Bernie Madoff Business Startup Kit -- Ponzi Schemes and Federal Prison
In January of 2008, Bernie Madoff would have made the list of top American success stories. He began life as a poor kid, the son of immigrants, attending public schools and saving his pennies as a lifeguard to found his trading company with $5,000. He parlayed this tiny investment egg into a billion dollar business startup, and also helped found the powerful and innovative NASDAQ stock exchange.
For nearly 50 years Madoff was an admired businessman and philanthropist, who started with nothing and made it big.
One year later, at the end of December 2008, Madoff was revealed as a crook. His lifetime of success was exposed as one of the greatest frauds in American history. He was accused of shaking his investors down for the awesome sum of $65 billion dollars.
Madoff was sentenced to 150 years in Federal Prison. By the standards of kid-glove treatment for white collar crime, Madoff was practically crucified. Madoff became the example, the criminal who would prove that the American justice system prosecutes frauds and business scams, high or low.
Bernie Madoff Business Startup
But the burning question is, how did Madoff do it? The short answer, he borrowed and scraped enough money together to look like a real business. Then he promised investors fabulous returns, far beyond what anyone else could promise. And he milked those promises for almost five decades. It was actually surprisingly simple.
Now for a bit more detail.
Madoff founded his firm Bernie L. Madoff Investment Securities LLC in 1960. The company started out as a penny stock trader, with $5,000 that Madoff had saved by working as a lifeguard and a $50,000 loan from his father-in-law. Penny stocks are stocks of companies that are too small to be traded on large exchanges like the NYSE. In 1960, they were difficult to invest in and track because there was no central exchange for quotes or payment. It was an area that was rife with shenanigans and market manipulation. The few specialist brokers who worked with penny stocks charged high fees, although trades could be legally carried out directly from firm to firm, which meant zero oversight and an open door for fraud.
Madoff's new business startup enjoyed early success, partly because his father-in-law Saul Alpern was an accountant. He steered his clients who were seeking large returns to Madoff's firm. Madoff also allegedly saved money by executing trades directly, avoiding the high fees that specialty firms would charge. After he was busted, many investigators wondered if he traded in the early days at all, since there were no records, it may have been a pure Ponzi play from the beginning. However, he eventually did trade and his volume increased dramatically, to the point where he was one of the largest "market makers" in the penny stock or OTC market. However, it is also known that trades he reported to his clients often did not take place at all, even in the 1990s and 2000s.
Eventually, Madoff worked with a group who created an electronic quote system for penny stocks, which grew into the mighty NASDAQ exchange. The NASDAQ is the second largest stock exchange in the world, second only to NYSE, and offers quotes, bids, and settlement digitally. Madoff and his family members had deep ties to the creation and growth of NASDAQ, which was the launch point for many large companies today, including Microsoft and Oracle.
Throughout this time period, Madoff was famous as a successful wealth manager and investor. He managed funds for individuals, insitutions and charities. Madoff offered fabulous returns, often in excess of 10%, sometimes vastly more. Since he generally far exceeded normal returns on Wall Street, for 48 years his customers were delighted with him.
Madoff was rich and respected. His family and friends were rich. Everything was hunky dory.
In December 2008, it all came crashing down.
Ponzi Schemes, A Diversionary Aside that is the Heart of this Cautionary Tale
A Ponzi Scheme is an investment fraud. It operates by taking money from investors and promising a high rate of return, say 50% per year for a nice round number. But, the manager of the investment pool actually has no way to earn 50% on the money. Instead he continues to solicit funds from new investors by promising high returns. The earlier investors are paid from the funds collected from later investors.
To offer an example, let's assume I will manage $1,000 for you, with a 50% return. I tell you I am going to invest it in a fabulous new social media platform that is about to break out. But, I don't invest it at all, I just put it in the bank. Then I go looking for ten more suckers like you, offering them the same deal.
When the year is up, I send you a piece of paper telling you that your investment has done as planned and that you now have $1,500 on account with my firm. Would you like to let it ride for another year, or make a withdrawal?
Most investors will let most of the money remain in the account. After all, where else will you make 50% returns? And even though some won't, it is no problem, because I now have $11,000 from suckers just like you, and I can easily pay back your money, plus the "earned" gains.
And of course, you tell all your friends, and pretty soon people with money to invest are beating a path to my door, begging me to "invest" their money for those fabulous returns.
That is a Ponzi Scheme. They are illegal, because like a game of musical chairs, the music eventually stops and the whole thing crashes down rather suddenly.
The other bad thing about Ponzi schemes is that they distort the market and suck funds away from legitimate investment.
As an inventor, you know that it is very hard to come up with a new invention idea that makes a profit. With all of the work required for product development, manufacturing, marketing, distribution, and more, creating a new invention is a time consuming and expensive process. It often takes years to generate any return at all. Legitimate business is a long game, and it rarely makes anything in the first few years.
Now just think about how much easier it would be to skip the process of invention, development, prototypes, invention manufacturing, distribution and marketing, and just promise the returns. Call yourself a "wealth management fund" say you are investing in innovative companies, keep the money in the bank rather than frittering it away on production, and you can claim high returns, without having to "do" anything at all. In fact, it is cheaper to do nothing. That is the beauty of the Ponzi Scheme.
Why Ponzi Schemes are Bad
You might be asking, why is a Ponzi scheme worse than buying a used TV that doesn't work, or a car that has a cracked manifold? Why should the government care? Isn't the rule in the United States, buyer beware?
Yes and no.
The problem with Ponzi schemes is that a successful one can attract a significant amount of money. Estimates of Madoff's crime range from $12 billion to $65 billion in losses and may be higher.
In other words, your broken television fraud isn't going to crash the economy. Billions of dollars does have consequences far beyond the gains and losses of individual players. The Madoff incident led to the closing of an important neurological research center at MIT, the closing of several charitable organizations, and you can be sure, a lot of scrambling to keep the doors open for hundreds more. It had real world consequences for thousands of people.
Ponzi schemes are also just plain bad for economic growth and stability.
Keep in mind, in the short run it is easier and cheaper to promise high returns and not actually enage in productive activity. Making a product is always more costly than making hot air that promises to make something. If the government alllows that kind of nonsense to become the norm, we will have lots of "economic" activity, but very little "stuff" to show for it. Think of it as a booming business in transportation bonds, without any roads or bridges.
So Ponzi schemes promise a lot. They can promise higher returns than anything else. And investors flock to them in search of those high returns. As the Ponzis grow, they absorb a high percentage of the capital that is available for investment. If you doubt that, just look at the S&L crisis, Global Crossing, and Enron, to name a few of the more noteworthy examples.
When the Ponzi schemes grow and flourish, new productive businesses are starved for capital. They can't compete with the fraudsters.
So the economic well-being of the nation gets hit twice. The obvious one is the losses that arise to individuals who invested in the Ponzi and get left holding the bag. But the big one from a macroeconomic perspective is that the investment in the Ponzi doesn't produce anything of value. When it goes bust, there is no railroad, or factory, or plane to show for it. There is nothing.
Productive industries are starved for capital when they need it for real investment and growth. And when the Ponzi implodes, it leaves a big gaping empty hole.
Look at it as an inventor. You need capital to get your startup business off the ground. With invention success you can offer investors a shot at 20% or even 30% returns per year, although only after five years. It is going to take time to bring your fabulous new invention onto the market.
A guy like Madoff on the other hand, can promise fat returns from day one. And he doesn't have to "waste" money on things like production, invention prototypes, invention safety standards, product testing, or government permits. He just fakes the paperwork and pays out the few investors who need to withdraw from the money machine every now and then. It's easy and lucrative.
And bad for the nation as a whole. That is why Ponzi schemes are illegal.
Bernie Runs Into Trouble
Madoff's scheme worked great for 48 years. He attracted billions of dollars of investment capital from all sorts of investors. Most of this was passive money, looking for high returns in a safe place. This meant that it was quite rare for the investors to ever ask to withdraw their funds. They were happy to take their fictitious financial reports and believe that they had "earned" fat returns, and let the cash ride for another year.
It was a little like playing in an illegal casino where you always win lots and lots of chips, but when it comes time to cash them out, there might be issues.
But for 48 years, there weren't any issues. Madoff managed to weather the financial storms of 1987, 1991 and the .com implosion of 1999. He continued to pay off investors who asked for their money and enjoyed a glowing reputation amongst the New York investing class.
Actually, that isn't quite true. In spite of his prestige and position on the NASDAQ Board, and many other important positions, many investment banks would not trade with the Madoff company because it was well-known that his returns were impossible and something fishy had to be going on. This worked fine for Madoff though, because as long as his trades never went through the major brokers, there was no paper trail to trip him up and land him in jail. If everything was internal or in companies that he controlled, he could play the shell game forever. And he almost made it to the end of his life.
Then 2008 happened. The mortgage crisis and the bankruptcy of Lehman Brothers led to a liquidity crunch. Suddenly, a huge number of Madoff's clients needed their cash immediately. And it wasn't there. Because he had spent it on himself, his sons, his own charities, the largest amount had actually gone to a man by the name of Jeffry Picower, who had to pay $7.5 billion back to the victim fund. By early December, while the world economy faced a liquidity crunch, it was clear to the Madoff family that there was no way they would be able to pay the demands or continue to hide their fraud.
The Madoff Sons Spill the Beans
On December 8, 2008, Madoff's sons told federal authorities that their father had said the Madoff company was a fraud and "one big lie."
The sons, other family members, and employees cooperated with the investigation. Madoff alone took the fall, refusing to cooperate in any way with the investigation. He was eventually sentenced on 11 counts for 150 years. One of his son's committed suicide exactly two years after blowing the whistle. The other son, Andrew, died in 2014 of cancer, leaving a $16 million dollar fortune that had Madoff's victims steaming mad. They felt that money should be returned to Madoff's victims, but paperwork protected small fortunes for all of the Madoff family and friends.
Other members of the Madoff family and circle of colleagues continued to be investigated by prosecutors on a number of allegations, including fraud and tax evasion. Many of these cases are still ongoing.
For the investment class, the Madoff case was a stunning blow. It was an ugly sequel to a wonderful rags to riches success story.
As a final caveat, it might be assumed that the government agencies would have strengthened financial regulation to prevent another Madoff case. In fact, they did the opposite. The Supreme Court has ruled that fraud must be proven before an alleged victim can demand access to the companies books and records. Had this ruling been in place before December 2008, the Madoff family would have had nothing to fear. They would have been safe as houses, because their clients did not have adequate information to prove fraud. Only the Madoff books could prove that it was systemic and ongoing. It is even easier to get away with today, than it was in 2008.
Protect Yourself as an Inventor
What can you do to protect yourself? We offer a few tips below.
- Be wary of offers that are too good to be true.
- Don't chase returns that are far above market norms.
- Don't cut corners on your accounting or investments.
- Avoid accountants who will cut corners, if they can fool the regulators, they can certainly fool you.
- Keep your eye on the long-term goal and you will be less likely to try a short-term quick fix.
- Set high standards for yourself and demand them from your staff and professional services.
Bernie Madoff's story is a tragedy. The greater tragedy is that there are many more like him in the investment community. He is just the one who got caught.
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