The Fraud of the Century:
The Case of Bernard Madoff
The fraud perpetrated by Bernard Madoff which was discovered in December, 2008 is based upon a Ponzi scheme. Madoff took money from new investors to pay earnings for existing customers. The greater the payout to retiring and withdrawing customer, the more revenue or clients he would need to start and “investment relationship” with Madoff. The Ponzi scheme was named after Charles Ponzi who in the early 20th Century, saw a way to profit from international reply coupons. International reply coupons were a guarantee of return postage in response to an international letter. Charles Ponzi determined that he could make money, legally, by swapping out these coupons for more expensive postage stamps in countries where the stamps were of higher value. While making a significant profit with this system, Ponzi got the idea of enticing investors to provide him more capital to trade coupons for higher priced postage stamps. His promise to investors was a 50% profit in a few days.
Touted as a financial wizard and the ‘Warren Buffet’ of his day, Ponzi lived outside Boston, he had a fairly opulent life bringing in as much as $250,000/day. Part of Ponzi’s success came from is personal charisma and ability to con even savvy investors. The promised payout was supported by the new investors anxious to take advantage of these robust returns because he appeared to create an image of power, trust, and responsibility. In July of 1920, the Boston Post ran an article exposing the scheme and soon after, regulators raided his offices and charging him with mail fraud knowing that his fabricated investment reports were mailed to his clients. The foundational operating principle of a Ponzi scheme is that you must constantly attract new investors to pay the old investors the ‘gains’ they were promised. Most Ponzi schemes self-destruct fairly quickly as the ability to keep attracting new investors dwindles. In the case of Bernard Madoff, he may have perpetuated the fraud for many years.
Bernard L. Madoff Investment Securities LLC: ‘All in the Family’
Bernie Madoff started in the investment business by legally buying and selling stocks not listed on the New York Stock Exchange (NYSE). Started in 1960 as a sole proprietorship, he served as a ‘wholesaler’ between institutional investors. In the early days, working with investment firms such as A.G. Edwards, Charles Schwab and others he made his money based on the variance between the offer price and sales price of stocks. In the 1990s, Madoff Securities was trading up to 10% of the NASDAQ shares on certain days. Early success and competitive advantage came from Bernie working with his brother, Peter (the first of several family members to join his firm) who after graduating from law school joined Madoff’s company and developed superior technology for trading buying and selling at the best prices. Madoff did not operate a hedge fund, which charges a fee for services and holds the money at a custodial bank. Madoff controlled the funds in house and made his money, in this division, from commissions on sales and profits and as far as has been revealed, the profits were not based on fraud.
As Madoff became more successful, he moved the company’s headquarters from Wall Street to Third Avenue to the red granite “Lipstick Building” built by famed architect Philip Johnson. Not unlike Ken Lay and his lobbying efforts to deregulate the energy and gas industry, Bernie became more involved in lobbying for regulatory changes which would make it easier to trade electronically. Peter took on more oversight of the firm’s securities business. Bernie served as Chairman of the NASDAQ in 1990, 1991, and 1993. Through his successful networking, visibility at the NASDAQ, and promise of consistent returns (10-12%) Bernie was drawing billions of dollars from hundreds of investors. In addition, he held a seat on the government advisory board...
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