Through A Hedge Fund Accounting Essay

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Introduction

Bernard Madoff had misappropriated US$64.8 billion through a hedge fund. In promising to pay investors double-digit returns annually and with his reputation as a former non-executive NASDAQ Chairman, Madoff attracted several affluent investors. However, not a penny of investor's money was traded in the stock market. How, then, did Madoff manage to pay all his investors such high returns?

BLMIS - A Giant Ponzi Scheme

Not all investors were paid high returns. Only those investors whose money was in Bernard L Madoff Investment Securities (BLMIS) for a year were paid returns. The investments of newer clients were used to pay off the returns of his earlier clients. This is called a Ponzi scheme, named after a similar swindler, Charles Ponzi. While other Ponzi schemes run for hardly a year or so, Madoff's game perpetuated for two to four decades, arguably.

The fraud is that of purchases that were never made and of profits that were never accrued. The capital sum, which should have been used to purchase US-issued securities, was used to disburse profits. Hence, no goods or equivalents were purchased and were never, naturally, sold either.

Modus Operandi

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Despite knowing that markets fluctuate, Madoff doctored his fund's performance curve to show an upward trend 96% of the time. If he did not, he knew, once the fund went "up" enough, some investors would withdraw their money to reap returns. As this was a Ponzi scheme, returning anyone's money will result in lesser working capital. So, he cleverly fabricated an upward trend of how the fund performed.There were so-called feeder funds, wherein other investment firms would invest in BLMIS - money that belonged to their own investors. Fairfield Greenwich was one such, which fed BLMIS with US$7.5 billion of the US$14.1 billion total worth. This firm claimed it had "an unusual degree of access" checking BLMIS records before investing the huge sum.

Madoff never entertained questions from clients nor clients who questioned a lot. Charities, including universities, were targeted for they rarely withdraw their investment. Not wanting to be questioned by auditors either, Madoff hired a lean three-member firm called Freiling & Horowitz to check the books of BLMIS. This audit firm had written to AICPA every year that it does not conduct audits. Hence, Madoff hired a firm, which never conducts audits, to conduct audits. There must be some regulation that prevents such tiny firms from auditing a giant firm; BLMIS was valued at US$17 billion.

How it came to light

Markopolos, a financial fraud investigator, interpreted that if a fund performs so well that its trend is predominantly upwards, there must be either insider information influences or it is a giant Ponzi scheme, illegal either way. He mathematically proved that Madoff's returns were impossible. Having studied this fund, Markopolos wrote to SEC five times, since 2001. Then, Madoff's hedge fund showed that he had traded a certain number of options which was more than the total options available in the market. Besides, Markopolos did business with the major traders in the market, none of whom recollected ever having done business with Madoff.

Madoff paid two software professionals well to program an IBM machine such that it would generate the data that would satisfy the terms of SEC or any other regulatory body. SEC employees, Markopolos notes, who specialize in law and other areas, cannot identify fraud this way, because they lack financial industry experience. Hence, any number of reports that could be sent by external investigators like Markopolos may get rejected.

Impact on regulators

If the SEC is a robust enough regulatory body, how did it allow itself to be misled by Madoff's manipulation of accounts? Despite eight audits between 15 years, SEC said that the records at BLMIS were clean. Clearly, if a regulatory body is as gullible as one of those many investors, investors need a more fool-proof system that insulates them from burning their fingers. In 2006, however, when Madoff provided SEC officials with false information about trading registration and other details, he thought he was in trouble. Yet, so negligent and obtuse, the SEC never investigated Madoff's trading transactions. SEC missed the 29 red flags that Markopolos had raised in his report. Madoff gave up only in 2008, when he could not mobilize funds to pay an investor who suddenly demanded all of his US$10 million back. Sadly enough, SEC could not nab Madoff until he surrendered himself and confessed his crimes. Recently, SEC looked into defining better regulations to provide better protection for its investors. A bill was hence introduced in the senate, which requires hedge funds to file an annual disclosure and enhance transparency in the system. But the impact of the fraud is transnational. The EU is considering a review of their regulations governing hedge fund investments that flow in and out of the EU. This follows France's having lost at least €600 million due to this scam.

Conclusion

SEC should not stop with merely adding newer clauses but enforce against such impermissible frauds. If the following suggestions are considered, investors may receive better protection:
  1. Norms must be set with regard to the size of a client organization that an audit firm can perform an audit on. For instance, if an audit firm's largest client has only a net worth of US$1,000,000, the next biggest client they can acquire should be limited to US$1,300,000 so that audit firms systematically rise to the ability to audit bigger organization. This is because bigger organizations have more scope for fraud. Hence only experienced firms should audit bigger organizations.
  2. Whether a company's shares are sold to mutual funds or other organizations, as long as the money actually belongs to an end-investor, companies must take up the responsibility of informing these end-investors about how much share they have bought. If the Fairfield Greenwich investors were in a position to check which end-companies are their money invested in, US$7.5 billion would have been safe. Such transparency, despite difficulty, if mandated by the SEC or other regulators can help protect investors.
  3. What lawyers view as a violation of the regulations, is limited to their knowledge in financial industry dynamics. SEC must hire more professionals with financial industry experience, who not only know the laws governing trade, but also how loopholes in the framework can be abused.
  4. Due diligence must be put into action. Fairfield Greenwich never studied how Madoff's fund performed so well or its portfolio. Had they done it, the impact of the scam would have been lesser by US$7.5 billion.

References

  1. Rega, John, "Madoff Prompts EU to Review Fund Rules Enforcement" Bloomberg, 15 Jan. 2009, Online
  2. Millstone, Ken, "How Madoff Pulled It Off", CBS News, 12 Mar. 2009, Online
  3. Kroft, Steve "The Man Who Figured Out Madoff's Scheme", CBS News, 1 Mar. 2009 Online
  4. Gagnier, Monica "The Rise and Fall of Bernard L Madoff", Business Week, 12 Dec. 2008, online
  5. Grey, Barry "The Madoff scandal", World Socialist Web Site, 12 Dec. 2008, online
  6. Gendar, Alison et al "Jerome O'Hara, George Perez arrested for allegedly creating computer programs for Madoff's scam", Daily News, 13 Nov. 2009, online
  7. Arvedlund, Erin "Don't ask, don't tell", Barron's, 7 May, 2001, online
  8. Elsner, Alan "Madoff documents reveal incredulous, unfocused SEC", Reuters, 31 Oct. 2009, online
  9. Burrows, Peter "How Madoff is burning the SEC", Business Week, 31 Dec. 2008, online
  10. Barlyn, Suzanne "Madoff case raises compliance questions", The Wall Street Journal, 23 Dec. 2008, online
  11. Moyer, Liz "Can new regulation stop another Madoff?", Forbes, 1 May 2009, online
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