Insider Trading

Ponzi Schemes

Bernie Madoff Revisited

On November 18, 2010, two members of imprisoned financier Bernard Madoff's inner circle were arrested on charges of conspiring in the largest financial fraud in history and helping to conceal it. The indictments of former employees Jo Ann "Jodi" Crupi and Annette Bongiorno bring to eight the number of people criminally charged since the December 2008 revelation of Madoff's multibillion-dollar decades-long fraud. According to federal prosecutors, Crupi and Bongiorno protected and perpetuated the Madoff Ponzi scheme while putting very real money in their own pockets. The feds brought conspiracy, securities fraud, tax evasion and other charges against the pair. The securities fraud charge alone carries a maximum possible prison term of 20 years.

It's been just about two years since Bernie Madoff was arrested.  S-MADOFF-large On December 10, 2008, Madoff's sons told authorities that their father had just confessed to them that the asset management arm of his firm was a massive Ponzi scheme, and quoting him as saying it was "one big lie." The following day, FBI agents arrested Madoff and charged him with one count of securities fraud. Madoff insisted he acted alone. A court-appointed trustee has sued Madoff's brother, wife, two sons and a niece over allegations they should have known about the massive Ponzi scheme, but none of them has been criminally charged.

In March 2009, Madoff pleaded guilty to 11 federal crimes and admitted to turning his wealth management business into a massive Ponzi scheme that defrauded thousands of investors of billions of dollars. Madoff said he began the Ponzi scheme in the early 1990s. However, federal investigators believe the fraud began as early as the 1980s, and that the investment operation may never have been legitimate. The amount missing from client accounts, including fabricated gains, was almost $65 billion. The court-appointed trustee estimated actual losses to investors of $18 billion. On June 29, 2009, Madoff was sentenced to 150 years in prison, the maximum allowed.

So, what is a Ponzi scheme? First, it was named after Charles Ponzi who emigrated from Italy to the U.S. in 1903 and became notorious for using the technique in early 1920.  Charles-ponzi A Ponzi scheme is one in which early investors are paid with the money of new clients rather than actual earnings because the schemer often never invests the original amount.  Charles Ponzi persuaded thousands of people to sink millions of dollars into a scheme whereby Ponzi purchased international reply coupons at low exchange rates and then redeemed the coupons for U.S. postage stamps worth higher values. Ponzi would then sell the postage stamps at the higher value, and lure investors with promises of a 50 percent return on their investment in 90 days but he diverted investors' money to support payments to earlier investors and for Ponzi's personal wealth.

Madoff's swindle was by far the largest ever. Several other Ponzi schemes, involving hundreds of millions of dollars, also collapsed under the weight of the market meltdown in 2008. The scheme typically collapses because the earnings, if any, are less than the promised payments to investors. So long as new investors are found, the money from the second investor can be paid as a return to the first; money from the third paid to the second. The problem arises when new investors dry up and/or when the earlier investors want to cash out.  

Another widely publicized Ponzi scheme occurred in June 2009. Texas financier Allen Stanford was charged in a 21-count indictment with orchestrating a $7 billion Ponzi scheme centered on the fraudulent sale of certificates of deposit to approximately 30,000 investors.  Stanford has pled not guilty to charges of fraud, conspiracy, and obstruction. If convicted of all charges, Stanford faces up to 250 years in prison.

The FBI doubled to 314 the number of investment fraud- cases in fiscal 2009 from a year earlier. The beat went on in 2010 when in June, Kenneth Starr, a financial advisor to Hollywood stars including Sylvester Stallone, Ron Howard and Martin Scorsese, was arrested on charges that he stole more than $30 million from clients in a Ponzi scheme.

The failure of ethical standards in developing and carrying out the Ponzi schemes is often overshadowed by the illegality of the schemes that are based on fraudulent intent and action.  People like Madoff, Stanford and Starr were in positions of trust and should have exercised a reasonable level of care in carrying out their fiduciary responsibilities. They violated that trust and abused their power as trustee of the funds. Their actions were motivated by greed and a belief they could get away with the fraud. Where have we heard that before?