Ponzi and ‘Pump and Dump’ schemes

We share the shock and dismay of our shareholders and others that the gold we thought we had at Busang now appears not to be there.

David Walsh, founder of the Bre-X mining company

Suppose you are hard up, but you live in a fairly prosperous community. You have an idea for improving the sales of your small, unprofitable business by buying a widget machine. A kind friend (Friend 1) lends you £10,000, telling you that he is not in a hurry to get it back. You rush home, delighted. Then it hits you: £10,000 seemed like a lot when you didn’t have it, but now that you do have it, it doesn’t seem quite enough.

You meet another friend, Friend 2, and casually mention how well the business is going (it isn’t) and that Friend 1 has just invested £10,000. Friend 2’s ears prick up. ‘What kind of a return are we talking about?’ she asks. You think quickly: deposit rates are about 4%, but the stock market is on a long-term slide ... what number should you tell her? Eventually you blurt out ‘10%’. Friend 2 looks at you narrowly. ‘10%? That seems awfully low.’ You don’t argue. You nod humbly. ‘Well yes,’ you say, ‘As an astute investor you may be able to find better deals elsewhere. I am just trying to give a realistic assessment of the potential returns on this project. I don’t want to disappoint anybody.’

A few days later Friend 2 contacts you. Now she seems to think that a 10% return isn’t so bad after all, and she wants in. With a big display of reluctance, you accept her investment of £15,000. You need to think. A few days ago you had nothing, now you have £25,000. That’s enough to buy a widget-making machine and pay for the company overheads for six months. Perhaps you should get to work. You start negotiating with manufacturers of widget machines.

Friend 3 calls you. He’s heard exciting things about your business from Friend 2. Can he invest, too? Well, you think to yourself, you could always use some more money. You take an investment of £5,000. Now you have £30,000. You buy a new car and new clothes. You have £12,000 left.

You are in the kitchen, telling Friend 2 about how your business is going. You’re carried away and start to exaggerate. You tell her that sales have shot up, and the money is pouring in. ‘Oh good,’ says Friend 2, ‘How about a distribution of profits?’ You write her a cheque for £1,500. As you are doing this, Friend 1 passes by and asks what is going on? Friend 2 tells him; so now you have to give Friend 1 £1,000 as his share of the profits.

But there have been no profits. You haven’t even bought the widget machine that is supposed to be generating these profits. You have £9,500 left. You had better buy a widget machine pronto and start production. Then Friend 3 telephones you, very apologetically – he needs his £5,000 back immediately. He isn’t worried about any profits, he says, he just wants the money back right now. You post him a cheque for £5,000. You have £4,500 left. That’s not enough to buy a widget machine. You had better get some new investors ...

Variations on the story above, the plot of a hundred plays and novels, occur often enough in real life, especially in closely linked communities where people are more likely to trust one another. Informal deals are struck, often on the basis of insufficient information, but the investors rely on the investment promoter’s sense of obligation to community members – ‘he is one of us, he can’t cheat me’ – to ensure that they get their money back. Exploiting communal ties of this kind, incidentally, is known as ‘affinity fraud’. Investors who would never invest money so informally with a stranger are often willing to trust a member of their own community, with whom they feel they will continue to have close contact.

You, the investment promoter in the story, did not start out with a carefully worked out plan to defraud anyone. A succession of bad decisions has put you in a predicament: either you go on getting more money from new investors, so that you can pay out returns and withdrawals to earlier investors, or the money will run out. Tempted by the prospect of receiving further investments, you misrepresented the prospects for the business and then spent a large proportion of the funds on things that made you look better, but did nothing to progress the widget machine project. Now you are going to have to maintain the lie and draw in even more investors, even if you sincerely intend to make the widget machine business work. In other words, you may not have begun with the intention of committing fraud, but you are now having to manage an elaborate deception on an ongoing basis.

The investors themselves have, of course, been negligent. They have not done their ‘due diligence’: they have not required a formal agreement covering all eventualities, they haven’t asked for any real detail about the proposed investment or the existing business, and they haven’t tried to verify independently any of the claims you have made to them. They have relied on the information that you have given them. They have been happy to receive the returns you have paid out to them because they believed your false statement that these sums were taken from the profits created by the business. The fraud described above is a hardy perennial, well known in the nineteenth century, and alleged by the SEC to have been the fundamental principle involved in the recent Bernard Madoff and Allen Stanford scandals in the ‘noughties’. It is known as a ‘Ponzi scheme’ after a case in the US in 1920 when Charles Ponzi operated a business that was supposed to be making profits by buying international postal reply coupons cheaply abroad and redeeming them at a profit in the United States.

Although the business was actually running at a loss, he attracted a large number of investors by promising inordinately high returns, and paying earlier investors returns not out of profits, but out of investment monies provided by new investors – this is the key feature of a Ponzi scheme. Ponzi schemes are destined to collapse because eventually it will become impossible to obtain new investment money to cover payments out. This may occur during a market downturn, for example, when many investors suddenly want to take money out of the market. Ponzi schemes are frequently private deals, but appear at almost every level of business, from the smallest to the largest, and can sometimes be maintained for years before they collapse. Every year, the regulators in the US and UK prosecute a number of Ponzi schemes, many of which do not receive much publicity. The Madoff and Stanford schemes are well known because of the staggering scale of the fraud – lesser Ponzi schemes affecting fewer people tend not to attract much attention. Madoff’s operation, however, is particularly interesting because of some clever features of the scheme, and is discussed in some detail below. First, however, we should consider another common form of market fraud, called in the US ‘Pump and Dump’.

‘Pump and Dump’ can refer generally to any type of fraudulent operation that involves persuading investors the shares of a certain company, often a small one in an obscure sector or market, are rising, in order to sell shares the fraudster bought earlier at a higher price. More narrowly, it may refer only to organisations that specialise in hard-selling a series of such companies to investors by media stories, telemarketing and internet campaigns. One of the largest cases of the former type was Bre-X Minerals, a Canadian mining company.

Bre-X was formed in 1989 by David Walsh and was based in Calgary, Alberta in Canada. It was listed on the small Alberta stock exchange but was largely inactive until 1993 when a geologist, John Felderhof, recommended a number of mineral deposit rights for sale in the Pacific Rim. Bre-X then employed Felderhof to manage the exploration of a site at Busang, in the Indonesian part of Borneo. During the exploration one of the team, a geologist named Michael de Guzman, reported that there might be as much as two million ounces of gold at Busang. Exploratory drilling at Busang continued, and soon there were estimates that the land held 30 million ounces of gold. Not surprisingly Bre-X’s share price began to go up, rising from a few pennies to over $14 by mid-1995. In April of the following year Bre-X was listed on the larger Toronto stock exchange, and the share price hit $280.

With analysts’ estimates of the value of the Busang find now going as high as 200 million ounces, other players wanted in on the deal. Indonesia was then ruled by President Suharto, who presided over a notoriously corrupt regime in which most of the profits obtained by exploiting the country’s immense natural resources were in the hands of members of Suharto’s own family and a small elite of cronies. Bre-X was forced to accept that they would have to share the find with some unwelcome partners. Eventually these partners turned out to be a large Canadian mining company Barrick Gold, who were linked with Tutut, one of Suharto’s daughters, and a US firm, Freeport-McMoRan Copper & Gold, which was associated with Bob Hasan, one of Suharto’s main business cronies. Bre-X had to agree to allow Freeport to operate the mine.

Freeport then took over and began to perform its own due diligence, drilling at Busang to verify Bre-X’s findings. Its initial reports were positive but by spring 1997 there was a problem: Bre-X’s samples had been found to contain 4.4 grams of gold per tonne, while Freeport’s samples, taken nearby, only contained 0.01 grams.

Freeport wanted an explanation. On 19 March David de Guzman, the Filipino geologist who had made the original findings, was flown by helicopter across the jungle to Busang. He never arrived. According to the pilot, de Guzman had jumped out of the aircraft of his own accord. It was widely believed at the time that de Guzman had been pushed out by Suharto’s men; subsequently, one of de Guzman’s widows has claimed that he is still alive. Whatever the truth of that matter, the cat was now out of the bag. Within a week Freeport announced that it had only found negligible amounts of gold in its samples, and, significantly, there were ‘visual differences’ between the flecks of gold in the Bre-X samples and those in the Freeport samples, which suggested one set of samples might have been ‘salted’. Bre-X announced that it was hiring an independent firm, Strathcona, to undertake further tests. In the meantime, shares in Bre-X were suspended.

Strathcona produced its report in May, which supported Freeport’s findings and stated that Bre-X’s samples had been interfered with. ‘Salting’ samples is a perennial hazard in the mining industry, and elaborate measures are taken to detect the practice. In the case of Bre-X, it is alleged that tens of thousands of mineral samples had been tampered with over a period of three-and-a-half years. Bre-X’s share price continued its downward trajectory on Strathcona’s news, and the company, which at the height of the excitement had had a market capitalisation of $6 billion, eventually went bankrupt. Bre-X’s founder, David Walsh, died in 2008, and a prosecution of John Felderhof in Canada ended in his acquittal, leaving the unfortunate Bre-X investors with no definitive explanation of who had engineered the fraud.

These investors had included established financial organisations such as Fidelity Investments and Quebec’s pension fund as well as a host of ordinary investors. The fact that Bre-X had been put in the TSE index after it was listed on the Toronto Stock Exchange (TSE) had made it much more ‘investable’ for funds that were looking for performance comparable to an index. According to Fidelity, who would not comment on the performance of its individual investments, overall its portfolio was up during the period in which it held some Bre-X shares – in other words, it had spread the risk across a range of investments, thereby reducing the damage from a bad loss on any single investment.

Bre-X had jumped through a series of regulatory hoops, both in Canada and the US, to satisfy the authorities that it had found gold. Although several of the principals involved did very well out of Bre-X, selling millions of dollars worth of shares before the price collapsed, no one went to jail. No compensation was paid. It was, perhaps, the perfect crime – we don’t even know for certain who committed it.

If you are the kind of investor who likes to dabble in high-risk/high-reward companies in lesser markets, you have to face up to the facts that, first, you cannot foretell the future and, second, some of your investments may incur heavy losses. Encountering a situation like Bre-X, you have to recognise the possibility, however remote, of fraud. Given these facts, it is foolhardy and amateurish to bet your entire portfolio on the outcome. Spreading the risk is the best defence against ‘Pump and Dump’ operations; it won’t prevent a loss on a given investment, but it will reduce the damage the loss causes you, allowing you to live on to fight another day.

Naïve investors often hope to make money fast by investing in a series of single, high-risk companies, often listed on obscure stock markets. There is a thriving newsletter industry that lives on such investors, generating endless ‘buy’ recommendations for such stocks. The truth is that most of these optimistic gamblers will lose money overall, but this does not prevent new people coming to the market every year with the same old naïve expectations.

So, if you are the kind of person who can’t resist taking a punt on some hot new company, just remember that someone may be running a ‘Pump and Dump’ scam, and don’t bet more than you are prepared to lose. Most people are not reckless gamblers, and are therefore less vulnerable to ‘Pump and Dump’ schemes. They are, however, very vulnerable to Ponzi schemes, especially if these schemes are dressed up as sound, conservative schemes that produce steady, modest returns, as was the case in the Madoff and Stanford affairs. Such investors rely heavily on the regulatory system to protect them and this led to an outcry when it emerged the SEC had been warned repeatedly something was wrong with Madoff’s operation but had failed to act. The SEC had been a ruthless enforcer in the 1970s and 1980s, but by the time of the Madoff revelations, the SEC had become a much less capable organisation. We will now look in more detail at how Madoff was able to run his scheme for so long.

The SEC and Bernard Madoff

Early on in his career, Madoff had been given office space in Manhattan by his father-in-law, Saul Alpern, an accountant, who also lent him $50,000 to invest. Soon after, Carl Shapiro, a rich businessman, gave him a further $100,000 to invest. Madoff used this money to trade actively, and the commissions he earned subsidised his small penny share broking business. He encouraged Alpern to bring him more customers, in return for a fee, and soon his client base exceeded the exemption then allowed by the SEC to small investment managers (managers with 15 or fewer clients did not have to obtain an SEC licence). In 1962 Madoff asked Alpern to merge many of the small investors he was finding into one account so that it would seem he still qualified for the SEC licence exemption, and shortly after Alpern merged his accountancy firm into Madoff’s, and brought in the accountant Frank Avellino to help find more investors.

Thus Frank Avellino became one of the first and longest-serving agents to ‘feed’ Madoff with new investors. This is of interest because his firm, Avellino & Bienes, was the subject of the first known Madoff-related complaint to the SEC, in 1991. This complaint illustrates a problem that many investors encounter from time to time: exaggerated assurances of safety. Two private investors with Avellino & Bienes provided the SEC with sales material from that firm, which should have set anyone’s alarm bells ringing. In a letter of 7 August 1991 from Avellino & Bienes, a potential customer was told that:

‘Avellino & Bienes invests with one particular Wall Street Broker (the same company since we first started doing business over 25 years ago) who buys and sells stocks and bonds in the name of Avellino & Bienes … We do not encourage new accounts and therefore we do not solicit same. We do, however, like to accommodate those individuals, etc. that are recommended as you have been … Summarily, this is a very private group and no financial statements, prospectuses or brochures have been printed or are available … The money that is sent to A&B is a loan to A&B who in turn invests it on behalf of A&B for which our clients receive quarterly interest payments … Interest rate is 16.0% annually.’

On the face of it, then, the deal was attractive – a loan to the firm in return for a healthy interest rate. What should always alarm an investor, especially a small one, though, is the claim to exclusivity and privacy; the fact is that investment managers will usually take anyone’s money, especially if, as in this case, the minimum investment was a low $5,000.

The SEC was also given a fact sheet produced by an investment adviser who was bringing new clients to Avellino & Bienes. This document asserted ‘Is it safe? Yes. 100%. At no time is a trade made that puts your money at risk. In over 20 years there has never been a losing transaction’ and went on to explain ‘all of these funds are send [sic] to a New York broker who invests same on behalf of Avellino & Bienes. The underlying trades, made for the account of Avellino & Bienes are, in general, made as simultaneous purchases of convertible securities and its short sale of the common stock, locking in a profit. Other forms of riskless trading are also used.’ These claims are the real give-away. Risk-free trading for 20 years? It’s as illusory as the philosopher’s stone sought by the mediaeval alchemists. As an investor, you owe it to yourself to understand exactly how it is being done, not just take someone’s word for it.

When they investigated, SEC staff reported that it seemed the firm had been ‘engaged in selling securities to the public, which are unregistered, in violation of Section 5(a) of the Securities Act of 1933’ and expressed concern about ‘the lack of transparency about how the monies were invested’ and the possibility the firm was running a Ponzi scheme. When the firm’s bosses, Frank Avellino and Michael Bienes, were brought in to explain themselves in July 1992 they stated that they had invested $400 million of investors’ money with Madoff along with a further $40 million of their own money, and described Madoff’s trading strategy as a series of complex hedges using puts and calls on major stocks, a ‘split-strike conversion strategy’.

Later that year an SEC team conducted a ‘brief’ examination of Madoff’s firm, principally to establish whether the trading positions reported by Avellino and Bienes were genuine. The investigators were not told that they were investigating a Ponzi scheme, and in any case the focus was on Avellino and Bienes, not on Madoff, and any documents Madoff provided were simply assumed to be accurate. Madoff’s paperwork appeared to confirm Avellino and Bienes’s story, and no check was made on where Madoff obtained the money to make payments to them. Investigators admitted at a later inquiry that they were aware of Madoff’s prominence in the industry and his good reputation made them feel there was no need to investigate his firm more thoroughly.

In November, the SEC filed a complaint against Avellino & Bienes for unlawfully selling unregistered securities (i.e. the loans investors made to them) as an unregistered investment company. No suspicion of fraud was mentioned, and neither was Madoff’s firm. The court appointed a receiver and trustee to liquidate Avellino & Bienes and to oversee the return of investors’ money. According to Lee Richards, the Receiver and Trustee, his responsibility was to ‘independently verify account balances on the records of Madoff, but not to independently verify that the securities Madoff were reporting actually existed. In other words, we’d go as far as Madoff’s records, and as long as they were consistent with what we thought investors of Avellino & Bienes were owed and indeed we got the money and securities, then I think … we had done our job.’ The following year, despite the court-appointed auditors’ complaints that they could not trace much of the firm’s paperwork, most if not all of the investors’ money was returned to them successfully, and the firm was fined $250,000, with its bosses, Avellino and Bienes, being personally fined a further $50,000 each and banned from selling unregistered securities in the future. According to one of the SEC’s staff lawyers at the time, ‘we were quite satisfied this was a very good result’, especially as the investors had all got their money back.

It could be argued that, without the benefit of hindsight, the SEC was not entirely unreasonable in its attitude. The big fear in financial regulation is that the small private investors don’t get all of their money back, as so often occurs in major financial scandals. Since they had no reason to suspect Madoff, the SEC appears to have assumed that all the misrepresentation and exaggeration had been done by Avellino & Bienes, and having made that assumption, could pat itself on the back for having nipped a problematic operation in the bud before investors lost any money. The investigation team was ‘relatively inexperienced’, according to the SEC, and although, as experts later pointed out, the fact that Avellino & Bienes had had such a very long relationship with Madoff should have stimulated the team to conduct closer checks on Madoff, it did not do so. At the time of writing it has not been established in this case whether or not Madoff did indeed provide phoney paperwork to the investigators or whether he repaid the money out of other investors’ funds.

Further SEC investigations

In 2000 the analyst Harry Markopolos approached the SEC with evidence that Madoff might be committing fraud, setting off an unsuccessful process taking years of bureaucratic misunderstandings and delays, which are discussed later (see Chapter 9.) In May 2001 two articles appeared questioning Madoff’s success, one in the obscure MARHedge trade journal entitled ‘Madoff tops charts; skeptics ask how’, and one in the better-known Barron’s magazine entitled ‘Don’t Ask, Don’t Tell’.

The MARHedge article stated that Madoff had $6–7 billion under management, which came mainly from three feeder funds, and reported that people were ‘baffled by the way the firm has obtained such consistent, nonvolatile returns month after month and year after year’, suggesting the complicated ‘split-strike’ options strategy Madoff claimed he was using to achieve these steady returns could not achieve such low volatility (here ‘volatility’ simply means the degree to which the returns vary in each period – normally in the stock market you would expect to see some variation in the returns over time).

The article provided much detail of Madoff’s smooth and superficially plausible explanations for this anomaly, but when pressed for specifics he replied, ‘I’m not interested in educating the world on our strategy, and I won’t get into the nuances of how we manage risk.’ The Barron’s article was rather more dramatic in tone, claiming that Madoff’s investor accounts ‘have produced compound average annual returns of 15% for more than a decade’ and reporting one investor as saying ‘What Madoff told us was, ‘‘If you invest with me, you must never tell anyone that you’re invested with me. It’s no one’s business what goes on here.”’ Although neither article accused Madoff of dishonesty, both had homed in on the nub of the issue: no one – except Bernie and, perhaps, his assistants – could explain how the split-strike conversion strategy that he claimed to use could, in fact, produce the pattern of returns he had been generating for so many years. According to the later inquiry, no one in the SEC’s North East Regional Office (which was responsible for Madoff) read either of these articles until years later.

In 2002 a different SEC department, the Office of Compliance Inspections and Examinations (OCIE) in Washington, DC, conducted an inspection of registered hedge funds, and in doing so asked hedge fund managers to report any suspicious activity that they might encounter. In early 2003 a hedge fund manager contacted an OCIE inspector with a detailed account of how, as part of their regular business, his firm had considered investing with Madoff’s feeder funds but upon performing ‘due diligence’ (the process of thoroughly investigating an investment) they had uncovered some alarming inconsistencies. The most notable of these was when the manager and a colleague, an expert options trader, were told by Madoff at a meeting that he traded options for his split-strike conversion strategy through the Chicago Board of Options Exchange (CBOE). The options trader pounced, asking Madoff how this was possible, since not enough options were traded on the CBOE to make Madoff’s strategy possible, given the huge amounts of money he was managing. The options trader subsequently telephoned former colleagues in the CBOE market ‘and I asked them all if they were trading with Madoff. And nobody was. Nobody was doing these OEX options. And in fact, the funny part about it was they all said, yeah. You know, I hear that he’s doing all these trades but, you know, we don’t see it anywhere’. In making his report to the SEC, the hedge fund manager supplied substantial detail, and included the MARHedge article of the previous year.

The OCIE did not act quickly. In the autumn of 2003 the hedge fund manager’s report was passed on to the OCIE’s Self-Regulatory Organisations Group (SRO Group). It did nothing until December, when it received another tip about Madoff from another SEC department, misleadingly suggesting that Madoff was ‘front-running’ (illegally buying and selling securities in advance of customers’ orders, a practice which the OCIE had already established could not account for Madoff’s performance). The SRO Group contacted Madoff, who later stated ‘it was readily apparent to him that they were focused on front-running and [he] thought it was part of a sweep that the SEC was doing on front-running’.

The picture of the SRO Group’s investigation of Madoff that emerged in the SEC inquiry of 2009 is distressing to those of us who still have some faith in officialdom: the operation was bungled outrageously. Staff testified that the department was expanding by recruiting young people, and many in the department were inexperienced, had received no training, and were expected to learn on the job. Many were lawyers who knew nothing about financial securities. The SRO Group did not request the help of in-house investment experts at the SEC. A ‘Planning Memorandum’ for the investigation was drawn up in December that appeared to miss completely the possibility of Madoff not front-running, but committing a much more serious fraud. The official in charge of the investigation was asked why he had not thought to investigate other issues highlighted in the hedge fund manager’s report of early 2003, which included the two points mentioned above – the strangely consistent performance of Madoff’s investments and the fact that the volume of options traded in the market did not appear to be large enough to support a split-strike conversion strategy on the scale Madoff would have to be doing it, if it were true – and doubts about the genuine independence of Madoff’s auditor. He replied that he did not remember seeing these points in the hedge fund manager’s report. When asked why he focused on front-running, he replied that ‘my group was responsible for trading exams, so we focused on, in essence, the trading aspect of the allegation. … it could be mainly because that was the area of expertise for my crew.’ Another official involved volunteered the information that he had focused on front-running because it ‘was just a theory that seemed to make sense to me, you know. … [M]y theory was, and I think I’ve since learned or come to understand that it’s not a very good theory … [was] it did seem likely to me that having access to that type of retail order flow could be valuable and that you could profitably trade ahead of it and make money’ and later admitted ‘I didn’t know anything, very little anyway, about hedge funds and mutual funds and how they operated.’

Thus, a group of wet-behind-the-ears lawyers with little knowledge of the securities industry set out to investigate if Madoff had committed a particular kind of offence – front-running – that any expert would have told them could not account for the returns Madoff was paying his investors. They chose to ignore specific and plausible problem areas that had been clearly outlined in the hedge fund manager’s report and the MARHedge article.

It gets worse. The team drafted a letter to NASD, a stock market in which Madoff was active, requesting all Madoff’s trading data, but did not send it. According to the SEC inquiry, this was apparently because it was quicker to use the data that Madoff supplied, and also because it was the OCIE’s habit to rely on data supplied by the firms it was investigating. Even in cases of suspected fraud! Nor did the team ask the firms bringing investors to Madoff for information about the feeder funds, as it had intended to do, according to its Planning Memorandum. When Madoff denied, early in 2004, that he was running a hedge fund, stating he was simply executing orders on behalf of institutional clients, no effort was made to verify these claims, even though they clearly contradicted the information given in the hedge fund manager’s report of 2002. Members of the investigating team spoke to the hedge fund manager, who evidently explained everything all over again, but to no avail – the team went merrily on in pursuit of evidence of front-running. One member of staff testified at the inquiry, ‘it’s just crazy stuff that goes on in this office. It was weird. It was like a sitcom or something. It didn’t exist in the real world …’.

Nevertheless, the investigators gamely tried to get to grips with the split-strike conversion strategy, but had difficulty in making sense of the data Madoff had provided. They also began to wonder if Madoff was actually acting as an investment adviser, even though he claimed he wasn’t. Then, suddenly, in April 2004, they were ordered to drop the Madoff investigation for the time being and concentrate on another priority, a claim that some broker–dealers were receiving, but not reporting, commissions from mutual fund companies as a reward for recommending certain mutual funds to their customers. In the same year, the SEC’s North East Regional Office (NERO) began an investigation of Madoff without any knowledge of the SRO Group’s investigation, which was only discovered when Madoff told them about it. NERO and the SRO Group communicated briefly about this, and the SRO Group sent NERO some files, but did not answer many of NERO’s requests for information. External experts from FTI Consulting were brought in later to analyse the mess, and concluded that because of the SRO Group’s avoidable foul-ups a good opportunity to discover Madoff’s wrong-doing had been missed in 2004.

The NERO investigation had started when an SEC examiner, during a routine examination of the fund-managing firm Renaissance Technologies LLC in 2004, had found some internal correspondence questioning Madoff’s operation, highlighting anomalies in Madoff’s equity trading, his misrepresentation of his option trading, his unusual secrecy, the questionable independence of his auditor, his unusually steady returns and his unusual fee structure. Ignoring much of the evidence in this correspondence, the NERO team chose to focus on only two possible forms of fraud, front-running and ‘cherry-picking’. Cherry-picking is the practice of performing transactions in the stock market and then deciding later which account to assign them to, depending on whether the result is profitable or not. The practice is illegal if it is not disclosed in advance to customers. These two fraudulent practices were bad choices for investigation, because it was unlikely that either of them could have produced sufficient profits to fund the returns that Madoff was giving to his investors. Also, the Renaissance correspondence had provided a very full analysis of why Madoff must have been misrepresenting the way he traded options (remember, Madoff always said that he made his money using a proprietary split-strike conversion strategy using options) – but the NERO team ignored this. As with the SRO Group, NERO did not use staff with the appropriate skills to conduct the investigation – instead of using experts on investment advisers, they used staff who were used to examining broker–dealers. Most of the material that NERO examined was provided by Madoff, and little effort was made to verify its accuracy with third parties – if this had been done, Madoff’s wrong-doing would have been revealed. NERO supervisors prevented investigators from pursuing various ‘red flags’ that came up during the investigation, and if they had done so they would have found Madoff had misrepresented many of the details of his operation to them. NERO’s final report found that Madoff was not front-running, accused him of a few very minor technical violations, and entirely failed to address many potentially serious issues the investigators had uncovered. They seem to have got quite close on occasion – Madoff had been angry and unsettled during the investigation, quite unlike his normally smooth and friendly handling of the SEC.

Some frauds just never go away

Pump and Dump and Ponzi schemes are unlikely ever to disappear. They are like beautifully adapted parasites, with every organ delicately calibrated to take advantage of their hosts.

Pump and Dump schemes work because the stock markets are skewed towards optimism – most investors hope to make money by holding investments whose prices go up, not down, and they are thereby automatically vulnerable to plausible stories that a given investment is going to go up – but was the Bre-X story plausible? Well, geology is a real science – it appeared to investors that a host of geological experts and regulators had endorsed the gold find at Busang. In reality, however, Bre-X had raised most of its money in private placements, involving much lower regulatory standards than a public offering. It had only ever published one prospectus, in 1989 in Alberta, long before it claimed to have found the gold. The fact that Barrick and other large mining companies wanted to get in on the Busang deal encouraged investors to believe that the deal must be genuine. The listing of Bre-X on the Toronto market index also seemed to be an endorsement. When quizzed later, geologists and industry analysts claimed it had seemed impossible that the find could have been salted on such a large scale. None of this amounted to overwhelming proof that the gold existed, but an incautious investor might be forgiven for accepting this circumstantial evidence. And that’s how this kind of fraud works: the deal is made to look real enough to attract the mugs. Nevertheless, rational investors should never be wiped out by a single Pump and Dump scheme, because rational investors do not put their entire portfolio into one tiny company listed on an obscure stock market, however attractive it may appear to be – they spread the risk across a range of investments.

Ponzi schemes, on the other hand, can be much more insidious, especially if they are designed to look as if they are conservative, stable investments. Although they are eventually doomed to failure, they can run on for years, and the fact that they pay returns regularly reassures existing investors. Ponzi schemes are skilfully tailored towards their target market: Madoff covered himself in respectability and conservatism to appeal to an affluent, fairly sophisticated clientele, but other schemes, in less sophisticated markets, are calibrated differently. For example, two large schemes in China required investors (mainly poor Chinese peasants) to feed ‘special ants’ in a box that would then be collected and ground up as an aphrodisiac – it’s hard to imagine Madoff’s victims finding the prospect of spraying sugar water on ants twice a day an exciting investment. A well-designed Ponzi scheme may be difficult for regulators to close down, even if they have suspicions. This makes them particularly dangerous to investors who rely on the regulators to protect them. In most cases, by the time the regulators act, it will be too late for many investors. Beware!