Corporate Scandal: Barnard L. Madoff - Assignment Example

Corporate Scandal Contents Contents 2 Overview of the corporation 3 of Scandal 4 How did the firm manage to hide irregularities 6 Who the Scandal affected 8 Recommendations 10 References 13 Overview of the corporation Barnard L. Mardoff or Barnie Mardoff was the founder chairman of investment firm named Barnard l. Mardoff investment securities LLC. Mardoff was a Jewish by origin and was born to Sylvia and Ralph Madoff. Mr. Ralph Madoff was a plumber and stockbroker by profession and Sylvia was a home maker. Madoff founded his investment firm named Madoff investment securities LLC in 1960. Madoff started his firm with $5,000 that he had earned from his earlier job as a lifeguard and installation of sprinklers. For opening his firm Madoff took a loan of $50,000 from his father in law. The firm initially started its operations by trading penny stocks, i.e. stocks of small companies which have less market capitalization and trade below $5 in the USA market. Penny stocks are very volatile and thus very risky for the investors who investors who invest in order to reap windfall gains. Madoff’s firm did not trade on the floor of the NYSE and rather traded in the OTC market. That is Madoff’s firms helped retail brokers trade directly with each other without intervention of an exchange. Thus it helped the stock traders maintain anonymity. Initially Madoff used the quotes available through National quotation Bureau’s stock quotes. But in order to compete in a better way with the firms that traded on the floor of New York Stock Exchange the firm developed a computer application that they used to distribute information of its quotes. This technology was later used to form NASDAQ. The firm commanded a good position in the market and at one time it was the largest market maker of NASDAQ and was the 6th largest in Wall Street among the market makers. The firm also had an investment management division that was not well published. The investment management arm also did advisory functions. His firm had several of his family members on board including his brother, brother’s daughter and his two sons. Mardoff and his firm was regarded as one of the masters in the third market with their average volume of trades equaling about 9% of the volumes traded by NYSE. Description of Scandal Besides running his legitimate business Madoff investment securities LLC in 1960 which dealt with OTC trading of securities without the involvement of stock exchanges, Madoff also run an investment management firm named Ascot Partners. Through its investment management firm Madoff sought investments from various class of investors including celebrities, common man, banks, and other fund houses and promised them of steady returns. Madoff said that he was able to generate steady returns for the investors through the purchase of option contracts of blue chip companies through a strategy popularly called as collar. In a collar 1. a long position is undertaken on underlying 2. a long put option at strike price to make the floor 3. a long call option at strike price to make the ceiling The last two strategies are used for risk reversal. So in short subtracting risk reversal from a position on underlying is called as collar. In an interview with Wall street journal he revealed his investment strategy. He said that in 70s he used to place his funds in convertible arbitrage positions of large cap funds which promised a return of 18-20% returns. In the early 1980s he started using future contracts and then at the end of 1980s when stock markets crashed he started using option contracts. However other financial analysts who tried to replicate his strategy failed to generate the amount of returns he was generating. However it was only in 2008 that Mardoff revealed the reality of his investment firm. In 2008 he was faced with a withdrawal of $7 billion but he had only $300-400 million in funds (Yang, 2014). So, he was forced to disclose that his firm was a huge Ponzi scheme business and all that he ever said about investments was all but a big lie. Since the firm was in Ponzi business the business was bound to fail one day or the other. But unlike other Ponzi schemes which promise to pay the depositors unbelievable returns his fund did not make such promises. Instead his firm only promised modest returns which were slated to remain constant over the years. Ponzi schemes in general work by paying money to the old depositors from the money collected from the new depositors. The reason however for which every Ponzi scheme inventively fails someday is the following 1. The owner of the schemes takes the funds and runs away. 2. The scheme fails to attract new investors, so lack on new investments dries up the cash flow and the old investors cannot be paid. 3. Suddenly many of the investors want to withdraw money at the same time. For his investment scheme (Ponzi scheme) Madoff targeted especially the Jewish community because it was more likely that the Jewish community would believe them more than other members of the society as people belonging to same cast. Additionally Madoff had a reputation in the financial circles and unlike other Ponzi business which do not have a recognized business, Madoff had another wing to is business which was pretty much real. How Madoff actually conducted his fraud business was pretty simple. His sprawling business only had a single accountant. Two back office workers generated false trading reports for Madoff based on the returns that he predicted for each customer. In some cases returns were predicted even before actual bank account was opened. Once the return that a customer would get was determined by Madoff the executives would track a false trade from history and enter it as starting amount. Then he would search for the closing amount and enter the same so that the difference of the two amounts gave the profit that Madoff predicted. Madoff himself confessed in his guilty plea that what he did was to essentially take investor’s money and deposit into a chase account. When an investor wanted return he would withdraw it from the chase account and pay it back to the depositor. The money that he used to pay back either belonged to the same or different depositor. Like most other Ponzi schemes Madoff used an investment formula that seemed to be too complex and like a black box for the investors. The Ponzi schemes say that they would like to keep their investment strategies secret in order to protect their business. What Ponzi schemes actually do is that they give falls claims to the investors that they are slated to earn such and such returns without actually giving them any. How did the firm manage to hide irregularities Madoff was perhaps able to pull off the largest fraud in terms of amount of money scale of operations involved. Through his firm ascot partners he was able to dupe investors by close to $70 billion. The firm operated a huge Ponzi scheme and still managed to remain undetected for about 20 years. The biggest question that arises is how Madoff was able to sustain his business and SEC could not detect any irregularities in it for so many years. In fact even in 2008 would Madoff have not actually prayed guilty, his ponzi scheme would have remained undetected and thrived without any threat. In finding out the answers it seems that there are several reasons as to how Madoff could prevent his firm from getting discovered. One of the most important reasons is that unlike other Ponzi schemes which do not have any actual business, Madoff’s firm actually had a business in the form of an OTC based security trading facilitator. Madoff was highly respected as a financial expert. He helped in founding NASDAQ, was in the organizations chair for a term, he advised SEC on several matters. So the investors and regulatory authorities were pretty sure and perhaps overconfident that Madoff would not have committed any fraudulent activities. In fact they were so sure about Madoff’s integrity that they thought that due to long term association that Madoff had with security market he might know or would have devised some mechanisms to make steady gains from security market investments. Madoff did not face investors pretty often and maintained an aura of secrecy around his investment firm. Madoff additionally unlike other Ponzi schemes did not promise high returns that were unbelievable to the investors. Instead Madoff promised his investors steady returns over the period of many years (Henriques, 2011). Madoff additionally did not spread his business to every nook and corner of the society. Instead he maintained a selective and exclusive list of clients that mainly included Jewish charitable organization. The reason why Madoff targeted Jewish institution was due to the fact that Madoff himself was a Jewish. Since Jews would most likely believe another Jew more than anybody else so would be able to get many investors. The reason for targeting charitable organizations is due to the fact that these institutions would not demand the return of their amount so quickly. Madoff reportedly had a secret formula which told him and his investment arm when to buy or sell a particular security and how to make a profit out of it. Being supposedly one of the most active traders in the market he made frequent and short term investments in securities. However the supposed profit that he made from these investments was small but steady. So the investment firm of Madoff was particularly liked by non profit organizations who liked the concept of receiving steady returns over a long period of time instead of very high returns (Lenzner, 2008). Madoff also used to pay off his investors regularly in fact it may be the case that earlier investors have been totally paid off by the Madoff led organization before his official declaration that his firm was a big lie (BERENSON, 2008). Another factor that might have helped Madoff to hide his firms’ irregularities is due to the fact that he maintained good terms with the government and several senators. He used to regularly make donations to several fed candidates and committees. The fact remains that there have been several allegations against him and his firm dating back to 1999 that his business was nothing but essentially a fraud business. However Sec failed to take serious steps against the organization (Markopolos, 2010). Allegations were first raised back in 1992 by a particular firm to SEC who complained that Madoff’s activities were fraudulent. However Madoff later settled the amount and the investigations were withdrawn. A particular incident between Madoff and SEC that needs to be dealt with particular attention is the incident of Mr. Swanson of SEC and Shana Madoff. Mr. Swanson was actually reported by two of his juniors at the office of the possible irregularities at Madoff but Swanson directed then to a different field of investigations (Moyer, 2008). Mr. Swanson then went on to marry Shana Madoff. It seems from the aforementioned incidents that everything was not innocent in the relationship between SEC and Madoff and SEC might have compromised some things in the particular case of Madoff. Who the Scandal affected The Madoff investment firm had taken investments from large no. of investors’ especially Jewish charitable institutions. The investors were mostly of the Jewish community and that too included charitable organizations, other investors who had invested their life savings into the organizations, banks and other hedge funds. When the investment firm and Mr. Madoff declared that his investment arm business was just a big fat lie and that he would be unable to pay back the claims of the investors it was devastating news for many stake holders. As per as the insiders of the business are concerned Mr. Barnie Madoff faced life term for his crimes. Among his sons Mark and Andrew Madoff, Mark committed suicide by hanging himself and Andrew died of lymphoma. Several employees who previously worked in Mudoff’s firm were found guilty and criminal proceedings were initiated against them. Madoff’s wife said in a statement that she and Madoff actually tried to commit suicide by taking sleeping pills. Another accused was Peter Madoff and proceedings were also initiated against him. Among the outsiders the affected included the members and employees of SEC who were investigated for alleged irregularities and not maintaining due diligence in their proceedings against Madoff. Proceedings were also initiated against several other investment and hedge funds and investment advisors who allegedly acted as feeder funds for Madoff’s fund. The failure of Madoff led investment fund would affect hedge funds in a major way as people might lose their confidence in them and start withdrawing their money and deposits from them. This sudden withdrawal of funds by the investors and loss of faith of investors in these hedge funds may push these funds towards the edge. Faced with such crisis many more funds may be forced to close their operations and that will lead loss of money for more investors. In addition to loss of faith of investors many investors were financially collapsed due to the failure of the investment arm. Among them are both retail investors who trusted Madoff led company with their life savings and non profit organizations as well. Among the non profit organizations are Yeshiva University who depended on Madoff’s firm to help run its institution. Then there is a sterling equity which is the investment arm of the Wilpon family. The lists also include other wealthy investors who had invested in other hedge funds. These hedge funds in turn invested their funds in Madoff’s company. There are also retail investors who invested and lost everything due to Madoff. According to Wall Street journal the clients who were worst affected by Madoff Scandal spread across the length and breadth of America. The worst affected by the Madoff Scandal are as follows 1. Fairfield Greenwich Group- $7.50 billion 2. Tremont Capital Management- $3.30 billion 3. Banco Santander-$2.87 billion 4. HSBC- $ 1 billion. Figure 1 Impact of Madoff (Source: Wall Strret Journal, 2009) Other funds who have lost between $100 million and $1 billon include RBS, Nomura holdings etc. Additionally the charitable foundations who had invested with Madoff are slated to attract penalties to the tune of $1 billion. The foundations attracted penalties because they did not diversify their investments as is required by norms and invested their fund in just one particular investment firm. Not only those who were not paid back by the firm are likely to be affected though because the court ruling in this case may cause earlier investors who had been paid for by Madoff’s firm to part with the profit portion of their investments which can be distributed amongst others who haven’t received anything. Recommendations The failure of Madoff’s business has exposed several loopholes in the mechanisms employed by SEC and other regulatory authorities in the way they deal and find frauds. As seen from the case of Madoff it is clear that SEC received enough information and tipoff about the fact that Madoff’s business activities were not correct and needed to probe with proper attention. However, SEC failed in all its attempts. In light of these events there are several steps that SEC can take in order to prevent such investments from happening in future. 1. Asking questions to show proof of the holdings of assets that a particular investment arm claims that it has. 2. Investigating whether any of the board members or employees of the institution has any relation with a particular investment firm other than simple business relation. 3. Checking books of account on regular basis and with due diligence to identify any mismatches in the statement. 4. Employing the functions of Chief vigilance commissioner to look whether the employees are fair in their dealings. 5. Not letting hedge funds go unlooked only because their head of operations is respected in the financial annals. 6. Perform regular audits of financial statements. 7. Not letting the hedge fund or investment fund bosses to chair any important commission. 8. Directing the hedge fund owners to clearly describe their investment methodologies. In essence to prevent such incidents from happening in future several steps needs to be taken by the government. Steps have to be taken both by security agencies and several other government organizations in this regard to prevent such incidents from happening in future. Stricter laws need to be instituted and enforced by the law making agencies to prevent such incidents from happening in future. So this requires a change in regulatory framework by the regulatory authorities. References BERENSON, A. (2008). Even winners may lose with madoff. Retrieved from: http://www.nytimes.com/2008/12/19/business/19ponzi.html?_r=0. Henriques, D. B. (2011). The wizard of lies: bernie madoff and the death of trust. NY: Henry Holt and Company. Lenzner, R. (2008). Bernie madoffs $50 billion ponzi scheme. Retrieved from: http://www.forbes.com/2008/12/12/madoff-ponzi-hedge-pf-ii-in_rl_1212croesus_inl.html. Markopolos, H. (2010). No one would listen: a true financial thriller. NJ: John wiley and sons. Moyer, L. (2008). SEC to probe its oversight of madoff. Retrieved from: http://www.forbes.com/2008/12/16/madoff-sec-probe-biz-wall_cx_lm_1216bizmadoff.html. Wall Strret Journal. (2009). Madoffs Victims. Retrieved from: http://s.wsj.net/public/resources/documents/st_madoff_victims_20081215.html. Yang, S. (2014). 5 years ago bernie madoff was sentenced to 150 years in prison - heres how his scheme worked. Retrieved from: http://www.businessinsider.in/5-Years-Ago-Bernie-Madoff-Was-Sentenced-to-150-Years-In-Prison-Heres-How-His-Scheme-Worked/articleshow/37604176.cms. Read More