Securities Law Blog

Bernard Madoff, one of Wall Street's best-known brokers and money managers, arrested last week after allegedly confessing to his sons that he had stolen millions, perhaps billions, of their clients' money. The whole thing was—as the criminal complaint quotes Madoff saying—"basically, a giant Ponzi scheme" in which investors who wanted their money back got paid with earlier investors' money. It is fitting that Madoff bilked investors in Boston, New York City and Palm Beach, Florida. Charles Ponzi-who didn't originate but certainly perfected the bilking techniques used by Madoff, was based in Boston, ripped off investers there and in Florida--and the federal government couldn't figure out what he was doing. This is from Ponzi's Wikipedia entry:

On November 1, 1920, Ponzi pleaded guilty to mail fraud, this was pre-federal securities law violations, and was sentenced to five years in federal prison. He was released after three and a half years to face state charges. He was again found guilty and sentenced to nine years. Before entering state prison, Ponzi jumped bail and fled to Florida, where he set up an investment scam to sell "prime Florida property" to gullible investors. The Florida authorities quickly learned of this scheme so he fled to Texas, where he shaved his head, grew a mustache, and tried to flee the country as a crewman on a merchant ship. However, he was caught and sent back to Massachusetts to serve out his prison term.

In the meantime, government investigators tried to trace Ponzi's convoluted accounts to figure out how much money he had taken and where it had gone. They never managed to untangle it and could conclude only that millions had gone through his hands.

There's no shortage of cases in which shady stock brokers, investment advisers and hedge-fund managers have disappeared with hundreds of millions of dollars, but the size of this investment fraud is well beyond anything in Wall Street memory. The amount of money involved—reported widely at $50 billion --is larger than the losses that took down Bear Stearns, bigger than the $7 billion in hidden losses in Societe Generale's Jerome Kerviel scandal, and these were big banks with thousands of clients. Madoff has harmed scores of individuals--and perhaps most troubling, many charitable institutions.

The question that everybody with big chunks of money parked with exclusive fund managers on Wall Street will be asking today is whether there are other possible Bernard Madoffs out there: high-profile managers who've been lying about their returns for years. The answer to this is going to be "yes," which leads to the second question of, "Is there any way to spot them?" Or, in other words: Is there a way to know whether a money manager's returns are too good to be true?

It's a question everyone wonders about but that few investors, even the big ones, ask directly, because there seems to be no way to answer it except by looking a fund manager in the eye and hoping you trust him. Ordinary intuition tells us that just by looking at a string of numbers in a fund manager's reports, there's no way to know if those numbers might be made out of whole cloth. But in fact, it turns out that there may be a good way to guess—and it could well have helped the investors who'd given their money to Madoff see what was going on earlier.

The key here is not looking just at how well Madoff seemed to perform. It's how consistently he seemed to be doing it. Stories in both the New York Times and the Wall Street Journal both noted the pattern. According to the stories, he seemed to make a return of 10 percent or 11 percent a year, year in and year out. And it wasn't just an annual return kind of thing. Almost every month, the WSJ story says, Madoff made somewhere between 0 percent and 2 percent. Hardly any losses, no really outsize gains. He reportedly said that he could consistently make those gains in an up or a down market through his "black box" method..whtever that means. The fact that some investors received no monthly statements and that others received statements that they couldn't understand should have been red flags--especially when it happened for many many years--but it didn't. Many investors quoted in the press have said that they just looked at the bottom line. Those seemed like reasonable returns and they were happy with them. Coomon sense disappeared. This is striking--many of these investors were once captians of industry--maybe even ruthless. I will bet you that they didn't build, and ultimately sell, their businesses by overlooking details. But when it came time to hand over all that hard earned money to Bernie Madoff--common sense disaapeared. Maybe it was the cult of exclusivity that Madoff created. His was a private club and you needed the proper introductions . This, by the way, was a tenet of Charles Ponzi. To conduct any good investment fraud, in Boston, Florida, or New York, you have to create demand. Tell an investor he can't get in, and he wants it even more. And then you have him. As The Wall Street Journal reported:

Details emerged Friday of how Mr. Madoff ran the alleged scam, fostering a veneer of exclusivity and creating an A-list of investors that became his most powerful marketing tool. From New York and Florida to Minnesota and Texas, the money manager became an insider's choice among well-heeled investors seeking steady returns. By hiring unofficial agents, tapping into elite country clubs and creating "invitation only" policies for investors, he recruited a steady stream of new clients.

During golf-course and cocktail-party banter, Mr. Madoff's name frequently surfaced as a money manager who could consistently deliver high returns. Older, Jewish investors called Mr. Madoff " 'the Jewish bond,' " says Ken Phillips, head of a Boulder, Colorado, investment firm. "It paid 8% to 12%, every year, no matter what."

The Madoff story is a bit of an anomaly in that, if what's in the criminal complaint is even close to accurate, he confessed to what was going on before the government came looking for an indictment. It's early to speculate about what might have motivated him, but it's a fair bet that protecting his sons, who ran the business with him, from prosecution would be high on the list of concerns.You can bet that right now, though, major investors are scrambling to crunch the numbers on other boutique managers. One thing that almost everyone on Wall Street has had drummed into them is that bad news is, in Wall Street lingo, "highly correlated": It tends to come in clusters and bunches. If one investment manager's holdings can go from $50 billion to zero overnight, it's likely there are several more multibillion-dollar blowups just waiting to rear their heads. Indeed, just a few days before the Madoff news hit, well-known New York City attorney Marc S. Dreier was accused of running a $300 million investment scam. Little has been heard of that case since Madoff was arrested. I know they say bad luck comes in threes--what about massive investment fraud? This should keep securities fraud attorneys busy for a very long time.

This information is brought to you by the Securities Attorneys at Michaels, Ward & Rabinovitz, LLP.