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Fraud in the financial sector has been evidenced for a long time. Many companies have either suffered bankruptcy, or some have spent a lot of resources trying to fix a fraud case. Such is the case of Madoff Investment because in 2008, it was reported that, the company was running the largest investor fraud scheme (Ponzi scheme) orchestrated by an individual (Shedlock 1).
Madoff investment securities was a wall street firm run by a successful businessman, Bernard Madoff, who also doubled as NASDAQ chairman, until his conviction in the Madoff fraud case.
After the arrest of Bernard Madoff, it was uncovered that the fraud was worth more than $64.8 billion and Madoff investments had accrued liabilities of over $50 billion (Shedlock 1). Due to the magnitude of this fraud, Madoff pleaded guilty to 11 counts of felony, and this assertion subsequently led to his sentencing in a federal court.
Until his arrest, Bernard Madoff ran a very successful company which he started, merely by investing $5,000 in Madoff investments, to be among the greatest players in the New York stock exchange (Shedlock 1).
However, this flamboyant side of his business life never came close to the scandalous business dealings he did behind the scenes. The Madoff investment scheme led to the loss of billions of dollars in investment money, through illegal wire transfers, securities fraud, mail fraud, money laundering, perjury (and the likes), but surprisingly, half of the investors did not lose any money in the scheme (Brown 2).
As a result of the fraud, several ripple effects have been evidenced in other companies, foundations and institutions which had business relationships with Madoff investment.
Some organizations such as Robert I. Lappin Charitable Foundation, the Picower Foundation, and the JEHT Foundation have temporarily closed business because of the freezing of Madoff’s personal and business assets, because they depended on the investment firm to finance their operations (Brown 2).
Among the third parties faulted for letting Madoff’s fraudulent dealings thrive is the US Securities and Exchange Commission; meaning that, there were mechanisms and institutions in place to check such kinds of illegal financial activities (Jerusalem Post 1).
However, in some way, such institutions failed to check the activities of Madoff investment firm; thereby allowing the thriving of fraudulent business transactions in the stock exchange. This goes against the mandate of such regulatory institutions because they are supposed to check the activities of financial companies, with the aim of protecting the interests of investors.
From the Madoff financial scandal, this study seeks to establish appropriate mechanisms which can be established to minimize, if not completely eliminate, financial fraud in the stock market sector.
Madoff’s investment strategy was a blend of several investment strategies meant to cushion its investors’ money against the uncertainties of the stock exchange.
One such strategy was the future adoptions strategy which the firm used to cushion its investors’ money against predictable events in the stock exchange; although almost concurrently, the firm was using Madoff’s sales pitch strategy which included purchasing blue chip stocks and taking options contracts which Brown explains as “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” (Brown 2).
It was affirmed that, the “calls” ensured the price of stocks remained high and the “puts” ensured the price of stocks never went lower than what was anticipated.
In interview excerpts done on Madoff, before his widely publicized arrest, he admitted that, he used future contracts on stock indexes and placed “put” options to see his company easily overcome the 1987 stock market crash in the US, but the biggest cover up to his fraudulent transactions came from a federal law which required companies to pay 5% of their returns (Brown 2).
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This provision allowed the Madoff fraud scheme to thrive because the firm could not be investigated, since it was largely managing charity money.
Financial analysts say that, for every $1 billion in foundations deposits made with Madoff investments, the firm made $50 million in revenues, and this return was guaranteed because the firm specifically targeted charities to avoid the high rate of withdrawals witnessed with other investment entities (Brown 2).
Madoff admitted that since the mid 1990s, his company never traded in the stock exchange and all the profits or returns associated with the firm’s financial books, during the same period, were fabricated; meaning that, the company’s wealth management wing was a complete hoax (Brown 2).
There was a deep sense of secrecy associated with Madoff’s operations because experts note that Madoff investment firm dealt with an exclusive clientele who were offered steady returns (not much) for a long time, as opposed to big returns; although the complexity was envisioned in the fact that, the returns framework adopted by the company to pay its shareholders was too complicated for the normal investor to understand (Tavakoli 1).
Furthermore, it is often said that, Madoff investment firm never publicly shared their financial investment documents with the public. Most of Madoff investment company’s operations and sales record also seemed to revolve around its founder, Bernard Madoff, as can be seen from his impeccable sales record, which saw the association of big investment firms such as Ascot partners with Madoff Investments.
For instance, the association of the firm with Ascot partners saw Madoff investment receive up to $1.8billion in investment money (Chernoff 1). However, Madoff’s sales record was often marred with allegations that, its proprietor sourced clients based on religious and ethnic prejudices, especially based on the fact that, he was Jew and therefore used the same basis to gain trust among most Jewish investors (Marketing Doctor 1).
There was also a sense of “oz” aura in the operations of Madoff investment because it was noted that, many of the company’s investors feared pulling out of the company because they would not find their way back into the company again (Chernoff 1). Though this aura characterized Madoff’s company operations, there were still a lot of evidences showing an inconsistent record of returns for the company.
There were more allegations of inconsistent company performances, especially based on the fact that, whenever investors wanted to pull out their money from the investment fund, they always got checks, before their withdrawal (Chernoff 1). This act bred hesitation among the company’s investors to pull out. Moreover, there were instances where the company posted profits when the stock market was poorly performing.
There was also unlimited access of Madoff and his investment firm to legislative power, and more so, powerful individuals in Washington (Chernoff 1). This association may not have been evidenced directly, but indeed, the company had access to some of Washington’s “high and mighty”, through subsidiary investment groups, affiliated with Madoff investments.
There were further claims, purporting that the company had special ties with the Securities industry and Financial Market Association because Madoff Bernard sat in the board of the Securities Industry Association, which ultimately gave him a lot of access to information regarding the regulation and the intrigues of the stock market (Chernoff 1).
In fact, it is reported that, some of Madoff’s family members sat in the board of the Securities industry and Financial Market Association (Chernoff 1).
It is further reported that, the Madoff family was consistently making financial donations to the Securities industry and Financial Market Association, and more family ties were evidenced in the executive board of the Securities industry and Financial Market Association, since Madoff’s niece sat as an executive member of the compliance and legal division unit of the institution (Chernoff 1).
Furthermore, she was married to a stock exchange commission employee – a relationship which obviously influenced the outcome of investigations into the Madoff financial fraud case (because the husband failed to investigate Madoff effectively) (Chernoff 1).
It is important to note that, the Security exchange Commission was supposed to investigate Madoff investments for allegations of financial impropriety and it unsuccessfully failed to uncover the financial fraud going on in the organization, for more than 16 years (Tavakoli 1).
The Madoff family relationships (with some of the stock market independent institutions) are said to have bred the Madoff fraud because it was difficult for the independent institutions (supposed to investigate such frauds) to carry out their functions effectively, if there was internal interference from powerful individuals within the institutions (Tavakoli 1).
From the above analysis, we see the apparent weak-points used by Madoff investments to perpetrate its fraud and effectively cover it up for a long time.
There are many lessons to be learnt from the Madoff investment scandal. From these lessons, several personal and policy changes ought to be initiated. On a personal level, the importance of risk management in any investment scheme cannot be overemphasized (Picerno 1).
The common misconceptions among many investors are that, loss is hard to come by, and therefore, investors operate in a manner that predisposes them to financial dangers. Perhaps, one basic common skill to be factored in financial management is common sense. Often, there are many issues that affect an investor’s ability to assess financial risk, and some of these reasons include, ignorance, greed and sometimes, fear.
Regardless, it is suggested that, any investor who ignores risk management is not any different from a driver who drinks while driving and expects that nothing will happen (Picerno 1). Sometimes an investor may get away with investing without a risk management plan, but if such a habit is upheld for a long time, the chances of experiencing financial losses are high.
From the Madoff investment scandal, it is clear that, investors are supposed to posses very high risk management skills as the first process of investment, before they decide to invest (because of a stock’s performance or any other reason) (The Opinion leaders 1).
For instance, during the Madfoff financial streak, the stock market was definitely experiencing a difficult financial time and stock prices were quickly tumbling down. However, Madoff investment exhibited an unfamiliar stock price pattern which represented the investment firm as almost immune to the financial market crash.
From this analysis, it therefore becomes clear that, though the investment firm was exhibiting a good stock market performance (while other companies failed in the same regard), 2008 still marked the year of its collapse and therefore the positive stock performance was in vain.
Often, risk management is synonymously referred to “breathing” (in the human body system), and the supportive premise for this assertion is the fact that, it is easier to control risk than is previously thought, but it is not as easy to control returns (Picerno 1). For instance, for a stock exchange investor, trading in different equities, it becomes very difficult, if not completely impossible, to control stock returns.
However, one cannot compare the risks associated with trading in one security as compared to trading in a pool of equities. Here, we see that, the risk of trading in one security is very high, but such a risk is effectively controlled when trading in several equities.
The risk management situation can be further improved if other asset classes, such as bonds, are included in the same investment pool because investors will have more confidence that their investment risks are effectively minimized.
From the Madoff scandal, we see that, risk management is an important tool in the successful management of investments, but more importantly, we see that risk management does not come as naturally to investors as it should. The Madoff investment fraud provides such a classic example to this assertion, especially after Wall street Journal (cited in The Wall Street Journal 1) provided this example:
“A woman, we are told, lost virtually her entire investment portfolio, valued at $2 million. To quote from the story, in 2001, acting on the advice of her broker, she poured something close to her life savings into a hedge fund linked to Madoff.
By October 2008, her account statement said her investment was valued at $3.8 million, according to the Journal. On Dec. 11, Mr. Madoff was arrested and confessed to a $50 billion Ponzi scheme. She lost the money” (The Wall Street Journal 1).
From this analysis, we see that, it is very important for investors to have a risk management plan to safeguard their investments in the stock market. Undertaking this initiative would also reduce the chances of investment companies collapsing with investors’ funds
Also, from the previous analysis of Madoff’s operational strategies, we can establish that, Madoff investment managed to hide its financial fraud because of the ties it had with independent institutions that were supposed to investigate it. For instance, there were concerns voiced to the securities exchange commission about Madofff investments and its allegations of making excessive profits, without justifying its means (Binyamin 1).
Such concerns were not effectively addressed, probably because Madoff’s family had substantial influence on the Securities exchange council. In this regard, it is important to establish that, institutions mandated to investigate investment firms should have complete autonomy from personal interests among investment companies.
In other words, persons deemed to have conflicting interests in the running of such independent institutions should not be allowed to sit in their boards. If such a strategy was initially adopted, Madoff investment would not find it easy to cover up the scandal.
Finally, though Madoff investments were a private entity, it should not be allowed to operate in a lot of secrecy, especially when the interest of the public is in question. In this regard, a policy should be introduced to legally require such companies to make public their financial statements (if the interest of the public is in question). This minimizes the chances of companies hiding illegal activities.
This study establishes that, the Madoff scandal thrived because of several weaknesses of system. The fact that Madoff had a lot of influence in the activities of the security exchange commission and Securities industry and Financial Market Association, posed a barrier to effective investigation of the activities of Madoff investment firm.
Furthermore, the secrecy in which the company operated created a sense of misinformation among the company’s investors and no one knew the formula used by the company to generate “strange” profits. To this extent, this study proposes several policy changes to increase the independence of independent institutions in the running of the stock market, plus remedial actions to improve the transparency of private institutions.
On a personal level, this study proposes to investors that effective risk management strategies ought to be practiced whenever investors transact in the stock exchange. A combination of these efforts would minimize the occurrence of financial frauds in the stock market.
Binyamin, Appelbaum. All Just One Big Lie. 13 December. 2008. Web.
Brown, Rebecca. How The Madoff Investment Scandal Was Uncovered. 2009. Web.
Chernoff, Allan. What drove Bernie Madoff. 2009. Web.
Jerusalem Post. Madoff Investment Scandal. nd. 2011. Web.
Marketing Doctor. Learning From A Ponzi Scheme – Madoff Knew His Target Market. 18 December. 2008. Web.
Picerno, Jim. The Madoff Scandal: What Are the Lessons Learned? 2008. Web.
Shedlock, Mike. Biggest Fraud in History $50 billion Madoff Ponzi Scheme. 2008. Web.
Tavakoli, Janet. Madoff Deserves Lots of Company. 2009. Web.
The Opinion leaders. Lessons from the Madoff Scandal: Deciding Which Funds Are Worth an Investment. 2008. Web.
The Wall Street Journal. The Madoff Case: A Timeline. 2009. Web.