Bernard Madoff

The former chairman of the Nasdaq and founder of the market-making firm Bernard L. Madoff Investment Securities. Madoff, who also ran a hedge fund, was arrested on December 11, 2008, for running an alleged Ponzi scheme; his hedge fund lost about $60 billion, but kept it hidden by paying out earlier investors with money from later investors.

The Ponzi scam is named after Charles Ponzi, a clerk in Boston who first orchestrated such a scheme in 1919. A Ponzi scheme is similar to a pyramid scheme in that both are based on using new investors' funds to pay the earlier backers. One difference between the two schemes is that the Ponzi mastermind gathers all relevant funds from new investors and then distributes them. Pyramid schemes, on the other hand, allow each investor to directly benefit depending on how many new investors are recruited. In this case, the person on the top of the pyramid does not at any point have access to all the money in the system. For both schemes, however, eventually there isn't enough money to go around and the schemes unravel.

The scale of the fraud is staggering. Tens of billions have been lost – perhaps as much as $60 billion over many years. Wealthy families, numerous charities, and even college trusts have been all but wiped out. The Palm Beach Country Club, where Madoff recruited many of his victims, investors. Perhaps the largest private victim is Carl Shapiro and family, who had known Madoff for 50 years and had $545 million invested. A number of large players were caught in the scam too. Britain’s HSBC Bank may have lost as much as $1 billion. Banco Santander had more than $3 billion in exposure through its money management arm.

Bernard Madoff was sentenced to 150 years in prison on June 29, 2009-- the maximum penalty the judge could give him for "extraordinarily evil" crimes in Wall Street's biggest and most brazen investment fraud. Madoff, who has been accused of bilking investors worldwide out of as much as $65 billion. The case has triggered widespread criticism of the U.S. Securities and Exchange Commission, which has been accused of missing red flags that could have brought the curtain down on his asset management business.

Madoff was arrested in December 2008 after his two sons told authorities that he had confessed to them that his investment empire was a sham. Bernard L. Madoff Investment Securities showed $65 billion in customer accounts weeks before his arrest, but the trustee winding down the firm has so far only been able to collect $1.2 billion to return to investors. Madoff told investors in the courtroom that he could offer no excuses, saying he tried to undo his crimes but "the harder I tried, the deeper a hole I dug for myself."

Why was nobody watching? There are countless ways to perform due diligence, but many methods miss the mark. While it's easy to blame the Securities and Exchange Commission (SEC) for missing the signs and accusations, there is a long line of interested parties who also failed to clue in to Madoff's scam.

One lesson to be learned by this event is that due diligence means more than just dropping by for a visit or relying on the opinions of others. It's a methodology that encompasses all aspects of an investment management organization, including investment policy, trading patterns and verification of investment returns. While there is no official handbook or checklist, a skilled due diligence team has the experience and know-how to complete the process.

Nothing stupefies like money. Even the savviest investors tend to look the other way when extraordinary returns are being made. This unfortunate human trait is the fuel behind speculative bubbles and the magic behind all financial scams.
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Cheers
Naveen Victor

Reference:
- Investopedia – How to Avoid Falling Prey To The Next Madoff Scam by Michael Schmidt, CFA
- Commodity Online – How Bernard Madoff Cheated Investors by Justice Litle
- Reuters
- Bloomberg