Fraud Examination Report

Bernard L. Madoff Investment Securities, LLC, Madoff’s $65 Billions Ponzi Scheme


Table of Content

I. Executive Summary

1. Introduction

1.1 Background story

1.2 Business Model

2. Investigation approach

2.1 Background research

2.2 Preliminary investigation

2.3 Investigation

3. Evidence gathering and analysis

3.1 Rubber-stamp — Allegation #1

3.2 Client’s Statement — Allegation #2

3.3 Market Volatility of Fairfield Sentry Limited

3.4 Net Worth Method

3.5 Link analysis

4. Recommendation

4.1 Charges and Statutory

5. Perfecting the Fraud & Recommended Controls

5.1 External Auditor

5.2 Improper client statement

5.3 Insufficient cash payment in return

6. Conclusion

Reference

Appendix

I. Glossary

II. Abbreviation


I. Executive Summary

This report provides background story, evidence gathering and analysis from Madoff’s Ponzi scheme. The methods of analysis include the investigation approach, business model, interview of victim, evidence gathering, link analysis and recommended control. Results will illustrate on how Madoff created the massive Ponzi scheme that had long-running since 1990 to 2008 and how to deter from the fraud. In particular, Ponzi scheme depends on the matter of time. For Madoff’s case was well-management that could hide under SEC radar for decades.

The report finds the mechanism of Madoff’s Ponzi. Link analysis can provide a clear image of fraudsters who were behind.

Due to the fact that some informations are not public, so there are some limitations in the report. They include:

  • Lack of confidential information of Madoff
  • Bernard L. Madoff Investment Securities ,LLC’s data is being kept secret.
  • Unable to apply Benford’s Law to company expenditure and personal level due to lack of data.
1. Introduction
1.1 Background story

Bernie and his wife, Ruth, found Bernard L. Madoff Investment Securities, LLC (“BMIS”) in 1960 and was headquartered in New York, New York. Acting as a brokerage firm, offering the trading and investment advisory service in Nasdaq Financial Market and financial security based on New York, U.S. Unlike any other Ponzi scheme, Madoff never promised a specific rate of return to his clients. It was estimated that Bernie had been running the massive Ponzi scheme since 1990s and had collapsed in December 2008 as his sons blew the whistle to the Securities Exchange and Commission. Hence, the total damage of the fraudulent was estimated at $64.8 Billions. Bernie surrendered to the authorities and was arrested on December 11, 2008. He was pleaded guilty to 11 charges and now serving 150 years prison term.

Ponzi Scheme was named after Charles Ponzi, who was the first person to commit the investment scheme to offer 50% and 100% profit by 45 days and 90 days respectively in 1920.

1.2 Business Model

Bernard L. Madoff Investment Securities, LLC provided investment advisory, wealth management for any level of investors and broker-dealer. They were a member of New York Stock Exchange (NYSE) and NASDAQ.

1.2.1 “Split-Strike Conversion” strategy

Madoff has conducted “Split-Strike Conversion” strategy for most of his client’s trading. It was a method to “buy share of companies to create a portfolio that represents a major index such as S&P 500”. When a strike price above the current index, Madoff technically could sell call options and generate profits, but it can limit gains as well. The call option premium cash will be paid off when the index falls of bought “put options” at the current index value. Hence, it will limit the loss as well and it was a legal outcome. With this strategy and testimony to back up. Madoff was able to attract more investors and manage their assets with “Split-Strike Conversion” strategy to invest in a basket of common stock.

1.2.2 Over-The-Counter (OTC)

Alongside with Split-Strike Conversion strategy, Madoff also executed the “Over-The-Counter” trading. By giving the client to be able to buy shares of small company, Madoff gained the advantage of the disclosing information of unlisted stocks. Therefore, he could engage the clients by paying no exchange fees.

1.3 Allegations

Securities Exchange and Commissions (“SEC”)’s financial regulator was alerted by financial analyst Harry Markopolos in May 2000 about Madoff’s massive Ponzi scheme. SEC had ignored Harry’s warning for several years. On December 2005, Harry raised thirty red flags with his submission to the SEC. Details of some allegations are as follows:

1.3.1 Appointed his brother-in-law’s firm to audit

Bernard Securities only allowed Friehling & Horowitz, an accounting firm based on New City, New York to perform audit. Bernie claimed that he wanted to protect his proprietary trading strategy, so he would never assigned any audit firm besides Friehling & Horowitz to perform. Hence, David Friehling was involved in rubber-stamping for misleading certified audit report and financial statement to the SEC.

1.3.2 Falsification of trading account

Fedelity Spartan account appeared in customer statement in 2008, since Fedility Spartan had been changed to Fedelity. In addition, Fedelity claimed that Madoff never had an account with them. Besides that he also purchased securities in overseas market instead of local as his client’s order. Perhaps, he never done any trades for his customers.

2. Investigation approach

U.S Securities and Exchange Commissions have rights to investigate the suspicious brokerage firm under their control. Common violations that may lead to SEC investigations below:

  • Misrepresentation or omission of important information about securities
  • Manipulating the market prices of securities
  • Stealing customers’ funds or securities
  • Violating broker-dealers’ responsibility to treat customers fairly
  • Insider trading (violating a trust relationship by trading on material, non-public information about a security)
  • Selling unregistered securities

Under Securities Exchange Act of 1934 regulations, target company and market participants in New York Stock Exchange, NASDAQ etc. are direct to SEC regulation with full cooperation under the investigation.

2.1 Background research
2.1.1 Corporate details check

To illustrate the background details of Bernard L. Madoff Investment Securities, LLC. Their bank accounts, assets under management, client’s document and statements are all concealed. In order to reveal, it is required some of powerful feature of auditing software. NUIX software is the primary approach which will be able to recover the concealed information, track bank account of BMIS. Meanwhile CAAT and ACL data analytics will be secondary approach to reveal the falsifying numbers in client’s statement compared to the existing trading data in the financial market.

2.1.2 Individual level check

Seeking for internal staff is the key to do link analysis to find those who helped Madoff creating the fraudulent scheme. An advanced OSINT tool has the ability to search in public and internal database which will allow investigator to screen through every relevant criteria such as email, staff’s profile, criminal case etc.

2.1.3 Bank statements

Payroll statements will be observed within any level of staffs with BMIS. Since obvious monthly salary to staff will take into account. Investigator may seek to link up all fraudster.

2.2 Preliminary investigation

Securities and Exchange Commission (SEC) was informed by financial analyst Harry Markopolos that Bernie Madoff was running a gigantic Ponzi scheme in 2000. SEC ignored the warning signs, perhaps they would be afraid of taking over Madoff. There could be more factors that mattered such as corruption. Thus SEC ignored, Markopolos still kept submitting relevant documents that it was impossible to gain continuously positive returns while market went down.

2.2.1 Hedge Fund Office

Finally, in January 2006, SEC launches its first investigation to find the requirement of Investment Advisors Act of 1940 of Bernard L. Madoff Investment Securities LLC (“BMIS”) between their hedge fund investors including Fairfield Greenwich Group (“FGG”). Moreover, it is set to find out if BMIS engaged in any fraud schemes. It was carried out by interviewing Madoff, his assistant and FGG’s staffs. As a result of work performed, “BMIS legally registered with Commission as an investment adviser, and FGG revised its disclosures to Investors to reflect BMIS’s advisory role”

In summary, it was found no evidence of fraud from both party against the enforcement action. Hence, Madoff was cleared and registered as investment advisor to FGG.

2.2.2 Individual Investors

Besides corporate company, Madoff was also able to attract individual investor to invest with him. In order to reach out the number of investors, investigation team would do the reverse engineering of “Social Feedback Loop” of Madoff’s strategy. Social Feedback Loop is a method to spread the words of mouth from successful investor to another in order to attract them to invest. Investigator should have reach at least five individual investors to get information on whom they invited to invest with Madoff.

Figure 1: Social Feedback Loop

2.3 Investigation
2.3.1 Interview and interrogation

Interview and interrogation would allow investigator to obtain sufficient information and evidence to arrest Madoff. Madoff’s Ponzi scheme involved in staff level within BMIS, high ranking position would be invited to interview in term of internal viewpoint. Ruth Madoff (his wife), Mark and Andrew (his sons) and Peter Madoff (his brother) as family member that possibly be his accomplice with his massive scheme are included in the interview. In addition, Harry Markopolos, a financial analyst who raised red flags to SEC would participate in order to obtain technical information regarding to his analysis data. Individual client, feed funder, and any third party that associated with Madoff would obtain the external viewpoint to the authority. It included Fairfield Greenwich Group, Friehling & Horowitz, Richard Spring etc.

In addition, three stages of interviewing technic will be adopt to this case in order to have effective process and outcome.

2.3.2 Expert witness

Their findings will absolutely unlock the mystery and mechanism of Madoff’s massive scheme. Starting from 2000, Harry Markopolos had actively presented his analysis of Madoff’s scheme to SEC with sufficient evidence. Markopolos knew probably too much about Madoff but SEC never listened to him. In fact, he would make a great expert witness to reveal the truth behind Madoff’s Ponzi scheme to the court.

2.3.2 Raid

As customer information privacy is the most priority of any brokerage firm. It would be impossible to access from inside out, investigator would hold rights and authority letter to get into BMIS’s customer-base. In addition, investigator would access to the monthly email that issued the monthly statement of customer. To identify the information of falsifying trading, it will be compared to the real trading data of specific date in the market. If some incidents are found in this process, authority can hold the rights to arrest any accomplices who created the counterfeit trading and document. Raid would be done during the interrogation of BMIS’s board and staffs. Without telling them in advance in order to leave them no chance to conceal any data. Payroll of management team will be taken into account and analyse personal income with “Net Worth Method” as a primary approach and “Benford’s Law” will be secondary approach.

2.3.3 Analysis of records

During the raid, the investigation team would come up with analytical data that can

allow SEC to identify the key measure of fraud. Screening the financial statement with auditing tool such as ACL and CAAT. ACL has the ability to track any evidence of counterfeit document. As a result of “Net Worth Method” and “Benford Law” would possible link to any significant party that involve in personal and company payment.

3. Evidence gathering and analysis
3.1 Rubber-stamp — Allegation #1

Friehling & Horowitz firm was under the investigation of American Institute of Certified Public Accountants. They involved in reporting SEC “unaudited statement” on behalf of BMIS. The firm’s name and signature appears on the “statement of financial condition” for Madoff Securities dated Oct. 31, 2006. They were against the Generally Accepted Auditing Standards (“GAAS”) as falling into the fraud and mislead the principle of profession.

3.2 Client’s Statement — Allegation #2

Under the investigation of the client’s statement that had involved in Madoff’s firm, it was reported that Madoff had never done any trading for investors. It had been falsifying the monthly statement and financial documents in order to hide the massive fraud instead and take away the investor’s money. Since customers were not able to access to their account electronically and they could only receive their monthly statement via email. Hence, this was a strength for Madoff to succeed in his fraudulent. In addition, over the counter trading methodology was carried on while the scheme which can totally support Madoff in term of hiding the financial numbers.

Table 1: Unnamed client’s statement on 30th September 2008

According to Table 1, under an investigation of client’s confidential information. It had been linked to Fidelity Spartan account which had been renamed by Fidelity. Nevertheless, Fidelity Spartan as an old name still appeared in the monthly statement. Perhaps, Fidelity reported that Madoff never had U.S. Treasury money market account with them. It concludes that Madoff had taken money for another purpose. Without accessing to electric data, investors weren’t able what their money up to.

Table 2: Customer balance under Bank of America Custodian

In table 2, there was no balance forward appeared in the very beginning of the month. As shown in the left, it was August 1st, 2004. Additionally, commas should be written after three digits number of shares in “Bought Received” column, for instance; it should be “7,986” instead of “7986” without commas.

Eventually, the numbers and formats of the statement had always forged but it still left with clue for investigator.

Table 3: Trading Slip of unnamed client

Table 3 accordingly, there was three business working days period between trading date and settlement date occured in September 2007. In fact, they should have operated the trading option through an exchange. Instead Madoff resisted that it was “over the counter” trading. In fact, the “over the counter” was rarely used for brokerage firm in Wall Street after the existing of computerised trading. In addition, there was commission charge of $18, since Bernie once said that he never charge a customer fee for asset management and profit. It could not appear in the trading slip, so it was marked to be an unusual activity that make up into Ponzi scheme.

In summary, trading accounts with Fidelity, S&P 100 had never existed within the Bernard L. Madoff Investment Securities. It has illustrated how Madoff had taken the investor’s money and conceal by depositing the cash to his own bank account.

3.3 Market Volatility of Fairfield Sentry Limited

Fairfield Sentry Limited under Fairfield Greenwich Group is founded by the partnership of Walter Noel, Andres Piedrahita and Jeffrey Tucker, were the largest feeder fund investing in Bernie’s firm. It apparently had been reported to lose $7.3 billion. It started when Madoff was introduced to Tucker and Noel in July 1989, Madoff was given the amount of $1.5 million to manage in trading market. Since then Fairfield Greenwich Group and Madoff had good relationship for 19 years and trust him to control their asset management, until the fraud collapsed. It was approximately raised $1.7 Billions fund from US and Europe investors (Carrick Mollenkamp and Sara Schaefer Muñoz, 2008, December 19). By 2008, it was assumed that Madoff had operated 48% of Fairfield Greenwich Group’s asset.

Figure 2: Market Volatility and Annual Return

Fairfield Sentry Limited was carried out in the market by “Split-Strike Conversion” of Madoff. As shown in the graph of Figure 2, their Net Asset Value moved up steadily without any impact of the market. It represented to lack of market volatility and rarely to happen. Compared to S&P 500 which was effected by the volatility, it appeared to move up and down by the time of trading and external factor and of course no risk. Hence, Madoff promises the return of 1% monthly and 10–12% yearly to Fairfield Sentry Limited.

3.4 Net Worth Method

Net Worth of Bernard Madoff and his wife, Ruth was estimated to be between $823 million and $826 millions in 2008 as below:

•Homes in Manhattan, Montauk, Palm Beach and France: $22 million.

•Cash: $17 million

•Securities: $45 million.

•Madoff’s net ownership interest in his investment business: $700 million.

•Four boats, including a 2006 yacht in France called “Bull”: $9.3 million.

•A 50% interest in a charter jet: $12 million.

•Ruth Madoff’s jewelry: $2.6 million.

•A Steinway piano and silverware in couple’s $7 million Manhattan apartment: $104,000.

Along with total liabilities of $265,000 as statement signed by Madoff on December 31, 2008 but without knowing the previous years assets own. Investigator couldn’t analyse by the “Net Worth Method” in order to find the percentage differences.

3.5 Link analysis

1. Bernard L. Madoff (Bernie), was the founder of Bernard L. Madoff Investment Securities, LLC (“BMIS”) in 1960. He was the mastermind of his massive Ponzi scheme, causing approximately $65 Billions. He was arrest on December 11th, 2008 after he confessed to his sons a day before. He was pleaded guilty to 11 felony counts on March 12,2009 and set to serve in prison for 150 years in June 29, 2009.

2. Peter B. Madoff is a brother of Bernie. They had been working beside each other over 40 years. Peter was his brother right-hand man. He was in charge of day-to-day operation of the trading firm. Peter invented the computerised trading system for his brother company. Peter was involved in the scheme by falsifying documents, lying to securities regulators and filing sham tax return, and was sentenced to 10 years in prison.

3. Frank DiPascali served as CFO and financial lieutenant of Bernard Madoff. DiPascali was the key player to run the succeed of Bernie’s scheme. He was Director of Options Trading and Chief Financial Officer of Bernard L. Madoff Investment Securities. He was recruited by Annette Bongiorno. During Bernie’s Ponzi Scheme, he was creating counterfeit documents and records in order to assist Bernie’s fraud. He was set to sentence 125 years in prison in 2009, while awaiting he has passed away due to lung cancer on May 7, 2015 at the age of 58 years old.

4. David G. Frehling, Maddoff’s listed accountant and independent auditor. As known as rubber stamper in financial statement allowing Madoff to conceal his scheme for 20 years. Frehling was potential to place 100 years in prison. He became an extraordinary cooperating witness in the stand, helping the court to reveal the truth. As his sentence is getting light, he was plead one year of home detention and one year of supervised release instead in May 2015.

5. Daniel Bonventre was executive Director of operations and as accounting, Danial had been working with Madoff since the 1960s. He involved in the scandal as increasing the financial data to yield previously nonexistent earning, as known as “Cook The Books”. He was the first one of ex employees to be sentenced to 10 years in prison.

6. Annette Bongiorno was Bernard Madoff’s long time personal secretary. She spent 40 years of her career ran the investment advisory and meanwhile a quarter of her four decades recording backdating trades for Madoff. While running the Ponzi scheme, Madoff was ordering Annette to type in the datas of trading which didn’t really exist. Annette herself never realised that she was being used for Bernie’s scheme. At the age of 66 in 2014, she was sentenced to 6 years term.

7. Joann Crupi was a Portfolio manager and oversaw Madoff’s main bank account. She was in charge of customer funds, bank loans and other money activities. She was set to face the maximum of 175 years in prison, then after the trial she was sentenced to 6 years in prison.

8. Jerome O’Hara and 9. George Perez were the programmers, involved by hiding the financial information for infrastructure the scheme and able to keep it alive. They were both convicted to assist the gigantic fraud and were sentenced 2½-year terms each.

Figure 3: Link Analysis

In summary, Madoff was a mastermind behind the fraud. Some of his employees honestly do not know that they were being used in order to create crime.

Bonventre, Bongiorno, O’Hara, Perez, Crupi and Peter are all found guilty in helping Bernie even if it was unintentional act. Key players who helped Madoff to hide the fraud for twenty years were DiPascali and Frehling. Madoff himself was pleaded guilty and served in prison for 150 years.

4. Recommendation
4.1 Charges and Statutory

STATUTORY MAXIMUM SENTENCES 
 United States v. Bernard L. Madoff

5. Perfecting the Fraud & Recommended Controls

All Ponzi scheme depends on the matter of time until it collapsed by itself or authority takes down. Madoff’s fraud was able to hide under SEC radar in two decades. With well-management of fraud and well-role play of his colleagues, so he could carry on for a very long time. On the other hand, he made some mistakes that would turn himself to the corner. There are some ways to perfect the fraud and recommended controls for Madoff’s case that could be effective as below:

5.1 External Auditor

External Auditor, Friehling & Horowitz firm had been audited Bernard L. Madoff Investment Securities from 1991 through 2008. Friehling was a certified public accountant (“CPA”) under the profession of American Institute of Certified Public Accountants (‘AICPA”). He would report directly to AICPA with any fraudulent. Instead he took himself involved his Madoff’s massive scheme by falsified the financial report to SEC and did not perform the audit regarding to Generally Accepted Auditing Standards Principle (“GAAS”). With his acknowledgement, Friehling intentionally made false statement “unaudited” in order to help Madoff.

Perfect the fraud: Madoff should engage another independent auditing firm to act as forging the financial statements. With the help of dual firms falsifying the document, it could help him to fly under SEC radar slightly longer.

Recommended control: I would recommend Securities Exchange and Commissions to set the regulation to all high ranking brokerage firm to have a reliable auditing firm, for instance, one of the Big four firms, KPMG to perform auditing for qualified statements with GAAS.

5.2 Improper client statement

Improper client statement, according to the link analysis, Frank DiPascali was only high school graduated and had no background on finance. Oppositely, he and other colleague were very helpful to Madoff in term of creating the fraud but technically he did not issue the proper client statement according to the evidence in table 2. This improper activity can lead to the investigation.

Perfect the fraud: Madoff himself would have taken care closely of any issued statement before hand and Leaving no gap for detective. Even it was not discovered by the time that he was arrested, it was still risky if any of his clients proposed to the authority.

Recommended control: Third party consultant should engage in client service in order to raise the red flag if any incident happened. Securities Investor Protection Corporation and Consumer Financial Protection Bureau should be engaging as well

5.3 Insufficient cash payment in return

Insufficient cash payment in return, In early 2000s, Madoff’s clients asked to withdraw their fund which approximately in total of $7 billion back in returns. Unfortunately for Madoff, he only had $200 million to $300 million left to give. As a result, he refused some of the requests and proceeded to pay some investors. It was assumed that $18 billions dollars went mystery. Obviously, his expenditure went to his sumptuous lifestyle.

It exceeded his own income. Then he had to run off with his investor’s money and reach the ceiling of possible return payment.

Perfect the fraud: Madoff should be more cautious with his exceeding expenditure and set the ceiling regarding to the funding resource and forecast of payment return if client request. Perhaps, he could not convert too much cash into property.

Recommended control: SEC would suspect its broker if any suspicious expense occurs. Since this area of business is sensitive and able to allow any broker to steal the money from investors. It should be red flags alerted if any broker spends quite big amount of money into any property. Hence, SEC should approach them immediately in order to remain the normal situation. Whistleblowing from household also encourage.

6. Conclusion

Madoff’s $65 Billions Ponzi scheme is the biggest case in the U.S history. He was the mastermind who perform the fraud by asking his employees to do fraudulent work without acknowledging them about the wrongdoing. He was able to hide from SEC radar for almost twenty years, it was because external auditor who submitted “unaudited financial statement” to SEC in order to conceal the fraud for him. SEC was warning in early 2000 by financial analyst, Harry Markopolos with sufficient document and analytical data that can arrest Madoff. SEC did not listen. By 2001 to 2008, he still kept alerting SEC for Madoff’s Ponzi scheme. In December 2008, Madoff confessed to his sons, Mark and Andrew. Then they decided to contact FBI and SEC. Madoff was arrested in his house on December 11th, 2008, a day after his confession. He was pleaded guilty with 11 federal folonies on March 2009 and now serving in prison for 150 years term.

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Appendix
I. Glossary

Cook the book : Cook the books is an idiom describing fraudulent activities performed by corporations in order to falsify their financial statements. Typically, cooking the books involves augmenting financial data to yield previously nonexistent earnings. Examples of techniques used to cook the books involve accelerating revenues, delaying expenses, manipulating pension plans and implementing synthetic leases. (Investopedia)

Over the counter : Over-the-counter (OTC) is a security traded in some context other than on a formal exchange such as the New York Stock Exchange (NYSE), Toronto Stock Exchange or the NYSE MKT, formerly known as the American Stock Exchange (AMEX). The phrase “over-the- counter” can be used to refer to stocks that trade via a dealer network as opposed to on a centralized exchange. It also refers to debt securities and other financial instruments, such as derivatives, which are traded through a dealer network. (Investopedia)

Ponzi Scheme : A Ponzi scheme is a fraudulent investing scam promising high rates of return with little risk to investors. The Ponzi scheme generates returns for older investors by acquiring new investors. This is similar to a pyramid scheme in that both are based on using new investors’ funds to pay the earlier backers. For both Ponzi schemes and pyramid schemes, eventually there isn’t enough money to go around, and the schemes unravel. (Investopedia)

Rubber-stamp : a person or organization that gives automatic approval or authorisation to the decisions of others, without proper consideration. (OxFord)

Split-strike conversion : A conversion is a strategy where the trader buys an underlying contract and sells an offsetting synthetic contract. (BusinessLine)

Volatility : Volatility is a statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility, the riskier the security. (Investopedia)

II. Abbreviation

AICPA : American Institution of Certified Public Accountant

BMIS : Bernard L. Madoff Investment Securities LLC

CAAT : Computer Assisted Auditing Techniques

CPA : Certified Public Accountant

FFG : Fairfield Greenwich Group

GAAP : Generally Accepted Accounting Principle

GAAS : Generally Accepted Auditing Standards

OSINT : Open Source Intelligence

OTC : Over-The-Counter

SEC : U.S. Securities and Exchange Commission


Writer: Souksawath Xaypaserth

This article dedicated to my individual assignment during my exchange program in Nanyang Business School, Nanyang Technological University, Singapore. I own the rights to publish publicly for any further study.