I. Introduction

The past few months have seen numerous financial frauds uncovered. Two of these frauds are particularly noteworthy. On December 11th, 2008, the largest of these financial frauds was unveiled when Bernard Madoff admitted to a $50 billion fraud through his firm, Madoff Securities.[1] On February 17th, the Securities and Exchange Commission (SEC) filed charges against Stanford International Bank relating to an allegedly fraudulent $8 billion certificate of deposit (CD) scheme.[2] Other alleged frauds have come to light, often in highly publicized and dramatic fashion.[3] These frauds suggest something is amiss in the markets.

In the midst of the current economic crisis, these alleged financial frauds have further destabilized a badly shaken market. While fraud is an unfortunate fact of the market, the allegations against Madoff and Stanford paint a picture of frauds that have reached massive proportions and that have been ongoing for years. The intention of this article is to examine the faults in the legal and regulatory systems that allowed for the aforementioned frauds to exist for so long and to become so large.

II. How Madoff Made off with Billions

In order to understand Madoff’s crime, a basic understanding of a Ponzi scheme is necessary. A Ponzi scheme is an illegal investment scheme offered by a promoter who promises unrealistic returns on investment capital, depending on new investors and reinvestment for its operation.[4] These schemes will eventually collapse, as they will inevitably grow too large to pay off all prior investors according to the returns.[5]

The ongoing story of Bernard Madoff’s downfall has caught the attention of the global media. When Madoff turned himself in and admitted his misdeeds, he was one of the most powerful men on Wall Street. He was a former chairman of NASDAQ. His firm was well-respected. Yet, this titan of Wall Street was running a multi-billion dollar Ponzi scheme.

Madoff’s story begins in the 1960s. Following a year at Brooklyn Law School, Madoff left to pursue a career on Wall Street.[6] His firm, Madoff Investment Securities LLC, started out matching the buyers and sellers of penny stocks in the over-the-counter market.[7] Eventually, his firm climbed the ranks and began trading in higher value stocks.[8] His firm was instrumental in the growth and development of NASDAQ.[9]

Using his success as a market maker, Madoff launched an asset management firm in the 1990s.[10] With his large social network and reputation, Madoff built up a large investment base, to the point where his Application for Investment Adviser Registration listed his total assets under management of over $17 billion.[11] While the market dropped 2008, Madoff’s firm continued to report their funds were up.[12] In spite of this, investors in Madoff’s firm began demanding redemptions in the billions of dollars.[13] Unable to continue these returns, Madoff admitted to running a Ponzi scheme and now finds himself facing criminal charges.[14]

Despite these recent revelations, a cloud of suspicion had followed Madoff’s investment firm for years. In 2000, fraud investigator Harry Markopolos contacted the SEC regarding Madoff’s suspicious investment strategies, but was rebuffed at numerous turns.[15] In his Congressional testimony, Markpolos said that it took him four hours of running mathematical analyses to determine Madoff was running a fraudulent operation.[16]

Yet, the SEC never examined the investment adviser arm of Madoff’s firm.[17] An SEC examination of the broker-dealer arm of the firm in 2005 yielded only three minor technical violations.[18] No one knew that the firm kept several sets of books and made numerous false disclosures despite allegations of fraud.[19]

As more information comes out about Madoff, it is clear that he had developed a close relationship with financial regulators.[20] During his stints as NASDAQ chairman,[21] he cultivated close relationships with NASDAQ’s internal regulators. He even boasted that he was so close to regulators that his niece married one of the SEC’s compliance officials.[22] Essentially, the regulators’ ties to Bernard Madoff and their ineffectiveness in handling this fraud raises serious questions as to the quality of financial regulation in the United States.

The most recent major financial fraud to break involves R. Allen Stanford, who is most well-known abroad for his sponsorship of cricket series.[23] Once the SEC locates Stanford,[24] he will face charges for fraud relating to his offshore financial operations through Stanford International Bank (SIB). According to an SEC complaint filed on February 16, 2008, Stanford International Bank (SIB), using Stanford Group Company (SGC) resources, sold roughly $8 billion in CDs.[25] These CDs offered “improbable” rates of return over the past 15 years through the bank’s investment portfolio.[26] While the portfolio claimed it was invested heavily in liquid investments, the portfolio was in fact tied up in illiquid investments.[27] In an unusual twist, SIB’s portfolio had exposure to losses resulting from Madoff’s fraud, despite their assertions to the contrary.[28] One of the major red flags in this case was raised when a lawyer for the Antiguan affiliate backed out of the case, disaffirming everything he told authorities about the bank.[29] Shortly thereafter, federal authorities took action.

Much like with Madoff, there were a number of concerns with how effectively Stanford’s financial institutions were regulated. In 2007, the Financial Industry Regulatory Authority (FINRA), a self-regulatory organization, conducted an investigation on SGC, resulting in a $10,000 fine for distributing marketing material that misrepresented the risks associated with CDs last year.[30] The investigation was criticized for not digging any deeper given how much of a warning sign this misrepresentation was regarding SGC.[31] The $10,000 fine also received criticism as a “slap on the wrist.”[32]

However, the most worrying aspect of this alleged fraud is the offshore component. According to the SEC complaint, SIB informed investors that Antigua’s Financial Services Regulatory Commission audited financial statements.[33] However, in truth, a small Antiguan accounting firm was responsible for auditing SIB’s investment portfolio.[34] Furthermore, while Stanford was ordered to repatriate his assets and Antiguan authorities are cooperating with the SEC, it can be enormously difficult to fully repatriate those assets to the United States, especially in offshore jurisdictions which are financial centers.[35] As this instance illustrates, these offshore jurisdictions only make it more difficult for regulators to properly carry out their functions.

Without belaboring the point, financial regulation in the United States needs reform. While these two alleged frauds may not be the norm within the regulatory community, these frauds have exposed a number of financial regulatory shortcomings. In both cases, FINRA and the SEC looked foolish for their lack of effective oversight. These frauds went on for years, yet regulators overlooked the red flags. Something needs to change.

Harry Markopolos’ testimony offers two interesting possibilities for reforming financial regulation that merit discussion. One of his suggestions is to provide for an increased regulatory role for the New York Attorney General’s Office and the Massachusetts Securities Division, both of which he believes have done a fantastic job.[36] While these two regulators handle cases in two of the largest financial centers in the world, there is a major problem with this approach. In his testimony before the United States Senate’s Committee on Governmental Affairs, former New York Attorney General Eliot Spitzer discussed the contingent commission scandal among insurance brokers. One of the things Spitzer outlined in this scandal was how difficult it was for States to effectively supervise firms that moved their operations to offshore jurisdictions.[37]

Jurisdictional competition would be the primary difficulty with increasing State financial regulation. Firms worried about the increased costs of regulation could simply move their operations to other countries that provide favorable laws to them. The Massachusetts Securities Division would have an enormously difficult time investigating financial crimes stemming from operations overseas. The current global economy requires the federal government’s influence, authority, and resources to carry out these investigations overseas.

Thus, the best option Markopolos puts forth is to rebuild the SEC. While attorneys are important for investigating and litigating financial crimes, the SEC needs to expand its resources to include more people who have industry experience and who have professional expertise in areas such as finance and accounting. Giving the SEC a diverse skill set would enable it not only to prevent frauds from becoming massive in scope, but it also would provide it with more points of view in formulating policy. Providing compensation for attending industry conferences and workshops would also provide enormously valuable information to the SEC. While the SEC might still have problems, at the very least it would have a much more skilled and capable workforce.

As this article has shown, there is not a single cause behind the failings of United States regulators. Setting aside the question of whether regulators are incompetent, corrupt, or somehow impeded from carrying out their duties, the fact remains that these financial frauds are blights on the market. What is especially disturbing about these frauds is not that they existed, but that they went on for so long and became so large. Red flags went ignored.

An unsettling reality is that there are other frauds comparable to these that are ongoing. Further revelations about these frauds will be forthcoming.  It is likely that these frauds will only further expose the shortcomings of current financial regulatory regimes. It is abundantly clear that the Obama Administration needs to overhaul these regimes in order to better detect, investigate, and prosecute fraud. Rebuilding the SEC would be a good start to restoring confidence in the markets. If President Obama does not take these measures, Madoff’s alleged $50 billion fraud may soon look like chump change compared to the next big fraudster who comes along.