Accounting Horror Stories
The Sheer Audacity of Bernie Madoff
‘Twas the night before Christmas, and all through the house, a crook was at work, he had gasoline to douse. With a velvet tongue and remarkable wit, the man gobbled up billions — there was no one he wouldn’t hit.
The holidays are upon us, and while most of us gear up to spend some quality time with friends and relatives we see maybe once or twice a year, the FloQast family has a gift to share. Halloween was nearly two months ago, but a very rudimentary search of the interweb concluded that there were so many financial crimes committed by accountants in the last 50 years that we could keep our wildly (mildly) popular “Accounting Horror Stories” series going.
If you were to take a poll about the first thing that came to mind when the phrase “financial crime,” the answers would vary. Enron would get a couple; WorldCom might get a few, but the undisputed champ would have to be one Bernard Lawrence Madoff. Over the course of some 50 years, Madoff would defraud investors of an estimated $64.8 billion. Here’s how he did it.
The Firm — The Origins of Bernie Madoff
Bernie Madoff Investment Securities LLC. started trading penny stocks way back in 1960, when Madoff was just 22 years old. He considered himself an outsider on Wall Street, scrapping for small deals and developing an unhealthy scorn for the welfare of others.
Over nearly half a century, Madoff built a reputation as a stock market wizard only the most fortunate had in their corner. He even served as Nasdaq chairman for three years in the early-1990s.
While all appeared to be well, Madoff was quietly at work. During this time, the profitable returns Madoff reported his investors kept them from looking too closely at what was — or wasn’t — really going on inside the firm.
The Fraud — The Origins of the Ponzi
At some point in that long and storied career, Bernie Madoff changed course. In interviews, even Madoff himself says he can’t remember when it started.
What began as a legitimate trading operation turned into the largest Ponzi scheme in history. But what exactly is a Ponzi scheme?
In 1919, Charles Ponzi stumbled on a business idea. Because of the exchange rate shifts caused by World War 1, Ponzi figured out that he could purchase postal reply coupons in his native Italy and redeem them in the U.S. at a 400-percent profit. But, in order to make serious money, he would need capital. He started looking for investors and opened his own company to promote his scheme.
In just under a year, Ponzi had brought in $2.5 million in investments (over $30 million in today’s dollars). His returns just kept bringing in new investors. The trouble is, Ponzi was paying each investor’s profits from new investors principle, never actually generating profits. In fact, he realized it would be too much work to bring the postal coupons over and never actually bought them in the first place.
Like Ponzi, Madoff had so many interested investors that he began paying out returns with the money he got from new investors. For years, there’s no evidence of actually buying stocks at all; He simply deposited the money.
Are You Qualified to Work for Madoff?
How do you keep something so ridiculous from being discovered? Nepotism and collusion. Want to know if you have what it takes to work for Bernie Madoff? Let’s find out.
For a firm managing as much money as Madoff, they had a strange taste in accountants. Instead of working with a Big 5 firm (It’s okay if you were expecting Arthur Anderson — I was too), Madoff’s auditor was Friehling & Horowitz, a firm based out of a strip mall with just three employees — including a receptionist and a retired accountant. Yep, that’s right, one guy in a strip mall. Seems odd, right? It turns out that one guy and his family would make over $5.5 million from their work with Madoff.
Within Madoff’s firm, things were kept close to the vest. Madoff’s staff included his two sons, compliance — if such a word can be used here — was handled by his brother and niece. Madoff’s HR — which provided phony salaries and benefits to employees who didn’t exist — was run by the son of Madoff’s trading supervisor. The assistant to the CFO was the son of Madoff’s Controller, who was, himself, the first person hired by Madoff from outside the family, back in 1964.
Now, don’t get me wrong: There’s nothing wrong with family businesses. I’m just having a really, really hard time not imagining a tight-knit family group sitting at a palatial estate, laughing at humanity’s stupidity, counting the cash, and doing things more closely-associated with Antonio Montana than with a man who donated over $6 million to cancer research.
Since there wasn’t much actual investing going on (if any), what exactly did employees do at Bernard L. Madoff Investment Securities, LLC.? The primary job description seemed to be creating false reports to look like a real company. They compiled historical data and created reports for investors so stakeholders would think trading was actually happening. “Employees” also created the necessary reports to convince the SEC they were legit — at the time, this mostly required the forms to be filled out, as the SEC didn’t follow up and verify the information.
Strangely, with nothing to do but create fake paperwork, even the paperwork wasn’t very good. The numbers Madoff was generating weren’t outlandish — which is one of the reasons he went undetected for so long — but they couldn’t have been earned if he were really investing in the stocks he claimed to invest in. In fact, Madoff reports showed purchases of various stocks on specific days but for amounts very different from the actual high for that day. This caught the attention of the man who would eventually help cause the fall of Madoff.
“The Brightest Warning Signal of All”
In 1999, Harry Markopolos worked for Rampart Investment Management. One of Rampart’s trading partners was getting amazing returns working with Madoff, and Markopolos was given the impossible task of replicating what Madoff claimed he was doing and generate a similar return and win the business of this trading partner.
Markopolos tried and failed, realizing that Madoff’s consistent returns, even when the stocks he claimed to rely on were down, were simply not possible. He shared his findings with the SEC, claiming that Madoff had to be running a fraud.
In order for Madoff’s supposed strategy to work, he would need to be purchasing certain options in quantities that just didn’t exist (On a side note, one of the things that led to Ponzi’s downfall was the discovery that he had to be buying far more of the postage coupons than were actually in circulation).
Markopolos continued to submit memos and reports to the SEC for years, but no action was taken.
The SEC’s internal investigation states that six substantive complaints over a 16-year period were received with no comprehensive investigation into Madoff’s firm.
I’ve got a bit of a confession. The header “The Investigation” is a bit misleading. The SEC never did perform a thorough investigation of Bernie Madoff. His downfall came in 2008, with the impact of The Great Recession. The plummeting market caused a run on Madoff’s fund, as many of his investors to redeem their “profits” at once. Without actual profits or new investors, Madoff wasn’t able to cover the redemptions and his fund went belly up.
Madoff confessed his scheme to his sons on December 10th, 2008 (by his own account, assuming they weren’t already involved) and his sons contacted the SEC. Madoff was arrested the next day by the FBI.
Madoff, already 71 at the time, was sentenced to 150 years in federal prison. He was, it was later estimated, responsible for $65 billion in investor funds being lost (although some may have been fabricated profits that never really existed). A settlement fund was established to compensate investors.
Peter Madoff, Chief Compliance Officer, was sentenced to 10 years and required to forfeit $90 million in assets to the settlement fund. CFO Frank DiPascali pled guilty but died before sentencing. Several other members of Madoff’s staff received sentences ranging from 6 months to 10 years. Accountant David Friehling testified for the prosecution and received 250 hours of community service.
According to my crack research team, Madoff had a heart attack in 2013. At some point, he may or may not have developed some sort of renal disease — cancer, specifically — and was reportedly close to death. Yet, somehow, he’s still ticking. Bummer.