Ponzi 101: How to Spot a Madoff Scheme

The dust has largely settled on Bernie Madoff’s media coverage.  Outside of a few television specials on the subject, the perpetrator of the largest Ponzi Scheme in history is quietly serving his prison sentence, and he will probably never again see the light of day as a free man.  Despite the fact that Madoff is behind bars, the effects of his actions still ripple widely in the financial industry.

Lately we’ve had more conversations regarding investment strategy and the way it fits into asset protection planning than ever before, and questions about Madoff are still fresh in the minds of many of our clients.  With that said, we want to take the time to address the elements that make a Ponzi Scheme possible.

What is a Ponzi Scheme?

First, a quick definition.  What is a Ponzi Scheme?  Broadly speaking, the operator of a Ponzi Scheme (or Ponzi Game) is a person who promises outsized investment returns, “sells” investors on the idea, takes investor money, and then uses money placed into the scheme by future investors to pay earlier investors.  Ponzi operators don’t actually make investments or, if they do, the investments are often losers.

Ponzi Schemes can last for as long as new capital is available and invested into the scheme.  When sources of “new money” dry up–when there are no new investors, as happened to Madoff when the markets crashed and a large number of people requested a return of their money–there is no cash available to honor redemption requests (i.e. to pay investors when they ask for their money back).

The Million Dollar Question (literally): How to Identify a Ponzi?

Madoff was brilliant in the execution of his Ponzi in that he gained such a wide following and enjoyed such a high level of trust from his investors that he generally enjoyed a reputation for trustworthiness.  On top of that, he made it seem as though opportunities to invest with him were scarce, so that people jumped at any chance to “get in” and often (or possibly always) failed to ask critical questions.

All Ponzis will typically have two attributes in common:

1. Internal (or wholly owned) accounting
2. Internal (or wholly owned) auditing

If an investment fund delegates either of those two functions to an outside, reputable accounting or auditing firm, it is almost impossible for that fund to perpetrate a Ponzi.  The simple fact is that with accurate and transparent accounting, auditing, and invoicing, it becomes quickly apparent when investment returns are falsified.

Madoff, as you might expect, operated an in-house accounting firm, and his auditors were employed by a firm that was wholly owned by Madoff.  In other words, there were no check and balances in place, nothing to keep to keep Madoff accountable to his investors . . . all of whom were duped by a marketing genius who was able to instill trust by delivering fantastic (but fake) results and engender a word-of-mouth following.

Ideal Situations

Ideally, if you invest in any type of fund–especially funds that are not registered with the Securities and Exchange Commission (“SEC”)–you should demand three things:

1. Cash controls by a third-party administrator: Let the fund manager worry about managing investments, not cash controls.  Make sure that cash controls are strict (where money can go, to whom, and when) and that they are transparent.
2. Accounting: Should be handled by a reputable firm that has many more clients than just the fund you’re considering.
3. Auditing: Make sure it’s handled by a firm that is in no way affiliated with the investment fund.

Follow that advice, and you’re largely taking Ponzi Risk off the table.  Call Lodmell & Lodmell if you have any questions about this topic or the financial markets in general.  Also, take some time to check out the videos at Mind of Money.