The Madoff investment scandal, sometimes known as Madoffgate, was a financial scandal discovered in late 2008. In December of that year, Bernie Madoff, the former Nasdaq chairman and founder of the Wall Street firm Bernard L. Madoff Investment Securities LLC, admitted that the wealth management arm of his business was an elaborate multi-billion-dollar Ponzi scheme. Madoff founded Bernard L. Madoff Investment Securities LLC in 1960, and was its chairman until his arrest. The firm employed Madoff's brother Peter as senior managing director and chief compliance officer, Peter's daughter Shana Madoff as rules and compliance officer and attorney, and Madoff's sons Mark and Andrew. Peter was sentenced to 10 years in prison, and Mark died by suicide two years to the day after his father's arrest.
Alerted by Madoff's sons, federal authorities arrested Madoff on December 11, 2008. On March 12, 2009, Madoff pleaded guilty to 11 federal crimes and admitted to operating the largest known Ponzi scheme in history. On June 29, 2009, he was sentenced to 150 years in prison, the maximum sentence allowed, with restitution of $170billion. He died in prison in 2021. According to the original federal charges, Madoff said that his firm had "liabilities of approximately US$50billion." Prosecutors estimated the size of the fraud to be $64.8billion, based on the amounts in the accounts of Madoff's 4,800 clients as of November 30, 2008. Ignoring opportunity costs and taxes paid on fictitious profits, about half of Madoff's direct investors lost no money.Prosecutors say half of Bernie Madoff's investors lost nothing in Ponzi scheme, a September 23, 2009 article from the New York Daily News. Retrieved September 23, 2009. Harry Markopolos, a whistleblower whose repeated warnings about Madoff were ignored, estimated that at least $35billion of the money Madoff claimed to have stolen never really existed, but was simply fictional profits he reported to his clients.
Investigators determined that others were involved in the scheme. The U.S. Securities and Exchange Commission (SEC) was criticized for not investigating Madoff more thoroughly; questions about his firm had been raised as early as 1999. The legitimate trading arm of Madoff's business that was run by his two sons was one of the top market makers on Wall Street, and in 2008 was the sixth-largest. Madoff's personal and business asset freeze created a chain reaction throughout the world's business and philanthropic community, forcing many organizations to at least temporarily close, including the Robert I. Lappin Charitable Foundation, the Picower Foundation, and the JEHT Foundation.
Background
Madoff started his firm in 1960 as a penny stock trader with $5,000 , earned from working as a lifeguard and sprinkler installer, and $50,000 that he had borrowed from his in-laws . His fledgling business, which he founded with his high school sweetheart Ruth Alpern, began to grow with the assistance of his father-in-law, accountant Saul Alpern, who referred a circle of friends and their families. Initially, the firm made markets (quoted bid and ask prices) via the National Quotation Bureau's Pink Sheets. To compete with firms that were members of the New York Stock Exchange (NYSE) trading on the stock exchange's floor, his firm began using innovative computer information technology to disseminate quotes. After a trial run, the technology that the firm helped develop became Nasdaq. At one point, Madoff Securities was the largest buying-and-selling "market maker" at the Nasdaq.
He was active in the National Association of Securities Dealers (NASD), a self-regulatory securities industry organization, serving as the chairman of the board of directors and on the board of governors.
In 1992, Randall Smith of The Wall Street Journal described him as:
Several family members worked for him. His younger brother, Peter, was senior managing director and chief compliance officer, and Peter's daughter, Shana Madoff, was the compliance attorney. Madoff's sons, Mark and Andrew, worked in the trading section, along with Charles Weiner, Madoff's nephew. Andrew Madoff invested his own money in his father's fund, but Mark stopped in about 2001.
Federal investigators believe the fraud in the investment management division and advisory division may have begun in the 1970s.Campbell, Jim. Madoff Talks. 2021, McGraw-Hill, ISBN 978-1-26-045618-9, p. 199 However, Madoff himself stated his fraudulent activities began in the 1990s. Madoff's fraudulent activities are believed to have accelerated after the 2001 change from fractional share trades to decimals on the NYSE, which cut significantly into his legitimate profits as a market-maker. With fractional trades Madoff profited up to 12.5 cents per share with each trade handled by his firm, but following decimalization this bid–ask spread between sellers and buyers was reduced to as low as one cent.
In the 1980s, Madoff's market-maker division traded up to 5% of the total volume made on the NYSE. Madoff was "the first prominent practitioner" of payment for order flow, paying brokers to execute their clients' orders through his brokerage, a practice some have called a "legal kickback". This practice gave Madoff the distinction of being the largest dealer in NYSE-listed stocks in the U.S., trading about 15% of transaction volume. Academics have questioned the ethics of these payments. Madoff has argued that these payments did not alter the price that the customer received. He viewed payments for order flow as a normal business practice: "If your girlfriend goes to buy stockings at a supermarket, the racks that display those stockings are usually paid for by the company that manufactured the stockings. Order flow is an issue that attracted a lot of attention but is grossly overrated."
By 2000, Madoff Securities, one of the top traders of US securities, held approximately $300million in assets . The business occupied three floors of the Lipstick Building in Manhattan, with the investment management division on the 17th floor, referred to as the "hedge fund", employing a staff of fewer than 24. Madoff also ran a branch office in London that employed 28 people, separate from Madoff Securities. The company handled investments for his family of approximately £80million. Two remote cameras installed in the London office permitted Madoff to monitor events from New York.
After 41 years as a sole proprietorship, Madoff converted his firm into a limited liability company in 2001, with himself as the sole shareholder.
Modus operandi In 1992, Bernard Madoff explained his purported strategy to The Wall Street Journal. He said his returns were really nothing special, given that the Standard & Poors 500-stock index generated an average annual return of 16.3% between November 1982 and November 1992. "I would be surprised if anybody thought that matching the S&P over 10 years was anything outstanding." The majority of money managers actually trailed the S&P 500 during the 1980s. The Journal concluded Madoff's use of futures and options helped cushion the returns against the market's ups and downs. Madoff said he made up for the cost of the hedges, which could have caused him to trail the stock market's returns, with stock-picking and market timing.
Purported strategy Madoff's sales pitch was an investment strategy consisting of purchasing blue-chip stocks and taking options contracts on them, sometimes called a split-strike conversion or a collar. "Typically, a position will consist of the ownership of 30–35 S&P 100 stocks, most correlated to that index, the sale of out-of-the-money 'calls' on the index and the purchase of out-of-the-money 'puts' on the index. The sale of the 'calls' is designed to increase the rate of return, while allowing upward movement of the stock portfolio to the strike price of the 'calls'. The 'puts', funded in large part by the sales of the 'calls', limit the portfolio's downside."
In his 1992 "Avellino and Bienes" interview with The Wall Street Journal, Madoff discussed his supposed methods: In the 1970s, he had placed invested funds in "convertible arbitrage positions in large-cap stocks, with promised investment returns of 18% to 20%", and in 1982, he began using futures contracts on the stock index, and then placed put options on futures during the 1987 stock market crash. A few analysts performing due diligence had been unable to replicate the Madoff fund's past returns using historic price data for U.S. stocks and options on the indexes. Barron's raised the possibility that Madoff's returns were most likely due to front running his firm's brokerage clients.
Mitchell Zuckoff, professor of journalism at Boston University and author of Ponzi's Scheme: The True Story of a Financial Legend, says that "the 5% payout rule", a federal law requiring private foundations to pay out 5% of their funds each year, allowed Madoff's Ponzi scheme to go undetected for a long period since he managed money mainly for charities. Zuckoff notes, "For every $1billion in foundation investment, Madoff was effectively on the hook for about $50million in withdrawals a year. If he was not making real investments, at that rate the principal would last 20 years. But by continuing to add new (if more volatile) investments, a Ponzi scheme built on that approach could thrive long into the future. [...] By targeting charities, Madoff could avoid the threat of sudden or unexpected withdrawals."
In his guilty plea, Madoff admitted that he had not actually traded since the early 1990s, and all of his returns since then had been fabricated. However, David Sheehan, principal investigator for trustee Irving Picard, believes the wealth management arm of Madoff's business had been a fraud from the start.
Madoff's operation differed from a typical Ponzi scheme. While most Ponzi schemes are based on nonexistent businesses, Madoff's brokerage operation arm was very real. At the time of its shuttering, it handled large trades for institutional investors.
Sales methods Madoff was a "master marketer" who, throughout the 1970s and 1980s, built a reputation as a wealth manager for a highly exclusive clientele. Investors who gained access, typically on word-of-mouth referral, believed that they had entered the inner circle of a money-making genius, and some were wary of removing their money from his fund, in case they could not get back in. In later years, even as Madoff's operation accepted money from various countries through feeder funds, he continued to package it as an exclusive opportunity. People who met him in person were impressed with his apparent humility despite his reported financial success and personal wealth.
A scheme that targets members of a particular religious or ethnic community is a type of affinity fraud, and a Newsweek article identified Madoff's scheme as "an affinity Ponzi". The New York Post reported that Madoff "worked the so-called 'Jewish circuit' of well-heeled Jews he met at country clubs on Long Island and in Palm Beach." The scandal so affected Palm Beach that, according to The Globe and Mail, residents "stopped talking about the local destruction the Madoff storm caused only when Hurricane Trump came along" in 2016. The New York Times reported that Madoff courted many prominent Jewish executives and organizations and, according to the Associated Press, they "trusted [Madoff] because he is Jewish." One of the most prominent promoters was J. Ezra Merkin, whose fund Ascot Partners steered $1.8billion towards Madoff's firm.