From The Sunday Times
December 14, 2008
Only Fools and Horlicks: possibly the biggest fraud in corporate history
The ‘superwoman’ fund manager is just one victim of an alleged £33
billion pyramid scheme
Dominic Rushe in New York and Iain Dey
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.
http://www.timesonl
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Sunday, 14 December 2008
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