A lot of people ask about Bernie Madoff and his scheme because they fear they could be similarly fleeced by their financial advisors. And that’s totally understandable; after all, giving all your life’s earnings to someone else so that they decide how to manage it is definitely scary. No one wants to lose everything they’ve worked so hard for, and they want to make sure that they’re making the best possible decision when choosing a financial advisor to rely on.

But while his scheme is well known, what’s less commonly understood is just how Bernie Madoff pulled off his scheme and what made it so effective. To protect yourself from similar scams, you’ll first need to understand Madoff, his scheme, the way he operated, and why he succeeded. So without further ado, let’s get started. 

Who is Bernie Madoff? 

Bernard Lawrence, or Bernie Madoff, was a famous American financial expert who pulled off the largest Ponzi scheme in history. He defrauded thousands of investors and stole tens of billions of dollars from them for a large period of time, possibly longer than 17 years!

He was a chair of Nasdaq in the early 90s and a pioneer in the electronic trading industry. During the course of his life, he managed to convince many people that he used a legitimate strategy to earn money and thus defrauded tons of investors over the course of decades. In 2009, his illegal scheme was fully uncovered, he got a 150-year prison sentence, and he had to forfeit $170 as restitution. Bernie Madoff died in prison at the age of 82 on April 14th, 2021. 

Madoff’s Notable Accomplishments 

Bernie Madoff first rose to notability as a scrappy market maker, very much someone who felt excluded from the traditional Wall Street “in crowd”. 

He started to see genuine success once he and his brother set to work in electronic trading. That venture created a massive flow of orders and gave him inside info on market activities. Soon Madoff and four other Wall Street personalities owned half of the order flow of the New York Stock Exchange, and by the late 80s, he was making around $100 million every year.

His Scheme, the Crimes, and the Scandal 

At one point, Bernie Madoff started to attract large investors by claiming to be making steady returns through a particular investing strategy that he called “split-strike conversion,” which is legitimate and completely legal. 

However, here comes the twist: Madoff deposited the money his clients gave him into a single bank account that he then used to pay other clients who wanted to cash out. Then he went out to fund his redemptions to attract new investors and make them give him capital. This is the backbone of a Ponzi scheme: paying returns using money from new investors. In a Ponzi scheme such as Madoff’s, there is no actual investment, just money being shuffled around.

The market crash and subsequent economic crisis of 2008 eventually put a stop to this, as Madoff was now no longer able to keep the money flowing and his scheme afloat. With the market in crisis, there were no new investors to keep paying in. 

In December 2008, Madoff told his sons what he had done. A day later, they turned him over to the authorities. Madoff always claimed that his sons, who also worked in his company, never knew about his schemes. 

No one knows exactly when Madoff started his scheme. He personally claimed it was at the beginning of the 90s, but later his account manager (who had worked for him since 1975) said that the scheme had existed for as long as he could remember. What’s even stranger is why Madoff did the scheme at all. At the time, he had more than enough money to live comfortably for the rest of his life and give some to his sons. When asked in court why he had been doing the so-called “Ponzi scheme,” he replied that he didn’t know. 

What the Scheme Was All About? 

Let’s get a little more detailed. Why were people fooled by this ages-old scheme? Most of Madoff’s clients were persuaded by the ultra-high returns he was producing. (Suspiciously high returns are often a warning sign of a Ponzi Scheme or similar scam.) And all that money made them look the other way. 

And what of the banks? Well, Madoff would deposit investors’ money into an account at Chase Manhattan Bank and let it sit there, earning the bank around $345 million in after-tax profit. 

When clients wanted to cash out, Madoff then funded the payouts through new capital. People were jumping on board this Ponzi train because they were wooed by his reputation for incredible returns. 

Madoff’s Carefully Curated Public Image

Madoff worked hard to achieve an “exclusive club image” and made a point to turn some people away. The allure of exclusivity can make people do some strange things.

Additionally, Madoff was respected and generous; he managed to impress his investors and the general public with his charity work and donations. This bolstered his trustworthy image, even if in the end he defrauded a large number of non-profit organizations, including the Elie Wiesel Foundation for Peace and the global women’s charity Hadassah. 

Madoff often used his connections and friendships to get new clients. For example, he exploited his friendship with J. Ezra Merkin to get an “in” with congregants, as Merkin was an officer at Manhattan’s Synagogue.  

It certainly seems strange that so many investorspeople with money, knowledge, and powerwere fooled for so long. But remember that after his “humble” beginnings defrauding personal connections, Madoff dealt largely with big institutions like hedge funds, pension plans and university endowments. These types of organizations have a lot of moving parts and were lured in by Madoff’s offers of the kind of long-term consistency that could bolster them for years to come:

    • Madoff offered impossible consistency. His public portfolio looked as if it stuck only to safe investments in so-called blue-chip stocks. Because there was no real investment, he was able to provide perfectly consistent returns, which assuaged people’s fears.
    • He publicly said that he was using a legal collar strategy called a split-strike conversion. A collar minimizes the risk as the underlying shares are protected by the purchase of an out-of-the-money put option. 
    • His returns were very high, consistently 10% or 20% per year. Madoff provided great (but not outrageous) returns and never failed to cash clients out when they were ready.

How Was the Scheme Uncovered? 

While Madoff’s empire may have crashed down all at once, the seeds of his downfall were planted over a decade before his arrest. The SEC (Securities and Exchange Commission) actually began their investigation of Madoff in 1992. The warning signs were there, and the fact that it took so long for him to be publicly outed was a source of pain for many of his victims, who felt the original investigations were not rigorous enough. 

One of the first whistleblowers was a financial analyst, Harry Markopolos, who in 1999 had claimed that Madoff was lying and filed a complaint against him in the early 2000s. That complaint was largely ignored.  

Later in 2005, in a letter to the SEC, the same analyst accused Madoff once again of running the world’s largest Ponzi scheme, and this time, his hard work paid off. Harry Markopolos’s proof was undeniable. Through a method known as the “Mosaic Theory,” Markopolos exposed Madoff’s scheme by showing that Madoff’s claims made no actual sense under scrutiny. How could he be making money off the companies he claimed to when the S&P was failing?

Markopolos also noted that Madoff was not paying the standard hedge fund fee and was applying for loans from European banks. During the same year, SEC finally asked Madoff for documentation on his trading activities, and he provided six-page list, which was entirely made up.

The gig was up.  

In Conclusion 

There are a few key takeaways from Bernie Madoff’s enormous scheme.

  • He had his eye on larger targets. This doesn’t mean that the average person is safe or immune to scams, but Madoff’s scheme quickly advanced to conglomerate clients with massive amounts of capital, like hedge funds. Madoff was already a millionaire before his scheme started to take off. He was not interested in small fish. 
  • “Too good to be true.” Investing is always going to carry some risk. The warning signs of a scam were there for those who were paying attention. 
  • An exclusive club. Madoff wasn’t offering his services to anyone who came knocking. He turned down many potential clients to make himself look more appealing. The financial world can seem impossibly complex to the average person, and positioning himself as an insider expert gave Madoff a definite edge. But exclusivity does not equal quality. 

Bernie Madoff’s scheme is famous for good reason; it’s got all the ingredients of a compelling story: millions of dollars, high society scandal, drama and tragedy. But it’s not representative of the average investor’s experience. Madoff’s story intrigues us so in part because it is so rare. 

Working with a financial advisor to reach your money goals should be within reach for everyone. A little bit of guidance and prudent thinking is all it takes to avoid being embroiled in a Madoff-Esque scandal. 

Look for an investment firm that has your best interests in mind and has proven trustworthy. Firms with fiduciaries on staff and a long, consistent history of realistic returns and open communication are smart choices when looking for investment help. 

Come chat with us to see how to get started on your financial journey. The professionals at Alpha Wealth Funds can help you out with financial advice that manages to grow your wealth and, most importantly, will keep you actively engaged throughout the process. Remember, it was ignorance that kept Madoff’s scheme afloat for so long. 

Please feel free to reach out to me on this or any of your investment needs or questions. I may not always have the answers at my fingertips, but I promise I will get them for you. Michael Torrence

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Michael Torrence – Investment Advisor Representative: Michael was born and raised in Ohio and attended The Ohio State University. After College, he was commissioned as a 2ndLt in the United States Marine Corps. He attended his initial training in Quantico, Virginia, then graduated at the top of his Primary Aviator Class and was selected for the Strike (Jet) Platform.

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