Learning from Financial Fraud Series Episode 6: Unpacking the Bernie Madoff Ponzi Scheme

Announcer  00:04

Welcome to the Treasury Update Podcast presented by Strategic Treasurer, your source for interesting treasury news, analysis, and insights in your car, at the gym or wherever you decide to tune in.

Jonathan Jeffery  00:19

Welcome back to the Learning From Financial Fraud Series on the Treasury Update Podcast. In this series, we explore multiple major financial fraud cases, we discuss how each one occurred and was kept hidden for a period of time, and we’ll dissect how it was eventually discovered, and get insight and guidance on how to prevent this type of situation from happening to you and your organization. Hi, I’m Jonathan, media production specialist here at Strategic Treasurer and your host for this podcast and I’m here with Craig Jeffery managing partner. Welcome, Craig.

Craig Jeffery  00:48

I’m glad to be back here. I’m surprised at how many accounting financial frauds there are. I think this series could go on almost forever. So there you go.

Jonathan Jeffery  00:58

Well, that is the plan. We’re gonna keep doing this forever. And when we get to Episode 50, you’ll have to recap all 50 So with that the first five cases we looked at in this series, we’re covering Parmalat, Satayam, Wirecard, FTX, and Enron Can you give a quick recap of what happened in each of those episodes for the listeners who haven’t heard about them?

Craig Jeffery  01:21

Sure, I’ll try to be quick Parmalat was an Italian dairy billions were lost. They were fictitious accounts. They fooled auditors by sending documents. That was a little over 20 years ago Satyam was Indian technology firm they exfiltrated over a billion dollars. They used internal collusion and fictitious employee accounts. There was a confession by one of the owners which triggered the collapse of that in the jail cases. Wirecard was brought about by lack of visibility, this idea of kiting funds moving around between different entities. As a huge payment company. The loss was massive FTX trading FTX is a think of cryptocurrency digital currency. They named stadiums they made all kinds of political donations, they use customer funds for personal use, and trade massive losses. The name bagman fried is a key player there. And number five, the Enron accounting scandal. This was the illegal use or inappropriate use special purpose entities where they would move losses out of the main Enron entity into the other special purpose entities and created trades that were not actual trades, but were more loans. This also brought about the downfall of the Arthur Andersen name. There we go.

Jonathan Jeffery  02:44

Nice. So if any of those sound interesting to you guys, all of them will be linked in the description. So feel free to listen to those afterwards. But today we are taking a look at the $65 billion Ponzi scheme that was run by Bernie Madoff. Craig, what’s the deal with Bernie?

Craig Jeffery  03:03

Bernie has now met his maker, he died when he was 82. So he’s no longer around. But the deal with Bernie is he ran this massive Ponzi scream, scheme. Maybe that’s a Freudian slip. Certainly those 40,000 people who lost money, screamed about that. But he brought it up to 65 billion, certainly, multiple billions were recovered, but huge, huge fraud, spent on cars, mansions, all kinds of lavish gifts. And it was centered on a number of things is keeping things hidden. There’s a lack of visibility to trades and the trading schemes. And he covered that up with a accounting firm, a firm that was doing the auditing, that he essentially had a type of control over. And so the checkers weren’t valid. The ones that were were checking the books weren’t. Nobody was checking on them. And there was a bunch of early warnings and repeated warnings, people saying it’s impossible to get these kinds of yields, and they were ignored for a long period of time. And this has really taken advantage of people’s desire for extremely outsize rewards consistent, outsized yields year over year over year, no losses but consistently beating the market, which I think we all know is too good to be true.

Jonathan Jeffery  04:27

So he probably started out with wanting to be one of those people that wanted to consistently beat the market and he realized he could leverage that.

Craig Jeffery  04:34

Yeah, it’s hard to say how what goes on in someone’s mind for doing well. He was certainly a smart person. He leveraged his his former positions of prestige and governing markets to do this activity then I guess once once it starts failing, there’s a problem. How do you cover it up? And then it just rolls and snowballs? I imagine that’s part of the part of the challenge that goes on. But he got 150 year prison sentence. So he still owes some years.

Jonathan Jeffery  05:04

So how exactly was he beating the market for these people? What exactly was he doing?

Craig Jeffery  05:11

While he wasn’t beating the market? So the question is, how was he beating the market, he was providing statements that appeared to be beating the market. And so you would get statements that showed you had made significant returns. So hey, I’m doing well, let’s pour more money into that. And it was consistently beating. So he was creating statements that showed them beating the market. And when people had to do withdrawals, because he was spending huge sums over time, he would pay if someone ever did a withdrawal for, you know, 50 million or 100 million, he would use all the new money that was coming in additional people, which is why it’s called a Ponzi scheme to pay them out. So he was just providing a statements like I created a statement and did an Adobe, and sent you the file. So here’s your statement, you’ve got 100 million, but I spent 90 million of it. How do you know from the statement, you’re lying on hey, these books are these books are checked, the validated the accounting firms looking at them got a good clean audit report, but it wasn’t clean. They didn’t have the assets.

Jonathan Jeffery  06:12

So he had already spent the money that was said it was invested, use new money to pay for whenever somebody to withdraw or interest or whatever.

Craig Jeffery  06:22

Yeah, and he’s pretty good. I mean, think about how many people you could convince to give that much money and you’re paying, you’re spending a ton. And you’re you’re trying to get more assets to come in to cover that. And you ran it up to 65 billion. I mean, that’s, that’s pretty big league stuff.

Jonathan Jeffery  06:36

Yeah, it sounds like he wasn’t able to recover most of it. So what were the losses for the victims of the scheme? How were the victims compensated at the end?

Craig Jeffery  06:45

Victims received some money back a number of them did, and I pulled some information about how many losses are worth, we knew there was over 40,000 people who are impacted. And these there were a number of feeder funds, so there’d be investment companies that were taking funds, and they would feed into the Madoff fund. And so there’s this amplification, it was like, there’s a Ponzi scheme. But there’s also a distribution element to it, that these firms thought this was a great investment, they had gotten in with the Madoff funds and would take funds from their customers, and feed them over to here and that that became a significant problem. So in terms of the size, Jonathan, as you look at that it’s the top 10 investors who lost in terms of their their exposure, at least the beginning, the top 10, all had a billion dollars or more in the funds, and the next six, were that weren’t recovered? Well, I don’t think we have I don’t think we have data on how much what the initial exposure and how much was recovered, we know that there was 14 18 billion of the 65 billion recovered, maybe there’s more than that. I don’t know that there’s an exact accounting, you know, for the 40,000 people what, what they had in there, what was recovered? How much of that 65 billion was inflated yield? So if you put in 100 million or became 112 million, 128 million, how much of that was inflated yields? And how much of that was actual money that came in? I don’t know that there’s a full accounting of that. Because the record keeping was so poor, but in terms of what people had and their potential exposure, these are some of the numbers that just say, Yeah, so 10, were over a billion. Another six were half a billion to a billion, another 11 were a quarter of a billion to half a billion. So just there, that’s 27 entities, you know, a couple individuals who had huge sums of money invested there that lost it, it’s been reported at least 18 billion was recovered. So how much was principal that was lost? How much was inflated earnings that were lost? How much was lost opportunity? Those are, those are really hard to say? Yeah.

Jonathan Jeffery  08:51

Okay. So we don’t have all the information on that. But we know that not everybody got their money back.

Craig Jeffery  08:56

No, I don’t know that anybody got all of their money back? I think the ones that got back, got some got a settlement for some.

Jonathan Jeffery  09:04

How did he keep this deceit going on for so long?

Craig Jeffery  09:07

Yeah, that’s a there’s a lot of movies about that. You know, I It’s hard to say, especially when there’s warnings and you go back and say there were all the signs. Why wasn’t that found sooner? You know, he was the he was a former chairman of NASDAQ. So he had had, you know, good street cred, good credentials. So he had the chops for it. He had consistent high returns. And people were trying to get in once people were trying to get in. It was this idea of hey, everything’s exclusive. Like if you want to get an amount of funds, you got to be an exclusive person or fund. That’s very restrictive. So people would be you know, asking and funds were asking heavily I don’t know about begging but but really working to get into the fund. And so there’s this whole process of he was able to go Get people to fall into this track. And then as he had a suppose it or an alleged track record of above average returns, that became here’s a paper trail, here’s the trajectory for a long period of time. And so he was able to keep it going, as long as he could take more funds, and redeem and support the redemptions that people were asking for that charities were asking for the banks were asking for that. Individuals were asking for it held up, they’re looking at their statements, it looked good.

Jonathan Jeffery  10:29

So when you see things now that are offered that, that offer a higher percentage than you’re going to get in the market? What concern should you have and like, let’s say your average market return is going to be?

Craig Jeffery  10:41

Well, let’s say it’s, you know, on the equity side, perhaps you’re looking at eight to half to 10 and a half over time, sometimes 11, you might be looking at that over the course of a long period of time, bonds will look different than, you know, short term cash instruments, you know, may look different as well.

Jonathan Jeffery  10:59

So if someone comes out with something new that’s offering 10% More than that, how do you verify that? How do you verify that what they’re doing is legit?

Craig Jeffery  11:10

Well, you know, there’s the the efficient frontier, you think about investments. If everything’s efficient, the higher risk you take should relate to a higher return. But higher risk will, you know, there’ll be a reversion to the mean. And so if you’re, if you’re taking something’s very risky, you should have significantly higher returns. And that may bode well for you for a period of time error may be disastrous as you lose very significant sums of money. So anything that might be favorable for a particular market conditions is something you want to understand what’s, what’s been invested, how it’s how it’s being tracked. But when someone says, we’re going to be we’re going to do 5%, better, or 8%, better than the market than other active or passive fund management firms. Like, how is that going to be possible that someone’s that far ahead for that long? And it’s, it has to be it has to be viewed as that’s exceptional? How is that going to work? Are they in a unique position? They’re the only ones who can do it, too. They have a monopoly somewhere, you know, like that would be invested in a company. But how many of those monopolies exist, that becomes very challenging to think you’re going to be that much above the market without a downside. Right? So more risk means you’re gonna have some volatility, and not having volatility is that can be somewhat of a question. If you’re getting outsized returns, there should be more risk.

Jonathan Jeffery  12:36

Yeah. So be skeptical and just weigh the risk. Yeah, I mean, move into that.

Craig Jeffery  12:42

Well, it is I mean, that’s kind of like being from Missouri, the show me state, there should be some skepticism, you should understand what you’re investing in, of course, right? Any, all the professional investment advisors say you should understand what you’re investing in, to some extent don’t, especially if you’re looking for outsized returns, if you’re looking for outsized returns, you’re going to concentrate that into fewer companies, not necessarily be in this massive fund. And certainly, some funds can do better for a time, but once they get to a certain size, they’re finding investments that are more preferable, or whatever the advantage they have, then they have too much money and it gets diluted, they have to go downstream and earn less. Gotcha. So what were the punishments? Well, the punishments, his his sons, Andy and Mark, turned him in. So punishments were I guess, you know, uncomfortable family dinners, whether they were at home or, or in prison. Yeah, he got, he got 150 years in prison. That was the that was the assignment, which, I don’t know that we have a lot of people living. I can’t remember what how old he was when he was convicted. I think it was in the 60s. You’re not gonna be living to be 200 years old, but he died in prison at the age of 82. So those were the those are some of the consequences for him.

Jonathan Jeffery  14:03

Yeah, I don’t know the difference between a life sentence and 150 years in prison. But they sound kind of similar to me.  What were the regulatory oversights that allowed the SEC and other regulatory bodies to fail in figuring out this Ponzi scheme?

Craig Jeffery  14:17

For some of the misses, you know, SEC, and others have an oversight responsibility. And so missing missing on those is significant. They received a number of warnings over over the years over multiple years, they’d receive warnings from people like this can’t be the case. Some people written this, like, I’ve run models, even if I if I’m selecting certain types of instruments based on what Madoff says, I can’t get to those yields. It’s not possible to do that. Even if you look back in time and say, I’m going to pick the best options, right? I’m gonna go and pick from these categories, whatever the best choices would be like it’s not possible to hit those types of returns and said They they investigated him at different times since 1992. And they always came away with you know, it was it was fine. From 1992 to 2000, a Harry Markopolos, filed a formal complaint with sec, some of the different agencies that overlook these didn’t necessarily coordinate as well as they should. But by 2005, the SEC looked for additional documentation on the training accounts. And Madoff did what? They weren’t accurate. So what he did, he created a fabricated list. And the SEC looked through and said, Hey, this, this works, they didn’t actually verify that those were trades held in accounts. So here’s the support, but it’s fictitious. So he provided a good paper trail. But there was no there was no actual action from that.

Jonathan Jeffery  15:52

A step up from creative accounting.

Craig Jeffery  15:55

Yeah, this is this is quite right. Like I papered it over, like, here’s my documentation for everything at work. And there’s there shouldn’t be a trust, but verify and the validation processes should be, hey, I’m looking at it. I’m gonna validate things. If I have questions, I’ll check on it. That this was this was at a massive level.

Jonathan Jeffery  16:12

So what kinds of things can Treasury can finance learn from this? What kind of things should we be looking out for in the future?

Craig Jeffery  16:19

That’s a good question. You know, when you had said, Let’s cover the Madoff Investment scandal, my initial reaction that went that one of my head was, why are we covering that? I mean, it was charities and individual investors that got ripped off, what does that have to do with Treasury and finance. But then I thought about a little bit more, I was like, Wait a second, there’s a there’s an organization here, the Madoff Investment organization, and how its regulated, that there’s a lot of learning that can take place outside of that. And so I realized, this is a, this is a good environment, and a good thing to talk about for Treasury and finance, in general. I guess a couple of things. When we we talked about what went on this ability to hide things, you know, how do you hide things, you know, you want to make sure there’s no visibility, or you want to restrict it to a certain few people. And, you know, the, the idea and the security principle of least privilege, the principle of least privilege. I know, you know, it’s, it’s the idea that people and ideas can only have access to the data and the functions that they need access to, because otherwise it’s, you know, someone gains control of an ID, they can do too much damage. People should only have access to information they need, or it can get out, you can have significant damage. It’s a way of protecting people protecting the organization, protecting your clients. But that doesn’t mean super secrecy and creating this complete opaqueness, and how, you know, what are some of the ways that we get around using that principle of least privilege to a detriment? is making sure that there’s fresh eyes put on processes, cycling your auditors through, you know, the new waters come through? They don’t they haven’t heard the same story for years in a row. And they’re too embarrassed to go back and ask a question that they they pass four years in a row. Same thing with staff. I mean, it used to be everyone was required at banks, for example, did it take two weeks of vacation off in a row? Why was that the case? Well, it made someone else had to do the work long enough. So that a number of the functions would be done, if someone’s gone for a week, they can usually let it sit, and the person can cover up, you know, if they’re xOP, their misappropriating funds, moving, moving funds out, or, or cooking the books, as it were, it allows them to adjust that. So that idea of rotating your staff getting fresh eyes on the process, and this can be you’re gonna have an external auditor to look at things, you can have someone to review or assess a process, you know, in your rotation of staff. You know, one thing that can also happen is having someone externally come in and run a function for a period of time, three months, six months, a year, or on a permanent basis, certain functions. When there’s this segregation of duties. And there’s somebody who’s apart from the, let’s say, the direct chain of command, it tends to be found out more quickly, just like you might have internal audit, you might have external auditors, they come in and they’re, they’re looking to make sure that everything’s accurate. Or they’re looking to they have to understand the process. They see what is going on. If something’s doesn’t smell right, doesn’t look right isn’t right. They have they have an easier way of identifying and escalating whatever the situation happens to be or whatever the problem is, to get that found out. So you know, so having a separate set of eyes, a fresh set of eyes, a different set of eyes, supports the segregation of duties.

Jonathan Jeffery  19:53

Yeah, that’s interesting getting a fresh set of eyes on things. One of the things we offer here at strategic treasure is staff augmentation. And so if you’re drowning in the daily workload demands of corporate finance, or if you feel stretched thin and you’re unable to focus on strategic initiatives, leave the day to day operational tasks to strategic treasure, our experts will seamlessly integrate into your existing team. Working alongside you to optimize cash management, and enhance risk management strategies will bring fresh insights and innovative solutions to your treasury operations will negotiate favorable terms and maximize your liquidity and investment opportunities, augment your staff with strategic treasure and gain a powerhouse of knowledge and skills without the hassle and cost of recruiting and training additional staff get in touch today and experienced the power of staff augmentation. You can learn more by visiting StrategicTreasurer.com. You have any final thoughts? Craig?

Craig Jeffery  20:48

Yeah, appreciate the little commercial in there. Well, a couple of things, John, at the end, you know, this, this scheme collapsed in 2008. It was exacerbated by the financial crisis that triggered withdrawals. And that allowed people to say, Hey, I can’t get all my money out. That’s a problem. It also showed a number of regulatory and governance failures. And this had a pretty big impact on customer confidence that because of the size, and the fact that, you know, these things have been investigated for so long. And you know, the idea that 14 billion had been recovered. But the couple a couple other things. At the end, you know, this idea of there’s a black box of secret trading, and people would look at it and say this can’t even going from what they’ve said, you can’t achieve these yields when you backward tests get tested, and you make the best choices that could exist. You know, I already mentioned something about secrecy versus the principle of least privilege. There’s an idea of I want to hide and keep things hidden. Versus Hey, there’s privacy, and there’s a principle of least privilege. There’s a there’s a significant difference between those two. And it became pretty clear that this is what was being done. And especially with things like you need to send everything with your personal email, we need to do personal emails to pass data and trade information around don’t use your work, email for that. This fake confirmation and valuation from an accounting standpoint, from those who are reviewing the records, and from a banking standpoint, all of those items are when you have good visibility. There’s the ability to confirm and validate these things apart from the person who’s saying, we have this much money, or this is the activity this is the return that independent valuation and validation is vital, so visibility is crucial.

Announcer  22:40

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