#56 - The Financial Crimes of Bernie Madoff and the Rise of Ponzi Schemes

Updated: Jun 11

-What is a Ponzi scheme -Creating the cash flow and the history of the scam -Who was entitled to compenstation -Who received compensation -Ponzi scehmes are on the rise

Much of this story was taken from CNBC - His Life and Crimes

Bernard Lawrence "Bernie" Madoff was an American financial businessman. He died 4/14/20 and he was 82. He is responsible for the largest Ponzi scheme in history. It is estimated that he took in $17.5 billion from investors. There are some that feel the Ponzi scheme should be renamed to a “Madoff” scheme.


What is a Ponzi Scheme?


It is fraud that lures investors by taking their new money and it is used to pay profits to earlier investors. All the investors believe that the money and the profits come from by way of legitimate businesses - such as investments, products or services.


This was all made famous by Charles Ponzi who back in was an Italian swindler and con artist in the U.S. and Canada. In the early 1920s he promised clients a 50% profit within 45 days or 100% profit within 90 days.


He claimed to buy discounted postal reply coupons in other countries to redeem them at face value in the United States. In reality, Ponzi was paying earlier investors by using the investments of later investors.


Madoff Making a Name for Himself


Madoff began to make a name for himself when he and his brother created

electronic trading capabilities. He pioneered after hours trading meaning that investors could trade at all hours of the day.

He was very well known for being on the forefront of technology and this helped him to become chairman of the Nasdaq in 1990 and was part of the organization in 1991 and 1993.

The Business Strategy in Two Parts

The first arm was a market making operation that brokers used to buy and sell stock. His firm made money from processing the transactions. His two sons were part of this business separate from other operations.

The second arm was his client investment business that was on a different floor. This initially started with friends and family; however, the business began to expand by referral. His mantra was to find the long term investor “buy and hold” meaning the money had a likelihood to remain invested. He eventually moved on to pension funds and other types of funds.

Creating the Cash Flow and The History of the Scam

To get major cash flow, Madoff turned to feeder funds. This is money that comes from individual investors that is pooled money to invest in other funds.

Reports are unclear; however, there is speculation that Madoff was trading legitimately; however, he lost money and this created a challenge; hence, when the feeder funds came in, it would pay money to earlier investors to keep everyone happy.

Reports say that he started his scheme in 1997 although some say that it began in 1981 based on data. By 2008, Madoff’s investors were receiving paper statements showing consistent returns showing a total fund value of $65 billion.

In the 1990’s the market was returning 20-40% and Madoff was delivering 12-15% which is fantastic compound interest. By providing consistent returns, people felt they were getting stability. This was considered as conservative and safe. Hence, no one questioned the results.

Madoff was able to achieve this by going to the newspaper and backdating trades and then reflected this information in his client statements - and this worked because he made everything up.

In September of 2008 when the financial crisis began to hit, many of Madoff’s investors panicked and wanted their money. The feeder funds that were paying other investors began to dry up.

From 1999 to 2008, Harry Markopolos had evidence suggesting Madoff was running a huge Ponzi scheme. He altered the U.S. Securities and Exchange Commission (SEC). In 2000, 2001, and 2005, he provided supporting documents, but each time the SEC basically blew him off.

Who was Entitled to Compensation

The money that people were entitled to receive in compensation was based on the money invested. Any monies that were falsified as gains was not recoverable. For example, if you invested $200,000 and your account statement says your portfolio was valued at $500,000, you could only be considered for $200,000.

If one took money out that was considered as a profit is owed back which is known as a clawback. For example, suppose that you invested $300,000 and your account statement says your portfolio was valued at $600,000. Now, during your time as a client took out $400,000; this means that you actually owe $100,000.

In the Madoff case, many investors did not have the money so they weren’t on the hook to pay it back; however, they were dismissed from the case. This means there retirement and budget planning were severely impacted.

Many lawsuits incurred over the clawbacks; however, for those that paid this money back, it helped to compensate other investors and the Justice Department. For example, Jeffry Picower who was a Madoff trustee died in 2009 and his estate gave back $7 billion.

When the dust settled, investors that made claims recovered around 70% of their money.

Who Received Compensation?

On the other hand investors that were part of the feeder funds were not entitled to compensation; however, they were entitled for money from the Madoff Victims Fund that was created by the Department of Justice. They were given $4 billion to find and assist with the victims. They also recovered funds by way of settlements with early investors and Madoff’s bank. They also raised money from the Madoff family by selling off possessions.

All told approximately $14 billion of the $17.5 billion that was invested was recovered.

Much of this story was taken from CNBC - His Life and Crimes

FYI: Their son’s claim not to have been involved but their trading business was showing profit with the help from Madoff’s side of the business.

Ponzi Schemes are not Over

According to the crowe.com, even before the pandemic, financial fraud was big business, costing victims $5 trillion annually. Since then, it has grown in new and unforeseen ways.

The Securities and Exchange Commission put out a warning in December that Ponzi scheme frauds are on the rise. That such scams would proliferate during a bull market, and amid a pandemic, were hardly a surprise to investigators.

“Fraudsters use times of uncertainty and change, such as the current COVID-19 pandemic, to lure victims into investment scams,” the SEC’s Office of Investor Education and Advocacy warned. Investors, it said, should be extra vigilant of “frauds like Ponzi schemes, fake CD [certificate of deposit] scams, bogus stock promotions, and community-based financial scams.”

The Finance Recap - Tips to Watch out for Ponzi Schemes

#1 When asking questions is not tolerated: When asking a potential financial advisor about his/her investment platform or strategy and they dodge your questions or ask for money upfront to learn more, this is a warning sign of being scammed.

#2 Always do your homework: It doesn’t matter how much you trust where the referral is from; Your job as a potential investor is to do your homework just like checking out someone on Google before dating someone. -Are they licensed independently? -What is their investment clearing house? -Do they have clientele that you can speak to? #3 The exuberant sales pitch: Beware of the “rah-rah” person that is out to recruit for the firm that is doing a sales pitch. Word of mouth is still the best method; and this leads back to doing your homework.

#4 Is the firm recognized: Is the firm listed in publications such as Forbes and Barrons that rate the top investors/firms each year? Is there a fully functional website?

#5 Understand the investment strategy: Have a grasp on how your money is being invested. Can you explain your investment strategy?

Can you point to what is performing well and what isn’t?

How is your portfolio stacking against the S&P 500?

Is it really low, really high or right in line? Where there is smoke, there is usually fire. #bloggingtips#WixBlog


Episode Link:

The Financial Crimes of Bernie Madoff and the Rise of Ponzi Schemes"


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