Bernie Madoff

In today’s regulatory environment, it’s virtually impossible to violate the rules.

Bernard Madoff

Bernie Madoff was sentenced to 150 years’ imprisonment in 2009 for running a massive Ponzi scheme. We’ll discuss the anatomy of Ponzi schemes in more detail in Chapter 3; in essence they are fraudulent schemes in which the fraudster pays investors their returns out of the money he is obtaining from new investors, rather than from genuine investment returns. Here’s the basic story of the Madoff affair: at the height of the US economic crisis in 2008 Bernie Madoff, a former chairman of NASDAQ (a major US stock market), was denounced to the authorities by his two sons for swindling a large number of investors, many of them wealthy, by running a fraudulent investment management business in which he produced false account statements for clients showing fictitious investment returns and funded any withdrawals out of other clients’ money. Many investors were unaware that their money was with Madoff because they had invested in funds operated by other firms that ‘fed’ Madoff’s fund with money (and are thus called ‘feeder funds’), often without informing their clients of this fact.

The vast scale of the fraud, the incompetence of the regulators, and behaviour of other market players with regard to Madoff, provide many insights into the dangers facing private investorsThe vast scale of the fraud, the incompetence of the regulators, and behaviour of other market players with regard to Madoff, provide many insights into the dangers facing private investors, and we will examine various aspects of the case throughout this book.

Madoff had started his first business in Wall Street in 1960, and by the time of his sentencing he owned three apparently solid financial services operations: a stock broker, a proprietary trading firm (for trading on the firm’s own account), and an investment adviser. What few people knew, until the collapse, was that for at least two decades Madoff had been running a gigantic Ponzi scheme through his investment advice firm. In December 2008 Madoff, then 69, had a meeting with his two middle-aged sons, Mark and Andrew, at which he confessed that he had been falsifying his clients’ investment returns for years, that the family was ruined and he expected to go to jail. He asked his sons to wait a few days before reporting him to the authorities so that he could disburse funds to various relatives and associates. Justice was relatively swift, and in March of 2009 Madoff made what appeared to be a full confession before a judge and received his sentence without standing trial.

The staggering scale of the fraud meant that the issue didn’t go away and, during the following years more and more information came to light. Initially, great attention was paid to the failure of regulators, especially the SEC (Securities and Exchange Commission), to act against Madoff in spite of the fact that they had received a number of credible complaints, dating back to 1992, there was something seriously wrong with Madoff’s operation. The most active of the complainers, the investment analyst Harry Markopoulos, emerged from obscurity to produce striking evidence that despite repeated efforts over several years, his denunciations of Madoff’s activities had been virtually ignored by the SEC (for a full discussion, see Chapter 3). Although it has now been satisfactorily established that Madoff’s scam dated back at least as far as the early 1990s, as he claimed in his confession, there are strong suspicions it may have begun much earlier in the 1960s when Madoff was just starting out.

Allen Stanford

I would die and go to hell if it is a Ponzi scheme. It’s no Ponzi scheme.

R. Allen Stanford, CEO Stanford Financial Group
(currently serving 150 years for running a Ponzi scheme)

In 2002 star investment salesman Charles Hazlett left his job at Prudential Securities to join the Miami office of Stanford Group Company, a financial services firm that was a part of the Stanford Financial Group, a network of privately held companies controlled by the billionaire Texan entrepreneur R. Allen Stanford. Like Stanford, his ultimate boss, Hazlett is a tall man, confidence-inspiring and with a thunderously loud voice.

The job offer had been too good to pass up: an annual salary of $180,000, a fabulous office overlooking the Miami waterfront, and a promise of up to $400,000 in bonuses. Hazlett got stuck in, selling what Stanford had to offer to investors, and within a matter of months he had become one of the firm’s top salespeople, earning a $100,000 BMW as a bonus. In the course of his discussions with his customers a number of questions had come up for which Hazlett was unable to obtain satisfactory answers from the firm. Why, for example, was the firm able to offer investors Certificates of Deposit (CDs) with rates of return higher than were available elsewhere? Why was the firm pushing this form of investment so hard? Why was the auditing being done by a tiny outfit? Why were the sales commissions on the sale of these CDs so much higher than the average commission rate for similar products? And, crucially, where was the firm investing the deposits it received from its customers?

Hazlett managed to get a meeting with Stanford’s young Chief Investment Officer, Laura Pendergest, then 28, but was unable to obtain any concrete answers from her; the meeting ended with Pendergest fleeing from the room in tears. Shortly afterwards, according to Hazlett, the Chief Financial Officer, James D. Davis, telephoned him and ‘was not very nice to me’. Hazlett soon left the firm; he had sold $17 million dollars’ worth of CDs during his time there, but called all of his clients to warn them to remove their money from Stanford.

The 2005 annual report of the main banking arm of the group, Stanford International Group Ltd, has a celebratory, though reassuring, tone. ‘20 years, $4 billion in total assets, and we still serve our first client’, runs a slogan on page 2. An anodyne statement from the bank’s Chairman, Allen Stanford, marvels at the pace of financial change around the world during the bank’s 20-year life and attributes the bank’s success in growing ‘from a few hundred clients in a handful of countries’ in 1985 into ‘a multibillion dollar institution that today serves over 35,000 clients in 102 countries around the globe’ to, among other things, ‘our ability to attract the best talent in the financial services industry’ and ‘our consistent profitability’.

To the average reader, there is nothing immediately suspect about the report. It is no more gushing than many other banks’ reports, and its emphasis on its human face and its dedication to honesty and personal service must have been appealing at a time when many banks seemed to be becoming increasingly depersonalised. But what of the bank’s location offshore, on a Caribbean island? Vice-president Eugene Kipper, pictured on page 12 of the report, had an explanation: ‘the Bank is domiciled in a well-regulated, low-tax jurisdiction’. It may be a matter of taste, but for the average investor in the US or Europe, no offshore tax haven is likely to offer quite the same level of investor protection as is provided in their own countries. And as events were to show, Antigua’s regulators were not all that they should have been (as we will see in Chapter 5).

In February 2009, the SEC, which had been investigating Stanford’s operations almost continuously since the 1980s, finally acted, filing a suit against Stanford in Texas for conducting ‘a massive Ponzi scheme’ and obtaining a court injunction to freeze the Stanford Financial Group’s assets. In April 2009 ABC news caught up with Stanford outside a Houston restaurant, where he declared tearfully, ‘I would die and go to hell if it’s a Ponzi scheme. It’s no Ponzi scheme’, and he continued to declare his innocence throughout his trial, saying, when he was sentenced to 110 years in prison on 14 June 2012, that he was not a thief and had not intended to defraud anyone. At the time of writing the Stanford story continues to play out. As already mentioned, Allen Stanford was sentenced to 110 years (in 2010 he received a savage beating in prison – apparently because he was hogging the phone) but a host of other lawsuits have not yet been resolved, including the trials of other key associates in Stanford’s operations.

Could you have spotted a problem?

Madoff and Stanford were two very different characters, but in their own individual ways they seemed, superficially at least, likeable and plausible. They inspired confidence, at least in the people who chose to invest with them – and that, of course, is an essential quality in a confidence trickster. The trouble is, all investment businesses that take money from the public must inspire confidence. How can you tell the difference between someone like Warren Buffett, the doyen of investors, who, the present writer believes, is a truly honest man, and someone like Bernie Madoff, who merely seemed to be an honest man? It’s really rather difficult, especially if you don’t have the numerical and analytical skills to penetrate the financial information about a firm.

Bernie Madoff’s hypocrisy beggared belief. For example, in a public panel discussion in 2007, he said:

... by and large in today’s regulatory environment, it’s virtually impossible to violate the rules. This is something that the public really doesn’t understand. If you read things in the newspaper and you see somebody violate a rule, you say well, they’re always doing this. But it’s impossible for a violation to go undetected, certainly not for a considerable period of time.

Paternal, relaxed, knowledgeable, modest, reassuring – that was how Bernie seemed, and is what many investors want. If you had been present at the discussion, could you really have guessed that Madoff had been running a Ponzi scheme the whole time?

In his own way, Allen Stanford was equally reassuring. He claimed that he lived frugally, but in addition to the vast sums he lavished on his corporate offices and developments in Antigua, which included building a huge complex next to the airport through which Stanford clients could pass without customs checks, he spent a lot on his own lifestyle. Between 2000 and 2002 he spent more than $400,000 on clothes at a Beverly Hills store, built a series of mansions in various countries, and purchased a string of private jets and boats, including a British naval frigate. Stanford knew how to live large, and he knew how to make the people around him feel good. As the business expanded, he became increasingly more ambitious in his public relations, giving frequent interviews to Forbes magazine and TV stations, and making a commencement address at the University of Houston.

For the British, Allen Stanford only swam into public view with his entry into the world of cricket. Like many non-US sports, cricket has gone without the dubious benefits of massive commercialisation bestowed on baseball and American football. In 2008, having built a fabulous cricket ground in Antigua (hugely popular with the locals), complete with a restaurant/sports bar called ‘The Sticky Wicket’, Stanford set up a $20 million winner-takes-all cricket match between England and a West Indian team. The match was part of the Twenty20 scheme, in which each side only has one innings, and the entire match lasts only between 3 and 4 hours. Stanford’s team won. He then struck a deal with the English Cricket Board (ECB) to pump some £11.4 million into the English game over five years. Eyebrows were raised, however, at the sight of Stanford carousing at a match in Antigua in the company of the English cricketers’ ‘WAGs’, one of whom was televised sitting on Stanford’s knee.

In general, Antiguans seem to have welcomed Allen Stanford’s financial domination of the island, mainly because he spent so lavishly on community projects and had become the largest private employer. He took Antiguan nationality in 2006 while retaining his US nationality and received a knighthood (Antigua and Barbuda is an independent constitutional monarchy whose head of state is Queen Elizabeth; its government thus has the right to recommend candidates for such honours). Locals ignored obvious questions about his modus operandi and the origin of his vast wealth, assuming, perhaps, that the US would probably get him in the end, but in the meantime he was doing more good than harm on the island.

Lessons from the past

Although the Madoff and Stanford scandals occurred at a time when overly lax regulations had allowed the financial services industry to drag the world into a serious financial crisis, neither of the two men are really typical of what was going wrong in the industry at the time. Neither Madoff nor Stanford were really ‘insiders’ with regard to the dubious practices that had become systemic in the investment banking world during the ‘noughties’. While they benefited from a period during which the main financial regulators, in particular the Securities and Exchange Commission (SEC), the main US market regulator, were unusually incompetent (see Chapters 3 and 5), their fraudulent operations had little in common with the misdeeds of the wider industry. Although the frauds were discovered during the financial crisis, they were not discovered because of investigations in response to the crisis, but because the market crash made it increasingly difficult for the fraudsters to conceal the shaky foundations of their schemes.

In previous crises, by contrast, the major fraudsters have often been seen as typifying the mode of wrongdoing of the time. During the 1990s, for example, the development of the internet gave rise to the ‘dotcom’ boom, during which a large number of internet-related companies became grossly overvalued as canny venture capitalists launched the firms on the stock market in Initial Public Offerings (IPOs) into which enthusiastic investors poured their money, even though many of these firms were not making any profits. There were, of course, some notable survivors, such as Amazon, but many of these firms had collapsed by the year 2000. Two iconic scandals, Enron (discussed in detail in Chapter 11), and Worldcom, came to be seen as symbolic of the dotcom bust; both firms had committed massive accounting fraud in an effort to prevent their share prices from dropping. Although neither firm was truly an internet start-up (Enron had started out as a Texan oil and gas company while Worldcom had grown to become the second largest telecoms company in America through a series of mergers and acquisitions during the 1990s), they were associated with the dotcom bubble because they were two really large firms, with apparently sizeable revenues, that appeared to demonstrate money could be made now, not just in the future, by internet-based businesses.

Investment booms generally begin for sound reasons: for instance, a technological innovation, perhaps coupled with a change in the regulatory regime, may emerge that people are clearly going to want, and early investors attempt to pick the operations which seem the most likely to scoop up a large chunk of the new business being created. In the 1840s, for example, the introduction of a railway system to Britain was clearly going to transform ordinary people’s lives, radically reduce transportation time and costs, make new conurbations and industrial arrangements possible, and so on. This was no illusion, but, during the Railway Mania of the 1840s, investors rushed to put their money into the new railway companies that were being formed, creating a feverish, over-optimistic atmosphere in which higher and higher prices were being paid for projects of poorer and poorer quality. Some of these railway projects were outright frauds from the beginning, others committed fraud when things began to go wrong, and still others completed their projects but found them to be less lucrative than they had hoped.

So it was for the dotcom boom of the 1990s. The underlying premise, that the expansion of the internet was going to create enormous efficiencies for both industry and the public, was perfectly sound, as were some of the businesses created to take advantage of the new opportunities. The trouble was, as both deserving and undeserving dotcom start-ups began to change hands for ridiculously high prices, it became increasingly difficult for investors to sort the wheat from the chaff, in an atmosphere of jargon-ridden, staggeringly arrogant ‘new economy’ talk emanating from venture capitalists, stock analysts, internet CEOs and other interested parties.

Worldcom began life in 1983 as Long Distance Discount Services (LDDS), which was set up by a group of private investors, including Bernie Ebbers, the future CEO, to take advantage of the deregulation of the telecommunications industry, which involved the selling off of many telecoms assets. LDDS made a living by buying long-distance telecoms capacity at wholesale prices from the main carriers such as AT&T and selling a long-distance call service at retail. Bernie Ebbers drove LDDS to grow by the aggressive purchase of other long-distance providers during the 1990s, changing the firm’s name to Worldcom in 1995.

Hailed as a ‘revolutionary’ and a ‘visionary’, Ebbers aimed to create a new kind of telecoms giant that would be able to offer the whole range of voice and data network services in a single, seamless digital package. In 1997, Ebbers moved in on a deal in which British Telecom was attempting to purchase MCI Communications for $19 billion; Ebbers offered $30 billion. When the deal went through, Worldcom had become one of the dominant telecoms players in the US. Wall Street loved it; Worldcom’s spending spree was driven by its ever-increasing stock price, and it looked as though Ebbers had got the formula right, as the firm bought up major internet providers, such as UUNET, fibre optic cable networks and other new capacity in preparation for the eagerly awaited communications revolution.

Between 1994 and the third quarter of 1999 (just before the MCI merger) the firm had enjoyed virtually uninterrupted growth in sales, and its share price had risen from $8.17 in early 1994 to $47.91 (adjusted for stock splits). Much depended on meeting Wall Street expectations in its quarterly figures, as this would help keep the share price up and facilitate further acquisitions. Worldcom fell foul of anti-trust (anti-monopoly) laws when pursuing its next target, Sprint, and the deal fell through in 2000. The failure of the Sprint acquisition signalled that mega-mergers were no longer going to be possible, and the firm would have to seek growth in other ways. The telecoms business was becoming less profitable, however, as competition increased and a glut in communications capacity began to develop. Worldcom’s share price had dropped to $18.94 by 1 November 2000. In 2001 the whole sector’s sales income and share prices dropped as it became clear that the glut in capacity would remain for years. In spite of the problems in the industry, Worldcom’s figures continued to meet Wall Street expectations of high sales growth. Finally, early in 2002, Worldcom had to release its fourth quarter 2001 results, which for the first time failed to meet analysts’ expectations. Ebbers put out optimistic messages, but had to resign in April. In June the firm announced that there were important irregularities in its accounts, and its shares were suspended.

What had been going on? According to prosecutors, as the telecoms sector began to go bad in 1999, Bernie Ebbers and a handful of senior executives came under great pressure to keep all the company news sounding good. Worldcom’s main expense was its ‘line costs’, meaning the price it had to pay for carrying a call from its starting point to its end point. Starting in 1999, Worldcom bosses started to reduce the reported line costs, keeping them to a ratio of 42% of gross income (which is what the Wall Street analysts were expecting). The real line costs were rising to above 50% of gross income, but the Worldcom insiders kept the reported costs down by using a number of improper methods; between 1999 and 2002, the firm hid more than $7 billion in line costs illegally. More than $3 billion of this was done by improperly ‘releasing’ sums of money, known as accruals, that had been set aside against expected future bills from suppliers. At the end of 2000, running out of these accruals, Worldcom bosses began to mark line costs as capital investments, rather than what they really were, suppliers’ services that had to be paid for; this manoeuvre was quite outside normal accounting practice, and had the added effect of making Worldcom appear to be profitable, when it was in fact beginning to suffer losses.

Bernie Ebbers, along with Worldcom’s CFO, Scott Sullivan, told Wall Street analysts that Worldcom was able to sustain its high growth rates because it could manage the industry-wide problems, by implication, better than its competitors could. Worldcom’s external auditors, the large firm Arthur Andersen, did not pick up any of the accounting problems; they were uncovered by three mid-level internal accountants, employees of Worldcom, who, between April and June 2002, conducted a clandestine investigation that revealed some $3.8 billion in misallocated items.

From the private investor’s point of view, the real scandal in the Worldcom affair was that allegedly independent experts, on whose opinions we have to rely, seem to have been asleep at the wheel. We rely on independent auditors to check that the accounts are accurate, and in this case Worldcom’s auditors, Arthur Andersen, failed to discover the problems. We rely on stock market analysts to apply their expertise appropriately and provide an honest assessment of the outlook for the company as an investment. In the late 1990s, Jack Grubman, senior telecoms analyst at the investment bank Smith Barney and widely regarded as an industry guru, continuously endorsed Worldcom even as its situation was worsening. Grubman was later banned for life from the securities industry by the SEC for producing misleading reports on a number of firms in the telecoms sector.

If you can’t trust the analysts and the auditors, who can you trust?

The answer is, of course, that it is all a matter of degree. You can trust some governments more than others, for example. The UK government can probably be trusted not to help itself to the contents of your savings accounts, but the Italian government did just this some years ago during a crisis. You can probably trust the major UK high street banks not to break the main banking regulations affecting consumers; the same could not be said for banks like Landsbanki (the Icelandic bank behind the Icesave scheme that collapsed in 2008) or BCCI (a large international bank that collapsed in 1991 leaving thousands of UK savers high and dry).

You can probably rely on your own accountant to tell the truth about your own accounts, but major accountancy firms, such as Arthur Andersen, have on occasion completely failed to spot accounting fraud in large companies they were auditing. At every level of the investment industry, and in the firms listed on the stock market, we can find examples of wrongdoing. These examples are not isolated, random occurrences; the type of fraud varies according to the opportunities available during a particular period, and frauds tend to be discovered in the aftermath of a market collapse, but at all times there is a danger of some kind of fraud. ‘Let the buyer beware’ is good, if not very reassuring, advice, and investors need to take some responsibility for the decisions they take. Protection is better for massmarket investment products, but returns may be lower and charges higher. Not every investment deal offers good value in terms of the trade-off between safety and risk (in fact, fraudsters often exploit the public’s confusion about this). Investors who would rather hand over their money to a reassuring, avuncular figure may find that they have trusted, say, a Bernie Madoff. As investors we need to develop our own skills, and our own antennae, to improve our ability to detect possible frauds. As the buyers, we have one great advantage: we can say ‘No’ and walk away. Any time that you feel you must invest quickly before the opportunity vanishes, the chances are you are not making a good investment; it is exactly this fear of missing out on something wonderful which drives investment booms, and forces share prices of fashionable companies and industries through the roof.