The Madoff Era

Era,
Fraud Schemes
 Part 1
The Madoff Era:
Ponzi Schemes
S & The New Wave off Fraud
 The Madoff Case
• Bernard Madoff Professional Career :
– Financial Services, Investment Management
– Former Chairman of NASDAQ Stock Exchange
– Founded Wall Street Firm Bernard L.
L Madoff Investment
Securities (BMIS)
– Philanthropist
 The Madoff Case
• Red Flags :
–EExpertt warnings
i b other
by th marketk t analysts
l t ((e.g. The
Th
World’s Largest Hedge Fund is a Fraud by Harry
Markopolos)
– "Bernie Madoff is running the world's largest
unregistered hedge fund...” –Harry Markopolos
– Unusual
U lb
business
i practices
ti
– Reputation of the auditor
 Madoff: A Ponzi Scheme
• Definition :
– A Ponzi scheme is an investment fraud wherein the
operator promises high financial returns or dividends
that are not available through traditional investments
investments.
Instead of investing victims' funds, the operator pays
"dividends" to initial investors using the principle
amountst "invested"
"i t d" b by subsequent
b t iinvestors.
t

Source: fbi.gov
 Ponzi Schemes
• History :
– Ponzi schemes are named for Charles Ponzi, who
deceived thousands of New England residents into
investing in postage stamps back in the 1920s 1920s. Ponzi
thought he could take advantage of differences
between U.S. and foreign currencies used to buy and
sellll iinternational
t ti l mailil coupons. P
Ponzii ttold
ld iinvestors
t
that he could provide a 40-50% return in just 90 days
comparedp to the interest rates for bank savings g
accounts, stocks and bonds.
 Ponzi Schemes
• How to protect against a Ponzi Scheme:
– Be skeptical about investments
– Be skeptical about reputations
– Diversification of investments
– Due diligence
– Avoid “deferred”
deferred payment plans
 Ponzi Schemes on the Internet
• Proliferation of advertisement videos for
business opportunities structured as Ponzi
schemes (i.e. YouTube.com).
• The Better Business Bureau identified nearly
23,000 videos.
– promoting
ti "cash
" h gifting"
ifti " or ""gifting
ifti club"
l b" programs
– nearly 60 million views
– fees ranging from $150 to $5$5,000
000
 Lessons Learned ((or Not))
from the Madoff Case
• What happened
- Scheme based on trust, reputation, fueled by lack
of diligence and regulatory failure
• What failed
- Common sense, individual diligence and
skepticism,
k ti i regulatory
l t and
d iinvestigative
ti ti b body
d
oversight and follow-up
• What can we learn
- Fraud won’t go away, diligence and attention to
red-flags is key
 Technology and Fraud:
Th N
The New WWave
• Many fraud schemes have been the same for centuries but
new technology has provided those seeking to commit fraud
with more tools and options:
– Greater reach to go after more victims
• Email hoaxes that go out to millions of people
• Websites that collect data from unsuspecting victims
– Greater anonymity
• Email and the web can provide a cloak of anonymity for those that
commit fraud
– Increased complexity (or at least apparent complexity)
• Many people aren’t technologically savvy, and those that commit
fraud prey upon this fact
 Current Economic Environment

• According g to the ACFE Report

p to the Nation on
Occupational Fraud and Abuse for 2008, US businesses
will lose an estimated $994 billion in fraud losses (7% of
their annual revenues)
• Instances of fraud will likely increase during this period of
duress
• Companies are facing issues concerning valuation of
assets such as asset-backed securities held as
investments or cash equivalents
Currentt Economic
C E i
Environment –
Psychology of
Investment Scams
 Current Economic Environment
• The Fraud Triangle
- Increase in the pressures and incentives during
current economic crisis

Pressure / Incentive

Rationalization Opportunity
pp y
 Current Economic Environment
2008 Occupational Frauds by Category ‐ Median Loss

Fraudulent 
Statements $2,000,000
Type of Fraud

Corruption $375,000

Asset 
Misappropriation
$150,000

$0 $500,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000

Median Loss

Data obtained from the ACFE 2008 Report to the Nation on Occupational Fraud & Abuse (based on 959 cases of occupational fraud).
 Psychology
y gy of Investment Scams
• 2006 Consumer Fraud Research Group study funded by
the FINRA Investor Education Foundation revealed the
following common tactics used by fraudsters as part of their
approach:
- The "Phantom Riches" Tactic - dangling the prospect of wealth,
ealth
enticing you with something you want but can't have. “These gas
wells are guaranteed to produce $6,800 a month in income.”
- The "Source Credibility" Tactic - trying to build credibility by
claiming to be with a reputable firm or to have a special
credential or experience. “Believe me, as a senior vice president
of XYZ Firm, I would never sell an investment that doesn't
produce.”
Source: http://www.finra.org/Investors/ProtectYourself/
Psychology
y gy of Investment Scams
•The "Social Consensus" Tactic—leading you to believe
that other savvy investors have already invested. "This is
how ___ got his start. I know it's a lot of money, but I'm
in—and so is my mom and half her church—and it's
worth every dime.”

•The "Reciprocity" Tactic—offering to do a small favor for

you in return for a big favor. "I'll give you a break on my
commission if you buy now—half off.”

•The "Scarcity" Tactic—creating a false sense of urgency

by claiming limited supply. "There are only two units left,
so I'd sign today if I were you.”
Source: http://www.finra.org/Investors/ProtectYourself/
http://www finra org/Investors/ProtectYourself/
Existing Securities Industry Regulations
• Securities Regulation
g
• Federal Regulation:
– Securities Act of 1933
– Securities Act of 1934
• Rule 10b – Anti-fraud provisions
• Investment Advisor Act of 1940
• Investment Company Act of 1940
Existing Securities Industry Regulations
• Sarbanes-Oxley Act of 2002:
– Certification
C tifi ti obligations
bli ti ffor CEO
CEOs and
d CFOs
CFO
– New standards for audit committee independence
– Enhanced financial disclosure requirements
– New protections for corporate whistleblowers
– Other criminal penalties:
p
• Document destruction
• Freezing of assets
• Bankruptcy loopholes
 Fraud Prevention and Detection
• Be cautious of "opportunities" to invest your money in franchises
or investments that require
q yyou to bringg in subsequent
q investors
to increase your profit or get back your initial investment.
• If the offer of an "opportunity" appears too good to be true, it
probably is.
is Follow common business practice
practice. For example,
example
legitimate business is rarely conducted in cash on a street
corner.
• Know
K whoh iis th
the promoter
t bbehind
hi d th
the ttransaction.
ti If you h
have nott
heard of a person or company that you intend to do business
with, learn more about them. Depending on the amount of money
that you intend to spend, you may want to visit the business
location, check with the Better Business Bureau, or consult with
your bank, an attorney, or the police.
 Fraud Prevention and Detection
• Be cautious of business deals that require you to sign
nondisclosure or non-circumvention agreements
g designed
g to
prevent the investor from independently verifying the
background and credentials of people with whom you intend to
do business.
• Do not invest in anything unless you understand the deal. Con
artists rely on complex transactions and faulty logic to "explain"
fraudulent investment schemes
schemes.
• As with any investment perform due diligence. Independently
verify the identity of the people involved, the authenticity of the
deal, and the existence of the security in which you plan to
invest.
 Current Economy and Fraud
• Current economic conditions increase
pressures and cause fraud to rise
• Red flags are important warnings
• A little fraud soon becomes larger if left to
grow
 Fraud Prevention and Detection
Initial Detection Method for Million Dollar Schemes 
46.2%
Tip 42.3%

20.0%
By Accident 22.8%

19.4%
Type of Detection

Internal Audit 18.6%
18 6%
All Cases

23.3% $1,000,000+
Internal Controls 16.7%

9 1%
9.1%
External Audit 15.8%

3.2%
Notified by Police 6.0%

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0% 50.0%
Percent of Cases

Data obtained from the ACFE 2008 Report to the Nation on Occupational Fraud & Abuse (based on 237 cases of occupational fraud
involving $1 million or more).
 Characteristics of Fraud (cont.)

• Employee Fraud Costs the Average

Business Approximately 6% of Total
Annual Revenue
• Fraud Costs U. S. Businesses More than
$400 Billion Annually
• Men
M C Commit it 3/4 off R
Reported
t dFFraud
d Cases
C
 Wh Commits
Who C it Fraud?
F d?
The 10 - 80 -10
10 Rule:
ƒ 10% of any Workforce Would Never Take
Anything
y g
ƒ 80% of any Workforce Would Take
Something if the Circumstances Were Right
ƒ 10% of any Workforce Would Take
Something Regardless of the Circumstances

Source: The Association of Certified Fraud Examiners

 Motive: Unshareable Need
(Usually Financial)

• Gambling
• Bad Investments
• Impatience for the Good Life = High Debt
• Drug and/or Alcohol Abuse
• Family Debt
• Extramarital Affairs
• Need to Meet Productivity Targets
Opportunity:
pp y An Opportunity
pp y to Commit Fraud Can Be
Real or Perceived. Those Who Think They
Will Get Caught Rarely Commit Fraud.

• Lack of Segregation of Duties (Do More

W/Less)
• Lack of Controlled Access to Vendor Master
File
• Lack of Accounts Payable Controls
• Fox in Charge
g of the Hen House
• The “Out Post” Effect
Rationalization: Most Fraud Offenders Have to Be Able
to Rationalize Their Behavior as
Something Other Than a Crime

• I’m Only Borrowing the Money

• y
Everyone Else is Doing
g it
• The Company Owes Me
• I’m Underpaid
• I Didn’t get my Bonus Because My Boss
Took Credit for my Work
• I’m
I’ BBored d
 Red Flags:
The Keys to Fraud Detection
• Frauds Typically Start Off Small And Grow Over
Time
• Fraud Affects the Bottom Line
• Prevention is Every Employee
Employee’ss Responsibility
• Ethics Must Start at the Top and Flow Downward
• Exposure to Fraud Can Be Limited by Restricting
pp
Opportunities Through g Effective Internal Controls
• Fraud is Present Within Every Organization -
Challenge - Identify and Minimize
• Nearly All Frauds Could be Detected More Quickly if
R d Fl
Red Flags are nott IIgnored
d