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A TIMELINE AND FRAUD TRIANGLE ANALYSIS OF THE SEC'S MADOFF PONZI SCHEME INVESTIGATION.

INTRODUCTION

In 1960, Bernard Madoff founded Madoff Investment Securities LLC. The firm operated for the next 48 years, investing funds for individuals and groups of investors. Through a series of botched SEC investigations, the firm continued to do business and attract investors until an economic downturn labeled the "Great Recession" accomplished what allegations and whistle blowers could not. The economic downturn of 2008 brought to light the largest known Ponzi scheme in U.S. history (Carozza, 2012).

The Madoff Ponzi scheme defrauded investors of between $10 billion and $65 billion (Carozza, 2009). Although the final SEC investigation did not determine when Madoff Investment Securities began operating the Ponzi scheme, outsider allegations and whistleblower reports date back to 1992. An interview conducted after Bernard Madoff's imprisonment reported that Madoff believed that without the economic downturn his Ponzi scheme could have continued to operate for years (Carozza, 2012).

LITERATURE REVIEW

Ponzi schemes represent a financial investment scam in which the fraudster uses money from new investors to pay earlier investors. Ponzi schemes fail when the fraudster is unable to raise the funds needed to pay earlier investors. Ponzi schemes derive their name from Boston Businessman, Charles Ponzi. In 1919 and 1920, Charles Ponzi defrauded investors of over $4 million, or almost $120 million in 2015 dollars (Altaian, 2008; Coville, 2013; Hussein, 2016). Charles Ponzi was an Italian immigrant who devised an investment scam based on the concept of International Reply Coupons for posting letters between the US and Europe.

After World War I, depressed and highly volatile currencies in Europe led to the US Postal Service and its European counterparts creating International Reply Coupons. International Reply Coupons allowed people to send a return letter for a preset postage rate. Charles Ponzi convinced investors that he could purchase International Reply Coupons in Italy for $1, with a US face value of $3.30. Ponzi promised a 50% return on investment in 90 days.

The problem with his scheme was that there were not enough International Reply Coupons in circulation. Charles Ponzi stopped purchasing the coupons and started paying off early investors with funds raised from new investors. The scheme failed when Charles Ponzi was unable to raise enough new investment funds to pay off early investors. In 1920, new paper reports exposed Ponzi's scheme, and a federal audit found that he defrauded investors of over $4 million.

Legal Definition of a Ponzi scheme

A fraudulent investment scheme in which money contributed by later investors generates artificially high dividends or returns for the original investors attracts large investments. Money from the new investors is used to repay or pay interest to earlier investors, [usually] without an operation or revenue-producing activity other than the continual raising of funds (Winters, 2012).

History of Ponzi Schemes

While Charles Ponzi remains the namesake for this type of investment scheme, he was not the original Ponzi Schemer. Altman (2008) points out that New Yorker William Miller (in 1899) should be credited with developing the Ponzi scheme over two decades before its namesake. Miller told investors he had a method to evaluate company earnings that offered an astonishing rate of return. He earn the nickname "520 percent," and was sentenced to 10-years prison when his scam was exposed by a newspaper.

Although Ponzi schemes bilked investors for the past 120 years, the 1990s and 2000s experienced a series of high profile, high dollar Ponzi schemes. Scott Rothstein, Tom Petters, and Allen Stanford all stole billions of investor dollars in the early 2000s (Altman, 2008, Coville, 2013; Hussein, 2016; Wells, 2010).

Hussein (2016) compares history's largest Ponzi Schemes by basing the size of each scam in 2015 dollars. Table 1 shows infamous Ponzi schemers, the time-frame of their scheme, the size of the scam in 2015 dollars, and the prison sentence received.

SEC Investigations of Ponzi schemes

The 11 Regional SEC offices investigated 300 Ponzi schemes between 2000 and 2012. Springer (2012) offered a summary of SEC investigated Ponzi schemes. Table 2 summarizes the investigations by SEC Regional office, including the number and percentage of times the SEC took legal action within the first two years of a Ponzi scheme identification.

In Table 2, Springer's (2012) research demonstrates that Ponzi schemes are not limited to any specific SEC region. While the New York office received the largest amount of media attention (due to the Madoff scandal), the Los Angeles office experienced the largest number of Ponzi schemes (61). The Chicago, Miami, and Fort Worth offices experienced more Ponzi schemes than the New York office. Only the Atlanta office exceeded 50% in its ability to take legal action against identified Ponzi schemes. The SEC average on taking legal action against identified Ponzi schemes was 39%.

Ponzi scheme Red Flags

Benson (2009) reviews 11 Ponzi scheme 'Red Flags,' categorized into the areas of incentive, opportunity, and attitude. Altman (2008), Coville (2009), and Wells (2010) offer similar lists of 'Red Flags' associated with Ponzi schemes:

1. Guaranteed return--investing involves risk and the elimination of risk is impossible

2. Promise of above market returns: schemer lures investors with promise of outperforming other investments

3. One person or tightly controlled investment company: easier to evade detection with limited access to company performance information

4. Growing pool of common investors: past Ponzi schemes targeted investors sharing a common background (ethnicity, social network, religious affiliation, etc.)

5. No separation of fund raising and investment duties: opportunity for fraud increases when the money manager is also the broker

6. Lack of outside audits: schemer resists outside audits to limit exposure

7. Lack of transparency: schemer dissuades investors from seeking independent professional opinions

8. Lack of professional licensing: while some schemers are licensed, the lack of a professional license is a clear 'red flag'

9. Claim of special or proprietary investment strategy: schemer will not clearly explain the investment strategy

10. Difficult to track assets: past Ponzi schemes did not offer investors statements to track assets

11. Extravagant lifestyle: past Ponzi schemers 'lived large' (on investor's money) to give the illusion of success and attract more investors.

Multiple Ponzi scheme researchers (Altman, 2008; Benson, 2009; Coville, 2009; Springer, 2012; Wells, 2010) point out that the use of caution in investing and consideration of the preceding investment "Red Flags" can reduce the likelihood of being swindled in a Ponzi scheme.

The promise of high financial returns coupled with the investor greed suggest that Ponzi schemes are here to stay. For the past 120 years, the Ponzi scheme has duped investors looking for a quick return on their money. What makes the Bernie Madoff story of great interest is the enormous losses faced by investors ($73 Billion) and the length of time Madoff ran the scam (1960-2008). Over two decades, outsiders contacted the SEC to complain that Bernie Madoff was operating a Ponzi scheme But it took the Great Recession and a drying up of investment funds to bring down the Madoff Investment Securities Ponzi scheme (Carozza, 2012, 2009, 2008).

TIMELINE OF THE MADOFF PONZI SCHEME

In his SEC report, Inspector General David Kotz (2010) pointed out six outsider complaints directed at Madoff Investment Securities. Each SEC complaint represented an opportunity to identify the Ponzi scheme and bring the Madoff organization to justice. However, incompetent and incomplete investigations allowed the Madoff Ponzi scheme to bilk investors of billions of dollars (Carozza, 2012; Kotz, 2009; Sheer, 2009). The following timeline is offered to lend insight regarding the SEC's missed opportunities to catch Madoff:

1. 1992--The investment firm Avellino & Bienes was investigated and determined to operate a Ponzi scheme. The investigation revealed the investment advice was offered by Bernard Madoff in the creation of the Avellino & Bienes scheme. The organization reimbursed investors. Madoff was never questioned about his role in Avellino & Bienes. No investigative follow-up occurred as to the source of the funds to repay investors, and no further investigation of Madoff was undertaken.

2. 2000--Between May of 2000 and October of 2005 Harry Markopolos, a former portfolio manager turned independent forensic investigative accountant, made three separate written complaints to the SEC regarding Madoff Investment Securities. Markopolos became interested in Madoff Investment Securities when former colleague questioned the consistent 1-2 percent monthly returns offered my Madoff, irrespective of overall market performance. In each complaint, Markopolos pointed out 30 red flags of fraud and stated, "The world's largest hedge fund is a fraud" (Carozza, 2009, p 36). In each case, the follow-up by the SEC did not lead to an investigation. Kotz's (2009) report pointed out that SEC personnel suggested that Markopolos was a competitor of Madoff and these complaints might be motivated by competitive rivalry.

3. 2003--An outside analysis of Madoff Investment Securities financial results by a hedge fund manager suggested that options trading purportedly conducted by Madoff did not match market trading statistics, and that no other investment firm had duplicated the consistent performance of Madoff Investment Securities. The complaint suggested either Madoff was not offering complete transparency regarding the option trading, or that he was conducting an elaborate Ponzi scheme.

4. 2004--An internal email included in SEC documents pointed out that Madoff option trading records was not reflected in the volume of options trading in the market.

5. 2005--An anonymous informant filed a SEC complaint. In this complaint the anonymous informant stated that as an investor in Madoff Investment Securities, the person had a suspicion of fraud and was removing a $5 million investment from the firm. The SEC determined that the complaint was filed by a competitor. Nevertheless, it was later revealed to be a Madoff investor.

6. 2006--Between December of 2006 and March of 2008, two complaints were submitted to the SEC by a "concerned citizen." The complaints suggested that Madoff kept two sets of books and that over $10 billion were at risk.

Beyond the six complaints to the SEC, two journal articles were written suggesting the Madoff Investment Securities was a Ponzi scheme. The first article appeared in Barron's and was titled, "Don't Ask, Don't Tell: Bernie Madoff is so Secretive, He Even Asks His Investors to Keep Mum" (Arvedlund, 2001). The second article appeared in MARHedge and was titled, "Madoff Tops Charts; Skeptics Ask How?" (Ocrant, 2001). Both articles suggested that Madoff was conducting a Ponzi scheme, and that the returns of the firm's investments did not match market performance.

How Madoff Perpetuated the Fraud

The simplicity of the Madoff fraud surprised SEC investigators, in that investor funds were places into a single Madoff Investment Securities bank account. While Madoff told investors that the funds were closed and no more investors were being accepted, he continued to accept investors. Longer-term investors were paid off with the funds from new investors. When an investor asked to withdraw funds from the firm, Madoff Investment Security personnel would fabricate investment transactions to cover-up the fraud (Carozza, 2012, 2009, 2008; Kotz, 2005).

SEC Investigation

Over the course of 16 years, the SEC conducted a series of investigations of Madoff Investment Securities. The investigations spanned several divisions and regional offices of the SEC. In each investigation the investigation team contained auditors that were either new to the SEC, untrained, or the team did not include proper accounting professionals. In multiple investigations the request for option trading transactions was not requested from third-party sources. When questions were raised by the investigators, "Assistant Directors" at the SEC refused to follow-up. A review of the investigations by Kotz (2009) revealed a breakdown in communication across SEC department and regional offices. This breakdown in communication played a role in the persistence of the Madoff Ponzi scheme.

FINDINGS AND RECOMMENDATIONS

The fact that multiple investigations, multiple complaints, and journal articles did not lead to uncovering the Madoff Ponzi scheme was an embarrassment to the SEC. The investigation that followed lead to a series of 69 recommended changes in the way the SEC operates (Carozza, 2010). Madoff Investment Securities was dissolved and Bernie Madoff received a 150 year prison sentence. Madoffs investors lost billions of dollars.

Kotz's recommended changes included a new process for handling complaints sent to the SEC. His recommendations included the need for improved policies and procedures. Recommendations also included new SEC investigator training programs and a new process for communicating between divisions and regional offices (Carozza, 2010). Each of these recommendations are reflected in the literature of Forensic Accounting education (Albrecht, Albrecht, Albrecht, & Zembelman, 2012; Hopwood, Leiner, & Young, 2012; Manning, 2011; Wells, 2005).

The results of the SEC investigations, both inside and outside the agency, point to a lack of training, a lack of manpower and failed communication. The majority of reports on the Madoff Ponzi scheme scandal suggest that adding people, training them in proper forensic accounting techniques, and improving communication will help avoid a similar fraud in the future.

A Deeper Dive

For many outside observers the answer of more people and more training does not go deep enough. The following analysis of Kotz's (2009) report suggests that further investigation of the SEC from an outside source is warranted.

The Kotz (2009) report states, "We did not find that senior officials at the SEC attempted to influence examinations or investigations of Madoff or the Madoff firm..." (p. 1). While this finding is made clear in the first page of the report, several statements found later in the report suggest an outside investigation of the SEC is warranted.

For over a decade a series of significant red flags were overlooked by SEC investigators, including letters from outside forensic accounting investigators, SEC internal reports, and an anonymous letter from a Madoff Investment Securities investor explaining why the investor was removing $5 million in personal funds from the organization. In several instances an SEC Assistant Director was directly responsible for squashing the investigation:

1. "...NERO examiners reported back to their Assistant Director...and were actively discouraged from forcing the issue." (p. 14)

2. "Their Assistant Regional Director denied their request (for further investigation)..." (p. 15)

3. "...they had caught Madoff in lies, the Assistant Director minimized their concerns, stating 'it could be a matter of semantics." (p. 15)

4. "The explanation was given that 'field work cannot go on indefinitely because people have a hunch..." (p. 16)

5. NERO enforcement...assign a team with little or no experience..." (p. 16)

6. (SEC) "branch chief... took an instant dislike to Markopolos." (p. 18)

The most concerning aspect of the Madoff case is the relationship between Madoff and the SEC. Madoff pointed out to investigators his strong relationships with senior members of the SEC (Carozza, 2012). His niece was engaged to an SEC Assistant Director after the completion of one of the investigations. It is possible that one or more people within the leadership of the SEC used an understaffed and undertrained organization to hinder the SEC investigations.

The fraud triangle (Wells, 2005) points out that financial fraud requires three conditions.

1. Perceived Opportunity--A senior employee in the SEC would have the opportunity to thwart the Madoff investigations.

2. Perceived Pressure--A relationship, financial or personal, could produce pressure to thwart the investigative process.

3. Rationalization--In a financial industry where billions are being made and lost, it is easy to rationalize that the losses of a few investors does not warrant the attention of a large regulatory agency.

CONCLUSION

The proceeding analysis of the Kotz (2009) SEC internal investigation report suggests that further examination of the case against Madoff Investment Securities is warranted. While the evidence outlined above does not represent a concrete case of fraud by members of the SEC senior leadership, the points simply suggest that there exists enough evidence to warrant further outside investigation of the financial and personal relationships between the SEC Assistant Directors mentioned in Kotz's (2009) report and the Madoff organization. It appears that the Ponzi scheme operated by Madoff Investment Securities lasted for years because a complete investigation was never undertaken. Based on a review of the SEC Inspector General's report, further analysis suggests the potential for internal collusion at the SEC. Due to a series of lapses in performance of investigative duties; the SEC internal investigation should be reopened.

REFERENCES

Albrecht, W. S., Albrecht, C. O., Albrecht, C. C., & Zembelman, M. F. (2012). Fraud examination (4th ed.). Ohio: Cengage Learning.

Altman, A. (December 2008). A brief history of Ponzi schemes. Time Magazine. Retrieved from http://content.time.com/time/printout/0,8816,1866680,00.html

Arvedlund, E. E. (May 2001). Don't Ask, Don't Tell: Bernie Madoff is so secretive, he even asks his investors to keep mum. Barron's. Retrieved from http://www.sec.gov/news/studies/2009/oig-509/exhibit-0156.pdf

Benson, S. (June 2009). Recognizing the Red Flags of a Ponzi Scheme. CPA Journal 79 (6), 18-25. Retrieved from Business Source Complete.

Carozza, D. (2012). 'The wizard of lies' describes a tragedy of Shakespearean proportions. Fraud Magazine, 27(5), 35-42.

Carozza, D. (2010). Watchdog monitors agency's progress after Madoff case. Fraud Magazine, 24(3), 36-40.

Carozza, D. (2009). Chasing Madoff: An interview with Harry Markopolos. Fraud Magazine, 23(3), 36-40.

Coville, T. (August 2013). The Legacy of Carlo Ponzi. Internal Auditor, 44-47. Retrieved from Business Source Complete.

Hopwood, W. S., Leiner, J., & Young, G. R. (2012). Forensic accounting and fraud examination. (2nd ed.). New York: McGraw-Hill.

Hussein, H. (April 2016), A brief history of Ponzi schemes. Retrieved from https://www.vice.com/en_us/article/exk4kk/the-ponzi-scheme-v23n2

Kotz, H. D. (2009). Investigation of failure of the SEC to uncover Bernard Madoffs Ponzi scheme. SEC Case No. - OIG-509.

Manning, G. A. (2011). Financial investigation and forensic accounting (3rd ed.). Florida: CRC Press.

Ocrant, M. (May 2001). Madoff tops charts; skeptics ask how. MARHedge. Retrieved from http://nakedshorts.typepad.com/files/madoff.pdf

Sheer, D. (2009). SEC never did competent Madoff probe, report finds. Bloomberg.com. Retrieved from http://www.bloomberg.com/apps/news?pid=newsarchive&sid=agBw9n2hZi5U

Springer, M. (2012). The Security Exchange Commission and Ponzi schemes: An administrative view. Proceedings of the Northeast Business & Economics Association, 297-300. Retrieved from Business Source Complete.

Wells, J. T. (2005). Principles of fraud examination. New Jersey: John Wiley and Sons.

Winters, S. (2012, October). Ponzi's and Pyramids. Michigan Law Review. 111(1), 119-144. Retrieved from Business Source Complete.

About the Author:

David C. Williams is Associate Professor of Business and MBA Program Director for Lincoln Memorial University. Dr. Williams brings two decades of senior executive experience (COO, General Manager, and VP of Operations) to higher education. His background joins administrative and faculty experience, with the management and business acumen gained running a series of quarter billion dollar companies.

David C. Williams

Lincoln Memorial University
Table 1
History's Infamous Ponzi Schemes

   Schemer           Year       Amount Scammed               Prison
                               (in 2015 dollars)             Sentence

William Miller       1899           $29 Million              10 years
Norman Hsu           1992           $93 Million              24 years
Charles Ponzi        1920          $120 Million               5 years
Lou Pearlman         2008          $360 Million              25 years
Gerald Payne         1996          $614 Million              27 years
Scott Rothstein      2010            $1 Billion              50 years
Tom Petters          2009            $4 Billion              50 years
Allen Stanford       2012            $8 Billion             110 years
Bernie Madoff        2008           $73 Billion             150 years

(Hussein, 2016, revised)

Table 2
SEC Regional Office Ponzi Scheme Identification

Region          # of Ponzi Schemes   Legal Action     Percent of
                                     Taken within    Action Taken
                                        2-years      within 2-years

New York              26                 11                42%
Boston                 6                  0                 0%
Philadelphia          17                  3                43%
Miami                 30                 12                40%
Atlanta               19                 13                68%
Chicago               46                 12                26%
Denver                19                  8                42%
Fort Worth            33                 15                45%
Salt Lake             19                  7                36%
Los Angeles           61                 28                46%
San Francisco         24                  8                33%
Total                300                117                39%

(Springer, 2012 revised)
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Author:Williams, David C.
Publication:International Journal of Business and Public Administration (IJBPA)
Article Type:Report
Geographic Code:1USA
Date:Dec 22, 2017
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