Markopolos Investigation of Bernie Madoff

Markopolos Investigation of Bernie Madoff

In late 2008, Bernie Madoff, a then-reputable career New York financial professional and a former NASDAQ Chairman, confessed to federal authorities that he had been running a tremendous Ponzi scheme from his financial investment and securities firm in midtown Manhattan (LeBor, 2010). That illegal operation was maintained on an entirely separate floor from the legitimate side of Madoff's firm. Over the course of several decades, it had fraudulently taken charge of more than $50 billion from hundreds of investors (LeBor, 2010). The operation was a classic Ponzi scheme in that it paid existing investors with the money contributed by newer investors. It was also a classic "affinity" scam in that Madoff preyed almost exclusively on fellow members of his social community, especially the New York Jewish community and Jewish philanthropic societies (Henriques, 2011; Kirtzman, 2010; Ross, 2009). Madoff perpetrated the scam by creating and regularly furnishing all his victims with false investment income statements that disguised the money they received from more recent investors as "investment income" from non-existent investments (Markopolos, et al., 2010).

For almost a decade preceding his confession and arrest in 2008, Harry Markopolos, a financial investigator in Boston, had attempted to alert the appropriate authorities to the illegal scheme being perpetrated by Madoff (LeBor, 2010; Markopolos, et al., 2010). Markopolos examined Madoff's supposed investments for the first time in 1999 simply because he had been instructed by his firm to deconstruct Madoff's investment strategy for the purpose of implementing one that might be similarly successful (Markopolos, et al., 2010).

According to Markopolos, it was apparent to him in "thirty" seconds that Madoff's operation was either a Ponzi scheme or the result of illegal insider trading; it took him only a few more hours of mathematical modeling to prove that Madoff's trading strategy was absolutely impossible (Markopolos, et al., 2010). He contacted the U.S. Security and Exchange Commission (SEC) numerous times in between 2000 and 2007, in connection with which he provided extensive documentation proving his allegations. Those communications were ignored, thereby allowing the scheme to continue to defraud more and more victims until Madoff finally confessed in late 2008 (Markopolos, et al., 2010).

The Initial Investigation of Madoff by Markopolos

In 1999, Harry Markopolos was employed by the Rampart Investment Management firm in Boston when he was asked to deconstruct the so-called "split strike conversion" investment strategy upon which Madoff had claimed to have relied upon to generate extremely consistent positive returns on his investments (Markopolos, et al., 2010). At that time, Rampart had been trading regularly with Access International which had simultaneously been investing in the hedge fund being managed by Madoff. Without necessarily suspecting any improprieties initially, the purpose of that investigation was simply to enable Rampart to create a similar investment product to compete with Madoff and secure more business from Access (LeBor, 2010; Markopolos, et al., 2010). In principle, Madoff had claimed that his "split-strike conversion" strategy was responsible for the ability of his hedge fund to regularly generate investment income of approximately 2% for all of his clients (LeBor, 2010; Markopolos, et al., 2010).

Markopolos applied his academic background in advanced mathematics to critically examine the earnings statements published by Madoff covering approximately the previous seven years of trading in conjunction with the strategy that Madoff claimed he had been using so successfully. According to Markopolos, he realize in thirty seconds that what Madoff had claimed was absolutely impossible (LeBor, 2010; Markopolos, et al., 2010). He then spent the next four hours constructing mathematical models to prove empirically what he suspected intuitively. Those models indicate that the success rate achieved by Madoff were the statistical equivalent of a Major League Baseball player maintaining a 0.960 batting average over a long-term career (Markopolos, et al., 2010).

Further investigation by Markopolos revealed that to execute the volume of trading necessary to support the strategy claimed by Madoff to be the method behind his success, Madoff would actually have to have traded more shares than the sum total of all tradable shares on the market (Kirtzman, 2010; Markopolos, et al., 2010). Markopolos then followed up with his extensive contacts in the financial trading sector and was unable to identify a single trader who was aware of any trades ever executed by Madoff. That immediately lead Markopolos to suspect that Madoff might not have ever even traded shares at all but was simply managing a tremendous Ponzi scheme, disguising the dispensation of new clients' money as dividends and investment income paid out to exiting clients (Markopolos, et al., 2010).

However, Markopolos also suspected that Madoff was involved in an illegal operation for a reason entirely distinct from any of the sophisticated mathematical methods that he used to analyze the supposed trading strategy itself. Specifically, he suspected Madoff because his professional behavior was so bizarre: Madoff, head of a prominent New York brokerage firm, would maintain a secretive money management business operation "on the side" of his mainstream business and why he would furnish his hedge fund management services to his hundreds of wealthy investors without ever charging a fee for his services (LeBor, 2010; Markopolos, et al., 2010).

Markopolos's Multiple Unsuccessful Attempts to Alert the Authorities

Markopolos contacted the federal authorities about Madoff for the first time in 2000, filing a formal complaint with the SEC field office in Boston (LeBor, 2010; Markopolos, et al., 2010). When that complaint failed to generate a formal investigation by that agency, Markopolos followed up with a much more extensive report in 2001 in which he detailed his suspicions and demonstrated the mathematical impossibility of the returns claimed by Madoff. In that second complaint, Markopolos also offered to conduct an undercover mission to secure records directly from Madoff's firm for comparison to records of the Options Price Reporting Authority (OPRA), which would have established conclusively whether or not Madoff had executed the trades that he claimed to have executed and actually generated the dividends he purportedly had been paying out. That complaint was also ignored by the SEC (LeBor, 2010; Markopolos, et al., 2010).

After that second attempt to alert the SEC to Madoff's operation, Markopolos then traveled to Europe to and had the opportunity to interview more than a dozen hedge fund managers, each of whom then believed that his fund was the only fund feeding Madoff new money (one from which Madoff was taking new money (LeBor, 2010; Markopolos, et al., 2010). That confirmed Markopolos's suspicions that Madoff's operation was nothing more complicated than a classic Ponzi scheme (Markopolos, et al., 2010).

Markopolos eventually compiled an even more extensive presentation that consisted of twenty-one pages and was entitled the World's Largest Hedge Fund is a Fraud, which he furnished to the SEC in 2005 (LeBor, 2010; Markopolos, et al., 2010). That report detailed a decade and a half's worth of Madoff's supposed trades during which Madoff reported only four months of losses. Incredibly, the SEC again failed to take appropriate action or to launch an official investigation of any kind based on the extensive information and analyses furnished by Markopolos.