The Madoff Fraud
Alinsunurin, Anthony
Cantalejo, Miguel
Deseo, Denmark
Lozada, Brian John
Pacaigue, Ma. Milcha
Key Terms and Concepts
• Hedge funds- is an investment fund that employs numerous strategies to
earn active return.
• Internal controls- mechanisms implemented by a company to ensure the
integrity of financial accounting information to prevent fraud.
• Counter-party- party on the other side of transaction
• Put options- contract giving owner the right but not the obligation.
• Ponzi schemes- fraudulent investing scam promising high rates of return
with little risks to investors.
Background of the case
One of the largest of these schemes ever carried in the United
States, it was uncovered in late 2008. The man in charge of the
operation, Bernard L. Madoff, got arrested for his scheme and pled guilty
to the embezzling of billions of US dollars.
It struck many as unimaginable how such a fraud could occur in
an environment so carefully controlled by regulations and supervised by
different institutions. The uncovering of the scheme rose questions on
how this could go undetected for such a long time, and what could be done
to avoid similar situations in the future..
Timeline of the case
• 1980s
Bernard Madoff, a renowned Wall Street trader, initiates Ponzi scheme to
take actions in his fraudulent activities.
• May 2000
Massachusetts financial analyst Harry Markopolos tries to alert financial
regulators to Madoff's fraud, saying his alleged trading strategy could never yield
such continuously positive returns.
• 25 November 2008
Ruth Madoff withdraws $5.5m from a Madoff-linked brokerage firm. She
withdraws another $10m on 10 December.
• Early December 2008
Bernard Madoff tells a senior employee of his investment firm that clients
had requested $7bn in redemptions, and he was having trouble coming up with the
cash to fulfil the withdrawals.
• 11 December 2008
Madoff surrenders to authorities, saying "there is no innocent explanation".
Madoff is freed on a $10m bond. Federal prosecutors eventually charge him with fraud,
international money laundering, lying to federal securities regulators, and other counts.
• 12 December 2008
A federal judge freezes Madoff's assets.
• 15 December 2008
A federal judge appoints a trustee to find funds to restore to Madoff's victims,
who number roughly 4,800 in the US and abroad.
• 17 December 2008
Madoff's wife surrenders her passport. He is confined to his luxurious $7m
Manhattan apartment and ordered to wear an electronic tag after failing to find anyone
outside his family willing to guarantee his $10m bail.
• 15 January 2009
Financial services regulators say no evidence exists that Madoff ever traded a
single share on behalf of his investment clients, in more than 40 years of examining his
books.
• 12 March 2009
Madoff jailed after pleading guilty to all 11 charges against him.
• 14 March 2009
Madoff appeals for bail and reveals his wife's huge fortune.
• 16 March 2009
US authorities to seize $69m of assets held in Ruth Madoff's name, including a
Manhattan penthouse and $17m bank account
• 18 March 2009
Madoff accountant, David Friehling, charged with fraud as prosecutors claim he
helped deceive investors by rubber-stamping accounts for 17 years.
Statement of the problem
• The counter-party credit exposures for UBS and Merill would be too large for
these firm credit departments to approve. The SEC should ask BM for trade
tickets showing he has traded OTC options thru these two firms.
Then the SEC should visit the firms’ OTC derivatives desks, talk to the
heads of trading and ask to see BM’s trade tickets. Then ask the director of
operations to verify the tickets and ask to see the inventory of all of the stock
and listed options hedging the OTC puts and calls.
• It is mathematically impossible for a strategy using index call options and
index put options to have such a low correlation to the market where its
returns are supposedly being generated from. The strategy depicted retains
100% of the single-stock downside risk since they own only index put options
and no single stock put options
• Madoff does not allow performance audits. One London based hedge
fund, fund of funds, representing Arab money, asked to send in a
team of Big 4 accountants to conduct a performance audit during
their planned due diligence.
Analysis of the case
• The method of the scam was a classic Ponzi scheme. The Ponzi scheme
generates returns for older investors by acquiring new investors. This was
basically how the advisory and investment management division of Bernard
L. Madoff investment securities LLC operated.. When a customer made an
investment, he simply put the money into a bank account, and when asked for
a withdrawal he took the money piled up in that account. Withdrawals were
simply covered by new investments.
• Madoff used a variety of techniques that made it difficult to disclose the scam.
At the end of each month Madoff sold all stocks and financial instruments so
that the hedge fund only reported the amount of cash to the authorities.
Further on, investors did not have any online access to their investments,
instead they received a mail with their account information and balance each
month
Alternative courses of action
• One of the most important ones is redoing the complaint system. By
following up complaints as they arrive, the SEC will hopefully be
able to detect Ponzi schemes much earlier. In the case of Madoff’s
scheme, the case would have been resolved much quicker if tips
would have been handled better.
Another issue for the SEC is that there was a lack of knowledge in
finance within the organization. This is a problem since they need to
be able to detect schemes made by people with far more superior
knowledge in the field.
Recommendations
• The errors and ignorance at the SEC is still the only variable proven to
enable the Madoff fraud to continue over a decade. There were probably
more factors that mattered, like corruption and loopholes therein. However,
the most immediate actions to prevent similar events of occurring must take
place internally in the commission.
• The enhancement of the SEC and maybe the start of specialized regulators
seem to be the right way to prevent future frauds, but if the risk can be fully
eliminated is for the future to find out
Conclusions
• The systemic failure of numerous Madoff investors, who arguably are
sophisticated investors, to conduct due diligence may not be an isolated
event. It illustrates the general failure of sophisticated investors to conduct
due diligence on privately offered securities transactions—a problem that is
not restricted to offerings of financial instruments or pooled investment
vehicles, such as hedge funds, but can also exist with investments in
“operating” companies
• Another move taken by the SEC is “Improving Risk Assessment
Capabilities” which means that they improve methods and strategies to
better identify what risks there are for the investors in different areas. This
way, it’s easier to find the firms that may need an inspection and therefore
also a greater chance to find the firms which isn’t following the law.