Here are some things fraud hunters should never forget about the Madoff Ponzi scheme
Corporate frauds are cyclical, meaning that they tend to come in waves, particularly when the markets perform poorly or a recession hits. (That is, when the scandals themselves aren't the actual cause of the recession as we saw in the financial crisis of 2008.)
These fraud waves have a pattern to them that is now familiar to most observers of Corporate America: A series of very similar frauds and schemes crop up devastating investors, employees, and pensioners and damaging the financial system itself. The judicial/enforcement system struggles to hold anyone responsible, managing a few scapegoats or forcing big companies to write checks they can cut without even having to check their account balances at the bank. Next, politicians and regulators hoot and holler and pass a series of laws to ensure that, “something like this never happens again.” About a decade or less passes and the process starts all over again. Lather, rinse, repeat.
Working backwards, we saw this pattern play out last decade with the mortgage financing schemes that ruined several major banks and resulted in the Dodd-Frank Act. In 2002, it was Enron and friends with their fake accounting that resulted in the Sarbanes-Oxley Act. The 1990s brought a wave of accounting “shenanigans” with drugstore chain Phar-Mor and retailer Gottschalks. The 1980s was banking again with the Keating Five and the Savings and Loan Crisis that resulted in the 1989 passage of the Financial Institutions Reform, Recovery, and Enforcement Act. So on and so forth, back to the financial market corruption of the 1920s that precipitated the Great Depression and the Securities Act of 1934, and on to the beginning of human transactions.
The point is that there will always be frauds and scandals and there will always be a regulatory reaction aimed at stopping the most recent fraud wave that will actually do very little to stop the next fraud wave. There are plenty of characteristics that frauds have in common, however, and some good lessons for fraud investigators that come from large frauds like Enron and the Madoff Ponzi scheme. At the Audit World 2016 conference we held in Boston earlier this month, Frank Casey, one of individuals who first uncovered the Madoff Ponzi scheme, recounted his pursuit of Madoff along with a team that included Harry Markopolos and others. Casey identified some lessons that still resonate from the Madoff fraud.
1: Never Too Big to be Corrupt
One of the biggest reasons that the Madoff fraud was able to go on for so long was that so many people, says Casey, thought Madoff was too big and powerful to be wrapped up in a scam. “They thought, ‘he’s too big to be crooked,’” says Casey. Madoff had been non-executive chairman of Nasdaq, after all. His firm was revered and its size made Securities and Exchange Commission officials and others worried about making any allegations against it. The same can be said about Enron. At its peak it was ranked seventh on the Fortune 500 list and had a market cap of $70 billion. If you are suspicious something is amiss, don’t be put off from taking a look because the entity or person is too revered or you think it is too big to be based on fraud.
2: If It’s Too Good to Be True it Probably Is
The way that Casey and his associates first became suspicious of Madoff is by trying to replicate his results. They wanted to develop a competing fund with similar characteristics but found it was impossible to do. They computed the odds that Madoff was that lucky in making his investment choices and found they were beyond astronomical. Casey compares it to a Major League Baseball player hitting .925 for 10 years straight. "he seemed to be picking all the winners and avoiding all the losers every time, and every investor knows that's impossible to do."
The options backdating scandal, where companies were issuing options to executives that were struck at a date in the past when the price was lower, was found in a similar way, when a professor charted option grant dates and found that companies seemed to have an amazing knack for issuing options at just the right time to make them more valuable to executives. Be suspicious of stellar results all the time. Everyone and every company has a bad day at some point.
3: Be Suspicious of Secrecy
One of the things that Madoff did to cover his tracks, says Casey, is that he created excuses and incentives for those he took money from to remain quiet. As Casey approached people who were investing with Madoff they always told him they were sworn to secrecy. Madoff would tell investors that the fund was closed, but he would make an exception for them if they promised not to tell anyone. This allowed Madoff to operate in the shadows. Fraudsters, says Casey, often invent reasons for secrecy to keep people in the dark and to keep them from comparing notes. In fact, one of the big red flags for Casey and his team was that Madoff didn’t put his name on his marketing materials. “That was a big clue for us,” says Casey. “I’ve never seen a product offering where the manager’s name wasn’t listed on it, especially someone with Madoff’s reputation.”
There were people and institutions that had separate parts of the Madoff story that, if put together, would have revealed the fraud long before it emerged. Claims of hiding information for “competitive reasons” could be to conceal that what is really going on isn’t exactly legal.
4: Don’t Fall for False Complexity
Another similarity between Enron and Madoff is that they both were able to perpetuate their frauds by claiming that what they were doing was very complicated and couldn’t easily be understood. Analysts called Enron’s reporting “a black box.” When Casey and his team took the evidence they had collected on Madoff to the SEC, he says “their eyes glazed over.” Many people told Casey that he just didn't understand what Madoff was doing, even though he was a leading expert in complex securities. If someone tries to put you off by saying that it's too complex, ask them to explain it to you and don't stop until you have a full understanding.
5: Be Persistent
Perhaps the biggest thing to come from Casey’s recounting of “hunting Madoff,” as he puts it, is how persistent he, Markopolis, and the others were in pursuing him. Casey tells about how Markopolis, who had filed a public complaint with the SEC about Madoff, was concerned for his life. “He started every day from 2005 to 2008 by checking over his car for bombs,” says Casey. The team confronted the SEC about Madoff several times during those years with evidence about the scandal. When they were rebuffed again and again, they continued to investigate and collect information. They refused to give up despite the dangers and the difficulties and eventually prevailed in exposing Madoff.