The key to staying alive in this complex world is a competent investigation. It's why the lord gave us five senses, maybe more, and a brain.
A competent investigation is one that is conducted with integrity.
This includes a lot of things, but one of them is the avoidance of preconceived conclusions.
There's a difference between a true investigation and case-building, yet in the investigations I'm most familiar with, criminal investigations leading to prosecutions, it is said that every investigation leaps from true investigation to case-building at some point.
The problem is that this leap occurs inside the head of the investigator, or worse, his or her boss. You have to smoke it out to know when it occurred. Sometimes you have to wait until cross-examination at trial, which is waay far down the road. In my Foxglove case, the fascinating story of poison-murder that lacked only two things, poison &murder, I the investigation endured for four years before the indictment and arrest, and two more (with my client and her family in jail), before I was able to cross-examine the first prosecution witness, the medical examiner who had concluded he'd detected poison, in the form of an unprescribed (because not required) heart medication in the blood sample of my client's aged (91) and wealthy close male friend. My client was young and charming of course, and a Gypsy, so this made for a story that neither police nor press could leave alone. This first witness testified, however, that the result he'd obtained from the blood he'd drawn and personally tested in his private lab (which violates the standards of the Society of Forensic Toxicologists which prohibit self-testing to avoid operator error, which occured here) could have been explained innocently from drinking coffee, chocolate, or tea. I also got him to admit he'd used the wrong test. He'd used a "clinical" test (used to make gross measurements based on large test samples) when what he was looking for was the last molecule of this foxglove plant derivative called digoxin. This requires a more sensitive and precise method of testing. No other lab consulted by the prosecution was able to replicate the result of the medical examiner. The case folded on the day my co-counsel subpenaed the prosecutor who'd run with the case for two years to no beneficial effect. A multimillion dollar effort went down the toilet.
We were talking about the competency of investigation. The best single quote I can offer on this is by Richard P. Feynman, the Nobel laureate in physics who advised Caltech graduates, people who go into the field of scientific investigation that:
The first principle is that you must not fool yourself...but remember, you are the easiest person to fool.
Why is this?
Because many investigators don't really want to investigate, they want to support a conclusion that they favor. Homicide detectives may be under pressure to "solve" a bad murder and to make an arrest. They have a suspect who "looks good for it," perhaps a former convict who'd done something similar to arouse suspicion previously. Maybe he committed this crime, or maybe he didn't, but if the detectives get their hopes up, they're apt to lean on the guy to encourage him to 'fess up, telling him things will go better, the victim's family deserves to know why, etc. Since a lot of criminal aren't too bright to begin with, and most detectives at least have some brains and can be quite manipulative, the stage is set for a false confession or a false conviction.
Why? Because the investigation, if there was one, switched too soon from true investigation (where you're trying to find out what really happened, even if you have to let this suspect go free) to case-building.
What brings this on is that we've been paying attention to the economy lately, what with it headed down the toilet. Yesterday it turns out that a guy who for decades has been seen as the world's greatest trader, he never loses, was arrested by the Wall Street Police Department (the SEC) for what he is said to have admitted was no more than a $50 Billion Ponzi scheme. A Ponzi scheme is where the money you take in today is used to pay the investors who came in yesterday. It requires new suckers daily. Bernie Madoff says he did this for years.
However not everyone bought the guy, even though the SEC investigated him in 1993 and gave him a clean bill, which may account for why subsequent complaints were not pursued until the truth was found out.
There's a firm called Aksia which was hired to investigate Madoff's businesss because it's clients, big investors and hedge funds, needed to know whether Madoff was as good as his reputation suggested. His friends raved about him. He never lost their money. He always paid off a nice return. He was able to do this, of course, so long as he had access to new revenue from new big investors. Ponzi schemes cannot run forever, however. So now the floor has collapsed and a lot of heretofore wealthy people have gone broke. Madoff lost all their money, in some cases, unless they had a few bucks stuffed under the pillow. They can try to sell the condo in Florida, but who's buying condos in Florida these days? Not too many people.
How did Aksia figure out that it needed to advise its wealthy clients that Madoff Securities should be avoided? I mean the man was once head of the NASDAQ stock exchange where most of the high tech stock is traded. He was golden. But all that glitters is not gold.
The New York Times, in reporting on the Madoff Debacle, noted that Aksia had sent a letter to its clients crowing about how it wasn't taken in. You can read about the caution flags that caught its eye in its letter, below. They seem to have done a competent investigation, one that reached the proper conclusion, despite considerable odds. Apparently they had no need to believe in Bernie Madoff, as the latter's clients apparently did. These clients failed to investigate competently. They took the word of their own family members and friends who relied on the distribution checks sent out by Madoff periodically for years, but they never looked to see how he generated the money to fund the checks. Their investigation was lacking the one thing it needed: integrity. Integrity is the willingness to find out something you don't want to know.
This is a costly mistake.
The NYT article follows the Aksia letter.
Dear Clients and Friends,
It was announced earlier today that the Bernie Madoff of Madoff Securities was arrested
on several counts of securities fraud. It is alleged that he confessed to his employees that
the firm was a “ponzi” scheme that betrayed the trust and defrauded investors of an
amount which is at least $17 billion and maybe much higher.
As many of you know, Aksia published extensive reports on several of the “feeder funds”
which allocated their capital to Madoff Securities. Our decision to not recommend these
feeders was never based on the existence or discovery of a smoking gun; however, there
were a host of red flags, which taken together made us concerned about the safety of
client assets should they invest in these feeders. Consequently, every time we were asked
by clients, we waved them away from the Madoff feeder funds.
On the surface, these feeder funds had all of the makings of institutional quality funds.
They had substantial assets under management and were audited by large and respected
audit firms. They were managed and marketed by legitimate and registered investment
managers. They had long and impressive track records and a roster of professional
investors.
As a research firm we are forced to make difficult judgments about the hedge funds we
evaluate for clients. This was not the case with the Madoff feeder funds. Our judgment
was swift given the extensive list of red flags. Some of these red flags were as follows:
The Madoff feeder funds marketed a purported “Split-strike Conversion” strategy
that is remarkably simple; however, its returns could not be nearly replicated by
our quant analyst.
It seemed implausible that the S&P100 options market that Madoff purported to
trade could handle the size of the combined feeder funds’ assets which we
estimated to be $13 billion.
The feeder funds had recognized administrators and auditors but substantially all
of the assets were custodied with Madoff Securities. This necessitated Aksia
checking the auditor of Madoff Securities, Friehling & Horowitz (not a fictitious
audit firm). After some investigating, we concluded that Friehling & Horowitz
had three employees, of which one was 78 years old and living in Florida, one
was a secretary, and one was an active 47 year old accountant (and the office in
Rockland County, NY was only 13ft x 18ft large). This operation appeared small
given the scale and scope of Madoff’s activities.
There was at least $13 billion in all the feeder funds, but our standard 13F review
showed scatterings of small positions in small (non-S&P100) equities. The
explanation provided by the feeder fund managers was that the strategy is 100%
cash at every quarter end.
Madoff’s website claimed that the firm was technologically advanced (“the
clearing and settlement process is rooted in advanced technology”) and the feeder
managers claimed 100% transparency. But when we asked to see the
transparency during our onsite visits, we were shown paper tickets that were sent
via U.S. mail daily to the managers. The managers had no demonstrated
electronic access to their funds accounts at Madoff. Paper copies provide a hedge
fund manager with the end of the day ability to manufacture trade tickets that
confirm the investment results.
Conversations with former employees indicated a high degree of secrecy
surrounding the trading of these feeder fund accounts. Key Madoff family
members (brother, daughter, two sons) seemed to control all the key positions at
the firm. Aksia is consistently negative on firms where key and control positions
are held by family members.
Madoff Securities, through discretionary brokerage agreements, initiated trades in
the accounts, executed the trades, and custodied and administered the assets. This
seemed to be a clear conflict of interest and a lack of segregation of duties is high
on our list of red flags.
We believe that much will be written about this story in the coming weeks and we are
sure that your investment committees, chief investment officers and trustees will have
questions about this story and the work we do for you to help protect your fund’s interest
from such activity. As with the Madoff feeder funds and any other hedge funds, Aksia
will continue to place strong emphasis on independently verifying the information we
receive from managers. Basic steps of reference checks with market participants,
verification of the role of third-party service providers, and financial statement review
will continue to carry great weight in our recommendations despite the current investor
focus on market losses. Our Operational Due Diligence team has backgrounds in audit,
operations, risk management and fraud and investigations. Our investment teams have
backgrounds in trading, portfolio management and hedge fund investing. Our exclusive
focus hedge funds and this unique combination of skills provide a “360 degree”
perspective on hedge funds as evidenced by the work performed on Madoff Securities.
We have encouraged all of you to accompany our teams on site visits to familiarize
yourself with the work that we do in operations and investment reviews. We are in an
environment where the risks of investing go beyond market exposures and it is best that
we all deepen our understanding of the complexities of these vehicles.
Regards,
Jim Vos
Jake Walthour
CEO and Head of Research Head of Advisory Services
212.710.5757
212.710.5777
Look at Wall St. Wizard Finds Magic Had Skeptics
Look at Wall St. Wizard Finds Magic Had Skeptics
For years, investors, rivals and regulators all wondered how Bernard L. Madoff worked his magic.
But on Friday, less than 24 hours after this prominent Wall Street figure was arrested on charges connected with what authorities portrayed as the biggest Ponzi scheme in financial history, hard questions began to be raised about whether Mr. Madoff acted alone and why his suspected con game was not uncovered sooner.
As investors from Palm Beach to New York to London counted their losses on Friday in what Mr. Madoff himself described as a $50 billion fraud, federal authorities took control of what remained of his firm and began to pore over its books.
But some investors said they had questioned Mr. Madoff’s supposed investment prowess years ago, pointing to his unnaturally steady returns, his vague investment strategy and the obscure accounting firm that audited his books.
Despite these and other red flags, hedge fund companies kept promoting Mr. Madoff’s funds to other funds and individuals. More recently, banks like Nomura, the Japanese firm, began soliciting investors for Mr. Madoff internationally. The Securities and Exchange Commission, which investigated Mr. Madoff in 1992 but cleared him of wrongdoing, appears to have been completely surprised by the charges of fraud.
Now thousands, possibly tens of thousands, of investors confront losses that range from serious to devastating. Some families said on Friday that they believed they had lost all their savings. A charity in Massachusetts said it had lost essentially its entire endowment and would have to close.
According to an affidavit sworn out by federal agents, Mr. Madoff himself said the fraud had totaled approximately $50 billion, a figure that would dwarf any previous financial fraud.
At first, the figure seemed impossibly large. But as the reports of losses mounted on Friday, the $50 billion figure looked increasingly plausible. One hedge fund advisory firm alone, Fairfield Greenwich Group, said on Friday that its clients had invested $7.5 billion with Mr. Madoff.
The collapse of Mr. Madoff’s firm is yet another blow in a devastating year for Wall Street and investors. While Mr. Madoff’s firm was not a hedge fund, the scope of the fraud is likely to increase pressure on hedge funds to accept greater regulation and transparency and protect their investors.
On Thursday, the Federal Bureau of Investigation and S.E.C. said that Mr. Madoff’s firm, Bernard L. Madoff Investment Securities, ran a giant Ponzi scheme, a type of fraud in which earlier investors are paid off with money raised from later victims — until no money can be raised and the scheme collapses.
Most Ponzi schemes collapse relatively quickly, but there is fragmentary evidence that Mr. Madoff’s scheme may have lasted for years or even decades. A Boston whistle-blower has claimed that he tried to alert the S.E.C. to the scheme as early as 1999, and the weekly newspaper Barron’s raised questions about Mr. Madoff’s returns and strategy in 2001, although it did not accuse him of wrongdoing.
Investors may have been duped because Mr. Madoff sent detailed brokerage statements to investors whose money he managed, sometimes reporting hundreds of individual stock trades per month. Investors who asked for their money back could have it returned within days. And while typical Ponzi schemes promise very high returns, Mr. Madoff’s promised returns were relatively realistic — about 10 percent a year — though they were unrealistically steady.
Mr. Madoff was not running an actual hedge fund, but instead managing accounts for investors inside his own securities firm. The difference, though seemingly minor, is crucial. Hedge funds typically hold their portfolios at banks and brokerage firms like JPMorgan Chase and Goldman Sachs. Outside auditors can check with those banks and brokerage firms to make sure the funds exist.
But because he had his own securities firm, Mr. Madoff kept custody over his clients’ accounts and processed all their stock trades himself. His only check appears to have been Friehling & Horowitz, a tiny auditing firm based in New City, N.Y. Wealthy individuals and other money managers entrusted billions of dollars to funds that in turn invested in his firm, based on his reputation and reported returns.
Victims of the scam included gray-haired grandmothers in Florida, investment companies in London, and charities and universities across the United States. The Wilpon family, the main owners of the New York Mets, and Yeshiva University both confirmed that they had invested with Mr. Madoff, and a Jewish charity in Massachusetts said it would lay off its five employees and close after losing nearly all of its $7 million endowment. Other investors included prominent Jewish families in New York and Florida.
On Friday afternoon, investors and lawyers for investors with Mr. Madoff packed Judge Louis L. Stanton’s courtroom at federal court in Manhattan, hoping to question lawyers for Mr. Madoff and the S.E.C. But a deputy for Judge Stanton canceled the hearing, leaving investors with few answers. Several investors said they were planning to file lawsuits against the firm in the hope of recovering some money.
Based on the vagueness of the complaints against Mr. Madoff, his confession, as detailed in court filings, seems to have taken the F.B.I. and S.E.C. by surprise. Investigators have not explained when they believe the fraud began, how much money was ultimately lost and whether Mr. Madoff lost investors’ money in the markets, spent it, or both. It is not even clear whether Mr. Madoff actually made any of the trades he reported to investors.
The F.B.I. and S.E.C. have also not said whether they believe Mr. Madoff acted alone. According to the authorities, Mr. Madoff told F.B.I. agents that the scheme was his alone. He worked closely with his brother, sons and other family members, many of whom have retained lawyers.
Also likely to face very difficult questions are the hedge funds, investment advisers and banks that raised money for Mr. Madoff. At least some big investment advisers steered clients away from putting money with Mr. Madoff, believing the returns could not be real.
Robert Rosenkranz, principal of Acorn Partners, which helps wealthy clients choose money managers, said the steadiness of the returns that Mr. Madoff reported did not make sense, and the size of his auditor raised further concerns.
“Our due diligence, which got into both account statements of his customers, and the audited statements of Madoff Securities, which he filed with the S.E.C., made it seem highly likely that the account statements themselves were just pieces of paper that were generated in connection with some sort of fraudulent activity,” Mr. Rosenkranz said.
Simon Fludgate, head of operational due diligence for Aksia, another advisory firm that told clients not to invest with Mr. Madoff, said the secrecy of his strategy also raised red flags. And Mr. Madoff’s stock holdings, which he disclosed each quarter with the Securities and Exchange Commission, appeared to be too small to support the size of the fund he claimed. Mr. Madoff’s promoters sometimes tried to explain the discrepancy by explaining that he sold all his shares at the end of each quarter and put his holdings in cash.
“There were no smoking guns, but too many things that didn’t add up,” Mr. Fludgate said.
However, the S.E.C. had already investigated Mr. Madoff and two accountants who raised money for him in 1992, believing they might have found a Ponzi scheme. “We went into this thing just thinking it might be a huge catastrophe,” an S.E.C. official told The Wall Street Journal in December 1992.
Instead, Mr. Madoff turned out to have delivered the returns that the investment advisers had promised their clients. It is not clear whether the results of the 1992 inquiry discouraged the S.E.C. from examining Mr. Madoff again, even when new red flags surfaced.
According to an S.E.C. statement released on Friday night, the agency looked at Mr. Madoff’s operations twice in recent years — in 2005 and 2007. The 2005 review found only three technical violations of trading rules. The 2007 inquiry found nothing that prompted the regional enforcement staff to take further action by referring the matter to Washington, the statement said.
Meanwhile, Fairfield Greenwich Group, whose clients have $7.5 billion invested with the Madoff firm, said it was “shocked and appalled by this news.”
“We had no indication that we and many other firms and private investors were the victims of such a highly sophisticated, massive fraudulent scheme.”
At the court hearing, an individual investor, who declined to give his name to avoid embarrassment, expressed a similar sentiment.
“Nobody knows where their money is and whether it is protected,” the investor said.
“The returns were just amazing and we trusted this guy for decades — if you wanted to take money out, you always got your check in a few days. That’s why we were all so stunned.”
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