Introduction
Conceivably the most shocking problem facing savers in the wake of the Global Financial Crisis (GFC) has been the detection of a number of Ponzi plan around the world (Bhattacharya (2003). The latest conviction of Bernard L Madoff to 150 years in prison for his contribution in most probably the biggest, longest and most expansive Ponzi plan in times gone by (with deception in the vicinity of USD$65 billion)(Benson, 2009) brings to the fore the veracity that executive transgression is very much active and grounded the financial services industry.
As legislators set out on the unenviable journey of redesigning the regulatory structure that forms the base for the global financial system, this study advocates that such consideration must in urgency take into consideration the sufficiency and realization of present arrangements of fraud exposure. In proposing the discussion, it is my desire to zero in on the examination of performance distinctiveness of savings vehicles as a would-be red-flag pointer of fraud exposure.
It is confirmed, by means of the Madoff’s Ponzi scheme case, how a decisive assessment of a fund’s performance distinctiveness can contribute in the discovery of counterfeit tendencies. If people are to learn from the events that are still very fresh in our minds, then there is need to understand the drivers of fraud and the tell tale signs if it is to be minimized.
The analysis of the performance distinctiveness of various savings plans in the financial services industry is a traditional practice in the finance literature. Using the savings track record of an assortment of plans, these lessons have by and large narrowed down to appraising the dexterity (or otherwise) of the investment management industry. It is our conjecture that the potential for comparable investigations, used as a modus operandi within a structure of fraud exposure, has elicited moderately little consideration.
At present, even within the broader spheres of criminological investigation, fraud risk exposure remains an under-studied issue (Duffield and Grabosky, 2001). The test for stakeholders in the financial services industry is to come up with a reasoned and detailed set of tools that are methodically applied to fraud exposure in a given situation. As such, the objective of this paper it to make suggestions that could contribute to the growth of this area of learning.
Scope
This paper will look to confine itself to the Madoff’s Ponzi scheme while trying to understand whether it was possible to preempt it. With its collapse the question on many people mouths and minds was how could this have gone on for such a long time unnoticed. This paper will try to determine whether there were red-flags that were raised and if so whether they were visible or they were ignored.
Body
Recognition of Fraud-detection Factors
It is imperative to reflect on whether the evidence crucial to unearth Madoff’s Ponzi plans could only have been discovered as a consequence of a momentous distress to the market, equal in proportion and magnitude to the Global Financial Crisis. On the basis of the latest protests brought by the US Securities and Investment Commission (SEC), lawsuit records, trial papers and conclusion based on an examination into the lack of success of the SEC to unearth the Madoff plan, it is recommended that a number of indicators or red flags of deceit could have been recognized much earlier (SEC vs Madoff, 2008).
The SEC protest lists a number of operational red flags that were supposed to have been of instantaneous worry to shareholders, in addition to the function of feeder funds; the traditions of distinctiveness surrounding entry into Madoff-related funds; the unique remuneration arrangements of the feeder funds13 and the lack of base-plus-performance fees of Madoff’s operation; alleged auditor shopping by the feeder funds; and the appointment of a small accounting practice to audit Madoff’s operations. As Gregoriou and Lhabitant (2009) precisely sums-up, some of the outstanding operational features widespread among the best-of-breed hedge funds were evidently absent from Madoff’s operation.
It is highly likely fraud will be discovered more easily and fast when red-flags or tell-tale signs that are indicative of the fraud presence or higher probability of it being perpetuated are precisely recognized and the right action taken. Red flags are used to bring out glitches (discrepancies from standard patterns of behavior) (Duffield & Grabosky, 2001). In segregation, the tell-tale signs may not be a ‘smoking gun’, but may act as a medium for more comprehensive inquiry. Presently there exists minimal authoritative direction to the process of combining tell-tale signs within articulate and organized structure of risk and or exposure.
To carry this debate, one should firstly seek to analyze and understand fraud from a criminal point of view. Using the activities theory, Applying routine activities theory, transgressions happen as a result of the presence of a pumped-up criminal, the accessibility of appropriate goal and a short fall of competent protectors. Fraud is inspired by a permutation of an individual’s character and situational features.
Fraud happens when an opening for counterfeit action exists and the apparent probability of exposure is low. It has been contested that the world of finance is one that susceptible and attractive in terms of counterfeit behavior (Dunn, 2005).
Further, this background is one in which new prospects for fraudsters appear to materialize almost daily. This statement is partly based in the notion that surroundings or happenings can be classified along a fraud-risk range, with some circumstances being low risk while others embody high-risk contexts (Dunn, 2005).
Firms within the financial services industry, by their character, comprise a high-risk context where considerable prospects for fraud exist. Borrowing heavily from Cressey’s influential work on misappropriation(1955) serious financial deceit is normally committed by those who hold organizational positions that make easy the fraud within a background of legality: as often quoted, ‘the best way to rob a bank is to own one’. (Crawford cited in Black, 2005),
Organizations inside the monetary services business are eye-catching for two key motives. First, fraud carried out in such a context may entail considerable financial rewards dependent on the magnitude of the financial asset collection administered by the organization. Second, individuals within the business, predominantly senior management and chief executive officers (CEOs), can take the prospects accessible to them as a function of their justifiable control over the organizational financial asset collection to bring about fraud and protect themselves from exposure.
Therefore, it may be put across that a hearty fraud-exposure scheme – in this case, one expanded for the financial services industry – gives rise to the tailoring of the exposure scheme to this precise context, recognizing the unique types of tell-tale signs or incongruities that may be a pointer of fraudulent behavior. Grabosky and Duffield (2001) suggest that anomalies can be classified in three broad areas: behavioral, statistical and organizational.
Inconsistencies as tell-tale signs
It is the contention of this work that given the enormity and intricacy of the Madoff scandal, it is outside the scope of a single expose to consider with suitable intensity all the behavioral, statistical and organizational anomalies that make up the illustration. New research and scrutiny is being availed almost daily, especially in conventional and dedicated media outlets. To contribute to the contemporary discussion on dogmatic restructuring of the global financial structure, this paper focuses on the statistical variances relating to the Madoff case. Statistical glitches are defined as statistical incongruities.
A statistical incongruity example provided by Grabosky and Duffield is when tax subtractions in point of fact surpass a sensible percentage of earnings. As a general rule of thumb, statistical variances are those data’s or numbers that ‘stand out’ as not believable. This paper seeks statistical anomalies analysis presents an explicatory example of how particular tools selected due to their particular significance to the context being scrutinized may lead to earlier and more compelling discoveries of red flag markers of fraud.
Illustrating with the Madoff case, the critical statistical abnormality recognized is the inaptness between the equity-like profits attained over nearly twenty years of investing, with a perceptible dearth of risk. The fundamental source of data studied for this paper is the past performance of one of Madoff’s central feeder funds, the Fairfie Sentry Fund.
In this paper it is my desire to use eminent, frequently employed appraisal tools to consider the performance attributes of a Ponzi fund.
In other fields it has been highlighted that proceeds which are unusually high, have modest unpredictability and are devoid of comparability to proceeds of others using similar outlay strategies are potential red flags (Benson, 2009). Nevertheless, little leadership has been offered on the subject of the tools desirable to methodically assess these concerns and what reflection need to be considered to guarantee that the investigation which is embark on is actually suitable.
In sum, the investigation presented in this paper offers an orientation position for those mandated with undertaking due assiduousness of savings schemes. This paper further gives a set of prospective external control pointers (or red flags) that could be part of a much bigger system of fraud exposure customized to the requirements of the financial services industry. The prospective control indicators deployed take the form of expected arithmetical and quantitative tools to complement qualitative due diligence.
Conclusions and Future Directions
Adopting an expansive view of the impact of the Global Financial Crisis on the financial services industry, it is this paper’s desire to be found within an ever burgeoning body of work that has started to spotlight on what can be deduced from the present crisis that can be used to shield and avert a recurrent incidence of similar, future shocks to the global financial system. It is this papers point of view that the capability and execution of fraud exposure systems in the financial services industry be required to be addressed as a critical product of the Global Financial Crisis.
The previous examination zeroed in on the statistical inconsistency found in the Madoff case. The Madoff Ponzi scheme was used as a current case in point to demonstrate the tools and considerations that can be put to use to identify red flags of deceitful activity, and specifically the existence of a Ponzi scheme. This paper has tried to provide a solution to a one uncomplicated question; were the profits accounted for Madoff’s investment scheme basically too good to be true?
While this issue seems to be a on the face of it a simple one to answer given the study presented, the matter of standard determination and the search for a sensible alternative against which to appraise performance, remains contentious. on the other hand, it is argued that a matter-of-factly approach which take in to account peer-based and more conventional allusion rates can provide important positive insights into performance characteristics.
Lessons to be learnt: Execution of hearty Fraud-exposure Systems
It would be unwise to wrap up on the foundation of the results here that the recognition of statistical inconsistencies is the only retort to empowering existing fraud-exposure systems. Whereas the statistical tools and considerations made available in this paper are calculated to support the further growth of statistical controls in the recognition of red flags of fraud, it is accepted that this improvement must be embark on in tandem with developments to existing behavioral and organizational controls.
Substantiation of the need to embark on the concurrent assessment across these three types of inconsistent behaviors is in fact make available by the Madoff case itself.
One of the fascinating features of this case is that there were some analysts who were able to become aware of the fraud some time before its ultimate downfall. It is well written that Madoff whistleblower Harry Markopolos first sounded the distresses on the subject of the Madoff track record in 1999 (and on a number of now well documented occasions with the supervisory body over the following ten years) (AP, 2008). Hedge fund due diligence specialists Askia LLC suggested their customers not put in any money in Madoff’s feeder funds over a number of years due to a mixture of operational red flags (New York Times, 2008)
While the two sets of investigations by Markopolos and Askia LLC took opposed routes, they both had one ingredient in common: both individuals took a multi- dimensional approach to their individual scheme of fraud exposure – behavioral, statistical and organizational. This paper has tried to make available an input to what is presently recognized about the skills and tools that are obligatory to those who seek to discover statistical variances as red flags of fraud in financial services industry.
This is one set of skills that those for whom it is the responsibility to expose fraud require to grow on. It is anticipated that work will go on in further budding this area of uncovering, recognizing the range of statistical approaches that may preclude fraud identification. Into the bargain, similar work is required in creating new and more exact exposure tools in the areas of behavioral and organizational anomalies.
We cannot turn back time ‘ponzimonium’ as laid bare by the Global Financial Crisis has take place and in its wake it has left financial desolation for many. However, what can be reclaimed are those critical lessons about fraud exposure that are now known. The type and vastness of fraud that was left relatively unchecked until the impact of the GFC must not be allowed an encore performance.
References
Benson, S., (2009). Recognizing the Red Flags of a Ponzi scheme, The CPA Journal, Vol. 79, No. 6, pp. 1-24.
Bhattacharya, U., (2003). The Optimal Design of Ponzi Schemes in Finite Economies, The journal of Financial Intermediation, Vol.12, No. 1, pp.2-24.
Black, W.K (2005). Control Frauds as Financial Super-predators: How Pathogens Make Financial Markets Inefficient, The Journal of Socio-Economics, Vol. 34, pp. 734.
Cressey, D., (1955) Other People’s Money, Free Press.
Duffield, G., and Grabosky, P., (2001). The Psychology of Fraud, Trends and Issues in Crime and Criminal Justice no 199, Australian Institute of Criminology. Web.
Dunn, D., (2004). Ponzi: The Incredible True Story of the King of Financial Cons (Library of Larceny) (Paperback). New York: Broadway.
Gregoriou G. & Lhabitant. F., (2009). Madoff: A Flock of Red Flags, Journal of WealthManagement Vol. 12, No. 1, pp. 89.
New York Times, (2008). A copy of Askia LLC’s letter to clients. Web.
AP (2008). Madoff Whistleblower Went Unheeded for Years: Mathematical analysis in 1999 showed MAdoff’s returns were unreal. Web.
SEC (2009). Madoff, Bernard L Madoff Investment Securities LLC (No 08 CIV 10791). Web.