In Romania in the early 1990s – soon after it had shot Nicolae Ceausescu, its
communist dictator, and embraced capitalism – there was a rash of
get-rich-quick investment schemes in which thousands lost their paltry
savings.
On the Isle of Wight in 2001 a scheme called Women Empowering Women promised a
£24,000 return on a £3,000 investment. Men were banned. Just as well, said
some, when it collapsed in tears, debts, broken friendships and court
action.
This was “pyramid selling” in action – a confidence trick that rips off
foolish customers by pretending that money can be plucked out of the ether.
Who could be so gullible? Well, it turns out that naivety is not confined to
Transylvanian peasants and Sandown hairdressers.
Last week Bernard Madoff, a prominent Wall Street trader, was arrested and
accused of running a £33 billion pyramid scheme that fooled some of the most
prominent fund managers in the world, including Britain’s own “superwoman”
Nicola Horlick, and Man Group, the London hedge fund. It could be the
biggest fraud in corporate history.
This huge embarrassment for Horlick and the other wealthy victims offers some
light relief from the darkening recession, but it also raises new questions
about the way financial markets have been operating.
Alarm bells had been long sounding about Madoff. Letters had been sent to the
securities regulators questioning his business practices and analysts had
warned against investing with him, saying that his returns were too good to
be true. None-the-less, wealthy investors in America and Europe were taken
in – or suspended their disbelief.
Alphaville, a blog on the Financial Times website, yesterday featured a
podcast made in May in which Horlick told an interviewer that Madoff “is
very, very good at calling the US equity market . . . This guy has managed
to return 1% to 1.2% per month, year after year after year”.
As one financial commentator wrote yesterday: “Nothing stupefies like money.
Even the savviest investors tend to look the other way when extraordinary
returns are being made.”
IN America, pyramid selling is known as a Ponzi scheme – a backhanded tribute
to Charles Ponzi, an Italian immigrant with a long record as a swindler who
made more than $1m a week in the summer of 1920 by persuading people to
invest in his fraudulent Securities Exchange Company, which he said was
making 400% profits.
It was a classic pyramid: he lured investors into his scam by paying out vast
returns to a handful of people (himself included) amid great publicity. But
the company’s only income came from new investors who wanted a piece of the
action. Ultimately the Ponzi scheme collapsed, leaving the last people to
invest penniless.
Madoff – or “Made-off with ya money”, as he has been dubbed – now seems to
have an unchallengeable claim to Ponzi’s title as the biggest pyramid
swindler in US history. When the 70-year-old former chairman of the Nasdaq
stock exchange was arrested by the FBI on Thursday, he admitted that he had
been running a “giant Ponzi scheme”, according to prosecutors.
His apparently successful operation – which had $17 billion under management
from dozens of funds and hundreds of investors at the start of this year –
had been paying “profits” to established investors with money from new
investors.
It was a shocking fall for one of Wall Street’s biggest names and, as
investigations continue, one that leaves many unanswered questions.
America’s top financial watchdog, the Securities and Exchange Commission,
inspected Madoff’s business annually but failed to find any irregularities.
How was he able to get away with it for so long? Who was helping him and
what will it mean for his investors?
Britain’s most high-profile victim is Horlick’s Bramdean Alternatives, a
listed company in which Vincent Tchenguiz, the property tycoon, is reported
to have a £40m stake. Two county councils, Hampshire and Merseyside, also
had significant deposits with the firm. Bramdean said it had 9.5% of its
assets, worth about $20.9m, in funds that placed money with Madoff.
Bramdean said last night that the Madoff business “has been subject to due
diligence by many of the most experienced professionals in the global
markets”. It added: “It seems that criminal activity has continued
unfettered and undetected for years. This apparent failure raises
fundamental questions about the regulatory system under which this has
happened”.
Bramdean’s exposure is small compared with some of the other losers. The RMF
division of Man Group had $350m invested in funds that outsourced their
management to Madoff. The biggest victim appears to be the Fairfield
Greenwich Group, an American asset manager, which has $7.28 billion at risk.
Last night Royal Bank of Scotland admitted that it, too, had “some exposure”
to Madoff funds.
Some of the biggest names in fund management have been hit including
Santander, Union Bancaire Privée, BNP Paribas, the Tokyo-based Nomura
Holdings and Neue Privat Bank in Zurich. Banque Bénédict Hentsch, a
“white-glove” private bank based in Geneva, said it was exposed for $47.5m.
These losses translate into potential disaster for wealthy individuals in
Europe and America whose money was being funnelled into Madoff’s hands by
the big institutions. The alleged fraud has “swept up some of the most
prominent and wealthy Americans”, said Brad Friedman, a lawyer for some
victims: “Many who thought they were embarking on a comfortable retirement
have now been left destitute.”
MADOFF became a Wall Street titan from modest origins. He started his firm,
Bernard L Madoff Investment Securities, in 1960 with $5,000 that he had
saved working as a lifeguard at Rockaway Beach in Queens and at a job
installing sprinkler systems.
He fostered a veneer of exclusivity and created an Alist of investors that
became his most powerful marketing tool. From New York and Florida to
Minnesota and Texas, Madoff became an insider’s choice among well-heeled
investors seeking steady returns. By tapping into elite country clubs and
creating “invitation only” policies for investors, he recruited a steady
stream of new clients.
One of the largest clusters of Madoff investors was in Florida, where he
relied on a network of friends, family and business colleagues to attract
investors. “If you were eating lunch at the club or golfing, everyone was
always talking about how Madoff was making them all this money,” one
investor said. “Everyone wanted to sign up.” Another said Madoff’s clients
would joke that if he was a fraud he would take down half the world with
him.
Harder-headed professionals were not taken in. One highly respected
London-based investor said: “There have been many things that have surprised
me in the past 12 months but this is not one of them. To put it politely, Mr
Madoff never had a good reputation in the market. It was one of these things
that always seemed too good to be true – he never had a down month. We could
never quite work out what it was that he did.”
Salesmen who offered Madoff’s funds were often sketchy on the detail of how he
made his money. “The explanation was that he did this thing he described as
‘split strike trading’,” said one individual who turned down the chance to
invest. “After he described it, we always felt there was no way you could
make the kind of money he was making by doing that. It was one of a number
of red flags that jumped out.”
One Zurich-based investor said: “I first looked at the Madoff funds in about
2000 or 2001. I consider myself a fairly sophisticated guy, but I just
couldn’t understand this at all. Recently that’s become even more difficult
to understand. We saw a huge jump in volatility yet [he] was churning out
consistent returns. I was also suspicious that the guy had this huge firm
yet used a small firm of accountants in Westchester, New York, and half the
senior positions in the company seemed to be taken up by members of his
family.”
Madoff has so far maintained that he acted alone in orchestrating the fraud.
He was arrested last week after confessing to his sons Mark and Andrew, who
contacted the authorities. They hold senior positions in his firm but “are
not involved in the firm’s asset management business and neither had any
knowledge of the fraud before their father informed them of it on
Wednesday”, according to their lawyers.
Legal experts doubted that Madoff could have done so much damage on his own.
John Coffee, a professor at Columbia Law School, said: “It is very rare that
a fraud of this proportion could be handled by just one man. There are
trades and redemptions to be done that a 70-year-old man would have to work
20 hours a day to do.”
WHEN NEW RECRUITS RUN OUT, SO DOES THE MONEY
A pyramid or Ponzi scheme lures investors by ostentatiously paying out vast
returns to a handful of people and promising similar windfalls to new
investors.
But rather than earning money through investments, it funds its payouts by
recruiting an ever-increasing army of new investors whose money flows up to
the original investors. When the scheme inevitably collapses, the most
recent investors lose everything.
The methodology was demonstrated in the women-only “gifting” craze popular in
Britain a few years ago.
Investors in schemes such as Women Empowering Women had to hand over a “gift”
of £3,000 and then recruit two more gifters, each of whom would then recruit
two more in an ever-broadening pyramid.
They were promised £24,000 in return for their £3,000.
The prospect of acquiring money for free was heady and became the talk of the
Isle of Wight, where a large number of victims were concentrated. “It
wouldn’t be exaggerating to say you could walk down the high street of
Newport and see groups of people talking about it,” said Richard Stone, a
local trading standards inspector.
At the time, the trade department pointed out the flaw in the promise,
advising potential recruits there was no guarantee they would get their
money back as the scheme relied on an endless supply of recruits.
The department said: “Consideration of the mathematics shows it may not work
for the majority of participants. For each of eight investors to receive
£24,000 for their £3,000, it needs a further 64 people to invest. The 64
would need 512 investors, the 512 would need 4,096 participants and so on.
Eventually the supply of potential recruits will dry up, leaving most people
in the scheme with nothing.”
The schemes were able to operate outside investment laws because the investors
were technically offering gifts. The figure of £3,000 was well chosen: this
is the threshold above which gifts become liable for tax.
The 2005 Gambling Act and consumer protection legislation introduced this year
have made such schemes illegal, but in October there were reports of a
pyramid trying to get off the ground in Bristol and south Wales.
