Looming litigation and the red flags that were missed

Originally published in the July 2009 issue

While Bernard Madoff was awaiting sentencing at home in his US$7 million Park Avenue apartment the big questions being asked, both by victims of his alleged US$50 billion ponzi scheme investment fraud and market investors alike, were “why was he not stopped sooner?” and “what were the red flags?”. As the Serious Fraud Office continues to investigate any possible criminal involvement in the Madoff investment fraud by parties here in the UK, the lessons learnt and pending civil litigation will be just as relevant here as in the US. In order to understand what, if any, red flags went undetected, it is important to understand what a ponzi scheme is and how it operates.

According to the Securities and Exchange Commission (‘SEC’) “Ponzi schemes are a type of illegal pyramid scheme…” They are named after Charles Ponzi who, in the 1920s, persuaded thousands of people to invest in a postage stamp speculation scheme. Typically, investors are lured in with the promise of higher-than-average returns. The scheme works on a ‘rob-Peter-to-pay-Paul’ principle in that it constantly requires new investors to inject money into the scheme in order to pay the returns, and sometimes principal, of existing investors. Invested money is rarely used for its intended purpose and more often is put towards funding the lavish lifestyle of the scheme’s owner(s). Such schemes eventually collapse when investors seek the return of their capital and no new investors can be found to cover the withdrawals.

This sudden rush for withdrawal is precisely what happened in the case of Madoff. He had been operating what is now being hailed as ‘the world’s largest ponzi scheme’ for over 15 years, until the credit crunch and subsequent economic downturn prompted cash-strapped investors to liquidate what they believed to be their most liquid investment. Madoff eventually turned himself into the police on 11 December 2008. According to Harry Markopolos, would-be Madoff whistleblower, he had no choice but to do so: “Madoff had taken money from every corner of the globe and he had taken it from some very unsavoury characters. That’s why he didn’t flee; he had nowhere to run and nowhere to hide; so he did the logical thing – he turned himself in.”

So what happens now? According to The Wall Street Journal “you can almost hear it”; the sound of the oncoming Madoff litigation. Auditors, funds of funds, feeder funds, investment managers, accountants, administrators, banks and even the SEC are all in the firing line of as many as 120 actions filed to date, with many more expected in thecoming months.

Many of the lawsuits being brought cite a failure either to identify ‘red flags’ when undertaking pre-investment due diligence or accuse third parties of ignoring the ongoing ‘red flag warnings’, blinded by substantial management fees and large commissions.

Why these ‘red flags’ were not detected sooner will be the subject of debate in the coming months but for now, and with the benefit of hindsight, the following are just some that have been identified.

Lack of transparency – opaque strategy
Potential investors who asked too many questions were told they were not wanted. “It’s a take-it or leave-it black-box strategy. I invented this strategy and if I let third parties see what I’m doing, then they will duplicate…”

Obscure auditors
Friehling & Horowitz acted as Bernard L Madoff Investment Securities LLC (“BLMIS”) auditors. Friehling & Horowitz is a tiny firm consisting of three people (one partner who resides in Florida, one secretary and one CPA). They operate from a small office in upstate New York. Despite their relative size and lack of reputation, Friehling & Horowitz allegedly managed to audit a multi-billion dollar investment company. To add to that, Friehling & Horowitz have, for the past 15 years, declared to the AICPA (American Institute of Certified Public Accountants, the US professional accounting body) that they do not conduct audits.

No mention of Madoff

BLMIS marketing literature did not mention Bernard Madoff or BLMIS. Therefore, many investors had no idea with whom they were ultimately investing. While prior to 11 December 2008 the mention of the name Bernard Madoff would not have been a red flag in itself, it should have raised concern that investors were not told either who their investments were with or what they had invested in.

Related party/lack of skilled staff
Whilst disclosing US$17 billion of assets, BLMIS reported between one and five employees. In addition, the majority of these staff were either family members or closely related parties to Madoff himself.

Unregulated by the SEC until 2006

Thanks to a regulatory loophole, BLMIS was able to remain unregistered and therefore unregulated by the SEC until 2006. BLMIS therefore avoided audits by the SEC. Although this fact would not have been a ‘red flag’ in itself, as BLMIS was in compliance with requirements at the time, it should have prompted potential investors to perform further due diligence.

Consistent, positive annual and monthly returns
Contrary to industry trends, Madoff consistently reported positive returns. Of 215 months only 10 were reported as being down, with the fund displaying very low volatility.

Nobody could replicate the trading strategy
Despite efforts by potential Madoff competitors to replicate his trading strategy, no one, it appears, was successful. It was this that originally alerted Harry Markopolos, prompting a nine year investigation into his dealings, including two unsuccessful attempts at whistle-blowing to the SEC.

Fees charged
Contrary to industry practise Madoff did not charge the standard 2% + 20% fee, telling investors: “We’re perfectly happy to just earn commissions on the trades.”

Veil of exclusivity
Key to Madoff’s success and his ability to draw in new investors was the veil of exclusivity he managed to build around his fund. Investors were made to feel privileged to be let into his ‘club’ and were therefore falling over themselves to give him money. According to Markololos “He would simply lie and tell feeder funds, fund of funds and rich individual investors that he wasn’t really taking in new money to manage. He would say “but because I like you I’ll give you special access and allow you, and only you, to invest.” He was brilliant in letting smart investors walk away and not being offended by it.”

Paper copies of trading records sent to clients
Despite the size and supposed value of Madoff’s enterprise, BLMIS continued to send clients paper copies of their trading records rather than providing electronic access as is done by most brokers. This allowed BLMIS to manufacture trade tickets retrospectively, after investment results could be confirmed.

While potentially devastating to those investors who are now struggling to claw back whatever money they can from BLMIS, the Madoff case poses questions of current due diligence processes. The overriding lesson in all this has to be just how critical it is to conduct thorough and wide reaching due diligence on all potential new investments. This due diligence can no longer simply focus on investment performance but must cover external governance and utilise external oversight to challenge internal due diligence processes. With any luck, the reflection, analysis and internal reviews now being performed with the benefit of hindsight will equip companies to detect or at least avoid the next Madoff.


Julian Korek is one of the Founding Members of Kinetic Partners. He has over 20 years’ experience in the asset management industry. Emma Farnsworth is a consultant with Kinetic Partners where she specalises in Forensic and Investigation assignments.