Madoff: A Riot of Red Flags
The US$50b fraud by Bernard Madoff’s investment advisory and broker-dealer firms had an equally outsized list of red flags. Several ways in which Madoff carried out his operations were not only highly unusual but also gave him more discretion over his operations and subjected his activities to less scrutiny than a typical investment adviser or broker-dealer. Notably, Madoff did not operate a hedge fund nor charge performance-based fees. He claimed that his compensation came from trading commissions.
Although Madoff was a well-known industry professional and socialite, he kept details relating to his business in confidence and spoke only in very general terms about his business. While hedge funds typically do not make disclosures at the investment position level, Madoff’s conduct was extremely secretive even by hedge fund standards. Hedge funds typically make quarterly performance reports to investors, include details about operational and risk-management practices and stand ready to answer investor questions. Not only did Madoff fail to provide such information, but he was reportedly defensive about how his firm operated and did not tolerate investors that asked for details. The most some investors were ever able to obtain were paper trade tickets by mail. Even though Madoff’s brokerage purported to manage US$17b in assets, it was a very small firm whose employees included Madoff’s brother and two sons. BMIS was also audited by a modest accounting company with only one working accountant.
Red flags such as these alone are sufficient to warn any investor that Madoff did not deserve any substantial sum of money and especially not an investor’s entire portfolio or, worse still, the entire savings of charities and individuals. These red flags were noticeable to any investor willing to ask a few basic questions.
A second group of red flags should have also alerted those with some experience in the investment industry. Madoff did not just keep information from his investors; he failed to purchase services from the web of independent third-party service providers widely used throughout the broker-dealer and investment adviser industry. Investment advisers, including hedge fund managers, typically have their trades cleared by a prime broker, their client’s assets held legally by a custodian and the value of fund assets determined by an administrator. These third parties can provide an independent, though certainly not perfect, check on a manager’s activities and a safeguard for investors. Prime brokers, for example, typically have full transparency over a fund manager’s actual investment positions. Custodians prevent a manager from absconding with investment capital. Madoff, by contrast, apparently cleared his own trades (to the extent he actually made any), held his clients’ assets and determined assets values internally. These activities constituted a significant red flag as to the integrity of Madoff’s operations for anyone familiar with the basics of investment fund practices and hence the potential for abuse.
For investors with some degree of financial acumen and experience, Madoff’s reported investment returns were themselves red flags. Alternative investment funds are often marketed as being advantageous to traditional investments because of the former’s relatively low correlation to overall market swings. Indeed, hedge fund strategies managers often aim for absolute or positive returns regardless of market conditions.
Madoff, too, promised absolute returns, somewhere in the neighbourhood of eight to twelve per cent per year. What made Madoff stand out in this respect, however, was how well he fulfilled his promise. Madoff never had a year of negative returns and rarely even a down month in nearly 20 years of operation. Some investors may have overlooked the consistency of Madoff’s returns because they were relatively modest.
Finally, for investors with knowledge about option strategies and options market microstructure, the most important red flag of all was that Madoff’s trading strategy was literally impossible to implement. Madoff claimed to be pursuing a short-term “split strike conversion” strategy. This strategy was supposed to use put and call options to minimise losses and gains and at a general level was, therefore, consistent with Madoff’s stated return objectives. However, given the level assets Madoff claims to have managed, the trades should have clearly been reflected in price movements in the relevant options markets he claimed to trade in. Yet they were not. Because of the discrepancies between Madoff’s purported strategy and the actual market prices and movements of the options markets, Harry Markopoulos, a prompt and vociferous critic of Madoff, claimed he knew Madoff was committing fraud within in five minutes of looking at the issue and could prove it through a few hours of mathematical modelling.
Although Madoff would not have been able to perpetrate a US$50b fraud if not for fooling numerous investors for more than a decade, many investors did become suspicious of Madoff and refused to invest with his firm. Some large investment banks such as Goldman Sachs and Merrill Lynch were suspicious and refused to do business with him. In 2001, more than twelve anonymous investment professionals expressed their doubts about Madoff’s returns in an article published by MAR/Hedge. Funds of funds such as those operated by Ermitage and Bank of America also refused to invest with Madoff because of his lack of transparency.
Unfortunately, similar red flags likewise failed to deter investors in what has turned out to be another recent multi-billion dollar Ponzi scheme. As alleged by a Securities and Exchange Commission complaint, R. Allen Stanford and James Davis carried out a massive Ponzi scheme through two registered investment advisers and a private international bank based in St. John’s, Antigua. Stanford’s alleged scheme involved selling certificates of deposit but misappropriating investor capital through fake personal loans to Stanford and investments in unprofitable private companies controlled by Stanford.
Some of the red flags surrounding Stanford’s operations are more than passingly similar with those involved with Madoff’s scheme. Stanford was apparently vague about the details of his investment activities, used a small and unknown accounting firm as an auditor and had a board of directors that counted his father and college roommate as members. Stanford’s CDs were also marketed with consistent, double-digit returns, which were higher than those offered by US commercial banks. Investors with knowledge of finance should have wondered how Stanford’s CDs could pay so well.
Both Madoff and Stanford had several times been investigated by financial regulators, which therefore had their own lists of red flags. Madoff was reportedly investigated on eight separate occasions over 16 years by the SEC. This includes a 1992 investigation into a Ponzi scheme by other individuals using money managed by Madoff, a 1999 finding by the SEC of Madoff violating minor trade execution rules and a 2006 SEC investigation finding that Madoff had been misleading in the past. Stanford’s companies, for their part, were sued in 2006 and early 2008 by former employees alleging that Stanford was running a Ponzi scheme and had engaged in other fraudulent activities. Beginning in 2004, Stanford was investigated and disciplined several times by the financial industry’s self-regulatory authority (formerly the National Association of Securities Dealers and now the Financial Industry Regulatory Authority) and the SEC, which led to several disciplinary actions and fines. Of course, it was not until December 2008 for Madoff and February 2009 for Stanford that the SEC and other law enforcement authorities brought the fraudulent schemes to a close.
These Ponzi schemes will have a lasting impact on the investment advisory business. Investors are already demanding greater transparency by fund managers. They are also looking for other assurances of integrity. Some are threatening to pull out their investments unless desired changes take place and managers seem to be responding.
A case study is the prominent hedge fund DE Shaw, which it is reported, is hiring administrators to provide an independent substantiation of investment positions and cash balances (in addition to the independent check on assets prices that the fund already has a third-party perform). Hedge funds also seem to be taking greater steps toward industry-wide best practices and self-regulation. The fallout from Stanford’s fraud may have a particularly negative impact on offshore banks as investors and others unduly associate the geographic structure of the company with its fraudulent activities.
US policymakers are also responding. Lawmakers and regulators seem in general agreement that investment advisers, as a rule, should register with the SEC. Although new legislation has yet to be passed to that effect, it will likely be passed with broader reforms in 2009 or 2010. Like publicly listed companies, private investment funds may also soon have to be audited by an accounting firm supervised by regulators and subject to their rules or at least participating in the peer-review programme conducted by the American Institute of Certified Public Accountants. This may come in the form of requiring all registered advisers to use a qualifying auditor or perhaps more likely be based upon the size of assets under management. Reforms to regulators are also likely. The SEC has announced that it will review the ways it handles tips and Financial Industry Regulatory Authority separately established an office for whistle-blower complaints. And although position-level transparency to the public is unlikely ever to be required of all investment funds, regulators are likely to seek other avenues of disclosure. For example, regulators will likely keep this framework, first established in the fall of 2008, for periodic disclosures of significant short-sale positions.
Regardless of the operational risk management improvements made by advisers and the regulatory reforms, investors are well-advised to continue and increase their own diligence practices.