Saturday, August 29, 2009

One of Bernard Madoff's lieutenants, Frank DiPascali Jr., pled guilty last week to ten federal felony counts and settled an SEC complaint. Of primary importance to the thousands of investors who lost money in Madoff's Ponzi scheme, DiPascali agreed to cooperate with authorities in investigating the Madoff fraud. Because of DiPascali's cooperation, additional criminal indictments are certain to follow. In the ensuing process, the numerous civil actions for recovery of amounts lost will be significantly enhanced.

Who is Next to Fall?

DiPascali's former boss, Bernard Madoff (age 71), is now in prison with a 150 year sentence after pleading guilty to eleven counts himself. Madoff's plea over the $65 billion Ponzi scheme did not include cooperation or information regarding other's involvement. This is one of the reasons that DiPascali, as the first person to fully cooperate with the government, is important. In a seven-page agreement between the federal government and DiPascali, prosecutors will write a letter to DiPascali's sentencing judge spelling out his cooperation. This in turn will allow the judge to give DiPascali a reduced sentence. Without the reduced sentence, DiPascali (age 52) would face at least 120 years in prison for the ten guilty pleas that he made.

DiPascali spent 33 years working for Madoff and his firm (Bernard L. Madoff Investment Securities LLC, or BMIS), starting right after his graduation from high school in 1975. DiPascali admitted that from the late 1980s until December 2008, he assisted Madoff with the Ponzi scheme. During that time, DiPascali said no purchases or sales of securities took place. "It was all fake. It was all fictitious. … I knew no trades were happening".

As part of the cooperation that has already occurred, DiPascali provides details on how he and unidentified others helped Madoff used historical stock data from the Internet to create fake trade records, sent massive volumes of fraudulent account statements to clients, and executed wire transfers between accounts to create the impression that the firm was earning commissions. Although each of the following are owed due process protections, here are some leading candidates who likely would prefer that DiPascali follow Madoff's lead of non-cooperation:

1. The owners and management of any of Madoff's numerous feeder funds and investor referral sources - The largest of these feeders were Fairfield Greenwich Group, Ashcott Partners, and Tremont Advisors.

2. Andrew and Mark Madoff, Bernard Madoff's sons who ran Madoff's broker-dealer

3. Peter Madoff, Bernard Madoff's brother and general counsel, who worked in Madoff's operations for more than forty years

4. All key employees who programmed or operated any of the accounting or computer systems that Madoff's entities used

5. The owners and management of Cohmad Securities (whose name combines Madoff and Cohn, one of Madoff's neighbors), which was physically located within the same space as Madoff's operations, and which signed up numerous Madoff investors

6. Stanley Chais and his Brighton Company - Chais is a California investment advisor who steered money to Madoff, and who for years earned large profits from Madoff's investments.

7. Paul Kronigsberg, a New York city accountant - Mr. Kronigsberg prepared Madoff-affiliate tax returns, received regular payments for Madoff-entity work, and performed work for numerous Madoff investors

8. Shana Madoff, Bernard Madoff's niece, and her husband Eric Swanson - Swanson was with the SEC for ten years prior to departing in 2006. Shana Madoff served on a committee at the FINRA, a Wall Street regulator discussed below.

So far, the only other person charged in the fraud is Madoff's outside accountant, David Friehling, who pleaded not guilty in mid-July 2009.

Despite an agreement with prosecutors that DiPascali be granted $2.5 million bail pending sentencing, the judge denied bail after DiPascali's guilty plea because he feared DiPascali was a flight risk. Prosecutors desired bail so as to facilitate DiPascali's cooperation. Sentencing is currently set for May 15, 2010, although this date will be delayed considerably if prosecutors indicate they desire more time to obtain all information that they think DiPascali has.

The SEC's Complaint Provides New and Useful Details

The Securities and Exchange Commission (SEC) filed a complaint against DiPascali on August 11, 2009, which was also settled as part of the deal. The SEC complaint provides numerous details of how the Madoff fraud occurred and was covered up. Here are a few details and our comments on each:

1. There can be little doubt that the various feeder funds that provided investor moneys knew or should have known that something was foul. According to the SEC:

"Over time, this advisory business expanded and various accountants and financial advisors began soliciting individual investors around the country and providing the money they raised to BMIS. These "feeders" sometimes issued to investors promissory notes that guaranteed high rates of return ~ 19%) and then invested the proceeds with BMIS at higher rates promised by Madoff (~ 21%), seeking to pocket the difference for themselves. Unlike the friends and family accounts, Madoff and BMIS did not deal directly with these individual investors. Instead, Madoff dealt with the feeders and set up aggregate, pooled accounts at BMIS for each feeder, leaving it to the feeder to deal with the individual investors, issue statements to such investors, and make distribution payments to them."

Guaranteed returns of 19% or 21%? No one with any level of sophistication – certainly not financial intermediaries handling other investors' money – could reasonably believe that such returns were real.

2. The fact that a high-school-only educated person was running a supposedly sophisticated and gigantic securities operation on a day-to-day basis should have raised questions by both regulators and investors. Any legitimate feeder fund and any legitimate regulator should have immediately questioned the credibility and qualifications of an individual rising to the position DiPascali obtained. According to the SEC:

"DiPascali joined BMIS in 1975, at the age of 19, when BMIS was a small market-maker with approximately a dozen employees. A college dropout, DiPascali was introduced to BMIS by his neighbor and friend, a longtime BMIS employee who first joined in 1968."

3. As noted above, Madoff contends that he committed the fraud himself. Given the magnitude of the fraud, this was never plausible. The SEC complaint provides a glimpse into just how extensive the fabrications were. This means that, as DiPascali maintains, there are others to be implicated. According to the SEC:

"DiPascali helped Madoff structure and record non-existent trades that were reflected on millions of pages of customer confirmations and account statements distributed each year. Not one of the trades purportedly executed as part of this strategy ever occurred….

With the benefit of hindsight, DiPascali picked advantageous historical prices, often near the lows, to create the appearance of a profit once the purported trade was booked. DiPascali did the same for the options, virtually guaranteeing that the purported trading would appear to be profitable. … Since no actual purchase or sale took place, DiPascali could examine the historical prices of the securities comprising the basket, and pick such date and pricing for the 'sale' of the basket as was needed to achieve the targeted rate of return ….

Under DiPascali's oversight, BMIS' programmers organized the new accounts on a single IDM AS/400 computer. The accounts were set up so that one set of "trades" could be entered on an aggregate basis for all the accounts, and the computer would automatically allocate the fictitious trades, pro rata, to the various individual accounts. Once Madoff and DiPascali identified a basket trade that achieved the fictitious targeted return, the trade was proportionally replicated in each account automatically. The system then generated separate trade confirmations and account statements for each account based on its pro rata share of the purported trading and carried forward the account holdings from month-to-month."

4. Although the SEC would not want to criticize its own auditors, the SEC indirectly does just that in multiple places. Any competent auditor knows that part of the job is to obtain information from independent sources as an overall sanity test of what is being examined, even if this is as simple as news reports regarding the industry. Any such sanity test would have alerted the government auditors that Madoff's operation was not a small-time advisory business. Nevertheless, the government auditors who had the opportunity to catch the fraud were clueless about the entity that they were auditing. According to the SEC:

"Although great effort was made to conceal the existence of advisory accounts to the fullest extent possible, some audits and regulatory inquiries required an acknowledgment that the business existed and the production of books and records to substantiate the activity in those accounts. However, Madoff was careful to avoid ever disclosing the scope and magnitude of the accounts, hiding the fact that there were several thousand accounts with aggregate values in excess of $50 billion. Accordingly, DiPascali helped Madoff devise a shifting subset of 10 to 25 accounts - the "special" accounts - which they deceptively presented as the universe of BMIS advisory accounts. DiPascali and others then prepared various fake books and records reflecting only this subset. This way, BMIS provided auditors and regulators with just enough information to make the phony books and records appear credible but not enough to appreciate the magnitude of the advisory business."

5. The government auditors were lazy when deciding to not perform standard audit procedures that would have caught the fraud. Because the non-existent independent parties with whom confirmation should have been received were supposedly in far-away time zones (or required additional postage), the auditors simply bypassed standard independent confirmation. According to the SEC:

"BMIS received specific requests from regulators for order execution information for the advisory accounts. Since billions of dollars of fictitious trades were generally keyed into the AS/400 at one time, DiPascali could not use the data as it existed on the AS/400 because the order time would not be credible. Instead, he developed a report that would appear to reflect actual trading, at variable intervals and in different increments. To generate the report, DiPascali and 19 others created and used a random number generator program to break up the massive trades into orders of variant sizes and prices and to randomly distribute the trades across different times. Furthermore, to avoid the possibility that the pricing at those intervals might not match the consolidated trading tape, DiPascali directed that the orders be "executed" during the early part of the day in Europe (the middle of the night in the U.S.). Madoff, DiPascali and others then represented that the single execution price reflected on the investor confirmations was an average price for trading purportedly done in the European market….

The advisory account records on the AS/400 did not reflect any counterparty information (because none existed). To respond to inquiries from regulators and auditors, however, DiPascali had to create credible trade blotters for the BMIS advisory business that included counterparty information. Including counterparties, however, created a risk of detection because the regulator or auditor might approach the counterparty for its corresponding records and compare the two. This risk was particularly acute for option trades because Madoff and DiPascali, when pressed about the volume or pricing of option positions, would explain that the option trading was not done on any exchange but directly with counterparties over-the-counter. To alleviate this risk, DiPascali, at Madoff's direction, created a list of counterparties that were unlikely to be approached for verification. On the one hand, when regulators and auditors in the U.S. asked for the information, DiPascali provided a list of European financial institutions. On the other hand, when auditors for European investors asked for the information, DiPascali provided names of U.S. dealers. In addition to providing the list of names, DiPascali directed that fake trade blotters be prepared for only the "special" accounts to reflect fictitious trading with the various counterparties on the relevant list. These records were provided to regulators and auditors.

6. Like so many other Ponzi schemes that fell apart because of the recession, Madoff's Ponzi scheme also unraveled because of investors' unease with a falling securities market. According to the SEC:

"By the summer of 2008, the value of this affiliated account exceeded $5.5 billion. Following the market collapse in September 2008, however, investor redemptions spiked dramatically, requiring Madoff to distribute to investors more than $6 billion in the final three months of the fraud. …

In the final days of the fraud, the money available to meet investor redemptions had dwindled to a few hundred million dollars. DiPascali and Madoff discussed using the remaining funds to liquidate the accounts of family and friends of the firm, including employees, rather than honor redemption requests by BMIS' larger institutional investors. To that end, DiPascali reviewed BMIS investor lists and identified which accounts should be liquidated. With Madoff's approval, he then instructed that checks be prepared to liquidate those accounts. These checks, totaling more than $150 million, 15 were then prepared. However, Madoff was arrested and the checks were seized before they could be distributed."

Both the SEC and FINRA were Asleep

The SEC also enlightens an issue of how (and which) regulators were asleep while this fraud occurred. The SEC has publicly and deservedly taken a lot of bad press. But, FINRA should not be escaping regulatory blame. Madoff did not officially become a registered investment adviser until 2006. Through 2006, his business would have been regulated by the SEC and NASD (now called FINRA). Why should FINRA escape criticism in this scandal? According to the SEC:

"BMIS registered with the Commission as a broker-dealer in 1960 and as an investment adviser in September 2006. BMIS used to occupy floors 17-19 of the Lipstick Building in Manhattan, New York City. BMIS purportedly engaged in three different operations: investment adviser services; market-making services; and proprietary trading. BMIS is currently under the control of a trustee appointed pursuant to the Securities Investor Protection Act of 1970."

FINRA clearly directly regulates broker-dealers and broker-dealer activities with its advisory clients. FINRA would certainly agree that it has jurisdiction over a generic broker-dealer (i.e., someone other than Madoff) that the SEC describes in the above quote. Nevertheless, FINRA (including its former chief executive Mary Shapiro, who is now Chairperson of the SEC) steadfastly maintains that it does not have jurisdiction over Madoff. The SEC describes an operation that both the SEC and FINRA would regulate.

All firms that FINRA regulates are obligated by FINRA to carry Securities Investor Insurance Corporation (SIPC) insurance. This is important because SIPC is (i) covering (with limitations) claims made by Madoff victims, and (ii) using the Madoff loss as justification for enormously increasing the cost of SIPC insurance. If FINRA has no jurisdiction, why is SIPC involved in their claim process. The best explanation is that the thousands of phony statements Madoff sent out listed FINRA and SIPC as having jurisdiction over the accounts. Had FINRA and SIPC not been asleep, they would be aware that (i) Madoff's high-profile operation was actually under their jurisdiction, and (ii) thousands of statements were being sent each month that identified these regulators as having jurisdiction.

For information regarding how the Madoff scheme could have been easily identified, Largest-ever Ponzi scheme should have been obvious.

Fulcrum Inquiry performs forensic accounting and financial investigations, including fraud audits.