent in money to the fund and received regular statements showing the normal details, including account value and a list of trades done by the fund on the client’s behalf. Except for one thing- no stocks actually were ever actually traded for investors.1

Every transaction ever recorded was made up.

This is a classic Ponzi scheme, named after the Italian swindler Charles Ponzi who conjured up the ruse a hundred years ago. It is sometimes known as a pyramid scheme. People invest money which they assume is invested on their behalf. Instead, that money is instead spent by the scammer, often supporting a lavish lifestyle. If an investor wanted to redeem funds, that money would have to come from newly deposited funds from newer investors.

These schemes can go on almost indefinitely, as long as there is a constant flow of new investors. And since the “returns” were good, there was always a steady supply of investors.

The fund was allegedly delivering returns of about 1% per month while avoiding large down months by using protective puts (an options strategy where an investment portfolio is protected by put options).2

Madoff used the invested money as his personal slush fund, living quite the lavish lifestyle. He and his wife Ruth lived in a $7 million Manhattan penthouse and also frequented their Montauk, Long Island home, a mansion in Palm Beach, and chateau in France. They even owned a yacht called ‘The Bull’. The whole thing was a load of ‘bull’ to be sure.

According to Madoff, the fraud began after his fund got clobbered in the stock market crash of 1987, which he reportedly never really recovered from.3 The scam ended with the 2008 stock market collapse as existing investors tried to withdraw money en masse but were unable to do so.

The game was up and thousands of retirees realized they had lost their life savings. Many found themselves nearly broke and looking for work in their 70’s.

The Recovery

Irving Picard, an attorney for the law firm Baker-Hostetler, was named trustee in charge of the recovery efforts for the victims. He calculates that in total, $17.5 billion was invested into the Ponzi scheme (a.k.a. Madoff’s fund). As of February 2016, over $11 billion has been recovered, much better than originally thought.4 This money came from various sources including SIPC insurance and asset sales by Madoff and the few accomplices he had.

All significant assets of Bernie Madoff and accomplices have been seized and auctioned off to help pay for the victim’s recovery fund. Many of Bernie’s personal items fetched huge bids from fascinated bidders, including $14,500 for a Mets jacket Bernie wore.5 Picard is hopeful they can recover a few more billions.

Baker-Hostetler is estimated to be paid up to $1 billion in fees for heading up the recovery effort, coming up on its eighth year.6

According to an ABC News interview, victims who ‘invested’ $1,160,000 or less, were reportedly made whole.7 For amounts above that, investors will recover roughly 61 cents on the dollar.8 While this is good news for the majority of the victims, some had sold off the rights to their recoveries too soon. At the beginning, any recovery was doubtful, so an underground ‘market’ evolved where victims would sell their rights to any future recovery to certain traders (operating more like debt collectors or a vulture capital fund). Many sold for 30 cents on the dollar, so those traders potentially doubled their money.9

Here’s where it gets tricky. Let’s say you were a longtime investor and were receiving nice profits from Madoff’s funds. The trustee actually sued many victims, going after any phantom profits, even if the investors had no idea they were ill-gotten. And if it was spent, well that’s tough luck. The trustee had a plan to recover as much principal (originally invested money) as possible for the victims.

Since it was a Ponzi scheme, the profits were just deposited funds from new investors anyway.

There were a total of 15,751 victims according to Picard.10 Almost $800 million will be refunded through insurance from the Securities Investment Protection Corporation (SIPC). This government agency reimburses accounts up to $500,000 in the event of a firm going bankrupt (or through a fraud such as Madoff’s). This is a similar to the insurance a bank depositor receives when they entrust money with a bank.

Federally insured banks cover depositors up to $250,000 in case of a bank failure under the government’s FDIC program. This is up from $100,000 prior to the financial crisis.

But many investors won’t recover any of their losses because they were ‘third-party investors’, meaning they didn’t invest directly into Madoff’s funds. Instead, they pooled money together into ‘feeder funds’ which then invested in a variety of more exclusive funds they wouldn’t normally have had access to unless they met certain wealth requirements.

Because SIPC doesn’t cover third-party investors, 10,436 of the 15,751 victims (63%) could be shortchanged.11 Many of these investors had no idea their money went into Madoff’s fund and some had never even heard of him.

The Punishment

Bernie Madoff is now referred to as inmate #61727-054 at Butner Federal Correctional Complex, a medium-security prison in North Carolina, serving out his 150 year sentence for fraud. He spends his days cleaning computer equipment at the prison and occasionally speaking to former victims.

Bernie Madoff’s punishment also included personal tragedies since the scam was uncovered. His son Mark killed himself in 2010, on the second anniversary of Bernie’s arrest. He was found in his Manhattan apartment, hanging from a ceiling pipe as his two-year old son was asleep in his bedroom.12

Bernie reportedly has severe insomnia in prison dealing with the weight of his son’s suicide.13 His other son Andrew died of lymphoma in 2008.

Compliance Failure

So, how could this have happened? Well, there is a very good reason why Madoff’s fund received the benefit of the doubt. In addition to the hedge fund, Madoff headed a legitimate firm, Madoff Securities, a registered broker-dealer and one of the largest OTC market makers.14 Madoff was also the former Chairman of the NASDAQ exchange.

Where was the compliance, fraud investigators or operations personnel? How could so many fictitious trades be recorded with no one at the firm knowing? This can be chalked up to the secretive world of hedge funds, which are private pools of capital that don’t need to be registered (at least they didn’t during Madoff’s run).

There was a small number of co-conspirators involved in the fraud. Authorities determined financier Jeffrey Picower was in on the scheme with Bernie. Picower was found dead in his swimming pool after Madoff’s arrest. Over $7 billion was recovered from Picower’s estate, belonging to Madoff’s victims, even more than recovered from Madoff himself.15 Madoff’s younger brother, Peter, also apparently helped cover up the fraud and is serving a 10-year prison sentence of his own.

Others feel the blame lies with the SEC. Harry Markopolos, a portfolio manager for an equity derivatives firm in Boston had researched Madoff’s hedge fund and reverse-engineered the purported strategy to analyze the mathematics involved.16 As a Chartered Financial Analyst (CFA) and a Certified Fraud Examiner (CFE) Mr. Markopolos had the expertise. It didn’t take him long to determine that the fund must be a fraud- just by studying the marketing materials.

Markopolos concluded the Sharpe ratio (a measure of risk-adjusted return) was outrageously high and impossible to sustain over time.17 He didn’t know if it was a Ponzi scheme, but he knew the reported results weren’t the result of the stated strategy.

Markopolos warned the SEC’s Boston office about this discovery back in 2000. And again in 2001, 2005, 2007 and 2008.18 Unfortunately, the SEC either never investigated or didn’t relay the threat to another appropriate agency.

We like to think that something like this could not happen ever again. But you could have said that after the, the Barings Bank collapse or the Enron accounting scandal. Given the stakes, financial firms are investing in strong compliance, auditing and risk management professionals. Many with leadership and managerial experience can come in and help revamp an entire department.

A Master’s in Financial Crimes and Compliance Management or MBA in Fraud Management degrees are increasingly popular among professionals looking to change careers into compliance or fraud investigation. If you’re searching for well-paying financial careers with job security, consider learning more about these programs.



Masters of Fraud: Bernie Madoff
Article Name
Masters of Fraud: Bernie Madoff
Our Masters of Fraud series profiles the biggest Wall Street criminal of them all, Bernie Madoff. His exclusive hedge fund was a complete fraud.
Publisher Name
Publisher Logo