Lessons from Madoff
Uncle Bernie Madoff, at the time of his arrested in 2009, had a fund pretending to be worth USD $65bn.
Some of the key attractions of Madoff’s fund to investors was that:
- Madoff offered consisted steady returns of about 12% a year, a good solid return. Not exuberant
- Madoff gave the impression that he was exclusively dealing just with you, you were part of a VIP club (and don’t tell anyone)
- Madoff had a long investing career and reputation and he also ran a bone fide stock trading business
Madoff offered a Split Strike Conversion strategy. The strategy simply involved buying blue chip stocks and puts and options to protect against some of the downside risk. What was strange about Madoff’s strategy was that each month he would sell the stocks, puts and options and convert the money to treasury bonds.
Ponzi Scheme Red Flags
Some of the red flags of Madoff’s fund included:
- No segregation of duty. Normally funds require a segregation of duty between the investment manager, the broker and the custodian. In Madoff’s case, there was no segregation of duty. He was all three. He looked after the money, made the investment decisions and brokered the deals
- Despite being a $65 billion fund, it was audited by a tiny unheard of audit firm which employed just one auditor (who didn’t have an audit license)
- It made the consistent good 12% returns even when the markets were falling
But Madoff was making it all up.
How to fudge the numbers
Madoff worked backwards, looked at stock prices over the month and then created false purchase and sales documents for buying those stocks at the lowest prices and selling at the highest. When the auditors checked the trail of transactions they would go on to Bloomberg look up the price of the stock on the relevant day and confirm, yes, the price does tie up to Bernie’s broker document. That is to say, there was market evidence that the prices Madoff had for his transactions were bone fide.
The unusual thing is that this went on for over thirty years. Over that time the auditors, the investors and the SEC never ever checked with the central depository to see if Madoff ever actually bought any the shares he said he did. Which of course he didn’t.
The key lessons to be learned from Madoff are
- Look for evidence. Look for third party evidence that the ownership of investments exists.
- No segregation of duty? You’re asking for trouble
- A one-man band auditor? Really, what do you think
- Returns too good to be believed? Well they are
About the Author
Simon specialises in providing forensic accounting and valuation services. Prior to founding Lotus Amity, he was a Forensic Accounting partner with BDO Australia and led their National Forensics practice. He has worked as a forensic director for a major offshore forensic accounting practice which included assisting in multi-billion-dollar litigation in relation to the largest Bernie Madoff feeder fund. He has also held senior management positions with Deloitte and Crowe Horwath. Simon is a Chartered Accountant, CA Accredited Business Valuer and a Certified Fraud Examiner.