Weekend at Bernie’s

I. Introduction

The past few months have seen numerous financial frauds
uncovered. Two of these frauds are
particularly noteworthy. On December 11th,
2008, the largest of these financial frauds was unveiled when Bernard Madoff
admitted to a $50 billion fraud through his firm, Madoff Securities.[1] On February 17th, the Securities
and Exchange Commission (SEC) filed charges against Stanford International Bank
relating to an allegedly fraudulent $8 billion certificate of deposit (CD)
scheme.[2] Other alleged frauds have come to light,
often in highly publicized and dramatic fashion.[3] These frauds suggest something is amiss in the markets.

In the midst of the current economic crisis, these alleged
financial frauds have further destabilized a badly shaken market. While fraud is an unfortunate fact of the
market, the allegations against Madoff and Stanford paint a picture of frauds
that have reached massive proportions and that have been ongoing for
years. The intention of this article is
to examine the faults in the legal and regulatory systems that allowed for the
aforementioned frauds to exist for so long and to become so large.

II. How Madoff Made
off with Billions

In order to understand Madoff’s crime, a basic understanding
of a Ponzi scheme is necessary. A Ponzi
scheme is an illegal investment scheme offered by a promoter who promises
unrealistic returns on investment capital, depending on new investors and
reinvestment for its operation.[4] These schemes will eventually collapse, as
they will inevitably grow too large to pay off all prior investors according to
the returns.[5]

The ongoing story of Bernard Madoff’s downfall has caught
the attention of the global media. When
Madoff turned himself in and admitted his misdeeds, he was one of the most
powerful men on Wall Street. He was a
former chairman of NASDAQ. His firm was
well-respected. Yet, this titan of Wall
Street was running a multi-billion dollar Ponzi scheme.

Madoff’s story begins in the 1960s. Following a year at Brooklyn Law School, Madoff
left to pursue a career on Wall Street.[6] His firm, Madoff Investment Securities LLC, started
out matching the buyers and sellers of penny stocks in the over-the-counter
market.[7] Eventually, his firm climbed the ranks and
began trading in higher value stocks.[8] His firm was instrumental in the growth and development
of NASDAQ.[9]

Using his success as a market maker, Madoff launched an
asset management firm in the 1990s.[10] With his large social network and reputation,
Madoff built up a large investment base, to the point where his Application for
Investment Adviser Registration listed his total assets under management of
over $17 billion.[11] While the market dropped 2008, Madoff’s firm
continued to report their funds were up.[12] In spite of this, investors in Madoff’s firm
began demanding redemptions in the billions of dollars.[13] Unable to continue these returns, Madoff
admitted to running a Ponzi scheme and now finds himself facing criminal
charges.[14]

Despite these recent revelations, a cloud of suspicion had
followed Madoff’s investment firm for years. In 2000, fraud investigator Harry Markopolos contacted the SEC regarding
Madoff’s suspicious investment strategies, but was rebuffed at numerous turns.[15] In his Congressional testimony, Markpolos
said that it took him four hours of running mathematical analyses to determine
Madoff was running a fraudulent operation.[16]

Yet, the SEC never examined the investment adviser arm of
Madoff’s firm.[17] An SEC examination of the broker-dealer arm
of the firm in 2005 yielded only three minor technical violations.[18] No one knew that the firm kept several sets
of books and made numerous false disclosures despite allegations of fraud.[19]

As more information comes out about Madoff, it is clear that
he had developed a close relationship with financial regulators.[20] During his stints as NASDAQ chairman,[21]
he cultivated close relationships with NASDAQ’s internal regulators. He even boasted that he was so close to
regulators that his niece married one of the SEC’s compliance officials.[22] Essentially, the regulators’ ties to Bernard
Madoff and their ineffectiveness in handling this fraud raises serious
questions as to the quality of financial regulation in the United States.

III. Cricket
Impresario Finds Himself on a Sticky Wicket

The most recent major financial fraud to break involves R.
Allen Stanford, who is most well-known abroad for his sponsorship of cricket
series.[23] Once the SEC locates Stanford,[24] he will face charges for fraud relating to his offshore financial
operations through Stanford International Bank (SIB). According to an SEC complaint filed on
February 16, 2008, Stanford International Bank (SIB), using Stanford Group
Company (SGC) resources, sold roughly $8 billion in CDs.[25] These CDs offered “improbable” rates of
return over the past 15 years through the bank’s investment portfolio.[26] While the portfolio claimed it was invested
heavily in liquid investments, the portfolio was in fact tied up in illiquid
investments.[27] In an unusual twist, SIB’s portfolio had
exposure to losses resulting from Madoff’s fraud, despite their assertions to
the contrary.[28] One of the major red flags in this case was
raised when a lawyer for the Antiguan affiliate backed out of the case,
disaffirming everything he told authorities about the bank.[29] Shortly thereafter, federal authorities took
action.

Much like with Madoff, there were a number of concerns with
how effectively Stanford’s financial institutions were regulated. In 2007, the Financial Industry
Regulatory Authority (FINRA), a self-regulatory organization, conducted an investigation on SGC, resulting in a $10,000 fine for distributing
marketing material that misrepresented the risks associated with CDs last year.[30] The investigation was criticized for not digging
any deeper given how much of a warning sign this misrepresentation was
regarding SGC.[31] The $10,000 fine also received criticism as a
“slap on the wrist.”[32]

However, the most worrying aspect of this alleged fraud is
the offshore component. According to the
SEC complaint, SIB informed investors that Antigua’s Financial Services
Regulatory Commission audited financial statements.[33] However, in truth, a small Antiguan accounting
firm was responsible for auditing SIB’s investment portfolio.[34] Furthermore, while Stanford was ordered to
repatriate his assets and Antiguan authorities are cooperating with the SEC, it
can be enormously difficult to fully repatriate those assets to the United
States, especially in offshore jurisdictions which are financial centers.[35] As this instance illustrates, these offshore jurisdictions only make it more difficult for regulators to properly carry out their functions.

IV. Regulators, Mount
Up!

Without belaboring the point, financial regulation in the
United States needs reform. While these two alleged frauds may not be the norm within the regulatory
community, these frauds have exposed a number of financial regulatory
shortcomings. In both cases, FINRA and
the SEC looked foolish for their lack of effective oversight. These frauds went on for years, yet
regulators overlooked the red flags. Something needs to change.

Harry Markopolos’ testimony offers two interesting possibilities
for reforming financial regulation that merit discussion. One of his suggestions is to provide for an increased
regulatory role for the New York Attorney General’s Office and the Massachusetts
Securities Division, both of which he believes have done a fantastic job.[36] While these two regulators handle cases in
two of the largest financial centers in the world, there is a major problem
with this approach. In his testimony
before the United States Senate’s Committee on Governmental Affairs, former New
York Attorney General Eliot Spitzer discussed the contingent commission scandal
among insurance brokers. One of the
things Spitzer outlined in this scandal was how difficult it was for States to
effectively supervise firms that moved their operations to offshore
jurisdictions.[37]

Jurisdictional competition would be the primary difficulty
with increasing State financial regulation. Firms worried about the increased costs of regulation could simply move
their operations to other countries that provide favorable laws to them. The Massachusetts Securities Division would
have an enormously difficult time investigating financial crimes stemming from
operations overseas. The current global
economy requires the federal government’s influence, authority, and resources
to carry out these investigations overseas.

Thus, the best option Markopolos puts forth is to rebuild
the SEC. While attorneys are important
for investigating and litigating financial crimes, the SEC needs to expand its
resources to include more people who have industry experience and who have
professional expertise in areas such as finance and accounting. Giving the SEC a diverse skill set would enable
it not only to prevent frauds from becoming massive in scope, but it also would
provide it with more points of view in formulating policy. Providing compensation for attending industry
conferences and workshops would also provide enormously valuable information to
the SEC. While the SEC might still have
problems, at the very least it would have a much more skilled and capable workforce.

V. Conclusion

As this article has shown, there is not a single cause
behind the failings of United States regulators. Setting aside the question of whether
regulators are incompetent, corrupt, or somehow impeded from carrying out their
duties, the fact remains that these financial frauds are blights on the
market. What is especially disturbing
about these frauds is not that they existed, but that they went on for so long
and became so large. Red flags went
ignored.

An unsettling reality is that there are other frauds
comparable to these that are ongoing. Further revelations about these frauds will be forthcoming.  It is likely that these frauds will only
further expose the shortcomings of current financial regulatory regimes. It is abundantly clear that the Obama
Administration needs to overhaul these regimes in order to better detect,
investigate, and prosecute fraud. Rebuilding
the SEC would be a good start to restoring confidence in the markets. If President Obama does not take these
measures, Madoff’s alleged $50 billion fraud may soon look like chump change
compared to the next big fraudster who comes along.


[1] Stephen Gandel, Wall Street's Latest Downfall: Madoff Charged with Fraud, Time, Dec. 12, 2008, http://www.time.com/time/business/article/0,8599,1866154,00.html.

[2] Press Release, Sec. and Exchange Commission, SEC Charges R. Allen Stanford, Stanford International Bank, for Multi-Billion Dollar Investment Scheme (Feb. 17, 2009), http://www.sec.gov/news/press/2009/2009-26.htm.

[3] One of the more colorful stories to come out in recent months is the story of Marcus Schrenker, who was under investigation in Indiana for allegedly defrauding investors. In January, Schrenker allegedly faked his own death in a plane crash, where he sent a distress signal and parachuted from his plane to a waiting motorcycle. Pilot Pleads not Guilty in Plane Crash Death Hoax, CNN, Jan. 22, 2009, http://www.cnn.com/2009/CRIME/01/22/fugitive.pilot/index.html.

[4] Frauds and Scams, Ponzi v. Pyramid; A Comparison, http://www.fraudsandscams.com/ponzipyramid.htm (last visited Feb. 17, 2009).

[5] Frauds and Scams, Ponzi Schemes, http://www.fraudsandscams.com/ponzi.htm (last visited Feb. 17, 2009).

[6] Julie Creswell and Landon Thomas, The Talented Mr. Madoff, N.Y. Times, Jan. 24, 2009, http://www.nytimes.com/2009/01/25/business/25bernie.html?_r=1.

[7] Id.

[8] Id.

[9] Stephen Gandel, Wall Street's Latest Downfall: Madoff Charged with Fraud, Time, Dec. 12, 2008, http://www.time.com/time/business/article/0,8599,1866154,00.html.

[10] Id.

[11] Bernard L. Madoff Securities LLC, Uniform Application for Investment Adviser Registration (Form ADV), http://www.adviserinfo.sec.gov/IAPD/Content/ViewForm/ADV/Sections/iapd_AdvAllPages.aspx?ORG_PK=0262B11C0008014200BE1FE001EB5709056C8CC0&STATE_CD=&TOTAL_DRPS=2&Print=Y. It is worth noting that the information on this Form ADV may be false or misleading, meaning the $17 billion could be smaller or greater in reality.

[12] Stephen Gandel, Wall Street's Latest Downfall: Madoff Charged with Fraud, Time, Dec. 12, 2008, http://www.time.com/time/business/article/0,8599,1866154,00.html.

[13] Id.

[14] Id.

[15] Jesse Westbrook, David Scheer, and Mark Pittman, Madoff Tipster Markopolos Cites SEC's 'Ineptitude', Bloomberg, Feb. 4, 2009, http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a_UBDG13Gld0.

[16] Testimony of Harry Markopolos, CFA, CFE, Chartered Financial Analyst, Certified Fraud Examiner before the U.S. House of Representatives Committee on Financial Services at 10-11 (Feb. 4, 2009), http://www.house.gov/apps/list/hearing/financialsvcs_dem/markopolos020409.pdf [hereinafter Markopolos Testimony].

[17] Stephen Labaton, S.E.C. Image Suffers in a String of Setbacks,N.Y. Times, Dec. 15, 2008, http://www.nytimes.com/2008/12/16/business/16secure.html.

[18] Id.

[19] Joseph Major, Madoff Kept Multiple Books, False Documents: SEC, Int'l Bus. Times, Dec. 16, 2008, http://www.ibtimes.com/articles/20081216/madoff-kept-multiple-books-false-documents-sec.htm.

[20] Julie Creswell and Landon Thomas, The Talented Mr. Madoff, N.Y. Times, Jan. 24, 2009, http://www.nytimes.com/2009/01/25/business/25bernie.html?_r=1.

[21] Id.

[22] Brian Ross and Joseph Rhee, SEC Official Married into Madoff Family, ABC News, Dec. 16, 2008, http://abcnews.go.com/Blotter/WallStreet/story?id=6471863&page=1.

[23] Kara Scannell, Miguel Bustillo, and Evan Perez, SEC Accuses Texas Financier of 'Massive' $8 Billion Fraud, Wall St. J., Feb. 18, 2009, http://online.wsj.com/article/SB123489015427300943.html.

[24] Randall Mikkelsen, Stanford Whereabouts Unknown after Charges: SEC, Reuters, Feb. 18, 2009, http://www.reuters.com/article/topNews/idUSWAT01100020090218.

[25] Complaint at ¶2, Sec. and Exchange Commission v. Stanford International Bank, Ltd., Feb. 16, 2009, http://online.wsj.com/public/resources/documents/Stanfordcomplaint20090217.PDF [hereinafter Stanford Complaint].

[26] Id. at ¶¶3-4.

[27] Id. at ¶8.

[28] Id. at ¶8.

[29] David Scheer and Alison Fitzgerald, Stanford Attorney's Exit 'Screams Fraud,' Spurred SEC, Bloomberg, Feb. 18, 2009, http://www.bloomberg.com/apps/news?pid=20601087&sid=a7cCkC33mzbg&refer=home.

[30] Jesse Westbrook and Ian Katz, Finra's Stanford Probe Raises Questions on Oversight, Bloomberg, Feb. 18, 2009, http://www.bloomberg.com/apps/news?pid=20601087&sid=ahaUscXNr5wY&refer=home.

[31] Id.

[32] Id.

[33] Stanford Complaint, supra note 25, at ¶ 43.

[34] Id.

[35] See, e.g., Sec. and Exchange Commission v. Brennan, 230 F.3d
65, 68-69 (2nd Cir. 2000) (providing an overview of how easily the defendant could move money from one offshore jurisdiction to another).

[36] Markopolos Testimony, supra note 16, at 47-49.

[37] Testimony of New York State Attorney General Eliot Spitzer on Insurance Brokerage Practices before the United States Senate Committee on Government Affairs at 14-15 (Nov. 16, 2004), htt//hsgac.senate.gov/public/_files/SpitzerTestimony.pdf.

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