Corporate Governance and Regulation - Coursework Example

• The origination of the Ponzi scheme and how Madoff used it

Ponzi scheme also known as a pyramid scheme was developed and implemented by Carlo Ponzi in the 1910s (Cantoni, 2009). Carlo Ponzi has developed an illegal scam, whereas he convinced potential investors to give their money to him in order to reinvest into profitable projects that were supposed to generate higher-than-normal return rates. This return rate was given as a specific percentage and was characterized by a short-term payoff period (Gossett, 2013). Ponzi or another individual facilitator of the scheme had to convince and ensure his investors that their investment was legitimate and was recognized as a “sure deal”, whereas high returns on investment were guaranteed. In order to make the scheme work, it was necessary to attract continuously new investors whose money would be used for paying out the returns to existing investors (Gossett, 2013). As the investors saw that the scheme worked and their expectations have been proved to be real, they actively reinvested their money back with the same scammer. Moreover, positive experience and human greediness encouraged other people including family members, friends, and colleagues to invest into this “doubtful” scheme (Gossett, 2013). The key success factor of the Ponzi scheme was a continuous inflow of new investors, whose funds were used for repaying promised returns. If there are not enough new investors, the scammer fails to pay out the originally promised returns to the clients, forcing them thus to demand their money back. Thus, the scheme, being not supported by any real assets or profitable projects flies apart as a house of cards. In 1920, Carlo Ponzi was accused for scams estimated at $159 million in today’s inflated currency and was sentenced to prison (Cantoni, 2009 ). Since then Ponzi’s name has become an eponym for this type of scams, which is used till today. There were several other individuals who attempted to implement Ponzi scheme including Franklin Delano Roosevelt, Lyndon Baines, and finally, Barnard Madoff (Cantoni, 2009).

Ponzi Scheme implemented by Bernard Madoff was based on the above described Ponzi scheme, but still had some differences that enabled him to keep his scam for relatively long period of time (Gossett, 2013). Madoff used Ponzi scheme in a way of using new investors for paying out the returns to existing investors. Madoff was one of the founders of NASDAQ, and his agency was actively involved in selling and buying stocks. During the period from 1970s to early 1990s, Madoff Investment Securities was one of the leading dealers on the market (Sepinwall, 2012). However, in the 1990s, Madoff ceased stock trading on behalf of his clients but did not tell this information to his employees and investors. Instead, he ensured active trading transactions by sending to investors regular statements with average growth rate of 12% (Sepinwall, 2012). As in the Ponzi sheme, Madoff used money of new investors in order to pay off to the existing investors who decided to withdraw their investments (Sepinwall, 2012). Madoff’s returns were consistent but modest, as he did not want to raise public attention. Using his position, influence, positive reputation and connections, Madoff was able to keep a pool of wealth investors and use this money for further fraud transactions (Gossett, 2013). People believed that Madoff’s position in NASDAQ and investment knowledge were the key factors to highly profitable investment decisions. Connections to powerful people also was one of the key success factors contributing to the longevity of the scheme. Moreover, Madoff was a great marketer who sold to their investors the idea of unique knowledge, exclusiveness and strategies that were difficult for understanding to non-professional finance people (Seven Pillars Institute, n. d.).

• Corporate governance theory applied to the Madoff Ponzi case

There exist many different theories of corporate governances that provide different views and perspectives of how organizations should be managed and governed. To the case of Madoff Ponzi scheme is best applied agency theory. Agency theory is based on the relationship between a principal and an agent, whereas an agent acts on behalf of the principal in pursuit of the principal’s interest (Tricker, 2012). Thus, agent is delegated relevant authority for decision-making and management activities required for achieving the goals set by the principal (Mallin, 2012). Usually, this theory is widely applied to the relationships between shareholders (investors) and managers, whereas managers act as agents on behalf of their shareholders (principals) for maximizing shareholders’ value Shareholders provide managers with authority and decision-making power so that they could lead the organization and achieve corporate financial and non-financial goals (Tricker, 2012; Mallin, 2012). This theory also can be applied to the Madoff Ponzi scam, as in this situation, Bernard Madoff and his agency acted on behalf of its clients – investors, pursuing greater returns on investment within a short period of time. Madoff was responsible for making effective decisions in terms of stock buying and selling, thus generating higher revenues for his investors.

However, the case also illustrates so widely discussed agency theory problem that is very common for agent-principal relationships. In theory, agent should act on behalf of the principal by neglecting his personal interests and setting the top priority on the principal’s interests (Mallin, 2012; Tricker, 2012). However, in practice, investors often face with the risk that their funds will be “expropriated or wasted on unattractive projects” (Baker et al., 2010:142). Adam Smith recognized and reinforced the problem associated with “the separation of ownership and control which can easily result in directors not being careful with shareholders’ money” (cited in Abid and Ahmed, 2014: 848). Madoff Ponzi scam perfectly illustrates the agency problem, as in this case investors have given their money to Madoff’s agency and delegated the right of using these money for generating higher returns. Instead of managing investor’s funds for maximizing their wealth, Madoff has used his position in pursuit of his personal welfare. Investors were misinformed and fully unaware of what really happened to their funds. In fact, they were so confident in Madoff’s investment skills and professionalism that for long period of time nobody could even guess that they were small pieces in a big play. This scheme has resulted in high agency costs incurred by investors when the fraud burst out. Investors were blinded by the positive reputation and exclusive knowledge of Madoff, and thus they did not even put efforts in order to bridge the information asymmetries by monitoring Madoff and his activities (Shapiro, 2005).

• Reasons and motives of individuals, banks and hedge funds behind decisions to invest in the Madoff fund. The funds, banks and individuals that lost money

While investing in with Madoff agency, there could be identified and discussed different motives varying by the type and profile of investor. While the profiles of individual investors, banks and hedge funds were different, all they pursued the motive of financial wealth generation. While it is possible to argue that human greediness was the key trigger behind the strategic decision to invest with Madoff, it is also possible to refer to the guarantees, reliabilities and trustworthiness of the scammer. Referring to the analysis of individual profile of the Madoff victims carried out by Lewis (2010), it is possible to state that the majority of individual investors were at the age of 66 and older and used their funds as part of the retirement plans. People preferred to be involved in doubtful investments rather than find some other opportunities or be employed temporarily or part time (Lewis, 2010). However, among the clients of Madoff also were celebrities and famous athletes who obviously were influenced by positive feedback of other investors. Hedge funds also were greatly interested in directing funds to Madoff as they acted as intermediaries, who received enormous return in hedge fund fees (Rhee, 2009). More specifically, the financial benefits were comprised of 20% of profit and 1% of assets under management (Rhee, 2009).

Among the victims of Madoff Ponzi fraud were different types of investors, both private and public, banking institutions and funds. According to the estimates, 339 funds of funds, 59 management companies and millions of individuals from more than 40 countries invested with Madoff Agency (Lewis, 2010). One of the largest victims of Madoff’s scam was bank HSBC, whose estimated costs account for about $1 billion. HSBC provided loans for $1bn to its clients who then reinvested in total about $500m in Madoff’s scheme (Blodget, 2008). Access international and Fortis Bank were another representatives of “bank victims” that incurred $1.4 billion losses each (Blodget, 2008). Among funds that have become victims of Madoff’s venture were such well known names as Tremont Capital, Pioneer Investments, Union Bancaire Privet, Benbasset & Cie, BBVA, Fix Asset Management, Maxam Capital Management LLC and many others (Blodget, 2008). Such individual investors as Stephen Abbott (lawyer from San Francisco), Lawrence Velvel (dean of the Massachusetts School of Law), Ezra Merkin (Chairman of General Motors Corp), Norman Braman (former owner of Philadelphia Eagles), Richard Spring (former security analyst), and many other people comprised the list of individuals who lost their money by investing in the Madoff fund (Blodget, 2008).

• The US corporate governance guidelines that can safeguard investors from such schemes in the future

The Madoff Ponzi scheme has revealed significant gaps in the corporate governance and legislation that have turned out into a financial catastrophe of the 21 century. In order to safeguard themselves from such frauds in future, investors have to take some basic measures that might help to avoid losses and legal prosecutions. First of all, investors need to ask themselves basic questions: whether the seller is licensed, whether the investment is registered and what are the risks associated with a particular investment (SEC, n.d.). Furthermore, investors have to be more knowledgeable and informed about the plan promising exaggerated returns/earnings, especially when there are no investment profits or product sales (FTC, 1998). Any program under “secret plan” should be perceived not as an exclusive opportunity to generate fabulous wealth but rather be sceptically and critically perceived as potential fraud or scam. Therefore, before investing into any project, potential investors have to research the company and understand well its business and services. Once the investment is made, it is critical to keep eye on the investment and monitoring decisions and statements made by the agent.