CASE 8

The Fraud of the Century: The Case of Bernard

Madoff
Daryl Benson

The fraud perpetrated by Bernard Madoff that was discovered in December 2008 was
what is known as a Ponzi scheme. A Ponzi scheme works similarly to a pyramid scheme.
Madoff took money from new investors to pay earnings for existing customers, without
ever actually investing the money. In order to keep making payouts to older clients, Madoff
had to continually attract new investors. The Ponzi scheme was named after Charles
Ponzi, who in the early twentieth century saw a way to profit from international reply
coupons. International reply coupons were a guarantee of return postage in response to
an international letter. Charles Ponzi determined that he could make money by swapping
out these coupons for more expensive postage stamps in countries where the stamps were
of higher value. Ponzi convinced investors to provide him with capital to trade coupons
for higher-priced postage stamps. His promise to investors who joined in his scheme was
a 50 percent profit in a few days.
Touted as a financial wizard, Ponzi lived a fairly opulent life outside of Boston. He
would often bring in as much as $250,000 a day. Part of Ponzi’s success came from his
personal charisma and ability to con even savvy investors. People trusted Ponzi because
he created an image of power, trust, and responsibility—much like Bernard Madoff did
nearly a century later. The largest problem with his scheme is that it did not work, much
like Madoff’s did not. In order to keep giving earlier investors their promised return, he
had to continually draw new people into the scheme. In July of 1920, the Boston Post ran an
article exposing the scheme, and soon after that regulators raided his offices and charged
him with mail fraud, knowing that his fabricated investment reports were mailed to his
clients. Most Ponzi schemes self-destruct fairly quickly as the ability to keep attracting new
investors dwindles. Bernard Madoff’s case was unusual because he was able to continue
his fraud for many years.

Linda Ferrell developed this case with the editorial assistance of Jennifer Jackson and Jennifer Sawayda. This
case was prepared for classroom discussion, rather than to illustrate either effective or ineffective handling of an
administrative, ethical, or legal decision by management. All sources used for this case were obtained through
publicly available material.

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BERNARD L. MADOFF INVESTMENT

SECURITIES LLC: “ALL IN THE FAMILY”
Bernard Madoff was not merely a criminal. He was also a highly successful, legitimate
businessperson. He started a legal, investment business in 1960 by buying and selling over-
the-counter stocks that were not listed on the New York Stock Exchange (NYSE). These
stocks were traded via the telephone with no automation. This meant that an in-the-know
individual such as Madoff could profit from variations between different quotes. Basically,
he served as a “wholesaler” between institutional investors. In the early days, working with
investment firms such as A.G. Edwards, Charles Schwab, and others, Madoff made his
money based on the variance between the offer price and sales price of stocks.
In the 1990s, Madoff Securities was trading up to 10 percent of the NASDAQ (National
Association of Securities Dealers Automated Quotations) shares on certain days. Early
success and competitive advantage came from Bernie working with his brother Peter (the
first of several family members to join his firm), who after graduating from
law school joined Madoff’s company and developed superior technology for
trading, buying, and selling at the best prices. Madoff controlled the funds
Madoff made in-house and made his money, in this division, from commissions on sales and
every client feel profits. The profits were not based on fraud; however, there is evidence that
Madoff occasionally injected funds from his illegal business into his legal one
like he or she was during times of low revenues.
As Madoff became more successful, he moved the company’s headquarters
his only client. from Wall Street to the famous “Lipstick Building” on Third Avenue built by
famed architect Philip Johnson. Not unlike Enron’s Ken Lay and his lobbying
efforts to deregulate the energy and gas industry, Bernie also became more
involved in lobbying for regulatory changes that would make it easier to trade electronically.
Brother Peter took on more oversight of the firm’s securities business. Bernie served as chair
of the NASDAQ in 1990, 1991, and 1993. In addition, he held a seat on the government
advisory board on stock market regulation, served on charitable boards, and started his own
foundation, all of which added to his credibility. He developed respectability and trust as a
highly knowledgeable investment specialist.
For years Madoff had been using his legitimate success and high visibility to start
a second business managing money. He seemed trustworthy and promised consistent
returns of 10 to 12 percent, attracting billions of dollars from hundreds of investors. Part of
the appeal of investing with Bernie was the appeal of exclusivity. Madoff made every client
feel like he or she was his only client. His inaccessibility and “invitation only” approach
to new investors created an air of exclusivity and desire to be involved. Ruth Madoff,
Bernie’s wife, also worked at the firm for a time, and often functioned as a friendly face of
the companies. Madoff was frequently excessively focused on work and order, while Ruth
was pretty, gregarious, and smart.
Bernie’s niece and Peter’s daughter, Shana Madoff, was a rules and compliance officer
at Madoff’s legitimate firm and worked under her father, who was head of compliance in
the market-making arm (not the firm’s money management business). Shana, was not
charged with any crimes, is married to Eric Swanson, a former Securities and Exchange
Commission (SEC) compliance lawyer. Shana Madoff has a respected career and was
honored by the Girl Scouts of America as a “woman of distinction.”
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Although also under investigation, neither of Madoff’s sons, Mark and Andrew, has
been charged with any wrongdoing. It was to them that Madoff confessed his crime, and
they were responsible for turning in their father to the authorities. The two deny any
knowledge of the fraud and did not speak to their father or mother for months after Bernie’s
arrest. The family emphasizes the separation of the legitimate, stock-trading business (run
on the nineteenth floor) and the illegitimate, investment management business (run on the
seventeenth floor) by Bernie Madoff.
In March 2009, when Bernard Madoff stated his guilt in court, he never indicated the
involvement of any other company employees or family members. He stated in the allocution
that “I want to emphasize today that while my investment advisory business—the vehicle
of my wrongdoing—was part of Bernard L. Madoff Securities, the other businesses that
my firm engaged in, proprietary trading and market making, were legitimate, profitable
and successful in all respects. Those businesses were managed by my brother and two
sons” (Madoff Plea Allocution, p. 2). Further investigation will determine the extent and
level of external support that Madoff had in defrauding thousands. Madoff chose to hire
inexperienced, sometimes uneducated individuals with no background in finance to work
in his investment management business. Some speculate that he did this so as to surround
himself with unknowing participants.

EXPLAINING THE GROWTH NUMBERS

Madoff staked his investment business on claims that he could consistently generate 10 to 12
percent returns for investors, no matter what the economic climate. Many of his clients were
already wealthy and just looking for a stable and constant rate of return. To these people,
his friends at the Palm Beach Country Club, for example, reliable constant returns managed
by one of their own seemed like the perfect way to go. His stated investment strategy was to
buy stocks, while also trading options on those stocks as a way to limit the potential losses.
His market timing strategy was called the “split strike-conversion.” With the large financial
portfolio Madoff managed, many indicate at least one “red flag” would have been the fact that
he would have had to make more trades than the market would physically allow just to meet his
everyday financial goals. Shocking to all of his clients, Madoff confessed in his “Plea Allocution”
statement that he never invested any of his client’s funds. All of the money was deposited in
banks, and Madoff simply moved money between Chase Manhattan Bank in New York and
Madoff Securities International Ltd., a United Kingdom Corporation. During his confession,
Madoff stated that his fraud began in the early 1990s.
To help continuously draw in new clients, Madoff developed relationships with
intermediaries, also known as “feeders” to his investment fund. They were other investment
managers who trusted Madoff to take care of their clients’ money, and it does not appear that
they were integrally involved in the fraud. Many of these feeders had themselves invested money
with Madoff. One such middleperson, Rene-Thierry Magon de la Villehuchet, committed
suicide after losing his life savings to Madoff. These feeders profited by receiving fees and
ensuring that Madoff had a stream of money flowing into his operation. Robert Jaffe operated
as a middleperson for Madoff starting in 1989 when he became the manager of Boston-based
Cohmad Securities, a firm co-owned by Madoff to attract investors. Jaffe was the son-in-law
of one of Madoff’s earliest investors and was a member of the Palm Beach Country Club. Jaffe
earned a small commission whenever Madoff took on an investor introduced to him by Jaffe.
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FINANCIAL SUPPORT NEAR THE END AND THE

ARREST
Toward the end of Madoff’s fraud, he was getting desperate for funds. As the economy
collapsed in late 2008, more and more clients were requesting deposits back. In order
to pay them and to not be exposed, Madoff needed more cash quickly. He resorted to
soliciting, and sometimes subtlety threatening, clients for more deposits—making them
feel guilty for not being better clients of such a distinguished investment firm.
A week and a half before Madoff admitted to his sons that he was operating a Ponzi
scheme, 95-year-old Palm Beach philanthropist and entrepreneur Carl Shapiro gave
Madoff $250 million. Shapiro lost that money, as well as $100 million in additional funds
that had belonged to a charitable organization. Martin Rosenman, the president of a fuel
company in New York, also provided an additional $10 million in deposits. Rosenman
is suing Madoff for the money. He alleges that Madoff told him that his funds would be
invested in a new fund, and was even sent a nineteen-page promotional piece in advance
of the investment.
Of course, even these hundreds of millions in additional deposits would not be
enough to cover Madoff’s losses. Possibly because he knew that the act was up, he turned
himself in to his sons. Madoff was arrested on December 11, accused of operating a
$65 billion Ponzi scheme. The official charge is criminal securities fraud. Madoff declared
to his sons that he had roughly $200–300 million left in the business and that he wanted
to provide the money to employees before turning himself over to authorities. This was
news to his sons; they thought the investment arm of the business held between $8 billion
and $15 billion in assets. The SEC records showed that the firm had $17 billion in assets
at the beginning of 2008.

THE INVESTIGATION AND CHARGES

Investigators in this case included the SEC, FBI, federal prosecutors from the U.S. attorney’s
office for the Southern District of New York, and the Financial Industry Regulatory
Authority. Forensic accountants will try to pull together the trail of investments and
spending to determine where the money went. There is a belief that multiple offshore
funds were created by Madoff to shelter assets prior to the collapse of the firm. Madoff’s
business was not registered with the SEC until 2006, after an SEC investigation.
Bernard Madoff has been charged with criminal securities fraud, and investigators are
now evaluating documents dating back to 2000. The charges did not come as a surprise to
the SEC when Madoff was finally exposed, however; beginning in 1992, federal regulators
had been investigating allegations of wrongdoing by Madoff. Table 1 provides a summary
of the nature of these investigations.
It is believed that much of the money invested with Madoff went either to offset
losses in his legal business or to fund the Madoff family’s lavish lifestyle. There is growing
evidence that although family members may not have known that Bernie was running a
Ponzi scheme, they thought nothing of treating his businesses like their personal piggy
banks. Investigators may pursue Ruth Madoff and their two sons in order to recover some
of the money owed to bilked investors.
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TABLE 1 Government and Regulatory Investigations of Bernard Madoff

Year Nature of Investigation

1992 SEC—Madoff ’s name came up in a Florida accounting investigation.

1999 SEC reviewed Madoff ’s trading practices.

2001 SEC—Harry Markopolos, securities industry executive, raised questions regarding

Madoff ’s returns.

2004 SEC reviewed allegations of improper trading practices.

2005 SEC interviewed Madoff and family but found no improper trading activities.

2005 Industry-based regulatory group found no improper trading activities.

2005 SEC met with Harry Markopolos, who claimed Madoff was operating the world’s
largest Ponzi scheme.

2006 An SEC enforcement investigation found misleading behavior, and Madoff

registered as an investment advisor.

2007 Financial Industry Regulatory Authority investigated Madoff, but no regulatory

action was taken.

Source: Associated Press, “The Many Fruitless Probes into Bernie Madoff,” APNewswire, January 5, 2009, http://news.moneycentral.msn.com/provider/
providerarticle.aspx?feed=AP&date=20090105&id=9486677, accessed January 5, 2009

INVESTORS IMPACTED
The very long list of Madoff clients is a who’s who of organizations, nonprofits, successful
entrepreneurs and businesspeople, as well as entertainers. The Fairfield Greenwich Group,
one of Madoff’s largest feeder funds, had around $7.5 billion, or more than half of its
assets, invested in the firm. The Noel family, owners of Fairfield Greenwich, has been so
disgraced by their association with the Madoffs that their membership to the Round Hill
Country Club in Greenwich, Connecticut, was revoked. Tremont Group Holdings, owned
by Oppenheimer, had $3.3 billion invested. Ezra Merkin, head of a GMAC-operated hedge
fund, lost $1.8 billion to Madoff.
Several victims have shared information about their history and relationship with
Bernie Madoff. Richard Sonking met with Madoff in the mid 1990s after his father, who
had an account with Madoff, recommended the investment firm for its steady 8–14 percent
returns. Sonking pulled together the minimum $100,000 required for investment at that
time, feeling confident that he was joining a highly select group of investors. Sonking
continued to place money in Madoff’s hands as he accumulated greater wealth. As with
all of Madoff’s clients, he was happy with the constant returns and with the detailed
statements that were mailed to him each month. Like everyone else, he never questioned
why Madoff did not make online records available, and he did not question the secrecy
to which Madoff swore his investors. Upon retiring in 2005, Sonking requested quarterly
distributions from his account. As with most of Madoff’s loyal investors, Sonking received
no warnings of fraudulent activity until he heard the news of Madoff’s arrest.
Loretta Weinberg, a New Jersey state senator, was a conservative investor who embraced
her late husband’s philosophy that you should live on half of what you make and save the rest.
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She had no investments with Madoff, but she did place money in the hands of Stanley Chais,
a Los Angeles money manager who provided quarterly investment reports and a 10–14
percent annual return. It just so happened that Chais was a feeder with Madoff, funneling
much of his clients’ money Madoff’s way. Until the Madoff scandal hit the press, Weinberg
had not even heard of Madoff. As a 73-year-old state senator making $49,000/year, she is
coming to terms with what it means to lose her entire $1.3 million in life savings.
Joseph Gurwin is 88 years old and lives in Palm Beach. Like many in Palm
Beach, he came to know Madoff and had become his friend through the local
social and philanthropic community. Madoff had a tremendous reputation for
Madoff had a secure and conservative financial management, and it was considered a huge
honor among the elites in Palm Beach to be invested with Madoff. Gurwin’s
tremendous foundation (The J. Gurwin Foundation, Inc.), operating with around $28
reputation for million in assets, donated $1.2 million annually to Jewish health care, services,
and programs for frail, elderly, or disabled younger adults. After investing
secure and heavily with Madoff, Gurwin’s charitable foundation lost all of its assets when
Madoff’s Ponzi scheme crashed.
conservative Law firms in Florida are representing clients who believed they were
financial investing with Westport National Bank (a regulated banking institution in
Connecticut), and not with Madoff, but who have received a letter from
management. Westport National indicating that the bank had a custodial agreement with
Madoff giving full discretionary authority to Bernard L. Madoff Investment
Securities. Madoff’s sweep went far beyond his immediate circle.

RESTITUTION FOR INVESTORS

So far, close to 9,000 people have submitted claims for restitution in the Madoff case.
Some are suing the SEC for not catching this fraud sooner. However, paying back all these
investors will be a difficult task. Although Madoff’s fraud is being billed as a $65 billion
Ponzi scheme, Madoff never had anywhere near that amount of money. The figure of
$65 billion is the total amount Madoff told people they had invested and earned with him.
The actual amount may be well below $10 billion. Investigators have considered pursuing
legal action against Madoff family members in order to pay all of these claims.
In reaction to all the ethical scandals being uncovered in the investment and finance
industries, the SEC is considering a new proposal that would place investment advisors
under more government scrutiny. The proposal would require that advisors like Madoff
demonstrate evidence to an independent accountant that they actually have the funds they
claim to have. Although Madoff was investigated by the SEC repeatedly over the years,
and in spite of skeptics providing the SEC with strong evidence that Madoff was indeed
running a Ponzi scheme, investigators never thought to verify whether Madoff actually
had all the money he claimed to have. This proposal to increase regulatory oversight comes
at a time when it has become clear how easy it is for investment professionals to misuse
client funds and then send them false reports to cover up their misdeeds.
Investigators are also looking into potential misconduct on the part of some of
Madoff’s clients. According to investigations, Madoff feeder funds withdrew over
$12 billion in 2008, with half of that money being withdrawn in the three months leading
up to his arrest—a huge sum that probably led to Bernie’s confession when he could
no longer pull together cash to make payments. Under federal law, the trustee for the
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Madoff bankruptcy suit can sue to retrieve this money in what are called “clawback” suits.
The argument is that $12 billion was essentially “stolen” from other investors who actually
owned the money. Hence, to protect their assets from seizure, many who received payout
funds from Madoff are transferring the money to irrevocable trusts, homes, annuities, or
life insurance policies.
One of these cases seeks repayment of $5.1 billion from a prominent Madoff client and
Palm Beach investor named Picower. Although Picower’s charitable fund was one of the
highest-profile victims of the Madoff downfall, investigators suspect some foul play. Part of
the concern is that as a professional investor, Picower should have known that the profits
he was getting from Madoff were too high. The accusations further state that Picower was
getting payments from Madoff to help perpetuate the Ponzi scheme, which means Picower
would have known about the scheme all along. This is only one of what will surely amount
to dozens of lawsuits related to the attempt to recover and redistribute funds from Madoff
clients. Undoubtedly this web will take years to untangle as investigators seek to learn who
knew about Madoff’s scheme and which ones are, therefore, guilty of being complicit.
As mentioned earlier, some investors are suing the SEC for negligence in its regulatory
responsibility and not being able to identify the fraud. Such attempts represent the first time
investors have sought restitution from a regulatory agency. Christopher Cox, SEC chair at the
start of the fraud investigation, has indicated that the SEC examiners missed “red flags” in
reviewing the Madoff firm. Allegations of wrongdoing started in the early 1990s, and Madoff
confirms fraud dating back to that time. Repeated investigations and examinations by the
SEC showed no investment fraud. Because many SEC employees have ended up working
in the investment business on Wall Street, there has been speculation that an overall lack of
objectivity clouded these investigations. Some suspect incompetence on the part of the SEC as
well. In the wake of the Madoff fallout, it has become clear that some SEC investigators were
sufficiently knowledgeable about the kinds of complex financial instruments used on Wall
Street. Thus, they should have been knowledgeable enough to be able to detect the fraud.
Perhaps the greatest restitution for some investors came as Bernard Madoff was
handcuffed and taken to prison after his twelve-minute-long confession of guilt in a Lower
Manhattan courthouse. Some victims asked the judge for a trial to uncover more about this
extensive fraud and to determine why the government regulatory system failed so many
investors. Judge Chin indicated there would be no trial since Madoff pleaded guilty and
there was an ongoing investigation at hand. Madoff was sentenced to 150 years in prison.

THE FUTURE OF CHARITABLE GIVING

Due to the widespread impact of the Madoff-related losses upon charities, nonprofits,
and educational institutions, donor skepticism and withdrawal are not unexpected
consequences. Some of the organizations affected included the Elie Wiesel Foundation
for Humanity, Yeshiva University, and Wunderkinder Foundation (Steven Spielberg’s
fund). This wariness comes at a time when the global recession resulted in losses of around
30 percent for many foundations’ endowments. The vast majority of nonprofits indicate
that the economy had a negative impact on fundraising, even before the Madoff scandal
was exposed. In the future, it is certain that charities and donors alike will approach the
donation process with greater care. One way to evaluate responsible charities is to develop
guidelines for giving, which would include knowing what materials are readily available
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to potential investors/donors from the organization, who is running the fund/charity, and
who is auditing the fund/charity. Another guideline is to diversify the investment portfolio,
which avoids putting all investments in one basket. This is exactly what many of Madoff’s
victims did not do, choosing instead to place all their assets into Madoff’s company and
losing their investments in the resulting scandal.

CONCLUSION
Bernard Madoff is accused of creating a Ponzi scheme that destroyed $65 billion in
investments. Many people are trying to understand how so many experienced investors,
including banks, insurance companies, and nonprofit foundations, lost billions of dollars
to an individual who was able to deceive them as well as regulators. Investigators are
trying to determine who helped Madoff carry off what some say could have been a 30-year
scheme that caused the $65 billion in losses that have affected thousands of people around
the world. Accountants, auditors, and regulators are supposed to be gatekeepers that
protect the public interest. Investigators believe that Madoff had a trading strategy that
failed, then after a while, he made few trades for many years and his operation consisted
of taking money from new clients and paying it out to existing clients, a classic Ponzi
scheme.
From an ethical perspective, this would be an example of white-collar crime. White-
collar criminals create victims by establishing trust and respectability. As in this case,
victims of white-collar crime are trusting clients who believe there are many checks and
balances to certify that an operation is legitimate. Madoff is an example of the classic
white-collar criminal. He was an educated and experienced individual in a position of
power, trust, respectability, and responsibility who abused his trust for personal gains.
From the inception of his investment business, he knew that he was operating a Ponzi
scheme and defrauding his clients. In the end, he said he “knew this day would come.”
An important question is how one individual could deceive so many intelligent
people and authorities that certified his operation as legitimate. Madoff’s accountants,
family, and other employees will have to answer to authorities about their knowledge of
the operations. For example, investigators have issued a subpoena for David Friehling, a
New York accountant who audited Madoff’s financial statements. Although only Madoff
was originally charged with misconduct and was adamant that he acted alone, other
participants will undoubtedly be discovered and charged. Madoff’s right-hand man, Frank
DiPascali, has admitted to knowing of individuals and firms complicit in Madoff’s scheme
who knowingly broke the law.
White-collar crime is unique in that it is often perpetrated by a rogue individual who
knowingly steals, cheats, or manipulates in order to damage others. Often, the only way
to prevent white-collar crime is to have internal controls and compliance standards that
detect misconduct. Perhaps the most difficult white-collar crime and fraud to expose is
that perpetrated by the top executive. We count on leadership within an organization to
create, manage, and motivate an ethical organizational culture with all the checks and
balances in place. In the Madoff case, there was the opportunity to deceive others without
effective audits, transparency, or understanding of the true nature of his operations.
As a result of this case, individual investors, institutions, and hopefully regulators will
exert more diligence in demanding transparency and honesty from those who manage
investments.
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QUESTIONS
1. What are the ethical issues involved in the Madoff case?
2. Do you believe that Bernard Madoff worked alone, or do you think he had help
in creating and sustaining his Ponzi scheme? Would this represent a conflict of
interest?
3. What should be done to help ensure that Ponzi schemes like this one do not happen
in the future?

SOURCES

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“Inside a Swiss Bank, Madoff Warnings,” Wall Street Journal, January 14, 2009, p. 1A; Catan, Thomas, Christopher
Bjork, and Jose De Cordoba, “Giant Bank Probe Over Ties to Madoff,” Wall Street Journal, January 13, 2009,
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Wall Street Journal, March 12, 2009, p. C3; Lucchetti, Aaron, “Victims Welcome Madoff Imprisonment,” Wall
Street Journal, March 13, 2009, http://online.wsj.com/article/SB123687992688609801.html (accessed September 2,
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madoff_victims_20081215.html (accessed September 2, 2009); “Plea Allocution of Bernard L. Madoff,” Wall Street
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