Madoff Scam

The Madoff Era Era, Fraud Schemes

Part 1 The Madoff Era: Ponzi Schemes S & The New Wave off Fraud

The Madoff Case • Bernard Madoff Professional Career : – Financial Services, Investment Management – Former Chairman of NASDAQ Stock Exchange – Founded Wall Street Firm Bernard L. L Madoff Investment Securities (BMIS) – Philanthropist

The Madoff Case • Red Flags : –E Expertt warnings i b other by th market k t analysts l t ((e.g. The Th World’s Largest Hedge Fund is a Fraud by Harry Markopolos) – "Bernie Madoff is running the world's largest unregistered hedge fund...” –Harry Markopolos – Unusual U lb business i practices ti – Reputation of the auditor

Madoff: A Ponzi Scheme • Definition : – A Ponzi scheme is an investment fraud wherein the operator promises high financial returns or dividends that are not available through traditional investments investments. Instead of investing victims' funds, the operator pays "dividends" to initial investors using the principle amounts t "invested" "i t d" b by subsequent b t iinvestors. t

Source: fbi.gov

Ponzi Schemes • History : – Ponzi schemes are named for Charles Ponzi, who deceived thousands of New England residents into investing in postage stamps back in the 1920s 1920s. Ponzi thought he could take advantage of differences between U.S. and foreign currencies used to buy and sellll iinternational t ti l mailil coupons. P Ponzii ttold ld iinvestors t that he could provide a 40-50% return in just 90 days p to the interest rates for bank savings g compared accounts, stocks and bonds.

Ponzi Schemes • How to protect against a Ponzi Scheme: – – – – –

Be skeptical about investments Be skeptical about reputations Diversification of investments Due diligence Avoid “deferred” deferred payment plans

Ponzi Schemes on the Internet • Proliferation of advertisement videos for business opportunities structured as Ponzi schemes (i.e. YouTube.com). • The Better Business Bureau identified nearly 23,000 videos. – promoting ti "cash " h gifting" ifti " or ""gifting ifti club" l b" programs – nearly 60 million views – fees ranging from $150 to $5 $5,000 000

Lessons Learned ((or Not)) from the Madoff Case • What happened - Scheme based on trust, reputation, fueled by lack of diligence and regulatory failure •

What failed - Common

sense, individual diligence and skepticism, k ti i regulatory l t and d iinvestigative ti ti b body d oversight and follow-up

• What can we learn - Fraud

won’t go away, diligence and attention to red-flags is key

Technology and Fraud: Th N The New W Wave • Many fraud schemes have been the same for centuries but new technology has provided those seeking to commit fraud with more tools and options: – Greater reach to go after more victims • Email hoaxes that go out to millions of people • Websites that collect data from unsuspecting victims

– Greater anonymity • Email and the web can provide a cloak of anonymity for those that commit fraud

– Increased complexity (or at least apparent complexity) • Many people aren’t technologically savvy, and those that commit fraud prey upon this fact

Current Economic Environment • According g to the ACFE Report p to the Nation on Occupational Fraud and Abuse for 2008, US businesses will lose an estimated $994 billion in fraud losses (7% of their annual revenues) • Instances of fraud will likely increase during this period of duress • Companies are facing issues concerning valuation of assets such as asset-backed securities held as investments or cash equivalents

Currentt Economic C E i Environment – Psychology of Investment Scams

Current Economic Environment • The Fraud Triangle - Increase in the pressures and incentives during current economic crisis Pressure / Incentive

Rationalization

Opportunity pp y

Current Economic Environment 2008 Occupational Frauds by Category ‐ Median Loss

Type of Fraud

Fraudulent  Statements

$2,000,000

Corruption

$375,000

Asset  Misappropriation

$150,000

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

Median Loss Data obtained from the ACFE 2008 Report to the Nation on Occupational Fraud & Abuse (based on 959 cases of occupational fraud).

Psychology y gy of Investment Scams • 2006 Consumer Fraud Research Group study funded by the FINRA Investor Education Foundation revealed the following common tactics used by fraudsters as part of their approach: - The "Phantom Riches" Tactic - dangling the prospect of wealth, ealth enticing you with something you want but can't have. “These gas wells are guaranteed to produce $6,800 a month in income.” - The "Source Credibility" Tactic - trying to build credibility by claiming to be with a reputable firm or to have a special credential or experience. “Believe me, as a senior vice president of XYZ Firm, I would never sell an investment that doesn't produce.” Source: http://www.finra.org/Investors/ProtectYourself/

Psychology y gy of Investment Scams •The "Social Consensus" Tactic—leading you to believe that other savvy investors have already invested. "This is how ___ got his start. I know it's a lot of money, but I'm in—and so is my mom and half her church—and it's worth every dime.” •The "Reciprocity" Tactic—offering to do a small favor for you in return for a big favor. "I'll give you a break on my commission if you buy now—half off.” •The "Scarcity" Tactic—creating a false sense of urgency by claiming limited supply. "There are only two units left, so I'd sign today if I were you.” Source: http://www.finra.org/Investors/ProtectYourself/ http://www finra org/Investors/ProtectYourself/

Existing Securities Industry Regulations • Securities Regulation g • Federal Regulation: – Securities Act of 1933 – Securities Act of 1934 • Rule 10b – Anti-fraud provisions

• Investment Advisor Act of 1940 • Investment Company Act of 1940

Existing Securities Industry Regulations • Sarbanes-Oxley Act of 2002: – – – – –

Certification C tifi ti obligations bli ti ffor CEO CEOs and d CFOs CFO New standards for audit committee independence Enhanced financial disclosure requirements New protections for corporate whistleblowers Other criminal penalties: p • Document destruction • Freezing of assets • Bankruptcy loopholes

Fraud Prevention and Detection • Be cautious of "opportunities" to invest your money in franchises or investments that require q yyou to bring g in subsequent q investors to increase your profit or get back your initial investment. • If the offer of an "opportunity" appears too good to be true, it probably is. is Follow common business practice practice. For example, example legitimate business is rarely conducted in cash on a street corner. • Know K who h iis th the promoter t b behind hi d th the ttransaction. ti If you h have nott heard of a person or company that you intend to do business with, learn more about them. Depending on the amount of money that you intend to spend, you may want to visit the business location, check with the Better Business Bureau, or consult with your bank, an attorney, or the police.

Fraud Prevention and Detection • Be cautious of business deals that require you to sign nondisclosure or non-circumvention agreements g designed g to prevent the investor from independently verifying the background and credentials of people with whom you intend to do business. • Do not invest in anything unless you understand the deal. Con artists rely on complex transactions and faulty logic to "explain" fraudulent investment schemes schemes. • As with any investment perform due diligence. Independently verify the identity of the people involved, the authenticity of the deal, and the existence of the security in which you plan to invest.

Current Economy and Fraud • Current economic conditions increase pressures and cause fraud to rise • Red flags are important warnings • A little fraud soon becomes larger if left to grow

Fraud Prevention and Detection Initial Detection Method for Million Dollar Schemes  42.3%

Tip 20.0% 22.8%

Type of Detection

By Accident

19.4% 18.6% 18 6%

Internal Audit

16.7%

Internal Controls 9 1% 9.1% External Audit 3.2% Notified by Police

0.0%

46.2%

5.0%

All Cases $1,000,000+

23.3%

15.8%

6.0%

10.0%

15.0%

20.0% 25.0% 30.0% Percent of Cases

35.0%

40.0%

45.0%

50.0%

Data obtained from the ACFE 2008 Report to the Nation on Occupational Fraud & Abuse (based on 237 cases of occupational fraud involving $1 million or more).

Characteristics of Fraud (cont.) • Employee Fraud Costs the Average Business Approximately 6% of Total Annual Revenue • Fraud Costs U. S. Businesses More than $400 Billion Annually • Men M C Commit it 3/4 off R Reported t dF Fraud d Cases C

Wh Commits Who C it Fraud? F d? The 10 - 80 -10 10 Rule: ƒ

10% of any Workforce Would Never Take Anything y g

ƒ

80% of any Workforce Would Take Something if the Circumstances Were Right

ƒ

10% of any Workforce Would Take Something Regardless of the Circumstances

Source: The Association of Certified Fraud Examiners

Motive: Unshareable Need (Usually Financial) • • • • • • •

Gambling Bad Investments Impatience for the Good Life = High Debt Drug and/or Alcohol Abuse Family Debt Extramarital Affairs Need to Meet Productivity Targets

Opportunity: pp y

An Opportunity pp y to Commit Fraud Can Be Real or Perceived. Those Who Think They Will Get Caught Rarely Commit Fraud.

• Lack of Segregation of Duties (Do More W/Less) • Lack of Controlled Access to Vendor Master File • Lack of Accounts Payable Controls • Fox in Charge g of the Hen House • The “Out Post” Effect

Rationalization: Most Fraud Offenders Have to Be Able to Rationalize Their Behavior as Something Other Than a Crime

• • • • •

I’m Only Borrowing the Money y Else is Doing g it Everyone The Company Owes Me I’m Underpaid I Didn’t get my Bonus Because My Boss Took Credit for my Work • I’m I’ B Bored d

Red Flags: The Keys to Fraud Detection • Frauds Typically Start Off Small And Grow Over Time • Fraud Affects the Bottom Line • Prevention is Every Employee Employee’ss Responsibility • Ethics Must Start at the Top and Flow Downward • Exposure to Fraud Can Be Limited by Restricting pp Through g Effective Internal Controls Opportunities • Fraud is Present Within Every Organization Challenge - Identify and Minimize • Nearly All Frauds Could be Detected More Quickly if R d Fl Red Flags are nott IIgnored d