Bernie Madoff Case

Bernie Madoff Case

Inside history’s biggest financial crime.

The bogeyman may not exist, but saying the name Bernie Madoff could send a chill down the spines of his thousands of investors whose envious portfolios went bust overnight.

Madoff—a financial investor whose skill and track record were so legendary that people begged to open accounts with his firm—crashed hard in December 2008 after the truth about his investments and returns finally came out. Madoff was running what turned out to be history’s biggest Ponzi Scheme.

To unravel his crimes, the FBI all but moved into Madoff’s offices. A team of nearly 15 special agents led the effort, along with law enforcement partners and a number of FBI financial analysts.

The work resulted in Madoff receiving a 150-year prison sentence, with his associates—several of whom claimed to have no idea about the scam—receiving varying sentences.

Madoff’s Beginnings 

In 1960, Madoff was a legitimate market maker—matching potential buyers with stocks. Then he opened a side business where clients gave him money to invest on their behalf, what’s called an investment advisory business. His father-in-law, a successful accountant, recommended clients to him. These referrals were a boon for the young Madoff up until he made a bad trade and lost a significant amount of money.

“He didn’t want to own up to the fact that he lost all this money for his father-in-law’s friends. So he started covering it up with all these other fake trades,” said Supervisory Special Agent Paul Roberts. “It just snowballed from there.” Each lie begat another lie, and the Ponzi scheme began.

How the Scheme Worked 

A decade later, Madoff hired a bond whiz named David Kugel for the legitimate side of his business. Kugel excelled in scouring the market to find bonds offered by companies that were priced lower than the company’s stocks. One could buy the less expensive bond, convert it to the higher priced stock, and then sell the stock, pocketing the difference. This price discrepancy is called convertible bond arbitrage and is a legitimate financial strategy.

Madoff asked Kugel to write down the details of his trades and share them with him and his bookkeeper, Annette Bongiorno, who started working at the firm in 1968. Kugel gave her detailed index cards that she kept in a box (investigators found these cards after Madoff was arrested).

The solution came from an unlikely source. Originally hired in 1975 at age 18 to be an errand boy, Frank DiPascali rose through the ranks of Bernie L. Madoff Investments and eventually devised a complicated strategy called Split-Strike Conversion.

What is split-strike conversion? Using split-strike conversion allows people essentially to buy stocks and then hedge the purchases by buying and selling options. An option is a separate transaction that allows someone to buy or sell a stock at a specific price at a specific time.

The strategy is legitimate but “doesn’t make money in the long term,” said Roberts. Regardless, it can turn a profit—and a hefty one when using fake numbers. To avoid any reporting with the SEC because the firm was not registered as an investment advisory business, the firm “reinvested” the stocks at the end of the month in treasury bills, which are not susceptible to an audit.

The Growing Scheme Draws Greater Scrutiny 

In 2001, two financial trade publications wrote articles that questioned Madoff’s investment advisory business, which wasn’t supposed to exist yet had the best returns on the Wall Street with a portfolio of nearly $7 billion. In an interview for the article from Barron’s, Madoff brushed off questions about his strategy, calling it proprietary.

“The articles are basically alleging that his investment advisory business—the worst-kept secret on Wall Street—might be a giant fraud,” said Roberts. The articles caught the SEC’s attention.

“Bernie starts getting scared,” said Roberts. He deployed the firm to create a massive supply of fake documentation so there are records to show the trades are legitimate.

DiPascali tapped two computer programmers he used to automate his split-strike strategy. Dubbed “the Computer Boys” by investigators, George Perez and Jerome O’Hara created the false records. To demonstrate just how far Madoff took this scheme, the firm created fake documents for all of its “trades.” The Depository Trust Company (DTC) maintains records of every stock that is bought and sold. Perez and O’Hara obtained real DTC statements and copied them en masse, even hiring another programmer to create a custom code that duplicated the statement’s unique font.

The team held the fake statements against windows facing the sun, comparing them to the actual statement. The fake statements were not perfect but good enough to fool an unsuspecting eye. “This is what they spent their time on. Hours and hours of doing this,” said Fish. Then it happened; in 2004, the SEC contacted Madoff to audit his firm.

The Audits Begin 

The SEC suspected that Madoff was front running stocks from his legitimate business as a market maker. The thinking went that as Madoff matched buyers and sellers, he became aware of non-public financial information and made his own personal trades before acting on behalf of his clients, which is illegal.

While Madoff had created thousands of paper documents to show his records were real, there was one area he didn’t resolve—identifying counter parties.

Since all of Madoff’s trades were fake, there were no counter parties. How could he get past the SEC?

SIPC

 But not every person who invested directly with Madoff received that windfall.

A SIPC trustee analyzed every Madoff account and calculated how much money was invested and how much money was withdrawn over the life of that account. If more money was withdrawn than invested, the account holder had to pay it back or be sued. And if clients simply lived off the interest from their Madoff accounts—or left an inheritance or opened accounts for family—those individuals could be in a situation where their accounts not only went bust, but they now owed money despite having never invested with Madoff themselves.

As mentioned, those second-level investors—the retirement accounts or other funds people gave to financial professionals to invest for them—were entitled to nothing.

Or so it seemed. As the FBI continued to seize assets from Madoff and his associates, the value of those items was distributed to a victim compensation fund managed by the Department of Justice. Those investors can submit a claim to get some of the money back, but they’ll never be fully compensated.

Lawsuits are still ongoing as the SIPC trustee claws back funds from the direct investors and claims are made against forfeited assets, but investigators and the trustee have combined forces to recoup billions for the victims.

The Legacy of Madoff 

The FBI continues to rank securities fraud as a high priority threat. While some changes have been implemented since Madoff’s plea, the main difference has been the growing awareness that this type of fraud exists.

“Even the term Ponzi Scheme became more popular after this case. People will call with a suspicion of fraud and they’ll say, ‘I think it’s a Ponzi Scheme,’” Roberts said. They aren't always right, Roberts said, but the term is now well known.