In December 2008, Bernard Madoff was charged with a single count of securities fraud stemming from a Ponzi scheme that was reportedly estimated at $50 billion. Madoff represented several individual investors, foundations, and charities, and the losses could result in the largest reported Ponzi scheme of all time. Professor Paul Rose, an expert in the field of securities regulation, discusses the unprecedented accusations.
What is a Ponzi scheme?
A Ponzi scheme is a kind of investment swindle that gets its name from Charles Ponzi, who ran a fraudulent investment scheme around 1920. Ponzi duped thousands into investing in a fund designed to speculate in postal coupons. Ponzi offered a 40 percent return in 90 days. However, Ponzi actually only invested about $30 worth of the funds in the postal coupons, so early investors were essentially paid from the funds deposited with Ponzi by subsequent investors. The collapse of the scheme was inevitable — soon there was not enough new money to pay the investors, and the entire scheme failed.
Bernard Madoff’s scheme was in effect a classic Ponzi scheme. Investors flocked to his exclusive funds, and he was able to make payouts for years as more investors kept investing with him. The surprising thing about Madoff’s scheme is the massive amount of the fraud as well as his ability to perpetuate it for a relatively long time. The scheme orchestrated by Charles Ponzi only lasted from December 1919 to August 1920. Madoff’s scheme has gone on since at least 2005, if not far longer.
If accusations are true, how did Madoff get away with such a grand scheme?
There are several explanations, I think. First, Madoff took advantage of his relationships with various individuals, groups, and charities. He appears to have taken particular advantage of many friends and contacts in the Jewish community. However, he also duped very sophisticated institutional investors, including hedge funds, multinational banks, universities, and even Abu Dhabi’s sovereign wealth fund.
Another explanation for Madoff’s success is simply his good luck: the economy and the markets were performing well enough so that investors were not cash-strapped and eager to pull their money out of the fund. Madoff apparently targeted passive, long-term investors, including charitable institutions or wealthy individuals, who would not need to withdraw from the fund to satisfy capital needs. However, once the bear market hit with full force, even many of these investors decided to withdraw their funds from the equity markets. This is the point at which Madoff knew his time was up. There were not enough funds to satisfy the requests from his investors, and so he admitted to his fraud. If there is a virtue in bear markets, it is that they serve to uncover frauds such as Ponzi schemes like Madoff’s.
Finally, Madoff also benefitted from some lax oversight, and he knew how to exploit regulatory weaknesses. There were signals along the way suggesting that Madoff’s investments were not all he claimed them to be. Evidence has surfaced suggesting that regulators ignored clear warning signs. The market also missed some opportunities to ask hard questions. For example, some analysts tried to replicate Madoff’s returns based on the portfolio information he disclosed, but were unable to produce similar results. The SEC received numerous tips that Madoff’s scheme might constitute a fraud, but its investigations failed to discover any problems.
What changes do you recommend to prevent this from happening again?
Although this may seem Panglossian in the face of a $50 billion fraud, I am not sure that we need drastic changes. A reasonable change would simply be to provide the U.S. Securities Exchange Commission with additional resources to pursue fraud. While mistakes were undoubtedly made in the Madoff investigation, the SEC is leanly staffed given the amount of investment activity it has been tasked to police. I also think it is a mistake to assume that just because we see fraud in the marketplace, the SEC or the market itself is completely broken down. Were we to adopt fraud prevention as the sole regulatory mission of the SEC, we would likely create such a burdensome regulatory apparatus that capital formation in this country would grind to a halt or move entirely offshore.
That being said, what do you think will be changed?
On Jan. 27, 2009, the Senate Banking Committee questioned officials from the SEC enforcement and the securities industry’s primary self regulatory organization, the Financial Industry Regulatory Authority, on the Madoff case. After hearing testimony on what went wrong, the committee asked both organizations to return in three months to provide an update on the effectiveness of the current regulations, along with any suggestions for further regulations to combat fraud. As with many high-profile frauds, Congress and enforcement officials are under significant political pressure to demonstrate that they are taking active steps to prevent similar problems in the future. The track record of regulators under political pressure to “do something” has not been good, however, and has sometimes resulted in regulation that does not perform as designed or produces negative and unintended consequences.
The most likely regulation that will be implemented in part because of the Madoff scandal will be new regulations for hedge funds. Regulators will see the scandal as evidence that even extremely sophisticated investors are often not able to adequately protect themselves. Many funds (including hedge funds) which cater to sophisticated investors may no longer be permitted to operate under the lighter regulatory burden they have enjoyed in the past. In fact, a bill expanding oversight by SEC over hedge funds was introduced by Senators Chuck Grassley and Carl Levin on Jan. 29. Among other things, the bill would make clear that the SEC has the authority to regulate hedge funds, and would require hedge funds to register with the SEC and cooperate with the SEC with any request for information or examination. Mary Shapiro, the new chairman of the SEC, and Timothy Geitner, the new Secretary of the Treasury, have also expressed a desire to see further regulation of hedge funds.
As attorneys, what should this story teach us?
Madoff’s fraud was certainly very shocking to his investors, many of whom probably knew him personally and some of whom had perhaps grown to think of him as not just a money manager but as a friend. He was a charismatic salesman. This charisma likely helped him deflect some of the questions that arose regarding his scheme. I think the Madoff story should remind us of the political idiom, “trust, but verify.”
What should I keep in mind when investing my own money?
Consistently outperforming the market, as Madoff had claimed to have done for years in a row, is a very difficult and unusual thing to do. Even very sophisticated institutional investors were duped by Madoff’s fraud, despite some clear warning signs. There is great wisdom in the old saying that if it sounds too good to be true, it probably is.
Professor Rose began as an assistant professor at The Ohio State University Moritz College of Law in June 2007. Prior to joining the Moritz faculty, Professor Rose was the visiting assistant professor in securities and finance at Northwestern University School of Law. Before joining Northwestern, Professor Rose practiced law in the corporate and securities practice group of Covington & Burling’s San Francisco office. He worked as an assistant trader in equity and emerging market derivatives at Citibank, N.A., in New York prior to attending law school at the University of California, Los Angeles School of Law. Professor Rose’s research interests include corporate governance, securities regulation, institutional investors, and comparative corporate law.
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