The “Madoff Scheme” and Failure of Regulation

The expression “Ponzi scheme” is not something we are terribly familiar with in India. To be honest, I heard of this concept only a couple of years ago. But now, these words are resonating in the media after the alleged fraud by Bernard Madoff came to light last week. New York Times’ City Room Blog has some background about Charles Ponzi:

““He had his nose pressed against the glass,” Mr. Zuckoff, a professor of journalism at Boston University and a former reporter for The Boston Globe, said in a phone interview on Monday. “He was not linked with Wall Street and New York, though he had dreams of being like Rockefeller.”

“Mr. Zuckoff’s book “Ponzi’s Scheme: The True Story of a Financial Legend,” published by Random House in 2005, traces how Mr. Ponzi duped tens of thousands of people out of millions of dollars in a short-lived craze that became the defining confidence scheme of its time. It was brief, lasting only from December 1919 to August 1920.

Born in northern Italy, Mr. Ponzi emigrated to Boston in 1903, at age 21. Soon he had learned English, held jobs as a waiter and bank teller and served time for forgery and smuggling (or what might be called human trafficking today, since it involved illegal immigrants from Italy).

Essentially, the scheme he devised involved buying postal reply coupons in European currencies at fixed, outdated rates of exchange and then redeeming them in the United States for dollars, generating a guaranteed profit.

“With successive waves of people entrusting him with their cash, Ponzi needed only enough money to pay off those people redeeming their coupons,” David Margolick wrote in The Times in a 2005 review of Mr. Zuckoff’s book. “Of course, with the prospect of increasing their savings exponentially every couple of months, few ever redeemed anything.”

Mr. Ponzi was convicted of mail fraud in 1920 and served time in federal and state prisons before he was deported to Italy in 1934, never having become a citizen. He died penniless in Rio de Janeiro in 1949 and was buried in a pauper’s cemetery there.”

However, the Deal Professor points to some differences between the Ponzi scheme and the “Madoff scheme”:

“The term “Ponzi scheme” is used with regularity to describe just about any type of securities fraud that involves a fast shuffle in which the promoter diverts assets from a get-rich-quick investment program. Perhaps we should dub a new type of fraud, the “Madoff scheme,” in light of the $50 billion fraud that prosecutors say Bernard L. Madoff perpetrated on a range of supposedly sophisticated hedge funds, financial institutions and wealthy individuals.

Charles Ponzi made his money hawking an investment in international postage stamps that promised to double investors’ money in 90 days, sucking in 40,000 people who lost millions.

Judging from the indictment, Mr. Madoff’s program was, in many ways, the exact opposite of the pyramid schemes that offer outsized returns on investments in everything from solar-powered gadgets to the latest social-networking site.

Rather than preying on retail clients dazzled by visions of quick riches, Mr. Madoff catered to the very rich, promising not great wealth — they already had that — but the steady returns that would keep their assets safe and secure.

The Madoff scheme is built on trust, rather than naked greed, although it is hard to describe his clientele as altruistic when they were happy taking in steady annual returns to pad their millions (or billions) in assets. By delivering what is reported to be consistent growth of 10 percent to 12 percent per year, regardless of the market environment, he played on the desire of his investors for enough money to keep them in the top 1 percent of the world’s richest.

Who roots for the hare over the tortoise, anyway? The widely admired trait of our leading investment gurus, like Warren Buffett and Bill Gross, is the slow-and-steady approach of the long-term investor who shuns the latest fads and ignores quarterly earnings hiccups. This was a stay-rich-for-a-long-time plan.”

What is puzzling is how Madoff managed to conduct his operations in a clandestine manner for several years all the while staying outside the purview of the regulator. The losses he built up reveal a startling amount of $50 billion – the number that is currently doing the rounds. This is said to be an all time record amount as far as financial frauds are concerned – but, I am tempted to ask what the ado is all about, since 2008 has been a year of financial records and lows anyway! Even though inspections and investigations were conducted by the SEC in the past, they did not unearth anything untoward. Curiously enough, newspaper reports suggest that finally it was Madoff who turned himself in before he was found out. The New York Times has a report on SEC’s previous investigations:

“The company was registered by Mr. Madoff as an investment adviser in September 2006. The commission as a practice tries to examine advisers within a year of registration, and then at least once every five years afterward. But commission officials said Mr. Madoff’s firm had never been examined.

Sixteen years ago, the agency sued two Florida accountants who had collected more than $440 million from investors to be managed by Mr. Madoff. The agency sued the accountants, but not Mr. Madoff, who said he did not know that the accountants were selling securities that had not been registered.

The agency said at the time that a court-appointed trustee had concluded all the money invested was accounted for. Former commission officials recalled that they closely examined the firm at the time and did not uncover evidence that Mr. Madoff had broken any rules.

In 2005, an examination by the commission’s office of compliance, inspections and examinations scrutinized the broker-dealer unit of the firm. It found that the unit had three relatively minor technical violations.”

There will certainly be a lot of soul-searching regarding the role and powers of the SEC in the days and months to come. This also serves as a reminder that detecting and acting upon financial and securities frauds is a tremendously onerous task, and may not always meet with success. In India, we are often quick to lament (including sometimes on this Blog, I must admit) about SEBI’s inability to succeed before the Securities Appellate Tribunal (SAT) in a greater number of its actions for insider trading, fraud, stock manipulation and the like. If the world’s leading securities regulator with a longer history and superior enforcement resources has missed its target by a wide margin, SEBI’s record perhaps deserves a more considerate response.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

1 comment

  • I heard this funny take on a Ponzi scheme on a net video: Isn’t a social security scheme such as the one in the U.S. a Ponzi scheme too? – with new entrants to the system contributing for the benefit of the existing members, while they themselves will almost certainly not receive pension benefits in the future.

Subscribe to Blog via Email

Enter your email address to subscribe to this blog and receive notifications of new posts by email.

Top Posts & Pages


Recent Comments


web analytics

Social Media