Madoff Scam: Another Blow to Industry's ImageLatest Fraud Scheme Only Increases Demand for More Regulation
It's just another blow to consumer confidence in the financial services industry.
Bernard Madoff, former chairman of the Nasdaq Stock Market and founder of the Madoff Securities firm, was arrested by federal law enforcement last Thursday and charged with running a $50 billion "Ponzi scheme" with a hedge fund that racked up billions in fraudulent losses. If convicted, Madoff will be held responsible for one of the biggest fraud cases in history -- and for giving another black eye to the industry, which is already reeling from the fallout of the subprime mortgage crisis and global credit crunch.
"I see this as another blow to the public's trust and confidence of America's financial markets," says privacy expert Dr. Larry Ponemon, Chairman of the Ponemon Institute, a research firm specializing in information security and privacy issues." I don't believe super regulators such as the SEC alone can overcome the massive amount of greed on Wall Street."
Madoff's closely-held firm was launched in 1960 and has more than $700 million in capital. His investment advisory business that ran the hedge fund served between 11 and 25 customers and had about $17.1 billion in assets under management. Madoff is believed to have been operating the hedge fund Ponzi scheme since 2005. With a consistent track record of solid returns of 8 percent or higher, his hedge fund was attractive to investors.
A Ponzi scheme is a scam that offers investors unusually high returns with early investors paid off with money from subsequent investors. Madoff told FBI agents that it was all his fault, according to a criminal complaint filed by the U.S. Attorney General's office. He paid investors with money that wasn't there. Madoff says "There is no innocent explanation." His house of cards began to crumble in the first week of December, when Madoff told a senior employee he was struggling to pay back $7 billion to hedge fund clients who had requested their money back.
The 70-year-old Madoff is charged by U.S. prosecutors with a single count of securities fraud. He faces up to 20 years in prison and a fine of up to $5 million. The $50 billion allegedly lost would make the hedge fund one of the biggest frauds in history. When former energy trading giant Enron filed for bankruptcy in the wake of its scandal in 2001, it listed $63.4 billion in assets.
Madoff also faces separate civil charges from the Securities and Exchange Commission (SEC). The complaint alleges a stunning fraud both in terms of scope and duration. The SEC says that virtually all of the hedge fund's assets are missing. Madoff was released after posting a $10 million bond secured by his Manhattan apartment.
How This Fraud Impacts the Industry
When Information Security Media group, publisher of BankInfoSecurity.com and CUinfoSecurity.com, conducted its Banking Confidence Survey in October, 96% of respondents said the financial services industry had lost significant consumer confidence in the past year. How does the Madoff scandal impact flagging confidence?
The timing of this arrest is seen as "rubbing salt in the wounds," says Tom Wills, Senior Analyst, Security and Fraud, Javelin Strategy and Research. The industry is already somewhere between pondering its future and fighting for survival. An as-yet unknown number of financial institutions are affected by this, but Wills hopes that they will assess their positions and then come clean as soon as possible. "This might not be immediately since Madoff was leveraged, and there will be some untangling to do to determine exactly who is exposed," Wills says.
Debra Geister, Director of Fraud Prevention and Compliance Solutions at Lexis-Nexis, also sees this as a negative for the industry, saying "This is going to contribute to the distrust factor that seems to be a general theme in the industry at the moment." The full impact will likely not be known for awhile. "It will be another blow for an already challenged market and will add to the current distrust and skepticism of the financial communities and the markets" says Geister.
"Even the good firms will have to work twice as hard to re-prove themselves," says Denise Valentine, Senior Analyst at Aite Group, a research firm that focuses on the industry. Many will turn to market outreach campaigns to highlight their policies and integrity, Valentine says. Preemptive communication with clients is the best approach.
Internal audit teams will be adding steps to examinations to assure a more comprehensive review. "Unfortunately, most firms will have to do more of this work with less staff," Valentine says, with a nod to recent layoffs. "Third-party audit firms may well have an added opportunity, as independent reviews are likely to bring greater comfort to clients and prospects. Mergers and acquisitions teams conducting due diligence similarly will have to investigate target firms more closely and it will likely take more time."
This latest scandal may not end with Madoff, warns another information security expert. "While the amount of money involved in staggering, this is one of many recent large-scale frauds by insiders in the financial and investment banking industries," says Kent Anderson, a member of ISACA's Security Management Committee and Managing Director of Encurve, a Portland, OR-based risk management firm. In every case to date, the root cause has been the lack of internal controls, lack of follow-up when deficiencies are found and weak oversight and regulation, he adds. "It remains to be seen what the knock-on effect will be to other individuals, institutions and hedge funds that had invested in Madoff's funds, but these appear to be significant and may lead to other investment failures," warns Anderson.
What Happens to Customer Confidence?
The Madoff incident will do little to shake confidence in the financial services industry "because confidence appears to be dead already," says Ponemon.
The saddest weight to the woes of the industry is that we have taken for granted the integrity of the system and the honorability of the people we do business with, says Aite's Valentine. "Here, a former chairman of the Nasdaq Stock Market and founder of a well-known securities firm is also a long-term swindler," Valentine says. Investors may well have lost so much money by now they are not sure it can get any worse. They will, however, be talking more frequently to their advisers. "For certain, advice will not be assumed correct. Investors may finally be propelled to better inform themselves about their investments, or at least will certainly to ask more questions," she observes.
"This news will certainly add to investor worries and increase calls for further regulation of hedge funds, especially from European countries," says Anderson. "What will make this case more worrying to investors is Madoff's position of trust in the industry."
There may be more panicky investors bailing out of the markets, observes Geister. "In a market that is already in distress, the concern is that this will continue to add to the panic and disillusionment," she notes. "I think that consumer confidence as well as investor confidence will plummet over this news."
What's Next -- More Regulation?
So, what next from the new presidential administration, which was already inclined to increase regulatory oversight of financial institutions?
Ponemon says this case may likely create another call to regulations such as a new "Sarbanes-Oxley on steroids" for companies operating in the financial services industry, especially focusing on hedge funds.
The fraud element will be a recurring theme in any kind of regulatory reform. "This scheme calls into question the current reporting standards," says Geister. "How can we trust SEC filings if the alleged activity went undetected for so long? Who audits these filings? How do we prevent this type of thing from happening again? I think that all deceptive practices and misrepresentations will impact the regulations changes, just as Enron impacted Sarbanes-Oxley's introduction to the market place."
Aite's Valentine also sees a major shift in regulatory approach. "This event will strengthen Congress' resolve - and the demand of their constituents whose frustration has already swung the pendulum - for more frequent/detailed audits and reporting requirements of asset management firms," she says. "In the end, this opens the door for strict regulation that follows all too literal rules, which generally have adverse effects."