How Madoff did it

The Ponzi fraud made fools of his investors, Wall Street, and federal regulators.

by Alyssa A. Lappen
FrontPage Magazine | Dec. 22, 2008

“The fool is obstinate, and doubteth not; he knoweth all things but his own ignorance.”
— Akhenaten (d. 1336 BCE)

No doubt, 16th century British writer Thomas Tusser (“A fool and his money are soon parted”) and 19th century showman P.T. Barnum (“There’s a sucker born every minute”) would have recognized them among an ever-rising number of glamorous clients victimized by the decades-long alleged Ponzi scam of former hedge fund manager and NASDAQ chairman Bernard Madoff. Some $50 billion evaporated, a figure also likely to grow in what may be remembered as the greatest investment fraud of all time.

Madoff is now on a collateral-secured $10 million bond, confined to his $7 million New York apartment with an electronic monitor and 24 hour daily curfew. Death threats reportedly assail the former hedge fund manager.

But the biggest fools may be at the U.S. Securities and Exchange Commission (SEC), which failed to properly police the U.S. financial markets. The Securities and Exchange Act of 1934 established rules to prevent such fraud. Observed SEC Chairman from 1937 to 1939 and Supreme Court Justice William O. Douglas, “without an SEC ‘shotgun in the closet,’ there was little incentive for an industry self-regulatory organization [SRO] to perform the unpleasant task of disciplinarian.”

The SEC long ago shelved its shotgun, too often letting financial villains escape with little or no punishment. University of Texas law professor Robert Prentice in 2002 cataloged a long history of abuses showing the need for stringent federal securities industry oversight.

Madoff was but one more case, albeit a giant one. He “kept several sets of books and false documents, and provided false information involving his advisory activities to investors and to regulators,” said SEC chairman Christopher Cox, admitting concern over possible SEC corruption. In 2007, Madoff’s niece and compliance attorney, Shana Madoff, married former SEC attorney and inspections officer Eric Swanson, who left the commission in 2006.

Over the years, plenty of fingers pointed at Madoff. The SEC could have collected sufficient evidence to lower the boom. It was certainly available.

As long ago as 1991, according to my former colleague Jack Willoughby, “the SEC charged two Florida accountants with raising $440 million in unregistered investment pools run by an unnamed broker who ultimately turned out to be Madoff. The funds were shut down.” Madoff, though, kept operating.

In 2000, a Boston securities trader and army reservist in intelligence and unconventional warfare, Harry Markopolos, alerted the SEC to his suspicions. Madoff attributed his investment prowess to buying and selling options on 30 to 35 stocks in the Standard & Poor’s 100 index, while also owning those same stocks. However Markopolos concluded, given the sums he claimed to manage, there were simply too few S&P 100 options then available to yield Madoff’s purported 12% annual returns.

After a colleague also questioned those results, Markopolos tested his thesis. The Boston trader attempted but failed to duplicate Madoff’s results, even using Madoff’s supposed market-neutral, “collar” or “split-strike conversion,” methodology. So Markopolos bought Standard & Poor’s 100 Index puts (rights to sell specific stock at a certain price on a set date) and sold out-of-the-money calls (rights to buy stock at set, higher-than-market price on a certain date) for the blue-chip stocks he also owned. The idea was to limit gains on a stock while preventing steep share price declines, thus producing good returns regardless of the market environment. No dice. The strategy did not work as Madoff claimed.

Markopolos then consulted Boston financial mathematician Daniel DiBartolomeo. He confirmed that Madoff’s strategy could literally not achieve his purported results. Markopolos and DiBartolomeo were not alone. In 2001, Barron’s reported that Madoff competitors, and some former investors had also likewise determined the strategy did not compute. They speculated that, as a trader, Madoff probably profited by “front-running” his customers—buying stocks before them, at lower prices, and quickly selling at slight markups. Any “seasoned hedge-fund investor knows the split-strike conversion is not the whole story,” one former Madoff investor told Barron’s. “To take it at face value is a bit naive.”

Also in 2001, the London-based MAR Hedge Fund Report questioned the ability of Madoff’s “feeder” Fairfield Sentry and Tremont Advisor funds “to provide such smooth returns with so little volatility.” One mutual fund with a similar method had since 1978 “experienced far greater volatility and lower returns during the same period.” It looked especially fishy, since Madoff Securities claimed to take no management fees, but to profit only from incentive fees off returns.

Meanwhile, Madoff not only managed the funds. His firm also executed commission-generating trades, and even cleared them—a clear conflict of interest. MAR cited over 15 traders, options strategists and hedge fund managers, wondering aloud why no one could match him. Former investors also disliked his secrecy, demands for asset custody and clearing, and his inability to explain specific results.

Increasingly suspicious of fraud, Markopolos continued pursuing his quarry more zealously. On Nov. 7, 2005, “under section 21A(e) of the 1934 Act” prohibiting front-running customer orders, he filed a 19-page memo entitled “The world’s largest hedge fund is a fraud.” Based on mathematical calculations concerning options and derivatives, statements from Madoff investors, Markopolos argued that Madoff ran a Ponzi scheme. He also noted that the fund was not organized as a hedge fund, but acted and traded like one, allowing third party fund of funds “to private label hedge funds” that in turn provided his broker-dealer and Electronic Communications Network (ECN) “with equity tranch funding.”

Thanks,” the SEC New York branch chief replied the same day. Whatever later transpired, Madoff continued operating.

In 2006, another warning came in. The SEC interviewed Madoff as well as former SEC official Jeffrey Tucker, who had then operated Madoff’s Fairfield Sentry “feeder” fund. The SEC concluded Fairfield Sentry “hadn’t properly disclosed to investors” Madoff’s direct control over its investments. Madoff registered, but kept operating.

Meanwhile, the SEC had foundered for decades as it empowered the financial industry to police itself through self-regulatory organizations (SRO) like the Washington, D.C.-based Financial Industry Regulatory Authority (FINRA). In 1977 the SEC blessed creation of the Securities Industry Conference on Arbitration (SICA), a group of SROs, the Securities Industry Association and “public members” to create a Uniform Code of Arbitration (UCA).

Had SEC officials considered more carefully, they might have noted the folly of trusting financial bodies and commercial institutions to protect investors while also governing themselves. Alas, the 1980s UCA code required U.S. investors, securities brokers, and their staff to accept, in advance, involuntary contracts requiring all future securities-related disputes to be resolved via binding arbitration. Even the Supreme Court played a critical role: It ratified these measures, in 1987, 1989 and 1991 decisions, mandating that even securities-related racketeering [1] charges be processed through binding arbitration.

A large percentage of those whom Madoff “exploited” were prominent Jewish community leaders and organizations, including film-maker Steven Spielberg, humanist and Holocaust survivor Elie Wiesel. publisher Mort Zuckerman. New Jersey Senator Frank Lautenberg, Hadassah and New York’s Yeshiva University. Hadassah, which runs Jerusalem’s world-famous Hadassah Hospital, lost $90 million, nearly a fifth of its $500 million endowment.

On Manhattan’s Upper East Side, Fifth Avenue Synagogue members, including synagogue chairman Ira Rennert, lost some $2 billion. That community is particular devastated since synagogue president J. Ezra Merkin’s investment firm had introduced many clients to Madoff. Merkin’s Ascot Partners lost some $1.8 billion in the fraud. Former L.F. Rothschild banker and the onetime mayor of Fort Lee, N.J., Burt Ross, also reportedly lost $5 million, virtually all of his personal financial assets.

The massive declines have now also begun to compromise FBI counter terror investigations, as the agency is forced to shift federal agents to the Madoff case, to determine how such a vast fraud escaped notice for so long.

Meanwhile, lobbyists and politicians reportedly received some $400,000 in Madoff donations over the years.

The biggest fool may have been Madoff, who inadvertently destroyed himself.

But besides his investors, the SEC and the Courts were also made to look like fools. Swift justice.

[1] Stephan Landsman, “ADR and the cost of compulsion; The Civil Trial: Adaptation and Alternatives,” Stanford Law Review, No. 5, Vol. 57, Apr. 1, 2005, Pg. 1593.
Alyssa A. Lappen is a former Senior Fellow of the American Center for Democracy, former Senior Editor of Institutional Investor, Working Woman and Corporate Finance, and former Associate Editor of Forbes. Her website is

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Alyssa A. Lappen is a U.S.-based investigative journalist. She is the former Managing Editor at the Leeb Group (2012-2017); a former Senior Fellow of the American Center for Democracy (2005-2008); and a former Senior Editor of Institutional Investor (1993-1999), Working Woman (1991-1993) and Corporate Finance (1991). She served six of her 12 years at Forbes (1978-1990) as an Associate Editor. Ms. Lappen was also a staff reporter at The New Haven Register (1975-1977). During a decade as a freelance, her work appeared in Big Peace, Pajamas Media, Front Page Magazine, American Thinker, Right Side News, Family Security Matters, the Washington Times and many other Internet and print journals. Ms. Lappen also contributed to the Terror Finance Blog, among others. She supports the right of journalists worldwide to write without fear or restriction on politics, governments, international affairs, terrorism, terror financing and religious support for terrorism, among other subjects. Ms. Lappen is also an accomplished poet. Her first full-length collection, The Minstrel's Song, was published by Cross-Cultural Communications in April 2015. Her poems have been published in the 2nd 2007 edition of Blood to Remember: American Poets on the Holocaust and both 2007 issues of Wales' award-winning Seventh Quarry: Swansea Poetry Magazine. Dozens of her poems have appeared in print and online literary journals and books. She won the 2000 annual Ruah: A Journal of Spiritual Poetry chapbook award and has received a Harvard Summer Poetry Prize and several honorable mentions.

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