Essay on Auditing and Corporate Governance: The Bernie Madoff Scandal

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Introduction

There are many in this world who are gifted, who excel beyond the rest. They are leaders, visionaries and pioneers. A mystic all-knowing confidence surrounds their image. Bernie Madoff was one of these people. He was one of the best traders in wall street, he was wall street. His consistent investment returns made him one of the best fund managers in the world. One couldn’t just invest with Madoff, one had to know someone, be vouched for, earn the right to have their money accepted by him.

Madoff served as a chair of NASDAQ and revolutionaries the trading business. He had spent decades building his multibillion-dollar empire until one day the house of cards fell and when the dust settled all that remained was a decade of lies at $65 billion dollar it was the largest Ponzi Scheme the world had ever seen.

About Bernie Madoff

Bernie Madoff started his investment firm in 1960, he started with $5,000 that he made during the summertime as a lifeguard and another $50,000 from his father in law, in total about $480,000 in todays money. In order to compete with large investment firms Madoff turned to technology, his firm pioneered the use of electronic trading opting away from historic human traders. With this focus on technology the company was able to provide a lower cost for their services which led them to have a substantial share of market transactions. While the numbers are hard to find it’s believed that at one point 5-10% of trades in New York went through the firm.

In 1971 NASDAQ was born it came with a wave of new innovation in electronic trading today. The NASADAQ is the second largest stock exchange in the world, its where companies like Microsoft, Apple, Amazon, Google and Facebook choose to trade their shares. Bernie Madoff would go on to be the chairman of NASADAQ in the early 90’s. It was a very highly respected position but as Wall Street was caught in the mystic of Madoff, no one knew that behind the walls of Madoff’s empire, something else was happening barring one.

The Investigator

Harry Makopolos was a financial fraud investigator who back in the 90’s was working as portfolio manager at Rampart Investment Management, in 1999 his firm had caught wind that a hedge firm manager of one of their partners was consistently returning a 1-2% profit per month. This turned out to be the work of none other than Bernie Madoff. Harry Markopolos was subsequently given the task of replicating Madoff strategy at his own firm Rampart.

As Harry began reverse engineering the strategy, he had no idea that he had just stumbled upon the biggest financial scam Wall Street had ever seen. According to Harry, it took him 5 minutes of looking at Madoff’s revenue stream to realize that things just didn’t add up. Madoff’s return was too consistent, when the market went up, Madoff made a profit and when the market went down Madoff still made a profit. Harry Markopolos was adamant that Madoffs returns weren’t real. The returns seemed to be unfazed by the market conditions. There was little to no fluctuations by the market moments.

Harry had two theories; either Madoff was trading on insider information or this was all a giant Ponzi Scheme

How did the scheme work?

A Ponzi Scheme is a pretty simple concept, investors would give their money to Madoff to invest and Madoff gives them a healthy return, the return doesn’t come from actual investments. He simply gives them a small portion of their initial investment and calls that a return, eventually the money dries up, so the stock needs to be replenished. Madoff then moves on to the next investor, so the scam grows larger. On paper, the investor has the money invested in Madoff’s firm and gets a good return, in reality the money is being siphoned into Madoffs own account as well as paying off the old investors to keep the lie afloat.

The reason as to how no one than got a wind of the fraud is because Madoff knew how to lie and how to be convincing of it and besides who would dare question the man who helped build the modern wall street.

As Harry began further deconstructing Madoff’s strategy, he immediately ran into mathematical inconsistencies, for example he calculated in order to Madoff’s Strategy to work he would have to abort more options on the Chicago board of options exchange than what actually existed, in addition he couldn’t find a single transaction by Madoff’s firm on the exchange. Harry spoke with a dozen equity firm but none of them had made any trades with Madoff and this was strange.

In reality, Madoff hadn’t made a single trade since 1993 or perhaps even earlier. In 2000, Harry Markopolos took his finding to Securities and Exchange commissions (SEC), but Harry didn’t have any hard evidence against Madoff. It was just a theory and some red flags therefore an investigation wasn’t opened. But Harry wasn’t the only one who was suspicious over Madoff. When asked about the same several years later, he confirmed that several people within Wall Street had been suspicious but when asked why none of them reported anything “People in glass houses don’t throw stones”

By 2005 Markopolos had uncovered many more red flags surrounding Madoff and the SEC eventually opened an investigation in 2006 but Madoff had ties with SEC and on occasion was even called to provide advice Madoff also knew how to get around the auditors. Testimony from former staff describe how they cooled down falsified documents in the fridge so that auditors wouldn’t notice that they have been freshly printed.

The investigation was closed 11 months later due to lack of evidence and soon after Madoff audaciously praised the SEC saying, “In today’s regulatory environment, it’s virtually impossible to violate the rules”. But Madoff at this time knew that it was only a matter of time before the hypocrisy in his words would be revealed. Ironically in the end it wasn’t anything that SEC or Harry Markopolos did that caught Madoff out. Greater forces came into play.

The Downfall

On December 2008, Wall Street was eliminated in red. Trillions of dollars was wiped out from the stock market and subprime mortgages in the US toppled the global economy. In rushes of Panic people were selling their investments and cutting their losses. Madoff knew that the end was near, he knew that no new money would be pumping in his accounts and his clients asked him for their original investments back. The scam would soon be over, so Madoff pulled every string to get some new cash.

Bernie had created the firm, “Madoff Securities International” a subsidiary based in London which suspiciously had no clients. This fraudulent firm transferred 164 million Euros in November. Billionaire Carl Shapiro invested $250 million dollars at the start of December and Madoff received another $10 Million Dollar investment a few days later. Bernie Madoff had seemingly asked the whole of Wall Street for cash, dishing out 19-page Booklet detailing his new investment scheme, but it seemed nothing was enough. The withdraws were still more than what Madoff could bring in. Investors wanted their money back and now the single fact was he didn’t have the money, so finally Madoff decided to turn himself in, he didn’t try to run or hide, he simply knew that it was the end, the gap was over and $65 Billion dollars were gone and thousands of investors were left to pick up the pieces, Madoff had been running this scheme in parallel to a legitimate side business, a business in which his sons Mark and Andrew worked, he told them that he planned to give out nearly $200 million dollar bonus to the staff two months early despite the firm haemorrhaging cash amidst the global financial meltdown, his sons argued against it but Madoff had no choice but to tell them exactly why it needed to be done he told them about the Ponzi Scheme and that he was planning to turn himself in at the end of the week after the bonuses were handed out. According to his sons this was the first they had ever heard about it, fearing that they had become accomplices in their fathers’ crimes they called a lawyer and turned their father in before he distributed the bonuses.

Madoff was later arrested at home, then released on bail under house arrest, as Bernie Madoff and his wife Ruth sat at home on Christmas Eve the reality of their world falling apart sunk in Madoff would now face life imprisonment.

In the end Madoff didn’t fight, he admitted his crime, he offered his remorse but offered no excuses. $65 Billion dollars of investment had been wiped out from billionaires’ holdings to everyday people’s pension funds across the US. As if this wasn’t bad enough that the economy was in meltdown, people had now lost their savings too. Madoff pleaded guilty and within a few months was sentenced to 150 years in prison.

Today he is simply known as inmate no. 6177-054 at a medium security prison in North Carolina at age 81, he will live out the remainder of his life there. While in prison both of Madoff’s sons passed away, Mark committing suicide after the scandal and Andrew dying from cancer.

Role of Auditor

The difference between this case and other hedge fund frauds in which auditors have been held liable is that Madoff was not actually a client of any of the large auditing firms. Madoff’s firm used the small New City, N.Y., accounting firm Friehling & Horowitz — which reportedly had offices in a strip mall and had only three employees, including a secretary, an accountant and a partner in his seventies who lived in Florida. It was found that KPMG, along with the other auditors of the Madoff feeder funds , did very little to ensure and check the underlying assets of the firm.

Cindy Fornelli who is the executive director of the Center for Audit Quality, which is a Washington-based public-policy organization that represents public-company auditors, contends that all the Madoff case amounts to is a lack of sufficient regulation, not a failure of the accounting profession. ‘It is not the responsibility of the accountant for a capital-management firm to audit the underlying investments of the firms it invests in,’ says Fornelli. ‘The auditor is not in a position to test the existence of the underlying securities — especially in a fund-of-funds situation.’

References

http://nymag.com/intelligencer/2009/02/harry_markopoulos_is_testifyin.html
http://nymag.com/intelligencer/2008/12/bernie_madoff_in_todays_regula_1.html
https://ftalphaville.ft.com/2008/12/15/50445/madoff-in-todays-regulatory-environment-its-virtually-impossible-to-violate-rules/
http://content.time.com/time/business/article/0,8599,1867092,00.html

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