The handwriting was on the wall, ten long years before the Madoff Ponzi scheme unraveled – the largest investment fraud in Wall Street history. In 1999, one of Madoff’s competitors, Harry Markopolos, did the math and notified the SEC of his findings – Madoff’s “split-strike conversion strategy” didn’t add up. No one listened. If that wasn’t enough, in 2005, even the SEC’s own New York branch chief, Meaghan Cheung voiced her concerns. Still, no one listened.
In examining Markopolos’ original mathematical findings, Utpal Bhattacharya, professor of finance at Indiana University’s Kelly School of Business explained, “If the standard deviation is too low and the mean too high, something is wrong” (Levisohn, para. 5). Clearly, something was wrong, very wrong for Madoff’s investors. What allowed it to “go wrong” was the fundamental failure of the investors to do their own due diligence. While many look for those to blame and there are many, ultimately the primary fault lays with both the individual investors as well as the feeder fund managers. But, let’s examine the culpability of the individual investor first.
“If it seems too good to be true, it probably is”
Greed is seductive. Madoff’s Ponzi scheme was an utterly bold and brilliant “get rich quick” scheme perpetrated on mostly affinity investors – the Jewish community who shared the opportunity to invest in the Madoff Funds with only their most deserving friends by word of mouth. Indeed, the seeds of Madoff’s deception were planted well below the rich soil of greed from the onset. Madoff counted on that.
Madoff understood the frailty of human nature and was well versed in the workings of several of humankind’s deadliest sins, including, greed itself. He knew that “getting yours” not only appealed our basest of natures, it also facilitated secrecy among his investors. That “if I share this with you, there’ll be less for me” mentality helped Madoff keep the lid on his scheme.
So, who is really to blame? In the majority, individual investors certainly knew that the Madoff Fund was “too good to be true.” Most could not have amassed their wealth without understanding some basic economic principles such as “return on investment” or ROI. Madoff Funds, according to the bogus statements issued by Madoff’s stealth accounting firm, Friehling & Horowitz, attested that the funds were consistently yielding a return far beyond any another. But, very few cared enough to question why that was – after all, “I’ve got mine”.
Had they cared enough, they would have done the math as Markopolos did and challenged the “certified” results. Better yet, if one is putting their life savings or nest egg at risk, wouldn’t it be prudent to have an independent and impartial accounting body confirm that it all was indeed as good as it seemed? If they had, they would have uncovered a three-person accounting firm issuing statements for a 50 billion dollar company who contrary to law was not reporting to the government and had not had an independent audit in 15 years. Ignorance, it would appear, is bliss.
“From the heavens falls the rain”
That leaves us with the feeder funds managers. These managers helped to globally nourish the soil with copious amounts of liquid cash on behalf of their investors, most of which were all too trusting. Were the funds managers duped as well or were they complicit in their own greed?
Let’s examine some fundamentals. A business is unashamedly in business to make a profit. This is often, but not always, accomplished by the corporate entity providing a product or service of value to its customer – say managing a fund for individual investors. Now that seems straightforward, doesn’t it? Well, no, not always. If a company’s primary objective is make a profit, does that mean it can be accomplished at any cost? The answer is most always, “yes” unless doing so clearly breaks the law.
“Summer – a season of harvest: The Madoff feeder funds”
What is important to understand is that a hedge fund manager will most always receive a luscious commission on behalf of his firm for placing their company’s investor’s money within a “feeder fund” such as Madoff’s. Therein lays a conflict of interest. Unlike a private investor who buys into a fund for a price expecting a modest return on their investment, a fund manager makes money at least two different ways. As such a decision must be made. And, it is a crucial one. It is either ethical or unethical.
In such a situation, a fund manager or his corporation may choose to receive a lush commission, (if not a kick-back) from a monster feeder fund as well as the modest commissions from their individual investors for investing such funds – it all about the money. Or a fund manager or his corporation may choose to accept a more modest commission from a vetted feeder fund that has also proven “due diligence”. Then the fund manager can prudently invest monies on behalf of their investors while also making modest commissions and fees from the individual investors.
According to the financial gurus at investorwords.com, a feeder type fund is one “which invests solely through another fund, known as the master fund. Shares are sold to investors through the feeder fund, but are invested through the master fund.” Although slightly convoluted, that is indeed quite simple. However, the Madoff fiasco has called to question several fundamental regulatory, legal and ethical issues which are not so easily explained.
For this and other reasons, it is often difficult to assess the disparity between the accountability of an individual vs. the corporation. Herein lies the adage, “Who’s guarding the hen house?” or better yet, “Let the buyer beware”.
The Madoff Ponzi scheme could not ever have amassed so much damage without the full support of fund managers throughout the world. This complacency, or worse yet complicity, allowed billions of dollars to disappear before everyone’s eyes. Some notable players such as J. Ezra Merkin and Walter M. Noel, Jr. are just a few with these fiduciary responsibilities who seemed more interested in management and incentive fees for themselves and their companies than fulfilling their obligation to their clients.
The Supreme Court of the State of New York in their indictment of Merkin and his oversight of his particular feeder fund, The Gabriel Capital Corporation, summed up the ethical collapse succinctly:
J. Ezra Merkin betrayed hundreds of investors who entrusted him with their savings by recklessly feeding their funds into the largest Ponzi scheme in history, while falsely claiming he actively managed their funds. Merkin held himself out to investors as an investing guru, collecting more than $470 million in management and incentive fees from his Ascot, Gabriel and Ariel funds. In reality, Merkin was but a master marketer, his efforts substantially directed only at convincing investors—including many charities—to invest in his funds. Merkin’s deceit, recklessness, and breaches of fiduciary duty have resulted in the loss of approximately $2.4 billion. 2. Merkin’s Ascot funds, Ascot Partners, L.P., and Ascot Fund Limited (together, “Ascot”) were formed in 1992 to be, and always were, “feeder” funds that entrusted Bernard L. Madoff with virtually all of their assets.
Similarly, in Massachusetts, Walter M. Noel, Jr., who founded the Fairfield Greenwich Group, was acknowledged by Diana B. Henriques in the New York Times as having a “gilded resume and a family linked by marriage to wealthy investors in Europe and Latin America . . .” (Henriques, para. 12). Mr. Noel and his company netted over $450 million in fees and incentives alone. In the end, the State of Massachusetts struck a deal with the Fairfield Greenwich Group and settled for a mere $8 million and dropped the fraud charges. By my math – that’s not bad for “a day’s work” if ethics is not an issue.
However, let’s be clear about the implicit responsibilities of fund managers such as these. As stated by the Oppenheimer Funds corporate website, the key fiduciary responsibilities of a plan sponsor (a.k.a Fund Manager) include executing “all fiduciary responsibilities with the care, skill and diligence of a ‘prudent’ person acting in a similar capacity; make fiduciary decisions in the sole interest of participants and beneficiaries.” Clearly this was not done in the case of Mr. Merkin nor Noel. It is well acknowledged that Madoff’s firm had not performed an external audit of its finances in 15 years. They had the responsibility to know that and to avoid a fund such as this one. Even some of the “big boys” – KPMG, PricewaterhouseCoopers, BDO Seidman and McGladrey & Pullen failed to explore beyond the surface.
In her article, “How to Spot the Next Bernie Madoff”, Laura Cohen cautions all investors to look for a third part custodian and to vet the accountants. Madoff investors received statements from Madoff Securities accounting firm rather than from their fund manager. Red flag. Who’s managing my money exactly? Or, who am I paying to manage my money?
More to the point, as mentioned earlier, Madoff Securities hired/created a three person firm, Friehling & Horowitz, housed in a strip mall to do their accounting. And again, let’s do the math and a gut check. 50 Billion dollars in funds accounted for by just three individuals. Is that even humanly possible? Big red flag.
Often times, in the ways of the “street,” if a company doesn’t like the reports the accountants are issuing, they will just find another accountant. However, a company that has had far too many accountants may be a tell tale sign that the company may be one that ethical accountants cannot stomach. Madoff solved that problem by creating his own accounting firm. Buyer Beware.
“The Fall – the 2nd season of harvest and deceit: The Government and Madoff”
Edmund Burke, the English philosopher said, “The only thing necessary for the triumph of evil is for good men to do nothing.” All along the way some good and otherwise decent men and women failed to do what was right or failed to do anything at all. When we cannot as a society rely upon the frailties of human nature, we look to a greater community – our government to help keep individuals and corporations in check.
Most can recall the recent action of the peanut processor in Atlanta that knowingly shipped salmonella tainted peanuts which resulted in at least 8 deaths and sickened more than 529 other Americans. If this company, the Peanut Corp. of America, seems too insignificant to interpret the ethics of a corporation, let us recall that the American-as-mom’s-apple-pie corporation,Sara Lee, was indicted in 2001 for knowingly selling listeria tainted meats that killed 15 people. For this, the corporation was charged with a misdemeanor and fined a mere $200,000. Does that seem equitable considering the loss of life? By contrast, should an individual point a loaded shotgun towards another and accidently pull the trigger, would not the person with the shotgun be charged at the very least with felony manslaughter for the death of the other? Most often, yes they would and they would also be vulnerable to a civil suit on behalf of the bereaved family. For this and other reasons, it is often difficult to assess the disparity between the accountability of an individual vs. the corporation. Herein lies the adage, “Who’s guarding the hen house?”
Despite Madoff’s esteem among his peers in the financial world – Madoff was a former chairman of NASDAQ – he clearly operated without morals, ethics or regard for the law. Yet, how often does an individual garner immortality by having an official SEC exception named for him? In this case, Madoff lobbied the SEC to open their minds and allow him a new way to trade securities in the management of funds, he was after all acknowledged as a “market-structure expert” (LUCCHETTI, para 14). The SEC finally said “OK” and this became known as the “Madoff Exception”. Is it so difficult to imagine how reluctant junior investigators might be to press this immortal regarding the activities of Madoff, his advisory business or his separate Bernard L. Madoff Investment Securities? And could this explain why the SEC failed to heed the warning of one of its own, Meaghan Cheung? How could she possibly know better than the revered Madoff? In the end, in a final cruel blow, it was the SEC who pushed her in front of the news cameras and “under the bus” to explain to the public why the SEC had not uncovered the scheme.
On December 15, 2008, Kara Scannell (2008) of the Wall Street Journal observed that “though [Madoff] was gathering investors' money and choosing how it was invested, he wasn't a registered investment adviser until 2006. Some people described his business as a hedge fund, but he didn't create a formal fund into which investors could put their money” (Scannel, par. 6). So, how could that happen? Again, was the “Street” and the SEC confused by the “Madoff Exception”? On any other matter, these types of anomalies would have been a big red flag to anyone without the attachment of Madoff’s name.
Remember, Harry Markopolos, who did the math, saw the handwriting on the wall and notified the SEC in 1999 that Madoff’s “split-strike conversion strategy,” didn’t add up? Much later, Markopolos would recall that he made this calculation in less than “five minutes”. For him, it was so simple, almost child’s play. Why couldn’t the SEC see it as well? Was Harry Markopolos just recast by the SEC as the wolf in contemporary retelling of Aesop’s classic sour grapes story? What could he possibly see in less than five minutes that the SEC could not for nearly ten years afterwards? Ungodly greed and deceit may be the answer. It appears the SEC is not able to scan the playing field for that. Or, worse yet, as with others, the SEC had a conflict of interest.
Nonetheless, according to the United States of America, citizen investors shouldn’t need private citizen or fox to sound the alarm. It has that covered – The U.S. Securities and Exchange Commission. According to the agency’s website, its mission “is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” Sounds almost simple, doesn’t it? Yet if one remembers or reads why it was created in the first place, the Madoff disaster seems all the more puzzling. The SEC was born out of an earlier disaster that is chillingly all too familiar to the one before us now. Or, in the SEC’s own words:
Tempted by promises of "rags to riches" transformations and easy credit, most investors gave little thought to the systemic risk that arose from widespread abuse of margin financing and unreliable information about the securities in which they were investing. During the 1920s, approximately 20 million large and small shareholders took advantage of post-war prosperity and set out to make their fortunes in the stock market. It is estimated that of the $50 billion in new securities offered during this period, half became worthless (SEC, para. 14)
Even the sum of money involved seems as if it was foretold by Nostradamus - $50 Billion. Isn’t that the same estimate of what Madoff “controlled himself? Yes, and that’s conservative. So, how is it that one man, singularly responsible for a minimum of $50 billion investor dollars escapes the eye of the institution dedicated by Congress to prevent such things? That is the $50 billion dollar question.
Even Meaghan Cheung an upper level manager with the SEC’s New York City bureau, would have her findings dismissed by her superiors. Could it have anything to do with the fact that since 1991 Madoff and his wife have contributed about nearly a quarter of a million dollars to federal candidates, parties and committees? Or, was it incidental as in at least one case, where an SEC investigator was re-tasked in her investigation of Madoff by her superior who latter marries into the Madoff family. One hopes not. The SEC report steadfastly denies it.
On December 15, 2008, Kara Scannell (2008) of the Wall Street Journal observed that “though [Madoff] was gathering investors' money and choosing how it was invested, he wasn't a registered investment adviser until 2006 – a clear violation of the Investment Advisers Act of 1940. Some people described his business as a hedge fund, but he didn't create a formal fund into which investors could put their money” (Scannel, par. 6). Again, was the SEC confused by the “Madoff Exception” or was it something else?
Mark Skousen, writing for the conservative magazine Human Events said in December of 2008 that the number one lesson to have learned from the Madoff case is that you “can’t count on the federal government, especially the SEC”. He offers that many within the SEC will migrate in their careers to the same investment establishment that they once eyed like hawks. Or more to the point, author Aaron Knapp recalls American history. In his three part article, “The SEC Fiddled While Rome Burned” he aptly recalls the question posed to FDR in appointing Joseph P. Kennedy as the first chairman of the SEC who was himself a former stock speculator if not a rogue. Roosevelt replied, “Takes a thief to catch a thief.”
The real insight might come from Allen Sloan who explained this mystery in a way that most Americans can understand – through baseball. He said, “You’re likely to get caught if you run a few inches outside the baseline, because regulators are set up to catch that. But run so far out that you’re playing on a whole different ball field? You can get away with that if you’re enough of a financiopath, and your luck holds.”
The SEC cannot be held up to an ethical light as they have failed a far simpler test – their mission, chartered by Congress to protect the investor. No matter in which ballpark one stands, a home plate unprotected, dooms the home team.
“The Winter of our Discontent: The aftermath of the Madoff Affair”
“Now is the winter of our discontent
Made glorious summer by this son of York;
And all the clouds that low’r'd upon our house
In the deep bosom of the ocean buried.”
(Shakespeare, Act 1, scene 1, 1–4)
Can we believe as Richard III does in Shakespeare’s historical play that the bad times are now behind us? Let us not be so foolish. The Bard himself was well aware of and recounted often in his works the folly of men and women, even those considered “good”.
The desolate fields of security traders lay barren by Madoff’s nuclear winter of deceit stand barren as a reminder that greed and its ally, deceit, has the ability to bury us.
One would hope that this living parable played out on the world stage will serve as a cautionary tale to all investors to always do their own due diligence before investing with anyone, no matter how luminous they may appear.
Furthermore, accountants of every kind and fund managers alike must know that Sarbanes-Oxley has guaranteed them a prison sentence in the United States, thus making deception a high stakes game.
And despite a 477 page report perfunctorily explaining why it did not do its job, the SEC itself still has plenty of explaining to do and bridges to mend with its citizens who were guaranteed safe passage through financial currents such as these.
In the end, one must acknowledge that we will never be immune to humankind’s frailties, the government cannot protect the citizen investor and the investor sometimes believes that there’s “easy” money to be made. In all cases, whether by the hands of others or our own, we are deceived.
No comments:
Post a Comment