The Madoff Scandal

By now, you've probably heard something about this incredible story. An investment adviser named Bernard Madoff was arrested last Thursday on charges that he has been running a $50 billion Ponzi scheme (pyramid scam) for over 20 years. It's not only the size of the alleged scam that's so breathtaking, it's also the roster of clients who have been fleeced. It includes:

• Ultra-rich individuals of all sorts
• High-profile corporate executives and entrepreneurs
• A U.S. Senator who's a retired entrepreneur himself
• Leading hedge funds and other investment firms
• International banks
• Universities
• Charitable foundations

In short, the victims of Madoff's chicanery include many, many people and institutions that one would presume to be savvy investors. Yet, incredibly, none apparently bothered to look closely into actually how Madoff was running their money. They accepted at face value the bogus account reports that he supplied, unaudited by any independent outside firm. Two months ago, I offered some observations on how the financial system is based on trust. Unfortunately, con artists like Madoff frequently take advantage of this culture of trust, as well as the excessive greed that grips some investors.

This is not a fine hour for the SEC, which has received a variety of complaints about Madoff since 1992, but has failed to uncover any wrongdoing beyond minor, technical violations in his market-making business. Instead, the SEC named him to a blue-ribbon panel studying market structure in 2000, and frequently has invited him to participate in round-table discussions. Moreover, Madoff once served as the chairman of NASDAQ. Extremely curious is how Madoff waited until 2006 to register as an investment adviser, although he had been functioning as one for decades. Somehow, the SEC failed to notice this. Somehow, the SEC did not count it a major violation for Madoff to have skirted the law for so long.

The lead editorial in yesterday's issue of The Wall Street Journal made some very cogent points.

• Police can't stop every burglary, and regulators won't prevent every fraud.
• Crooks will always be among us, and it's naive to believe that a new law or regulation can make them go away.
• Too many investors, even supposedly smart ones, forget the need for diversification and diligence.

There's also a interesting postscript here, in the legal concept of fraudulent conveyance, the transfer of stolen property. The analogy is with someone who innocently has received stolen goods, and who must return them to the rightful owners. Similarly, unsuspecting investors who cashed out of a Ponzi scheme (pyramid scheme) at a profit will have to surrender those gains to help repay other investors who suffered losses because they were left holding the bag when the music stopped. Odds are that the redistribution of these gains, however, will make up only a small fraction of the losses suffered.