Bernie Madoff & the Worst Pyramid Scheme in U.S. History

It is said that we are the product of our upbringing, so it probably would not surprise you to learn that the biggest and worst financial fraud committed through a pyramid scheme in US History, was achieved by a man who was raised by parents that also commit financial frauds.
Bernie Madoff was raised watching his parents Ralph and Sylvia Madoff run a business that was not successful in the financial trading world. That company was named Gibraltar Securities. Due to the fact that Sylvia failed to accurately report their company’s financial condition, the SEC closed the business in 1963 and started its investigative proceedings to determine if charges were needed to be brought against Gibraltar Securities. However, the SEC declined to continue with its proceedings against Gibraltar Securities in a deal that required them to stay out of the trading business. Even though it was admitted that they falsely reported the company’s financial condition. “The firms conceded the violation, but requested withdrawal of their registrations; and in this connection they represented that they are no longer engaged in the securities business and do not owe any cash or securities to customers. The Commission concluded that the public interest would be served by permitting withdrawal, and discontinued its proceedings." (Nicholas Varchaver, 2009)
Even though Bernie watched his parents as they ran their business and also watched them have to deal with the SEC for violations that they committed, Bernie did not appear interested in the financial world at that time. But, like all young people, Bernie did develop an interest in financial trading and he took the money that he had saved from his job as a lifeguard and started his financial investment firm Bernard L. Madoff Investment Securities, LLC after dropping out of law school.
Over time the Bernard L. Madoff Investment Securities gained many new clients from well-known businesses to famous celebrities. The word was out that if you invested with Bernie Madoff, you would get an awesome return on your investment. It was worth the risk. Little did the clients know that they have now become a part of the biggest pyramid scheme on record in U.S. History.
How did Bernie get people to invest? Well, conversations took place that told an investor how they would get a nice return on their investments. So like all pyramid schemes, a person invests a certain amount of money like one million. Then another person invests $1.5 million. Bernie then informs the first investor that they have earned a small, reasonable and non-red flag raising amount to their initial investment. This goes on and on from one investor to the next, and as long as you continue to have new investors or your current investors add more money into the pyramid you can show small returns to your investors that keep them happy and eager to invest more. It is when the investors want to pull all of their money out of the business that things can and usually do start to unravel. “A Ponzi scheme — as anyone smart enough to engineer one knows — is a plan that is uniquely without an exit strategy. It requires a constant infusion of new investors to pay off a growing body of existing ones, and ultimately it becomes impossible to find enough suckers”. (Kluger, 2008)
You have to wonder why seemingly intelligent people would not hesitate to take a large portion of their own financial security’s and lay them in the hands of another. We have all been taught that if it sounds too good to be true then it probably is. The other side to that is anyone that was hesitant probably took that leap of faith because they are being told and shown by other investors how much of a return that Bernie is getting for them. Greed will always win out even with red flags being raised. “Greed on the part of investors is one of the major factors in Ponzi schemes. Investors are chasing high returns and they are ignoring red flags – in a good economy, people are not shocked by [promises of] high returns, while in a bad economy, people take bigger risks”. (Cook, 2014)
The question becomes, how did Bernie pull this off for so many years? Actually having a legitimate legal running successful company to further your reputation as a highly successful investor really helps, but how do you have billions of dollars invested in your company, that is ultimately already lost before you even cash the check given to you? That in itself must have taken a lot of time and energy, and when the scheme was discovered, Bernie stated that he alone ran his scheme. For someone that has no problem stealing money from his investors, it seems odd that his reason to take all the credit for the running of this scheme would be to protect the others that were involved. Is he really protecting them or is his ego so big that he wants all the credit? That is a question that we will never have the answer to unless Bernie himself answers it.
But there is one person who has come forward. Frank DiPascali, the former financial chief, became the star witness against Bernie Madoff. Mr. Depascali was very forthcoming in giving information and he detailed how the scheme was able to be hidden for so long, and how it all comes down to technology. What? How does technology have anything to do with hiding a pyramid scheme? Well, Bernie had an emergency operations building that housed different versions of computers, software programs, printers, copiers, paper, company logos, and company leader head. This building and its contents were one of the main ways that Bernie was able to fool the SEC for so long. When creating false financial records for the different businesses that he was reported to be doing trading on in the stock market, Bernie ensured that his employees had all of the necessary tools to be able to create these false records and have then appear to be originally created in the year that the supposed trading was done. “Madoff made sure employees obtained just the right paper, computer printing fonts and layout format needed to fabricate bogus reports that would convince anyone the fakes were genuine documents from the Depository Trust Co. securities clearinghouse”. (McCoy, 2013) This was but one way that Bernie handled his scheme. Another way was when a client passed away, Bernie would make sure that false trading showing loses where recorded to make the final payout to the client as small as possible. That seemed to work for a while until one client passed away and Bernie was not notified by the clients attorneys of the death. By the time Bernie was informed the account for the dead client was far above what Bernie preferred it to be. This unsatisfactory balance was not acceptable to Bernie as he instructed his employees to create an entirely new and different set of financial transactions that were fictional. “They then filled the account with losing trades to produce a $1,772,000 loss, which reduced the last payout to match Madoff's expectations”. (McCoy, 2013)
Ultimately, Bernie was able to continue this scheme because his clients were shown their profits on paper reports. Bernie only had to worry about when a client choose to withdrawal their money, and when that happened Bernie would have more false transactions created and applied to the account to reduce the amount of the payoff that Bernie was willing to pay. It makes you wonder if people who are active in the trading of stocks and bonds, ever look beyond their paper statement showing their profit or loss. Wouldn’t it make sense to demand that every single transaction performed for your account be documented and sent directly to you right away? You could then compare those statements to the final statement received when closing out the investment account.
With all of the things that Bernie did to keep his scheme going, it does make you wonder what type of internal controls were in place that would have identified these fraudulent transactions. But internal controls would not have worked here as it appears everyone that worked for Bernie was aware of this illegal activity. So there was no one to ask questions. That is why there needs to be an outsider to evaluate a company’s internal controls. If the Madoff Company had ethical people to monitor internal controls, those people could look to the Treadway Commission for guidance. The Treadway Commission established a business model that all companies could compare their internal controls against to evaluate their effectiveness.
However, an internal control is only as good as the people who are doing the evaluation. If a person who monitors and evaluates a company’s internal control, is a person operating unethically, then having an internal control is mute as any violations would not be reported or corrected. Instead they more than likely would be hidden. Again, this is why I think it is imperative for an external neutral party be the one to evaluate and monitor a company’s internal controls. That is what the SEC is supposed to be for. The SEC investigates companies that are suspected of fraud in their business dealings. Like all things, not everything is perfect. The SEC is not perfect and in fact the SEC was a complete failure when it came to any investigations pertaining to Bernie Madoff. At a senate hearing, a report from the Attorney General referenced multiple areas that failed in the investigation. This report highlighted that the SEC has/had incompetent supervisors and inexperienced investigative staff. The incompetent supervisors did not understand different types of fraud. “Incompetent supervisors directed their offices to look only for the types of fraud they understood and failed to recognize the type actually being committed in the Madoff case”. (Hearing, 2009) “Inexperienced SEC staff simply accepted Mr. Madoff’s claims without making the single phone call or sending the single letter that it would have taken to verify the information they were given”. (Hearing, 2009)

What was really incredible was that the SEC had been receiving information that Bernie Madoff’s business was not on the up and up. The SEC however did not take any action. “SEC Staff had received multiple complaints over a period of 16 years, from 1992-2008, that Bernie Madoff’s business was not legitimate, but had not taken any effective action”. (Hearing, 2009) While there are many things out there in the business world to help identify where fraud may occur, or how a company can identify a fraud that is being committed at their business, it still takes trained, experienced managers and auditors for fraud detection to be successful. “SAS 99 requires auditors to ask management questions about their awareness and understanding of fraud. Auditors will then make a decision as to whether they need to ‘educate’ management about fraud and the types of controls that will deter and detect fraud. The standard also requires auditors to make inquiries of the audit committee, internal audit personnel and others within the entity”. (Statement on Auditing Standards No. 99: Consideration of Fraud, 2014) Auditors are also required to document their discussions about fraud with the company’s management. “Auditors must document: (1) how and when the brainstorming session occurred and who participated, (2) procedures performed to obtain information to identify and assess fraud risk, (3) specific risks of material misstatement due to fraud (must specifically include discussion of revenue recognition) and the auditor’s response to those risks, (4) results of the procedures performed to address the risk of management override of controls, (5) conditions and analytical relationships that led to additional audit procedures or other responses, and (6) nature of communications about fraud made to management and others”. (Statement on Auditing Standards No. 99: Consideration of Fraud, 2014)

While we now know that the lack of knowledge in detecting fraud, inexperience to successfully perform a fraud investigation, and poor communication helped Bernie Madoff get away with his crimes for so long, we have all learned from those mistakes and changes were recommended in a Senate hearing about the failure of identifying Bernie Madoff’s crimes. “The SEC staff should be trained in markets and investment strategies so they can know fraud when they see it, and the SEC should hire staff with real-world experience”. (Hearing, 2009)

The business world is forever changing, and we all need to keep up as unethical people will continue to find a way to commit fraud, and we need to be prepared to detect that fraud and stop it in its tracks.
References

Cook, B. (2014). Red Flags Flying. Retrieved from International Bar Association: http://www.ibanet.org/Article/Detail.aspx?ArticleUid=716b512e-ebb3-4217-843b- cfdc85fa8dca
Hearing, S. (2009, September). OVERSIGHT OF THE SECURITIES AND EXCHANGE
COMMISSION'S FAILURE TO IDENTIFY THEBERNARD L. MADOFF PONZI
SCHEME AND HOW TO IMPROVE SEC PERFORMANCE. Retrieved from GPO.Gov: http://www.gpo.gov/fdsys/pkg/CHRG-111shrg55785/html/CHRG-111shrg55785.htm Kluger, J. (2008, December 31). Putting Bernie Madoff On The Couch. Retrieved from Time
Magazine : http://content.time.com/time/health/article/0,8599,1869123,00.html
McCoy, K. (2013, December 9). Bernie Madoff sweated scam's intricate details. Retrieved from
USA Today: http://www.usatoday.com/story/money/business/2013/12/07/madoff- sweated-scam-details/3890069/ Nicholas Varchaver, J. B. (2009, January 16). Madoff's mother tangled with the feds. Retrieved from CNN Money: http://money.cnn.com/2009/01/16/magazines/fortune/madoff_mother.fortune/index.htm? utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+rss%2Fmoney
_topstories+(Top+Stories)
Statement on Auditing Standards No. 99: Consideration of Fraud. (2014, February 27).
Retrieved from Wikipedia: http://en.wikipedia.org/wiki/Statement_on_Auditing_Standards_No._99:_Consideration_ of_Fraud