“A typical Ponzi scheme involves taking money from investors, then paying them off with money taken from new investors, rather than paying them from actual earning.”
Amy Goodman, American Columnist (from the 2011 article “The Real Ponzi Scheme is Wall Street”)
I asked myself this question after watching the Netflix Documentary “Madoff, The Monster of Wall Street”. The four-part documentary details the rise and fall of Bernie Madoff and his $64.8 billion-dollar Ponzi scheme1. I first want to acknowledge and give grace to those who lost their hard-earned money in this scheme. For the world watching, it is easy to point to the obvious signs of fraud now. I won’t do that here. My goal is to look at how Bernie’s status gave him unchecked power and control over people. I also want to teach investors how to spot red flags that could warn you of an investment scam.
How It Started
Bernie Madoff created Bernard L. Madoff Investment Securities LLC in 1960 with $5,000. He was a broker-dealer2 for penny stocks. What made Bernie’s company competitive was that it used computer technology to generate quotes for stock prices. Today, it is common practice to buy and sell stocks online. However, in the late 1970’s and early 1980’s you called your broker to buy or sell a security. They then called someone else to execute the trade. The process took days. Bernie was able to reduce the amount of time it took to place a trade thus making his firm attractive to clients. Bernard L. Madoff Investment Securities LLC eventually took this technology and formed what is now known as the NASDAQ.
How It Ended
According to the plea allocution Bernie started managing funds3 for family and friends in 1991. This fund was not registered with the SEC thus run illegally. This fund was exclusive and discreet. His clients were asked to keep quiet about the fund and who was running it. This illegal fund, raised and distributed billions of dollars over 15 years without investing any of the money received. In 2008, at the height of the financial crisis when families across the world were losing their homes and jobs, his clients began to request to withdraw their money. And with no new money coming in and large sums of money going out, the Ponzi scheme collapsed.
As stated earlier I give grace to his victims. These were people and companies who were lied to for many years. He targeted his friends, retirees, family, wealthy and his own Jewish community. He bankrupted people and ruined entire family relationships. It was greed and the love of money that are to blame. It was the work of many people, not just Bernie, that kept this scam going for as long as it did.
Red Flags
Let’s look at three red flags in Madoff’s Ponzi Scheme (and many other scams) that should prompt you to dig deeper on whether it is legit.
He wasn’t registered as an investment adviser4. To take money from investors and pool them in funds you must register with the SEC. He did not do that. He ran his investment firm under the table without oversight. If someone is pitching you an investment, make sure they are knowledgeable with every detail and are legally registered to be in business.
He promised and delivered (for a while) consistently high returns5. This is the main indicator of any scheme. No investment can guarantee you consistent high returns. No matter how unique and smart leadership is. If that were the case everyone would do it and everyone would be rich. If someone promises you above average returns and no losses, they are lying to you.
His fund used exclusivity to create a sense of urgency and frenzy. Most scams require you to act fast to prevent you from missing out. Bernie branded his fund as invite only. And if he should allow you in the private community that means you should act fast and ask no questions.
Bonus: Listen to the Critics
Madoff’s critics were very vocal about his inability to generate the type of returns he delivered. Once other firms heard about Bernie’s method of gaining high returns they wanted to replicate his split strike options strategy and they couldn’t. It was mathematically impossible. Other firms were the first to know that he was lying about how he created high returns for his clients. The first article was written in 2001, 7 years before the firm crumbled. One skeptic most vocal was Harry Markopolos. He wrote two memos (the first in 2000) to the SEC providing details outlining Madoff and his team’s Ponzi scheme, both were completely ignored. Being able to listen to a critic of your investment gives you a balanced view of the good and the bad.
The truth is, there will be other Bernie Madoffs and Ponzi schemes. As investors, we must do all we can to protect our capital. The age old saying “If it is too good to be true, it probably is” is key. You can be optimistic and skeptical at the same time.
Glossary
- Ponzi Scheme-an investment fraud that pays existing investors with funds collected from new investors. Usually, promising high returns with little to no risk. (via Investor.gov)
- Broker-Dealer-a person or firm that buys and sells securities6 for their clients. Think Charles Schwab or Fidelity Investments. These firms make money from fees when you buy or sell.
- Investment Firm/Fund– A partnership, trust or corporation that pools money from investors and invest it in security instruments for gain. (via FinanceWalk)
- Investment Advisor- a person or company that makes recommendations on how to invest your money for a fee.
- Returns-money made (or loss) on an investment.
- Securities-a financial instrument that holds monetary value. (ex. stock, CDs, bonds, cryptocurrency)
The principles of money 
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