Introduction
In 2009, a market maker and investment advisor Bernie Madoff was sentenced for 150 years in prison after pleading guilty to eleven federal crimes. The reason for such an unusually severe punishment was running the largest fraudulent scheme in the history of the United States, otherwise known as the Ponzi scheme. The convict’s charges ranged from fraud and money laundering to perjury and theft. The scale of the offenses was so significant that even today, very few of Madoff’s victims are not quite able to recover from their losses. The case of Bernie Madoff is symbolic of the culture of greed, dishonesty, and deception, which makes it compelling to study it in more detail. This essay discusses the Ponzi scheme, its origins, and its current economic impact on consumer confidence and investment banking.
Madoff’s Ponzi Scheme: Origins, Motivation, and Enabling Factors
The Ponzi scheme is defined as an illegal business model in which an individual or a company pays returns to its old financiers from investments made by their new financiers. In other words, in the Ponzi scheme, no actual profit is earned: instead, the system is sustained by luring newcomers and convincing them to make an investment. The origins of the scheme fate back to the early 1920s when an Italian man Charles Ponzi first invented the idea of paying later investors with old investors’ money. As described by Azim and Azam, Ponzi promised his customers a 50% return rate within 45 days and 100% profit within 90 days (125). The scheme only survived for one year until it was discovered and eradicated.
However, the Ponzi scheme did not lose its allure for the decades to come and continued to evolve. Today, Madoff’s financial fraud is considered to be the largest and longest-lasting scheme in history and one of the worst white-collar crimes of all time. Azim and Azam offer a compelling perspective on what enabled the growth and development of Madoff’s Ponzi scheme almost a century after it was tried for the first time and resulted in failure and criminal charges (125). According to Azim and Azam, the case of Bernie Madoff can be analyzed by using the fraud triangle: a concept that is used for understanding how fraudulent crimes are committed. The three corners of the fraud triangle denote motivation, opportunity, and rationalization (Mansor 39). Motivation includes pressure or incentive to commit fraud; opportunity stands for an environmental or personal disposition (Mansor 39). Lastly, rationalization means excuses that a person might make to justify what they are doing.
Regarding the first element, as noted by Azim and Azam, Madoff was under the influence of both pressure and incentives to proceed with building a fraudulent scheme (130). An accomplished businessman, Madoff felt the need to sustain his lucrative lifestyle (Azim and Azam 130). When it comes to the second element, the case becomes more interesting from the standpoint of business law. When looking back at Madoff’s background, one may notice that his resume was flawless. Prior to being involved in the Ponzi scheme, he was a chairman of the NASDAQ and several industry association boards. On top of that, Madoff was known for his generous donations to charities and politicians. His humanitarian endeavors together with his lofty status on Wall Street presented an opportunity to take advantage of his reputation, blinding others to his crimes.
When investigating Madoff’s Ponzi scheme, it was discovered that the auditing of the company was administered by an unknown accounting firm. Upon further investigation, the said accounting firm was found to have only three members: a partner, an accountant, and a secretary. The so-called “external auditor” did not exist, though such a position was listed among the company staff. By not having an independent auditor examine the company’s papers, Madoff was breaking the law. For small and medium enterprises, the only type of financial assessment that is needed on a regular basis unless bigger issues arise is an internal audit. However, larger companies, especially those that have gone public, are obliged to do external auditing by law.
In the United States, where Madoff’s scheme was taking place, external audit requirements are grounded in the Sarbanes-Oxley Act of 2002 (“What is an external auditor? Do boards need one?”). The act provides sufficient requirements that an external auditor needs to meet to be considered independent. In short, there are a few factors that can shift an auditor’s neutrality outlined by the U.S. Securities and Exchange Commission. In Madoff’s case, the issue lied in the way in which the unknown accounting firm was practically advocating for the audit client by submitting false reports on their behalf.
Lastly, the third element of the fraud triangle, rationalization, also played a role in the making of the largest Ponzi scheme in history. According to Azim and Azam, Madoff essentially shirked the responsibility for his giant but a shaky scheme to investors themselves (132). He supposed that they should have known better than trusting him without making any additional inquiries about the nature of his business (Azim and Azam 132). Indeed, there were no reliable public records regarding Madoff’s company’s business activities; its purpose remained vague and undefined. Next, the convict believed that he was not stealing money from the disadvantaged: he was sure that his scheme was mainly attracting rich investors who would not suffer significant losses if that investment would not work out for them (Azim and Azam, 132). In reality, however, the collapse of Madoff’s scheme hurt a large number of middle-class investors as well as people who were managing employee benefits and retirement savings through his company.
Ponzi Scheme and Business Law in the United States
As mentioned earlier, one of the illegal decisions that Madoff made to cover for his fraud was not to have an actual external audit. This subsection overviews the wide range of financial crimes that Madoff was charged with back in 2009 and discusses them from the standpoint of the business law. The Federal Bureau of Investigation reports that Bernie Madoff pleaded guilty to “11-count criminal information.” The judge famously called Madoff’s crime “extraordinarily evil (Smith 215).” He elaborated that what Madoff did was not a “bloodless” financial crime that only took place on paper (Smith 215). Instead, it took a staggering toll on American society, its safety, and its financial growth prospects (Smith 215). Among the criminal charges that the perpetrator has faced are the following:
- securities fraud. Securities fraud, also known as stock or investment fraud, is defined as a white-collar crime that can take a variety of forms. Typically, securities fraud involves lying or misrepresenting information that is used by investors in the decision-making process. In 2009, the persecution established that Bernie Madoff repeatedly deceived his clients, regulators (despite sworn testimony), and submitted false reports. Henriques opines that Madoff exploited not investors’ greed but investors’ fear, which makes his scheme different from the traditional one. In the early years of Madoff’s company, investors could make more money with mutual funds. Yet, they would often refuse such opportunities and chose the security consistency that Madoff could offer;
- investment adviser fraud. This charge is similar to the one above: in essence, Madoff violated his fiduciary duty. He deceived his clients and did not act in their best interests;
- Mail fraud and wire fraud. In the United States, they are considered federal crimes and include mailing or otherwise electronically transmitting information associated with fraudulent activities. In Madoff’s case, he used postal services to transmit fraudulent information. As for the second charge, he was caught depositing investors’ money in his own bank account;
- International money laundering to promote specified unlawful activity and international money laundering to conceal and disguise the proceeds of specified unlawful activity. Offshore financial institutions are often used for illicit activities, which was the case for Madoff who sough money laundering and tax evasion;
- Money laundering. This charge is similar to the one above, safe for the fact that Madoff was also laundering money domestically;
- Perjury. Madoff was found guilty of lying to the Security and Exchange Commission (SEC, the US government);
- False statements and making a false filing with the SEC. As mentioned before, the lack of external audit and the lenience of financial institutions allowed Madoff to repeatedly submit false reports with regulators that misrepresented the value of his assets;
- Theft from an employee benefit plan. Madoff was charged under Section 664 of the US Code, “Theft or embezzlement from employee benefit plan.” For example, in one instance, a part of a $54.5 million theft came from an employee benefit plan, which is punished with up to five years in prison (“18 U.S. Code § 664. Theft or embezzlement from employee benefit plan”). The retirees of that corporate plan lost their life savings as they were exploited in a personal scheme of the felon.
The Influence of Madoff’s Fraud on Consumer Confidence and Investment Banking
Ten years after Madoff was imprisoned, his victims have yet to recover from their financial losses. A fraud as scandalizing, profound, and destructive as the one committed by Madoff created a serious breach in consumer confidence and jeopardized investment banking. This subsection discusses the impact of Madoff’s fraud on consumer confidence and investment banking. Trust is a necessary prerequisite of financial transactions (Gurun et al. 1341). Normally, an investor needs to have trust in a financial intermediary at least to some degree before making a decision.
However, in recent years, with the rising muddle of financial crime, trust dynamics have evolved beyond recognition. Smith cites an economy professor, Paul Seabright of the University of Toulouse, France, who provides a sobering perspective on what he thinks is happening on the market (Smith 236). According to him, today, people are more prone to entrusting complete strangers with large sums of money (Smith 236). Gurun et al. opine that the case of Madoff and his Ponzi scheme is particularly useful for analyzing the effects of fraud on investment banking (1341). Firstly, the scheme reached an unprecedented scale, swaying thousands of investors. Secondly, trust and its violation was a central topic in many victims’ testimonies. Lastly, since the Ponzi scheme constructed by Madoff affected a particular group of investors, it is possible to understand how a trust shock spreads through social networks.
The study findings by Gurun et al. demonstrated that trust had actual economic effects and was a driving factor behind many economic activities (1351). Following the collapse of Madoff’s grandiose lie, a few trends came into prominence and drew researchers’ attention. Firstly, RIAs (registered investment advisors) in regions where communities were largely affected by the fraud were more likely to close. A large number of firms exited the financial intermediary market altogether, with an approximate closure rate of 30%.
Apart from that, as shown by Gurun et al., the persecution and imprisonment of Madoff made people more cautious about investment banking and lost a big part of their confidence in their investment activities (1351). Closer analysis revealed that bank branches located in regions with Madoff’s victims had seen an abnormal surge in cash deposits. In other words, former investors were overwhelmingly deciding to abstain and keep their money in their bank accounts for the time being. Smith cites another survey that shows that a large share of wealthy Americans (63%) lost faith in financial institutions altogether (240). Some of the responses from the said survey reflected deep disappointment in how the system is operated and the many loopholes that it enables through the lack of comprehensive legislation. In words of one of the respondents, it is impossible to have trust anymore when one of NASDAQ’s chairman is revealed to be a criminal.
Aside from that, Ponzi schemes, especially what Madoff has built, exposed the faulty notion of the sophisticated investor. Smith writes that the 1933 Securities Act allowed issuers who offer securities to sophisticated investors to forego registration. The rationale behind the act was that investors had resources and competence to fend for themselves and act in their best interests (Smith 2015). Wall Street concurred with that sentiment: the biggest players would state that those who do not know the rules of the game should join at their own peril. In other words, investors were seen as rational creatures who were able to bear the burden of responsibilities were an unfavorable turn of events to occur. On the political side of things, the 1933 Act suggested that sophisticated investors do not need protection that would otherwise be mandatory if registration provisions were in place. Contrary to that belief, the unraveling of Madoff’s Ponzi scheme in the early 2000s demonstrated that investors were often far from rational and could still fall prey to frauds.
Smith explains that aside from Madoff’s spotless reputation, what made his scheme sustainable for such a long time was a phenomenon called “information asymmetry (237).” In economics and contract theory, information asymmetry pertains to the study of decision-making in transactions. The notion denotes a situation in which one party has more information than the other. According to Smith, with Ponzi schemes, information asymmetry grows rapidly as the fraud finds new victims (240). It becomes increasingly difficult to disclose any information about the real nature of a company, which misleads investors.
Following Madoff’s case, the US had to introduce new laws to prevent similar situations from happening in the future. Many experts found the inaction of the SEC to be a major factor in the longevity of Madoff’s Ponzi scheme. Smith explains that the first signs of distrust in his company dated back to the late 1990s (240). In 1999, Henry Markopolos, an economist and an expert in financial derivatives, provided a mathematic prove of the unfeasibility of Madoff’s financial returns (Smith 240). Yet, it was not until 2008 that Madoff was finally taken into custody. Since then, the SEC has taken aggressive preventive measures. Namely, it revitalized its enforcement division and improved the handling of complaints and tips (U.S. Securities and Exchange Commission). The commission encouraged insiders’ cooperation and enhanced its risk assessment capabilities among other measures.
Conclusion
Madoff’s Ponzi scheme dismantled in 2009 demonstrated the faultiness of the existing investment-banking system. A Ponzi scheme implies paying later investors with older investors’ money, which secures high returns of investment at first but inevitably collapses. While Ponzi schemes date back to the 1920s, what Madoff built almost a century after the first-ever attempt was profoundly disturbing and hurt both wealthy and middle-class Americans. From the legal perspective, Madoff committed a multitude of crimes: he faced eleven charges in total, ranging from mail fraud to international money laundering. As a result, consumers’ trust was violated, which led to the closure of a large number of companies and people withdrawing from investment activities. In response to the financial catastrophe that Madoff’s scheme was, the SEC developed several measures that might or might not restore consumers’ trust.
Works Cited
18 U.S. Code § 664. Theft or Embezzlement from Employee Benefit Plan. n.d., Web.
Azim, Mohammad, and Saiful Azam. “Bernard Madoff’s ‘Ponzi Scheme’: Fraudulent Behaviour and the Role of Auditors.” Accountancy Business and the Public Interest, vol. 15, 2016, pp. 122-137.
Gurun, Umit G., Noah Stoffman, and Scott E. Yonker. “Trust Busting: The Effect of Fraud on Investor Behavior.” The Review of Financial Studies, vol. 31, no. 14, 2018, pp. 1341-1376.
Henriques, Diana B. The Wizard of Lies: Bernie Madoff and the Death of Trust. Macmillan, 2011.
Mansor, Nils. “Fraud Triangle Theory and Fraud Diamond Theory. Understanding the Convergent and Divergent for Future Research.” International Journal of Academic Research in Accounting, Finance, and Management Science, vol. 1, 2015, pp. 38-45.
Smith, Felicia. “Madoff Ponzi Scheme Exposes the Myth of the Sophisticated Investor.” University of Baltimore Law Revue, vol. 40, 2010, pp. 215-250.
The Federal Bureau of Investigation. Bernard L. Madoff Pleads Guilty to 11-Count Criminal Information and Is Remanded Into Custody. 2009, Web.
U.S. Securities and Exchange Commission. The Securities and Exchange Commission Post-Madoff Reforms. n.d., 2020. Web.
What Is an External Auditor? (And Do Boards Need One?). n.d., Web.