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The Madoff Red Flags, Let’s Count Them at Trader’s Narrative

The Madoff Red Flags, Let’s Count Them

After writing that Madoff offers the biggest due diligence lesson for investors, some argued that the red flags are only obvious in hindsight and wouldn’t have been if so clear if one had to make the decision before Bernard’s admission of running a Ponzi scheme.

To be generous, I’ve assumed that the whole nature of the trading strategy, the inability of others to reverse engineer it, and the eerie equity curve it created, were not red flags.

So let’s count the other red flags and see if they were numerous enough and obvious enough. (The thumbnails are from the SEC’s website and clicking on them will take you to the larger version.)

Madoff Investment Securities was both the broker dealer and investment advisor:
madoff broker dealer SEC investment adviser public disclosure red flag madoff broker dealer 2 SEC investment adviser public disclosure red flag

Madoff traded in the same securities that he recommended to advisory clients:
madoff conflict of interest SEC investment adviser public disclosure red flag

Madoff not only was the broker dealer, creating a conflict of interest where his firm was trading in the same securities as he was trading for clients, but he actually had custody of the assets!

madoff custody of client assets SEC investment adviser public disclosure red flag

They got into some hot water over some small compliance issues. Madoff’s firm was censured and fined a small amount $7,000. This meant they did have a blot on their records:

madoff violation 2 SEC investment adviser public disclosure red flag madoff violation SEC investment adviser public disclosure red flag

Jim Vos, head of Aksia - a hedge fund advisory firm, noticed that although Madoff’s firm was supposedly highly advanced and automated, they sent paper copies of their trading records to clients instead of providing electronic access to the firm’s trading platform.

Madoff Investment Securities’ auditors were Friehling & Horowitz, a 3 person team which consisted of one lone CPA with a small 13′ by 18′ office in New York. Hardly adequate to monitor a firm that traded a good chunk of NYSE and NASDAQ volume.

Shockingly enough, Madoff didn’t take the usual 2/20 fees most hedge funds do. Instead he only profited from the trades that his firm was doing for the “investment fund”, claiming that this was enough. Given this form of compensation, it is very possible most “sophisticated investors” assumed that Madoff was involved in some sort of shenanigans but turned a blind eye for those stable returns.

Here’s an excerpt from a 2001 Barron’s article on Madoff Investment Securities secrecy:

Curiously, he charges no fees for his money-management
services. Nor does he take a cut of the 1.5% fees marketers like
Fairfield Greenwich charge investors each year. Why not? “We’re
perfectly happy to just earn commissions on the trades,” he says.

Perhaps so. But consider the sheer scope of the money Madoff would
appear to be leaving on the table. A typical hedge fund charges 1% of
assets annually, plus 20% of profits. On a $6 billion fund generating
15% annual returns, that adds up to $240 million a year.

The lessons of Long-Term Capital Management’s collapse are that
investors need, or should want, transparency in their money manager’s
investment strategy. But Madoff’s investors rave about his performance
– even though they don’t understand how he does it.

Madoff Investment Securities was a family business, with Madoff’s brother, sons and daughter as well as his niece (married to a previous SEC compliance officer) all worked at the firm.

mark madoff and bernard madoff investment securities

“All of his family members grew up with this being our lives. When it is a family operated business you don’t go home at night and shut everything off, so you take things home with you, which is how all of us grew up”

Mark Madoff (pictured on the right with his father, Bernard L. Madoff, left)

Peter Madoff, pictured below, was a senior managing director and head of trading and compliance at Madoff Investment Securities. He began at the firm in 1965. With so much family involvement, one can’t help but ask how much they knew and if it was even possible for one lone patriarch to organize, control and maintain such a huge fraud all by himself.

peter madoff bernard l madoff investment securities Click to see large version:
madoff family business SEC investment adviser public disclosure red flag

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10 Responses to “The Madoff Red Flags, Let’s Count Them”  

  1. 1 aboutoretire

    Although I have empathy for those investors who lost their wealth, it is not hard to conclude that they were very lax or even lazy in their deliberations when they choose to join the Madoff club. Futhermore all eyes are now looking to the SEC for a possible scape goat. That is passing onto them powers that we are not prepared to give up. Do we have to have a policeman to hold our hand everytime we cross the street ? We are all consenting adults and have to take responsiblity for our decisions however silly and reckless they may apprer in hindsight !!

  2. 2 Russ Abbott

    I’ll repeat my challenge. What are the red flags in the economy that we are ignoring now, and what should we do about them?

    Now that I think about it, 9/11 had a similar collection of red flags that were not followed up.

    It’s certainly useful to learn lessons from past mistakes. Once we see how a particular pattern of red flags may lead to a potential disaster, we can be on the lookout for that pattern in the future. But I’m still not convinced that it’s as easy as suggested to see red flag patterns that we had not previously experienced and respond to them before they turn into disasters.

    So again, here’s my challenge to anyone who thinks it was stupidity or laziness that produced the Madoff affair. What are the current red flag patterns that we are not seeing, and what should we do about them?

  3. 3 Russ Abbott

    What do you think would have been the response before 9/11 to the suggestion that everyone who boards an airplane be required to have their belongings inspected, including removing their shoes and possibly being patted down by guards? Who would have agreed to the lines that would cause? Who would agree to pay for the inspectors and the inspection machinery? Who would have agreed to set aside the space in airport terminals to do the inspection? Who would have agreed to require that airports divide themselves into sanitized and unsanitized areas and control passage from one to the other. Before an event, it’s very difficult to imagine what the world will look like after the event.

  4. 4 Babak

    Russ, your challenge is a non sequitur because you are confusing a specific investment fund with the economy and 9/11. The red flags were there as you can see above - all of those things are extremely out of the ordinary and should have given anyone pause.
    btw, there were warnings of 9/11 Bush just ignored them

  5. 5 Matt Rafat

    Babak, thank you for pointing out that these investors failed to perform due diligence. More on this after the jump

    I hope the blogging community won’t let Madoff’s investors get a taxpayer bailout.

  6. 6 alex farguson

    Hi, I can’t understand how to add your site in my rss reader. Can you Help me, please :)

  7. 7 Babak

    alex, you can just google ‘how to use RSS’, it is really easy.

  8. 8 JR

    God has finally balanced the accounting of the Madoff scandal. One son dead, one to go. AMEN

  9. 9 Richard

    JR, I am glad you know all the facts here….. So the father sits in jail while the son gets lawsuit after lawsuit filed against him. The feds have still not found enough evidence to put a single indictment against the son. Maybe the son is or was guilty but all I am saying is can you only imagine if the son was not guilty. You are working for your father figuring you got life made. The you find out your father has been scammiing everyone including you and now everyone thinks you are just as guilty as your father. That sounds like the type of person who can not take it and kills himself. The type who knows he is scamming everyone would not care. There is no balance here anywhere. And I am sure God did not want the son to take his own life.

  1. 1 Bernard Madoff — Hiding in plain sight under the cover of SEC regulation |

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