Ethics In Business: The Bernard Madoff Investment Scandal

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The organizational leadership of Bernard Madoff Investments Securities LLC was held by Bernard Madoff himself. Madoff's charismatic leadership style included seducing friends, those in secluded groups, and even his own employees. He seduced his clients by making them to believe they were investing in something special. He would often turn people away, which helped Bernard in courting people and charities with more assets to offer. Bernard Madoff created a system which was promising high returns in short terms and was nothing else but the Ponzi scheme. The system's idea relied on funds from the new investors to pay misrepresented and extremely high returns to the existing investors. He was doing this for years; tempting billions of dollars from wealthy individuals, charities by getting them to invest in his hedge fund. And they did so because of the extremely high returns, which were promised by Madoff's firm. But if anyone would look deeply into the structure of his firm, it would definitely show that something is wrong. This is because nobody can make such big money, especially if no one else could at the time. How could one person, Madoff, who held all his clients assets, priced, and managed them. It is clearly a conflict of interest. His company was showing profits year after year, despite most of the companies having looses. In fact, Bernard Madoff's case is absolutely amazing, both in its range and in its list of investors who got caught up in it.

Bernard Madoff - Case Summary

Bernard Madoff opened his firm in 1960. His business began to grow when his father-in-law Saul Alpern, who was an accountant, came to the firm. Because there were a lot of competitive firms at that time, Madoff decided to use innovative computer information technology to spread its quotes, which later on became the NASDAQ. This technology provided his firm with a really good income and at this point his securities become the largest buying and selling "market maker" at the NASDAQ. Eventually, his scheme reached a staggering 50 billion dollars under his management. It came to an end after market conditions let to a considerable amount of redemptions when investors started to take their money back.

After Bernard Madoff, former NASDAQ chairman, was arrested on December 11, 2008, he acknowledged that his performance was nothing but the Ponzi scheme. He pled guilty to the biggest investor fraud ever committed by anyone on March 12, 2009. On June 29, 2009 Bernard Madoff was put in jail, and will spending there long 150 years.


Madoff was able to align himself with government, rich individuals, and businessmen. This empowered him to have an unlimited access to different groups of investors. Among Madoff's Ponzi scheme victims, it is easy to find wealthy individuals, charitable organizations, and its stakeholders, such as employees, communities, vendors, and government.

Investors that took the biggest losses, which was billions, because of this scheme are marked in the Wall Street Journal; among them are Fairfield Greenwich Group, Tremont Capital Management, Banco Santander, Fortis, and others.

Investors lost their money because of their lack of conscious and unwillingness to understand or realize that it is impossible to have such high returns in a legally managed investment operation. They also failed to understand that one day they could lose everything. They would rather believe in a fairy tales about high returns in short terms, without any consequences.

7 Steps

1. What are the facts of the case?

Madoff's business had obvious facts that showed he was doing a scheme. First of all, because he was being a pioneer in electronic trading, he refused to provide his clients with the on-line access to their accounts and sent out statements by mail. Though, most hedge funds in that time were e-mailing statements to their investors, in order to provide its customers with convenience and the ability to analyze their account. It should have been an important signal to investors, but it was ignored.

Secondly, Madoff's firm processed all of its trades and appeared as its own broker-dealer. This made impossible for the outside investors to verify their actual holdings. In fact, one of Madoff's unusual tactics was to get rid of his holdings by selling them at the end of the period. It helped him to avoid filing disclosures of his holdings with the SEC. As well, he was always refusing to talk to any outside audit for the reason of secrecy of his firm. This should raise questions and concerns amongst its investors, but again it did not.

The fact that Madoff's fund only had five down months since 1996 could have shown investors that Madoff's business was at least suspicious and warned them to avoid investing in his hedge fund. It is, for sure, impossible in investment or any business to have only a couple down months in more than 10 years of a company's performance.

Besides, there are some known factors that helped Madoff to commit his fraud for years, including the following:

Madoff had a good reputation in the investment field over the years.

Madoff knew how to create the aura of trust.

Madoff constantly promised high and stable returns to his investors.

2. What are the ethical issues?

In 1980s Bernard Madoff was providing payments to his brokers to perform the customers' orders through his brokerage. Later this system received a name, a "legal kickback", and because of this he became the biggest dealer in the U.S. stock market. When academics questioned the ethics of these payments, Madoff replied that those payments did not change the price that the customer received, and were a legal business transaction.

The SEC investigated Madoff's fraudulent practices and they had concerns that his firm did not show its customers' orders to other traders, but they could not find anything illegal in the period from 1999 till 2000.

As well, Madoff was too secretive about his investment performance and kept all financial statements closely protected. He usually refused to meet directly with his investors. After some time, he decided to invent a new investment method that was promising constant returns to selected investors, rather than supplying all new investors with high returns. This new innovation was too complicated for outsiders to understand. That should, for sure, raise some questions in his investors, but they did not demand any information and explanation. Of course, there were some investors in the Madoff case that used caution and could see that something is not really clear in his business, and as well because they did not want to lose their money, they removed it. And it was their best decision in regards to this fraud.

3. What are the norms, principles, & values related to the case?

The culture of a company is heavily influenced by the actions of upper-level management. Their actions are seen by workers throughout the organization and help develop a cultural norm within the company. When lower level employees witness those above them acting unethically, they will think that those actions are acceptable and the norm. This can lead to all types of unethical actions like, fact concealing, budget twisting, and many other unethical actions that were prevalent in the Madoff case.

Ethical boundaries aren't always clearly defined. The ethical action is not always perfectly obvious, placing investor's money into risky investment while trying to gain in the short term is illegal. However, if not done carefully, it could be viewed as unethical. Because of this, it is necessary to train employees in ethical decision making processes. Then they will be able to make the right decision when the ethical thing to do is not completely obvious. In addition, an ethical environment must be set by management, in order to promote good ethical decision making processes.

Making the correct decision in an ethical dilemma requires good judgment. Having a good example to follow definitely helps. However, a person's values and beliefs are important in making an ethical decision. If a decision does not seem morally right, then it is most likely not an ethical business decision. Promoting strong values and internal judgment helps employees at all levels of a company behave ethically.

4. What are the alternative courses of action?

a) It is very important to provide education to board members about financial and operational matters, as well as analyze and modify all procedures in governance policy and investment policy areas, and always to remember to avoid conflicts of interest in business practice.

b) It is also important to provide investors with company's records, for the purpose of due diligence. Inform and explain to the investors about each company's performance, even though it is a time consuming process. This effort will demonstrate a company's commitment to its investors.

5. What is the best course of action?

The best course of the action is definitely to be open and clear with investors and committed to the best practices in governance and operations. This will help the company to succeed in the competitive investment environment.

6. What are the consequences of each possible course of action?

These actions will open new horizons to interest new investors and will lead the company to profit and success.

7. What is the decision?

The shocking Madoff scandal and an unfavorable economy created challenging times for stakeholders. In order foster a competitive environment that will interest new investors, a company needs to legally make profits and always provide clients with all the information. Laws are the minimum code of conduct to which the company has to abide by. The company can always take further actions, beyond what the law requires, in order to ensure investors confidence.

"What recommendations would you make to your client about the existing 35% investment with Bernard Madoff?"

I would explain to the client that keeping 35% investment in one investing company can be very risky, especially if the company is Bernie Madoff's which is not regulated or publicly traded.

I would further advise my clients the following:

Sell off 30% investment with Bernard Madoff.

Invest 20% in equity mutual funds.

Invest 5% in equity exchange-traded funds.

Invest 5% in individual stocks.

"What recommendation would you make regarding the $100,000 they currently have in cash?"

I would advise that the $100,000 in cash cleverly would be to invest in different areas, such as in hedge fund - the $15,000, Treasuries - $25,000, mutual fund - $10,000, Madoff's fund - $10,000, and the rest $40,000 to spend on buying fixed asset.

"How would your recommendation be affected if your client tells you that they would like to give the additional $100,000 to Madoff to invest?"

My recommendation would not change if my client tells me that they would be interested in investing additional money in Madoff's fund. This is because my recommendation is based on the fundamentals of investments. However, I would spend more time explaining to my client the excessive risk they are taking by putting a significant portion of their eggs in one basket.

"With the information you have at this point in the case, is there anything else that you should do?"

Definitely, I have to inform the client of a possible risk of investing in Madoff's fund. I will present one some arguments, such as:

Bernard Madoff denied outsiders access to records.

The company hedge fund was not registered until 2006.

Madoff's fund rarely lost its value, even in times of economic downturn.

"Should you mention to your client that the $5 million in sales may draw the attention of the IRS, because of the relative size of that number compared to the rest of the return?"

Based on the AICPA's Statements on Standards for Tax Services (SSTS) and Treasury Department Circular 230, which provides authority to the Treasury allowing disbarment or suspension from practice before the IRS, it is not considered unethical to mention to my client that the $5.0 million investment sales can interest and raise questions of the IRS. Though, I should make the client aware that $5 million in sales will be a red flag for the IRS because of its relative size to the rest of the return. At the same time I would need to let the client know that any sales number must be supported by proper documentation that would unquestionably prove its validity.

As a professional tax practitioner, I would refrain from making those kinds of comments without any valid evidence. It can even be misleading to the client to give this kind of unsubstantiated advice.

"Should you discuss with your client the possibility that their account is being "churned"?"

I would not discuss with my client the possibility of the account being "churned" because it is beyond the scope of regular tax preparation. Additionally, churning, if proven can lead to prosecution of the broker since it is considered a fraudulent practice.

Churning has been labeled as a falsified practice in 1934. Churning is when stock-brokers execute a large volume of sales on their customers' accounts. Since those brokers are earning a commission on each transaction, they get paid more if they execute more transactions. So, those fraudulent brokers would carry out excessive amounts of small transactions, in order to earn their commissions, which would slowly drain the customers account. After awhile, the investor's account would be reduced because of the constant charges. Eventually, the customer's account would be drained and they would not know how it occurred, or that they had been defrauded.

In fact, if I would have suspicion that the client's account is being churned, I should disclose that to the client. Churning is illegal and unethical, and suspected churning should be addressed. I should share with the client that sometimes brokers and traders maliciously trade securities very actively in a brokerage account in order to increase brokerage commissions rather than customer profits. And in this particular case Madoff may be tempted to churn the client's account because Madoff's income is not transparent and could be directly related to the volume of trading of the client's account.

"Based on the information you have thus far in the case, what further information do you believe you need in order to prepare the tax return with regard to the Madoff investment?"

I would need following information:

The investment sale prices in order to estimate and accurately report capital gain/losses, and include the result in the gain/loss report.

The investment purchase prices in order to correctly calculate and report capital gains/losses, and include the result in the gain/loss report.

The date of the investment purchase and sale is also important in order to determine if the capital gain is short-term or long-term.

As well, I would need the following data to complete the return:

Investment sales price.

Investment purchase price.

Description of the securities purchased and sold during the year.

Gain/Loss from the options.

Market value of the open options at year-end.

For sure, in order to prepare tax return to the Madoff's investment I should obtain all necessary tax forms from Madoff's accounting firm, including a 1099B for sales, 1099DIV or 1099 INT. I cannot just rely on his accountant's explanation on how to calculate dividend and interest. Moreover, since options trading is a very complex subject I must do additional research on how to report income on options trading, and be sure that all the necessary tax forms are provided by Madoff's firm.

"We now know the Madoff investments for some period of time have been fraudulent.

Were there indicators that might have caused you to react differently with regard to your client's investment?"

There were the following indicators:

There was no online access to accounts.

There was no issuance of forms a) 1099B (for investment sales transactions), b) 1099 DIV, and c) 1099 INT.

David G. Friehling, a sole CPA practitioner, audited the hedge fund.

Madoff did not file any disclosures of his holdings to the SEC, because he was easily selling his holdings.

The business cannot have only couple down months when operating for years, it is impossible.

In other words, the Madoff case was filled with signs of fraud that could have led one to think that something was going on and changed the way the average investor feels about investing. Fraud comes in many forms, it can be as simple as taking money from a company's account, or it can become as complex as the Madoff case. In order to catch fraud in companies as complex as Mr. Madoff's, one must pay attention to more subtle signs that could point to fraud.

The transparency of Mr. Madoff's company was minimal and should have alerted someone that something was wrong. Mr. Madoff repeatedly denied outsiders access to records, which should have been available. The company's hedge fund was not registered with the SEC until late in 2006, which should have been another sign that something was amiss. This shows that Mr. Madoff had something to hide, because he did not want the SEC evaluating his hedge funds. In addition, the company's auditor was Mr. Madoff's brother-in-law, which opens the door for fraudulent activity. Auditors are supposed to be independent and definitely not family members of the company that they are auditing. This situation becomes more alarming when you consider that Mr. Madoff was frequently opposed to outside audits of any type. A family member as an auditor and a strong resistance to all other audits should have been the first sign that something fraudulent was occurring.

Funds managed by Mr. Madoff's company performed so well, that it could have been another clue to the fraud that was taking place. Forecasts were matching outcomes, in areas like earnings per share, to the point that it became unrealistic to be able to forecast that accurately. Earnings per share figures have so many variables that it is nearly impossible to predict them accurately time and time again. In 2008, one of Mr. Madoff's hedge funds, which invested in the S&P 500, gained almost 6% in value, while the S&P 500 itself was down over 35%. This was yet another clue that something in this company wasn't right. Mr. Madoffs' funds rarely lost value, even in times of economic downturn. So, while most investors were losing money in the market, Madoffs' funds continued to profit.

"With the advantage of hindsight, what additional due diligence could you have performed?"

"In regards to Financial Planning:"

A quick search on Google could have shown that Madoff's practice starting 1990s was exposed to accusations that he was front-running his investors, and the idea of this practice was to buy or sell shares before filling investors' orders. All of the articles and complaints about Madoff in the early 2000's would have been revealed as well.

Independently investors have to check the stock prices and trades on a daily basis.

Dig into the small accounting Firm that audited Madoff's Fund.

To check any Web sites in order to gain more information about his practice, such as the Financial Industry Regulatory Authority, or FINRA.

I would quickly come to the conclusion that my client should divest 100% of their investments in Madoff's fund.

"In regards to tax preparation:"

Dig further into the multi-page printout of listing of hundreds of transactions.

Request for a formal 1099B (for investment sales transactions), 1099 DIV, and 1099 INT.

Recalculate the gain/losses reported on the summary sheet.

"If you run across a similar situation in the future, do you feel any more comfortable about how to handle it?" Yes.

"Would you report such situation to SES, IRS, or other regulatory body?" Yes.

Madoff stopped trading and has been fabricating investment return of his clients during middle 1990 till 2008. He and his accomplices have committed fraud. The crime was committed based on the value of greed and a get rich quickly scheme. From the investors position, greed is also what fueled billions of dollars to be invested in Madoff's Hedge Fund.

Investors should have avoided the following:

Invest into an unregulated hedge fund.

Too little due diligence.

Higher than average returns usually cannot always be realistic.

Absence of the audit of financial statements.

Now that we know how Madoff performed his Ponzi scheme, we will able to figure out and try to avoid scheme in future, and do not forget to:

Broadly analyze the company performance.

Watch closely for warning signs.

Verify filing with the SEC.

Check for the company reputation.

6 Pillars



Though Madoff was performing the investment operations as a Ponzi scheme, but when his investors wanted to have their money back, they got it without any delays. Of course, this does not show his responsibility to all the investors, but a little percentage to those who were smart enough to withdraw their investment from his fund. Those investors definitely were aware that Madoff's firm does not conduct its business transactions according to law and ethics.

In fact, Madoff has violated mostly all 6 pillars, such as trustworthiness, respect, responsibility, fairness, caring, and citizenship. His only goal was to benefit himself and his family, while completely ignoring the well-being of others. Madoff cared little about those he harmed and only worked to better himself at the expense of others.

Therefore, from an ethical perspective, Madoff's scam was a white color crime. White color crime creates victims by establishing trust and respectability. As in this case, victims of white-color crime trusting clients, who believed there were many checks and balances certified the Madoff investment operation as legitimate. Madoff appears to be the classic white-collar criminal. He was an educated and experienced individual in a position of power, trust, respectability, and responsibility, who abused his trust of personal gains. From the inception of his investment business, he knew he was operating a Ponzi scheme and defrauding his clients. As a result, he is serving jail time and will be paying restitution for the rest of his life. In the end, he knew this day would come.