From Barings to Madoff: Lessons Learned
By Ian McCluskey
FRAUD PREVENTION
From Barings to Madoff: Lessons Learned
Regulations are no match for human failings. As lawyers, financial investigators and chastened investors continue to pick through the rubble of the Madoff scandal and other massive frauds, new, more inventive versions of the same old story are being written.
Ian McCluskey, Miami
On December 16, 2008, shortly after Bernie Madoff’s arrest, a team of FBI investigators sealed off the crime scene at Bernard L. Madoff Investment Securities LLC in midtown Manhattan and began sifting through the evidence. Former FBI Special Agent Keith Kelly, who joined Kroll earlier this year as a managing director in its financial investigations unit in New York, was leader of the FBI criminal investigation. For months, he and his fellow sleuths combed through 13,000 boxes of records in Madoff’s New York and London offices, revealing details of the scheme that bilked investors of an estimated $18 billion. While still ongoing, the criminal investigation has led to five arrests, three guilty pleas and nearly $8 billion recovered in forfeitures, helping to ease the pain caused by a massive scam that, for over 20 years, had fooled everyone.
The question now is – Will we be fooled again?
To answer that question, let’s first turn the clock back to 1995, when a rogue futures trader by the name of Nick Leeson based in Singapore lost a staggering $1.3 billion on unauthorized trades, leading to the collapse of Barings, London’s oldest merchant bank. “After Barings, people said ‘This can’t happen again,’” observes Richard Abbey, head of Kroll’s financial investigations practice in London, “but then came Madoff.”
And yet, the Madoff scam was hardly an anomaly. Only three months before Madoff gained instant worldwide notoriety, the collapse of Iceland’s three biggest commercial banks in quick succession led to a financial crisis that quickly spread to major investment funds across Europe. The bank failures spawned allegations of share manipulation, non-disclosed related-party lending and shareholders yielding undue influence over the bank operations. Richard Abbey headed a team of Kroll investigators tasked by a government appointed trustee to investigate the Glitnir Bank case.
Barings and Madoff were not rare or isolated cases, just spectacular bookends. In between those two events was a constant torrent of financials scams, which – while perhaps less colorful and certainly less publicized – resulted in financial ruin for unsuspecting investors across the globe.
What are the chances that, after the latest bout of pain caused by Madoff, investors and companies will remain more alert to red flags and more vigilant in applying the regulations and controls designed to thwart the scammers? It may be comforting to think they will, but perhaps not realistic.
For starters, the incentives for those who design complex financial scams and those whose job it is to supervise the financial markets will always be skewed in favor of the scammers, observes Eduardo Gomide, a managing director in Kroll’s Sao Paulo, Brazil office. “Auditing sophisticated financial products is as much, if not more, complicated than creating them. But is it likely that auditors will be compensated at the same level as the financial engineers (and scammers)? Hard to imagine,” says Gomide.
The bigger problem, however, notes Zoe Newman, a 10-year Kroll veteran, who has investigated fraud and corruption cases from the Ukraine to China, is that “controls and compliance systems are implemented and operated by humans.” Humans, of course, are imperfect. The Madoff Ponzi scheme and the Icelandic Bank collapses are not so much tales of inadequate regulations or controls, but rather tales of people in charge who failed to implement and operate those systems correctly, and investors who looked the other way.
Glitnir Bank provides a perfect illustration. Civil complaints filed by the bank appear to suggest that although the bank had set up a risk committee to analyze and approve loans in line with best practice, in reality it was often a formality. It is alleged that individual committee members were dominated by the bank’s powerful CEO, who personally approved many of the loans.
The Madoff case is a similar blend of incompetence and denial. In hindsight, the problems, the lapses, the inconsistencies all seem so glaringly obvious. Despite numerous sweeps of Madoff’s operation, Securities Exchange Commission (SEC) examiners never found evidence of fraud. And yet Madoff’s elaborate hoax could have been uncovered if someone had done some due diligence on Madoff, particularly the phantom securities that he claimed to have purchased on behalf of his clients.
As for the investors who were burned by Madoff, they easily rationalized their consistently high returns. If Madoff was a fraud, they told themselves, he would have been caught long ago. “In the end people believe what they want to believe,” says Keith Kelly. “That’s human nature.” Human nature is unlikely to change any time soon. Once the good times return, the painful memories will fade, complacency will set in and companies and investors will go back to the same patterns of denial. “Within a year, everything will be forgotten,” predicts Kelly. “It’s clear that risk aversion is already starting to decline.”
The great American circus impresario P.T. Barnum is credited with coining the phrase “A sucker is born every minute.” While that offhand dismissal of human gullibility may be accurate when applied to individual investors, surely large corporations, with their institutional checks and balances will not be so easily duped the next time. “The lesson that should have been learned is that every company can be defrauded and that you can’t ignore that in good times,” says John Slavek, a 13-year Kroll veteran, who heads a financial investigations team out of the Philadelphia office. “The fact is,” adds Slavek, “that without fraud, companies could be doing even better.”
While crime pays (at least until you get caught), so too, argues Slavek, does fraud prevention. So what is the likelihood that more companies will start making fraud prevention a priority? Again, it’s mostly wishful thinking. “Very few companies are pro-active,” concludes Slavek. “CEOs shake their heads at problems in other companies. Then it happens to them and they are shocked. When clients call us, there is usually a crisis and they are already feeling the pain.”
Nearly three years after the collapse of Lehman Brothers and the unearthing of Madoff’s elaborate Ponzi scheme, outrage and urgency are fading. The financial markets have recovered and many companies are enjoying record profits. In other words, conditions are ripe for more fraud. “People don’t want to do preventative work to see if it’s too good to be true. People move to the next big deal and it starts all over again,” says Abbey. And the next big thing might just as likely be in one of the high-risk emerging markets of Brazil, India, China, among others, which are attracting international investors in droves. “The big money is moving to new and un-regulated jurisdictions,” observes Abbey. “There’s little doubt that some investors will get burned.”
So what will the next big scam look like? At their core, says Glen Harloff, a managing director in Kroll’s Grenada office specializing in financial investigations in Latin America, “all Ponzi or pyramid schemes are basically the same; the only thing that changes is the vehicle or commodity used to entice unsuspecting investors.” When it comes to new investment vehicles, investors need to be aware of products offering high investment returns at little or no risk, secretive or complex investment strategies, and little to no transparency, says Harloff. “If any of these red flags appears, there is a good chance you may be looking at the next Ponzi scheme.”
As for the Madoff scam, we will still be talking about it for many years to come. Studies will show how the system broke down and that a lot of players in the market wittingly or unwittingly aided and abetted Bernie’s grand larceny. “It always comes out that someone should have known,” observes Abbey. “It’s a similar pattern that repeats and repeats.” Like his Kroll colleagues, former FBI Special Agent Kelly is under no illusion that the Madoff case represents a watershed in human history. “They may come in different shapes and sizes,” concludes Kelly, “but there will always be Madoff schemes.”
To view the original article, please click here.