A Century of Madoffs: Behind Ponzi Schemes
February 2009
IN THIS ISSUE
— Pay No Attention to the Man Behind the Curtain: How Ponzi Schemes Flourish
— Looting the Store as the Night Watchman Napped: Missed Signs in the Madoff Case
— In the next issue
GREETINGS!
Welcome to the February 2009 edition of our newsletter! In this issue, we’ll look at an age-old favorite fraud that finds new (though not always inventive) ways of re-creating itself: the Ponzi scheme.
PAY NO ATTENTION TO THE MAN BEHIND THE CURTAIN: HOW PONZI SCHEMES FLOURISH
There are times when events seem to interconnect with an almost cosmic sense of timing, as if sending a message to the broader population. When the fraudulent “investments” of financial adviser Bernard Madoff were made public in December 2008, resulting in investor losses estimated to be at least $50 billion, the financial crisis triggered by credit default swaps and the securitization of subprime mortgages was in full swing across the globe. The fact that Madoff, a former chairman of the Nasdaq stock exchange, had fooled celebrities, charities and even his own family members out of billions struck a global nerve.
Yet, as with most con men, what Madoff did was ultimately unoriginal, and only noteworthy for its breathtaking scope and arrogance (as well as the ignorance of regulators to allegations made as early as 1992.) The origins of the Ponzi scheme began nearly 20 years before Madoff was born, in 1919, when an Italian fraudster named Charles Ponzi realized he could profit from the variations in currency between countries by buying International Postal Reply Coupons in a weak currency country (Spain, at the time), and sell them in the United States for a tidy sum.
Using these proceeds as seed capital (and the IPRCs as the alleged vehicle for generating profits), Ponzi began to solicit investors with the promise of 40 percent annual returns, eight times the interest rate. Ponzi paid the promised returns to initial investors as more money poured in, but could not keep up with paying handsome returns as more investors took part.
His scheme lost Boston area investors at least $10 million; while on bail awaiting appeal of his state mail fraud conviction, Ponzi relocated to Florida, where he brazenly operated scam selling worthless swamp land (yet another of his famed legacies.) After a failed escape attempt from his Florida prison sentence, Ponzi served seven years in prison, was released, and tried to continue scams in Italy and Brazil before his death, destitute, in Rio de Janeiro in 1949.
LOOTING THE STORE AS THE NIGHT WATCHMAN NAPPED: MISSED SIGNS IN THE MADOFF CASE
Ponzi was infamous for his braggadocio and cavalier confidence, and Madoff followed suit, christening the 55-foot fishing boat he bought “Bull.” While Madoff knew his “investment firm” was full of bull, regulators at the SEC missed some key opportunities to look inside his false profits. (yet even the investment firm of his mother, Sylvia Madoff, had run-ins with federal regulators in the 1960s.)
To this day, Madoff Securities remains suspended — but active — with FINRA, the self-regulatory agency. Although FINRA (then NASD) first censured Madoff Securities in 1963, and also fined the firm in 2005 and 2007 for failing to display limit orders in a timely fashion, it appears that none of these inquiries analyzed how Madoff was generating the promised rates of return. Madoff Securities, which traded on the London Stock Exchange and was domiciled in the United Kingdom, said in its SEC 2005 Investment Adviser filing that it had more than $17 billion in assets under management for 23 accounts, solicited principally from charities and high net worth individuals. Yet between one and five employees — as we now know, only Madoff himself — was responsible for investment decisions at the firm, which said it employed between 51 and 250 people.
The recently known indicators of potential fraud are troubling, but the signs that the SEC was made aware of these indicators date back to 1992, when the SEC shut down three small investment firms that were working with Madoff, after the firms promised returns in excess of 20 percent. Madoff had to return the $454 million his partner firms had raised — “somehow, he got it done over a weekend,” a source reportedly said — but he was not sanctioned. Years later, after the SEC found no wrongdoing at Madoff Securities in 2005, an SEC compliance official, Eric Swanson, married Madoff’s niece.
From red flags raised in filings Madoff personally signed to coincidental, if embarrassing, family ties, regulators simply were not looking closely enough as Madoff made off with millions from reputable persons and charities. Significant regulatory reforms, such as requiring investment firms like Madoff’s to process client statements through an independent clearinghouse, are sure to follow after the revelation of this gargantuan fraud.
IN THE NEXT ISSUE
In the March issue of our newsletter, we’ll look at the Obama administration’s pledges of increased transparency regarding use of Troubled Asset Relief Program funds — what they’re trying to do, who supports and opposes the measures, and likely winners and losers.