In financial crimes, the physical evidences are often the data in financial statements and other documents. These data are faked with the purpose of giving an appearance of normalcy, that nothing is amiss or that the financial results are better than the actual reality. How can a detective uncover financial frauds based on data? This post underscores the need for vigilance on the part of everyone, from investors to financial intermediaries to regulators. The next post discusses a mathematical modeling that is a powerful and relatively simple tool for detecting potential financial frauds or errors.
Examples of financial frauds that may require deception using faked data include investment frauds. One type of investment frauds is that of Ponzi schemes. In such schemes, investors are promised a high rate of returns with little or no downside risks. The profits to the investors are usually very good at the beginning, which actually are not proceeds from legitimate investments but are funds collected from new investors. In other words, such schemes are one big lie and can only be sustained by having a constant stream of investors, essentially new suckers paying existing ones. When new money stops coming in, the game is over. There is definitely an incentive for the operators in these Ponzi schemes to put up the appearance of real investing, hence faking data.
The longest running Ponzi scheme that is also the largest in scope is the one perpetrated by Bernard L. Madoff.
Mugshot of Bernie Madoff
Madoff’s fraud scheme had gone on for decades with investors profiting handsomely year in and year out. It collapsed in December of 2008 when the great recession was underway. At that time, new moneys had slowed to a trickle. Then it was inevitable that the Ponzi scheme was exposed due to the fact that Madoff could not keep up with the avalanche of withdrawals.
On the book, the amount of losses suffered by the investors was estimated to be $50 billion. The exact amount of losses was hard to estimate since the amount of $50 billion included the fictitious profits reported to the clients. However, it is clear that the scope of the losses would be in the billions. Madoff started his investment fund in 1960. Though it is not clear when the investment fund became a Ponzi scheme, it is clear that the fraud went on for decades. To perpetrate the fraud in such massive scale and for so long, Madoff must have a team of people who helped him create the appearance that there were returns and helped him forge books, and file reports.
Administratively, the fraudulent enterprise was a massive undertaking that included a constant need for faking numbers. For example, the statements to the clients would show the trading activities with the trade prices and volumes. The faked numbers had to be good enough to look believable at least to the clients who do not have to professional expertise to scrutinize or who chose not to look closely. How about the professionals? Can the professional experts detect the frauds by poring over the statements and other documents?
Could Madoff be stopped sooner? The answer is almost certainly yes. If he was exposed 10 years earlier, many more families would be saved from financial ruins and emotional devastation.
The investment world is a competitive industry. The consistent and outsize returns of Madoff always raised suspicion among the competitors. Naturally the competitors would love the replicate the same kind of returns of Madoff. One analyst, Harry Markopolos, failed to find a way to replicate and concluded that Madoff’s scheme was either a Ponzi scheme or front running (buying stock for his own account based on knowledge of his clients’ orders). He alerted the Security and Exchange Commission (SEC) numerous times.
There are numerous other red flags that were raised over the course of the years. See the Wikipedia entry on Madoff’s investment scheme for details. Numerous entities, from SEC to the feeder funds the channel money to Madoff, all failed to detect the frauds. Maybe they chose not to look closely. In the case of the feeder funds (these are intermediaries that steered investors to Madoff), they had the incentive to not look closely. One such feeder was Fairfield Greenwich Group. They did not want to rock the boat. The gravy train was too good to pass up.
According to the Wikipedia entry on Madoff’s investment scheme, Madoff Securities LLC was investigated at least eight times over a 16-year period by the U.S. Securities and Exchange Commission (SEC) and other regulatory authorities. SEC investigated Madoff several times. In each instance, either Madoff was cleared or the investigation resulted in neither a finding of fraud nor a referral to the SEC Commissioners for legal action. Why did SEC not not uncover the fraud? Was it because Madoff covered his tracks so well that even the experts in SEC could not see anything wrong? Or they chose to not look too closely?
There are many intermediary entities involved in the Madoff’s fraud scheme, from the feeder funds to banks. The bulk of Madoff’s money was deposited at JP Morgan Chase. The top-notch bankers at Chase failed to detect anything wrong with Madoff either. Why? The fees were too good to pass off. Like the feeder funds, the gravy train was too good to pass up. Nonetheless, Chase was included in a law suit filed by Irving Picard, the court appointed trustee in charge of recovering assets from the Madoff investment scandal. According to the suit, Chase “was at the very center of that fraud and thoroughly complicit in it.” As a sophisticated financial institution, JPMorgan was “uniquely situated to see the likely fraud.” The dark role played by the bank and the feeder funds are described in this Fox Business article.
The investors in Madoff’s scheme are at a double bind. They lost the investments, in many cases their life savings. At best they can only recover a small part of the investments (only if they are direct investors with Madoff). If they are investors via a feeder fund, they are out of luck. Any legal action for them would likely be dragged on for years.
Could Madoff be caught sooner? The tools are available. Only if the people involved are willing to use them.
Mathematical modeling plays a pivotal role in detecting financial frauds, in particular, in raising red flags about fraudulent numbers. There are actually “simple to understand” and “simple to use” tools that are very effective (tools that SEC probably chose not to use). The next post is on Benford’s law, which is a great frontline tool for fraud detection and forensic accounting.
2017 – Dan Ma