Wednesday, September 16, 2009

Rogues, Rascals, and the Lessons Learned

I was privileged to speak yesterday to the Nashville Chapter of the Institute of Internal Audit about the Madoff fraud and its effect on investors. The following is an excerpt of a portion of that speech.

There were several components to the fraud that Madoff perpetrated, and these components or characteristics are present in many Ponzi schemes and frauds. The first is that Madoff used his affinity with certain groups to gain trust and access. Madoff played upon his Jewish heritage to gain access to members of his synagogue, to the Jewish Country Club of Palm Beach, and Yeshiva University to name a few institutions. He was a significant donor to numerous charitable causes, which not only gave him access, oftentimes gaining a position as a board member, but created the connection, the affinity, with that enterprise. He also used his geographic domain to create affinity with those he called neighbors. Whether it was from his Manhattan penthouse, his beachfront home in the Hamptons, his Palm Beach home, or his villa in France, Madoff lived in an exclusive world and courted those that inhabited that same world.

The strong affinity that investors had with Madoff broke down their natural wariness. "He's one of us" leads one to forgo the necessary verification of credentials and the accounting of assets. In the most vulnerable area of finances, people and institutions that should have known better, yet they let down their guard. Because "he's one of us". Unfortunately, the similarity with his victims was not on shared values, but on superficial details such as where he lived or funds that he was able to contribute to worthy causes. In essence, Madoff bought access and created an affinity with investors through a well crafted facade.

The second component of Madoff's strategy was essential to the longevity of the fraud, and that was the opacity of his operation. There was not a bit of transparency about what happened in Madoff Securities. Once an investors money disappeared into the firm, it truly disappeared. Clients were not allowed access to their accounts and the only statements they received were from Madoff's firm generated by Madoff's staff. Once funds were invested, clients relied solely on Madoff Securities to verify positions in their portfolio and the returns they were receiving. This situation perpetuated the fraud by allowing Madoff to show consistent returns, averaging 10% per annum, regardless of market conditions. Investors were duped into believing they were doing well because of the inability to actually verify the performance of their account.

Integral to the fraud was the lack of outside confirmation of the actual investments that were purportedly made on behalf of the investors. This was the final component of the fraud that Madoff committed. The lack of third party confirmation, such as by an independent custodian of the assets, allowed Madoff to report falsified positions in portfolios and fake returns. Investors with Madoff believed they held actual positions in his funds when in fact their investments were used to support the lavish lifestyle Madoff enjoyed. Without this component, the fraud would have never occurred.

In making this speech, I realized that many of the characteristics of a con like Madoff have been present in some of the past owners in the NHL. Predator fans can only look at former part owner Boots del Biaggio to see that he used his connections with those in the hockey world to gain access to the highest levels of the league and gain their trust (affinity). Boots parlayed his relationship with Mario Lemieux, Luc Robataille, and others to gain access and trust of Gary Bettman and the Board of Governors. His personal finances were obscured by his venture capital efforts which did not require public disclosure (lack of transparency). As his financial situation imploded, it was revealed that his certified financial statements that were presented to the league were fictitious (lack of confirmation). Boots, as have other disreputable owners, fit the profile of a con.

The league states in its constitution and by-laws that any potential owner will be subject to a vetting process. That process, however, is not spelled out. One can only hope that the league, like regulators in the securities industry, have learned the painful lessons that these rogues teach. Better and more thorough examination will hopefully prevent fraud and the painful fallout in both arenas.

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