Bernard Madoffs Ponzi Investment Scheme - Essay Example

?Bernard Madoff Ponzi Scheme Case Introduction Bernard Madoff operated what was considered to be one of the most successful investment strategies in the world, for more than seventeen years. His embezzlement of funds came to light in December 2008, as one of the most detrimental Ponzi schemes in history. Many large private investors, sophisticated bankers, hedge funds, charitable institutions, and others have been severely impacted by the Madoff’s fraud (Gregoriou & Lhabitant, 2009a). The former director of National Association of Securities Dealers Automated Quotation System (NASDAQ), had been “pretending to operate a hedge fund that turned to be an immense house of cards” (Cherry & Wong, 2009, p.369). The fraud caused investors to lose billions of dollars, and gave rise to a crisis of confidence in the capital markets. In reality, Madoff’s funds had no investment strategy to provide “hedges” against the usual forms of risk. For over a decade, there had not even been any trading of stock. In Madoff’s Ponzi scheme, the early investors were bought off with the money from the later investors; additionally, the payouts to the early investors were used as proof of profitability, to thereby convince later investors that the returns were legitimate. The bankruptcy trustee is implementing remedial measures including a “clawback” action for the later investors to recover the profits of the early investors. Thesis Statement: The purpose of this paper is to investigate the Bernard Madoff Ponzi Scheme Case, examine the reasons for the fraud to take place over several years, identify the warning red flags missed by the investors, and the preventive and recovery measures to be adopted in Ponzi cases, besides other related aspects. Bernard Madoff’s Ponzi Investment Scheme The investment operation of Bernard Madoff was exposed in December 2008 as an extensive Ponzi scheme. The term is derived from Charles Ponzi who organized such a scam in 1919, and it denotes a fraudulent investment arrangement in which investors give cash and property to the main individual in the arrangement. While misappropriating some or all of the funds, the investment operator reports to the investors that the funds made profits. These professed amounts, and those actually paid to earlier investors are funds received from later investors. The fraud is revealed usually when a large number of investors wish to withdraw their investments at the same time, particularly when there is insufficient in-flow of money from new investors. Thus, Bernard Madoff duped investors of an estimated amount of more than $50 billion, by the time the fraudulent scheme was uncovered (Mannino, 2010). Madoff’s alleged Ponzi had a reach across the globe of more than $50 billion. The sustained durability of the fraud for nearly two decades is considered to be due to Jewish money managers, severe regulatory shortcomings including ineptitude, and probable conflicts of interest by Federal Communications Commission (FCC), Securities and Exchange Commission (SEC), and other regulators and auditors. Madoff appears to have taken actions that reveal him as an equal opportunity thief, who unashamedly misappropriated funds from close relatives and charities in his scheme (Vinod, 2009). One of the main reasons for Madoff’s attracting a wide following was that he “delivered consistently high returns with very low volatility over a long period” (Bernard & Boyle, 2009, p.3). His technique to obtain these low risk returns was to use a split-strike conversion strategy. This requires taking a long position in equities together with a short call, and a long put on equity index to lower the volatility of the position. It was eventually revealed that these returns were false. The Madoff case raises obvious questions on why it was not discovered earlier, and the reasons for investors and regulators to miss the various red flags. The need for risk management and regulation through improved capital requirements for operational risk, is evident from the implications of Madoff’s embezzlement of investors’ funds (Bernard & Boyle, 2009). The Warning Red Flags and Regulators’ Negligence in the Madoff Ponzi Case Before investing, it was necessary for investors to identify any possible concerns through operational due diligence and quantitative analysis. Some salient operational characteristics common to the best hedge funds were missing from Madoff’s investment operations (Gregoriou & Lhabitant, 2009a). Further, there were three red flags that should have been a warning to the investors and regulating agencies. Firstly, Madoff “relied heavily on offshore vehicles to sustain his investments” (Dhesi, 2010, p.1377). Second, he had been subjected to repeated inquiries from the Securities and Exchange Commission (SEC). Finally, the auditor employed by Madoff was of doubtful qualities. The Securities and Exchange Commission’s (SEC) failure relating to the collapse of and exposure of the Madoff’s fraudulent financial empire, has been attributed to bureaucratic and administrative obstacles preventing the SEC from working effectively. “The SEC is the government agency that is supposed to ferret out securities fraud” (Macey, 2010, p.667). However, ferreting being time consuming, expensive, and risky, the SEC focuses on collecting fines from a large number of cases. If the investigative right had been applied by the regulating bodies, there would have been an immediate effect on Madoff’s expansive fraud by curtailing the fraudster’s ability to employ offshore funds to raise and hide capital. The SEC should have initiated investigations in countries housing these funds, as a result of whistle-blower allegations of a Ponzi scheme, as well as the knowledge that the Madoff business model depended greatly on foreign investment into its offshore feeder funds. Further, regulators should have been present in Barbados and other financial connectivities used by Madoff for his alleged asset-hiding scheme. This may have prevented the conman from burying the funds instead of cycling them back to investors. Additionally, investors involved in hiding their own personal wealth might have refrained from investing in a fund that would potentially receive intense scrutiny. At the same time, a single change cannot remedy such extensive fraudulent operations of several billions. “However, the threat of expanded jurisdiction might increase the scale of a considered con or aid in the repatriation efforts following a con” (Dhesi, 2010, p.1378). For appearing to produce impressive investment returns, Bernard Madoff used a sophisticated Ponzi scheme, a splitstrike conversion strategy. This technique is composed of “a long equity position plus a long put and a short call” (Bernard & Boyle, 2009, p.1). The authors of the study on Madoff’s splitstrike conversion strategy, examined his returns, and compared his investment performance with what could be obtained by using a split-strike conversion strategy, based on the historical data. Analyzing the “split-strike strategy in general, and deriving expressions for the expected return, standard deviation, Sharpe ratio and correlation with the market of this strategy” (Bernard & Boyle, 2009, p.1), the researchers found that Madoff’s returns were considerably outside their theoretical boundary. Hence, the returns should have raised suspicions about Madoff’s investment operations. Fig.1. below represents the strategy followed by Madoff. It is a simple model combining a protective put and a covered call. First, a basket of stocks highly correlated to the S & P 100 index is bought. Next, sell out-of-the-money call options on the S & P 100 with a notional value similar to that of the long equity portfolio. “This creates a ceiling value beyond which further gains in the basket of stocks are offset by the increasing liability of the short call options” (Gregoriou & Lhabitant, 2009, p.7). Fig. 1. Unbundling the split-strike conversion portfolio (Gregoriou & Lhabitant, 2009, p.7) Further, by buying out-of-the-money put options on the S & P 100 with a notional value similar to that of the long equity portfolio, a floor value is created below which further declines in the value of stocks is balanced by gains in the long put options. The terminal payoff of the resulting position is illustrated in Fig. 1. above. Option traders refer to it as a “collar” or “bull spread”, and after establishing the position it can be left until the expiration date of the options approaches. This is Madoff’s split strike conversion. Collars provide some downside protection at a lower cost than that of buying puts alone. Additionally, collars are used to exploit the option skew as in a situation where at-the-money call premiums are higher than the at-the-money put premiums. “Officially, Madoff claimed to implement this strategy over short term horizons, usually less than a month” (Gregoriou & Lhabitant, 2009, p.7); while the remaining time the portfolio was professed to be in cash. Madoff promised to return 8 to 12 percent every year reliably, irrespective of market trends. A sample track record, of Fairfield Sentry Ltd. one of Madoff’s split-strike conversion strategy feeder funds, is represented by Fig. 2. below. Fig. 2. Track record of Fairfield Sentry Ltd, one of the Madoff split-strike conversion strategy feeder funds (Gregoriou & Lhabitant, 2009, p.9) Based on fees, leverage and other factors, results can vary from one feeder to another; however Madoff’s generally posted persistently smooth positive returns. “Over his “seventeen year track record, he apparently delivered an impressive total return of 557%, with no down year and almost no negative months (less than 5% of the time)” (Gregoriou & Lhabitant, 2009, p.8). Thus, the stability of this track record along with its positive skewness created the compelling argument to invest with Bernard Madoff. Though returns were not outsized, they appeared consistent and predictable. The Ponzi scheme in Madoff’s case was probably extremely difficult to detect. But, the number of due diligence red flags were considerable and unsettling; hence it should have prevented potential investors. Safeguarding Future Investments from Fraud and Ponzi Schemes By exposing corruption, conflicts of interest, and fraud, future Ponzi schemes need to be prevented. Legally permitted secrecy for the operators of hedge funds, facilitates fraud. Hence, Vinod (2009) advocates reforms for enhancing transparency in financial transactions, and in accounting and audit reports. An immediately feasible reform is the divesting of custodial and brokerage operations from financial advisors, since self-regulation does not work in the presence of conflicts of interest. Such separation through divestiture would help prevent future Ponzi schemes, and reduce broker frauds. Off-shore entities also need to be stricly regulated. Further, all managers and regulators at financial institutions should be tested for achieving a clear understanding of a few dozen tools and risk assessments in modern quantitative finance. Particularly for hedge funds which rely on proprietary models and positions, mandatory disclosure is advocated as an essential regulatory tool, permitting market participants to assess manager risks without adversely impacting manager actions. This would allow “investors to avoid operational risk” (Brown, Goetzmann, Liang & Schwarz, 2008, p.29). Mannino (2010) adds that the new Internal Revenue Service (IRS) guidelines issued through Revenue Ruling 2009-9 addresses proper tax treatment of losses from fraudulent invesment schemes. For recovering benefits that have been conferred under a claim of right, and to prevent the occurrence of unfairness, the use of “clawback” theory has been discussed by Cherry and Wong (2009). Clawbacks can be through avoidance of preferencs, avoidance of fraudulent transfers, and recovery of avoided transfers. Both intermediaries and investors are potential defendants in clawback litigation. “The clawback actions and other litigation arising out of the collapse of the Ponzi scheme orchestrated by Bernard Madoff will try to right many wrongs” (Wiener, 2009, p.237). Achieving resolution without intensifying the damage should be focused on. Writing clawbacks directly into contracts provides an important way of prospectively changing the legal landscape to protect investors and shareholders (Cherry & Wong, 2009). Conclusion This paper has highlighted the Bernard Madoff Ponzi Scheme Case, investigated the occurrence of the fraud over several years, and examined the reasons that permitted the deceptive investment scheme to operate over several years, the various red flags, the reasons why investors missed them, and the SEC’s failure to ferret out securities fraud. Further, the splitstrike conversion strategy claimed to be used by Madoff, the technique employed by Fairfield Sentry, one of Madoff’s feeder funds, and its track record were outlined. For safeguarding investments from fraud, the importance of mandatory disclosure, the need to incorporate new IRS guidelines for correcting fraud, and the use of clawback as a recovery measure written into contracts, were discussed. The collapse of Madoff’s investment scheme will serve as an expensive lesson in due diligence. Whether the investors considered the returns to be high or Madoff too respectable to resort to fraudulent practices, all the investors “chose faith over evidence” reiterate Gregoriou and Lhabitant (2009, p.8). They overlooked the red flags, the lack of salient operational features of trustworthy hedge funds, and the evidence indicating the lack of transparency in the processes. This recent case will go down in the history of investment schemes as a reminder that the reputation or the track record of a manager cannot form the basis for investment. References Bernard, C. & Boyle, P. (2009). Mr. Madoff’s amazing returns: An analysis of the split- strike conversion strategy. The University of Waterloo, Canada. Retrieved on 15th September, 2011 from: http://www.northernfinance.org/2009/program/papers/233.pdf Brown, S., Goetzmann, W. N., Liang, B., & Schwarz, C. (2008). Mandatory disclosure and operational risk: Evidence from hedge fund registration. Journal of Finance, 63(6): pp.2785-2815. Cherry, M. A. & Wong, J. (2009). Clawbacks: Prospective contract measures in an era of excessive executive compensation and Ponzi Schemes. Minnesota Law Review, 94: pp.368-417. Dhesi, N. S. (2010). The conman and the sheriff: SEC Jurisdiction and the role of Offshore financial centers in modern securities fraud. Texas Law Review, 88(6): pp. 1345-1381. Gregoriou, G. N. & Lhabitant, F. S. (2009). Madoff: A riot of red flags. EDHEC Risk and Asset Management Research Center, EDHEC Business School, Nice, France. Retrieved on 15th September, 2011 from: http://www.thehedgefundjournal.com/research/edhec/edhec9-2.pdf Gregoriou, G. N. & Lhabitant, F. S. (2009a). Madoff: A flock of red flags. The Journal of Wealth Management, 12(1): pp.89-97. Macey, J. R. (2010). The distorting incentives facing the U. S. Securities and Exchange Commission. Harvard Journal of Law and Public Policy, 33(2): pp.639-671. Mannino, L. L. (2010). IRS offers relief for investors of fraudulent investment schemes. Review of Business, 31(1): pp.84-90. Vinod, H. D. (2009). Preventing Madoff-style Ponzi enabled by Jewish reputation, Incompetent regulators and auditors. Fordham Institute of Ethics and Economic Policy. Retrieved on 15th September, 2011 from: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1320069 Wiener, T. M. (2009). On the clawbacks in the Madoff liquidation proceeding. Fordham Journal of Corporate and Financial Law, 15(1): pp.221-239. Read More