Monday, December 15, 2008

Madoff: Mystique or Mistake?

The stunning fraud allegedly confessed last week by investment advisor Bernard L. Madoff, resulting in up to $50 billion of losses by his own estimate, has investors reeling and questions being asked about the role of regulators and auditors. SEC's Dec. 11 press release, SEC Charges Bernard L. Madoff for Multi-Billion Dollar Ponzi Scheme notes:

  • “According to regulatory filings, the Madoff firm had more than $17 billion in assets under management as of the beginning of 2008. It appears that virtually all assets of the advisory business are missing.”

The scale of the alleged fraud, according to Madoff’s own confession to at least one of his senior employees (said in various reports to be his sons) indicates he may have made off with $50 billion.

“Madoff told these employees that he was "finished," that he had "absolutely nothing," that "it's all just one big lie," and that it was "basically, a giant Ponzi scheme," as cited by the SEC.

According to the SEC’s press release:

  • Andrew M. Calamari, Associate Director of Enforcement in the SEC's New York Regional Office, added, "Our complaint alleges a stunning fraud that appears to be of epic proportions."
  • SEC Enforcement Director Linda Chatman Thomsen stated, "We are alleging a massive fraud — both in terms of scope and duration.” She added, “We are moving quickly and decisively to stop the fraud and protect remaining assets for investors, and we are working closely with the criminal authorities to hold Mr. Madoff accountable."

Jesse Westbrook and Saijel Kishan of Bloomberg have compiled a list showing Madoff’s Investors Had More Than $24 Billion With Firm: Table. Among other Bloomberg reports, see Madoff Confessed $50 Billion Fraud Before FBI Arrest by David Voreacos and David Glovin.

How did Madoff, a man of such stature – incuding serving as the former chairman of Nasdaq – fall so far? And how did investors and others not see this coming? The Wall Street Journal has a whole collection of stories in its Complete Coverage: Bernard Madoff. One such article, How Bernie Madoff Made Smart Folks Look Dumb, (the weekend Intelligent Investor column by Jason Zweig) explains:

  • “The accounts managed by Bernard L. Madoff Investment Securities LLC reported gains of roughly 1% a month like clockwork, with nary a loss, for two decades. Why did that freakishly smooth return not set off alarms among current and prospective investors? Of all people, sophisticated investors like Mr. Madoff's clients should know that if something sounds too good to be true, then it's not. But they believed it anyway. Why?”

Here is the answer, according to Zweig:

  • “Mr. Madoff emphasized secrecy, lending his investment accounts a mysterious allure and sense of exclusivity… If you did get invited in, then you were anointed a member of this particular club of ‘sophisticated investors.’ Once someone you respect went out of his way to grant you access, says Prof. Cialdini, it would seem almost an ‘insult’ to do any further investigation. Mr. Madoff also was known to throw investors out of his funds for asking too many questions, so no one wanted to rock the boat. This members-only feeling blinded many buyers of Mr. Madoff's funds to the numerous red flags fluttering around his operation.”

Although some of the firm’s webpages are no longer directly visible from the homepage (but come up in search results) Madoff’s professional stature was formerly described on his firm’s website on a webpage entitled Madoff Securities: Quality Executions and Service Through Innovative Technology, which linked to a webpage entitled, The Owner’s Name is On the Door, providing this information about the prestigious roles held by Madoff, who founded the firm in 1960, and his brother Peter, who joined the firm in 1970:

  • “Bernard L. Madoff has been a major figure in the National Association of Securities Dealers (NASD), the major self-regulatory organization for US broker/dealer firms. The firm was one of the five broker/dealers most closely involved in developing the NASDAQ Stock Market. He has been chairman of the board of directors of the NASDAQ Stock Market as well as a member of the board of governors of the NASD and a member of numerous NASD committees…

    Peter B. Madoff has also been deeply involved in the NASD and other financial services regulatory organizations. He has served as vice chairman of the NASD, a member of its board of governors, and chairman of its New York region. He also has been actively involved in the NASDAQ Stock Market as a member of its board of governors and its executive committee and as chairman of its trading committee. He also has been president of the Security Traders Association of New York. He is a member of the board of directors of the Depository Trust and Clearing Corp. He is a member of the board of the Securities Industry Association.”

The webpage closes: “These positions of leadership not only indicate the deep interest Madoff Securities has shown in its industry, they also reflect the respect the firm and its management have achieved in the financial community.”

Visitors to the home page of the Bernard L. Madoff Investment Securities LLC,, will now simply see a message saying:

  • “The Honorable Louis L. Stanton, Federal Judge in the United States District Court for the Southern District of New York, has appointed Lee S. Richards of the law firm Richards Kibbe & Orbe LLP receiver over the assets and accounts of Bernard L. Madoff Investment Securities LLC (“BMIS”) as per the attached order. Link to Order

Various articles have reported how wealthy investors and charities, have in some cases virtually been wiped out by their losses of funds invested with Madoff. How could such investors, many supposedly sophisticated investors, have not suspected something was amiss with the year-in, year-out steady returns? Zweig, author of WSJ”s Intelligent Investor column quoted above, posits:

  • “The biggest dirty secret of the ‘sophisticated investor’ [is that] due diligence often goes undone.”

There were some warning signs, as noted in Gregory Zuckerman’s report in the WSJ, “Fees, Even Returns, and Auditor All Raised Red Flags.” He notes:

  • “The first tip-off for some was the steady returns generated by the firm in every kind of market. Mr. Madoff would buy a basket of stocks resembling an S&P index while simultaneously selling options that pay off for the buyer if these stocks soar, while also buying options that pay off if the index tumbles. The supposed goal was to have smooth, steady returns.”
  • “Harry Markopolos, who years ago worked for a rival firm, researched Mr. Madoff's stock-options strategy and was convinced the results likely weren't real. ‘Madoff Securities is the world's largest Ponzi Scheme,’ Mr. Markopolos, wrote in a letter to the U.S. Securities and Exchange Commission in 1999. Mr. Markopolos pursued his accusations over the past nine years, dealing with both the New York and Boston bureaus of the SEC, according to documents he sent to the SEC reviewed by The Wall Street Journal. In a statement late Friday, the SEC said ‘staff from the Division of Enforcement in New York completed an investigation in 2007, and did not refer the matter to the Commission for enforcement action.’ The SEC said it reopened the investigation Thursday. It's not clear what the focus of the 2007 investigation was, or why it was closed. A person familiar with the matter said it related to issues raised by Mr. Markopolos.”

The role of regulators with respect to Madoff is also addressed in Marcy Gordon’s Associated Press article, carried by Friday night, “Madoff Case Raises Questions About SEC.”

Perhaps, as posited by WSJ’s Zweig, investors simply trusted Madoff, overwhelmed by the mystique factor.

But Jim Vos, CEO and Head of Research of Aksia LLC, an independent hedge fund research and advisory firm, was not among those who took things at face value, as noted in the WSJ. Vos is becoming something of a celebrity now, (see Vos on this Bloomberg video)since he advised his clients not to invest with Madoff.

It is well worth reading Aksia’s letter to its clients and friends, posted by the New York Times among others, which explains why Aksia dissuaded its own clients from investing in Madoff’s funds. Some red flags noted in Aksia’s letter, summarized by Peter Cohan in BloggingStocks, include:

  • Unknown accounting firm. Madoff used an accounting firm Friehling & Horowitz that employed three people -- one was a 78 year old living in Florida.
  • Incomprehensible investment strategy too good to be true. Madoff employed a "split conversion strategy" which was never clearly defined and whose returns other traders could not duplicate.
  • Deception about technology. Madoff claimed it was technologically sophisticated but a visitor to its offices found paper tickets sent through the mail.
  • Family control of key jobs. Madoff staffed key control jobs with family members and it was extremely secretive.
  • Violation of segregation of control principles. Madoff failed to separate the jobs of initiating trades, holding assets, and reporting on their condition.”

Audit Firm Under Scrutiny
The three person audit firm – Friehling & Horowitz - cited in Aksia’s letter, is discussed further in the Bloomberg article, Bernard L. Madoff Securities’ Auditor Prompted ‘Red Flags.’ The authors of the article, David Glovin, Karen Freifeld and David Voreacos describe Madoff’s audit firm as follows:

  • “Friehling & Horowitz operates from a storefront office in the Georgetown Office Plaza in New City, sandwiched between a pediatrician’s office and another medical office. An office for the Rockland County Bar Association is also in the building.
  • A woman who works in a nearby office, who didn’t want to be identified, said Friehling doesn’t come to the office regularly.
  • When he does, he is the only person there. Another woman in a nearby office, Leslie Cousar, said the man who comes to the office does so for 10-to-15 minute periods, and wears tight pants and tie-dyed shirts. Cousar said she never saw anyone else going to the office during the day, but at about 5:30 p.m. another man would use the office.”

Friehling, the immediate past-president of the Rockland County Chapter of the New York State Society of CPAs, wrote occasional columns in the NYSSCPA newsletter, including The More You Give, The More You Receive (May 15, 2008) and Cheating on Taxes is Cheating on Ourselves (April 1, 2008).

The Rockland County District Attorney has opened an investigation on the audit firm, reports Karen Freifeld in Madoff Auditor Under Investigation by New York State Prosecutor. She notes:'

“We’re trying to determine if there have been any state crimes here,” Rockland County District Attorney Thomas Zugibe said in a telephone interview today. “When you have a key player like that operating in your county, you have to look.”

Further Analysis, Recommendations
Roger Ehrenberg, managing partner of IA Capital Partners Inc. and former Managing Director and Co-head of Deutsche Bank’s Global Strategic Equity Transactions Group, makes some interesting observations and recommendations about the Madoff matter in his Information Arbitrage blog in his post, The Real Take-Away From the Madoff Scandal. Ehrenberg says:

  • “Madoff is a completely different kind of firm. It is a broker/dealer with an asset management division, enabling it to rely entirely on itself for trading and settlement. Further, it used a no-name, three-person accounting firm, unheard of for a firm of Madoff's size, scope and complexity.
  • A purely rational trader of Madoff's stature would have set up a hedge fund business to extract 2/20 from his clients. I guess we now understand why; it would have subjected his portfolio to the unwanted scrutiny of his prime brokers.
  • By keeping his game completely in-house and on the down low, it essentially fell through the cracks of our regulatory structure. Will this cause the SEC to redouble its efforts in regulating broker/dealers? Force changes in transparency, similar to what I've pushed for in the OTC derivatives market to the broker/dealer community? Or is it simply a matter of creating rules that ensure credible third-party involvement in the validation of assets under management/NAV in order that Madoff's brand self-dealing couldn't be sustained?

To prevent a scandal like the Madoff case from happening again, Ehrenberg recommends focusing on what's needed, such as segregated custodial funds validated by third parties,rather than regulatory or other solutions that are based on public relations.

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