Bernard Madoff was able to pull off what is allegedly the largest investor fraud in history because people trusted him. But why did people believe his lies when there were so many reasons not to?
It was the skeptics who spotted Mr. Madoff's alleged deceptions. Most notable among them was a derivatives expert named Harry Markopolos, whose 19-page memo sent to the Securities and Exchange Commission in 2005 provided 29 compelling red flags that the regulator should have found sobering.
Apparently, the SEC found it easier simply to believe Mr. Madoff than confront the cold, hard facts.
The analysis provided to the SEC by Mr. Markopolos was sophisticated but certainly not beyond the comprehension of a prudent investment expert such as a competent regulator or a diligent investment fiduciary. Indeed, a number of dedicated fiduciaries, including several large financial institutions, investment advisers, retirement plan sponsors and endowment administrators, found Mr. Madoff's magical ability to generate consistently stellar returns to be too good to be true.
Good fiduciaries are necessarily skeptical, so they sought verification of key information before they would invest. Their due diligence paid off; they uncovered troubling information in six areas of essential inquiry for fiduciaries.
First, Mr. Madoff didn't use an independent custodian. By both directing trades as money manager and keeping track of the funds as custodian, he had an opportunity to cook the books, and he allegedly seized it. Concerns about these commingled roles were magnified when Mr. Madoff refused to provide investors the capability to view account holdings online and served as the sole source of brokerage account statements.
Second, his financial auditing was provided by a tiny, obscure accounting firm. Reportedly, this firm employed just one practicing accountant and routinely indicated to the New York-based American Institute of Certified Public Accountants that it didn't perform audits. Thus, another important component of a system of checks and balances was inadequate at best.
Third, Mr. Madoff produced his own performance reports and wouldn't allow independent performance audits. Given the incredible returns being claimed for the fund and the opportunity for shenanigans afforded by closely controlled trading and record-keeping functions, unverified performance had to be considered suspect.
Fourth, the extraordinary investment success claimed for the fund didn't jibe with reasonable investment benchmarks, and the results couldn't be substantiated when subjected to fundamental testing of the trading strategy. The analysis provided to the SEC by Mr. Markopolos amply demonstrated that Mr. Madoff's returns weren't possible, at least not without breaking the law. He correctly concluded that the most plausible explanation was that Mr. Madoff was paying early investors from the money contributed by later fund entrants — a classic Ponzi scheme.
Fifth, the business structure of the fund made little economic sense. Moreover, it seemed designed to avoid regulatory oversight and to frustrate due-diligence efforts by prospects and clients. Rather than organize as a
hedge fund and charge a lucrative performance-based fee, Bernard L. Madoff Investment Securities LLC operated as a commission-based broker-dealer with distribution provided through hedge funds of funds. By acting like a
hedge fund manager, organizing as a broker-dealer and registering with the SEC as an investment adviser, it seems that the New York-based firm was able to exploit arcane regulatory structures by seeding confusion as to what set of rules should apply. As a result, Mr. Madoff apparently fell through the regulatory cracks.
Finally, he showed little appreciation for, and no processes to apply, fiduciary standards of care. Mr. Madoff boasted to those whom he trusted and those who trusted him that he subsidized returns in down quarters to maximize reported performance and minimize volatility (risk). This is in itself illegal manipulation. Mr. Madoff refused to accept prospective investors at first to create the aura of exclusivity. He rejected potential investors who asked penetrating questions, reacting to such inquiries as an affront to someone so accomplished in creating wealth.
Congress is deliberating how the nation's financial regulatory structures should be revamped. At the same time, fiduciaries must recognize the crucial role they play in applying sound verification processes, and a healthy dose of skepticism, in making each and every investment decision.
Blaine Aikin is president and chief executive of Fiduciary360 LP in Sewickley, Pa.
For archived columns, go to
investmentnews.com/fiduciarycorner.
