For traditionalists on the Street, a stock market was a centralized trading floor where men in loud-coloured jackets stood face-to-face and shouted bids at one another for a few specified hours each day. That “auction” model—with stock traders bidding against one another like so many art collectors at Sotheby’s or Christie’s—seemed increasingly inadequate as mutual fund managers and other professional investors came to dominate the markets and as over-the-counter stocks became more attractive to them.
As an OTC trading house, Madoff’s firm had never conducted business in the traditional auction-market way. The over-the-counter market, with tens of thousands of unlisted stocks, had no central trading floor where traders could shout out their bids. Instead, it was more like a vast telephonic flea market, whose map was the Pink Sheets. A dealer like Madoff could pick up some shares at one flea market on Monday and try to sell them at a higher price at another flea market being held that day, or at the same flea market on another day.
By the time someone in one flea market noticed a dealer’s price tag on a stock, the shares could be selling for more or less somewhere else. So dealers such as Madoff put a comfortable cushion between the price at which they would buy a stock from another trader and the higher price at which they would sell it. That cushion was called “the spread”. Another term for it would be “profit”.
Spreads on over-the-counter stocks were enormous—sometimes as high as 50 percent—and those fat profits were almost completely hidden from the actual retail investor. Getting a piece of those profits was the hard part.
The market was dominated by a handful of big wholesale dealers with big inventory. Like hundreds of other small dealers, Madoff struggled to get attention. “Often as not, Madoff’s firm did not get called when there was business to do,” a reporter noted in Traders Magazine.
Along with a cadre of other far-sighted brokers, Madoff quickly saw that if the Pink Sheets were computerized so that their prices could be constantly updated and made available to every dealer—as on the ticker on the Big Board—the dealer offering the best prices for a stock stood a better chance of getting noticed. “We felt, as a small market-making firm, that this would level the playing field for us,” he told one writer. It would also give a much-needed boost to his stock-trading business.
He was not alone in his conviction that the Pink Sheets could be automated; there are at least a half-dozen people with a far better claim than his to having “invented” the automated market that became NASDAQ. But he backed the idea early and emphatically, even as some other market makers resisted it because “you had to show your hand, and they didn’t want to do that,” Madoff recalled. “If somebody just called you up from the Pink Sheets, you could say the price was stale and give different quotes to different people. The system we were proposing would give prices a level of transparency. It was quite controversial.”
The federal regulators, however, were on his side. They quickly saw that computerizing the Pink Sheets would shed more light on price quotes and create more competition in the OTC market. That could narrow spreads and give investors a better deal.
In its push for more automation, the SEC demanded the help of its industry-run partner in the financial regulatory field, the National Association of Securities Dealers, or NASD. For three decades, the policing work of the SEC had theoretically been augmented by the NASD’s own security measures. The organization was empowered to licence brokers and to establish and enforce trading rules. Chronic scandals in these years, however, showed that the NASD’s resources often fell short of its responsibilities. Its leadership was divided between small firms fretting about costs and giant firms worrying about investor backlash. And, like any watchdog that is fed and petted by the people it is supposed to be watching, its appetite for fierce enforcement was more of an ambition than a reality.
As divided and occasionally compromised as it was, the NASD’s leadership saw that the status quo was not an option. The group’s automation committee had struggled for years to automate price quotes in the OTC market, and in February 1971, to the muted alarm of the established traditional stock exchanges, an automated system built for the NASD by a computer company called Bunker Ramo made its debut, linking dealers across the country via an electronic network. It was called NASDAQ, an acronym for National Association of Securities Dealers Automated Quotations. Improvements to its primitive archetype—built on a software chassis similar to those already running airline and hotel reservation systems—would follow.
Madoff allied himself firmly with the forces of automation—and somehow his small firm found the money to invest in equipment and software. Did he get some of that money from the investors that Saul Alpern, Frank Avellino, and Michael Bienes were collecting? At least one former employee later thought so, according to allegations in subsequent litigation. But Madoff emphatically denied stealing from customer accounts during the 1970s and ’80s and, nearly two years after his arrest, no evidence had been made public that contradicted him. In any case, the regulatory battles over automation would allow Madoff to add a few brushstrokes each year to his portrait as a committed market innovator, an ally in the crusade to drag the nation’s tradition-bound markets into the modern age.
It is no coincidence that this transformation of the Madoff firm’s reputation—from a struggling over-the-counter trading house to a cutting-edge market innovator—began with the arrival of Bernie’s younger brother, Peter.
Peter Bennett Madoff was in nursery school when his father’s business failed, and he was a teenager when his brother Bernie married Ruth Alpern. His sister, Sondra, was more than a decade his senior. Like many last-born children, he made his own path—a more seamless transition to adult life than his older brother managed.
Instead of attending Far Rockaway High School, he applied and was admitted to Brooklyn Tech, one of the most prestigious competitive state-run schools in the country. He graduated from Queens College in Flushing, New York, where he met his future wife, Marion, and earned his law degree from Fordham University in 1970, just after his daughter, Shana, was born.
By then, Bernie had a growing family. His first son, Mark, whose arrival in March 1964 prompted Ruth to end her brief tenure as Bernie’s office manager, was followed by another son, Andrew, born in April 1966.
Despite the difficulties of breaking into the clubby over-the-counter market, the Madoff firm was apparently doing very well. Bernie moved his young family to Roslyn, on Long Island’s increasingly affluent North Shore, and commuted each day to newer and larger offices at 110 Wall Street, about six blocks from the Fulton Fish Market on the East River. He and Ruth joined a country club; she enjoyed summer days there with the boys, and the family’s golf games improved.
It appears that Peter worked at his brother’s firm while he was still at school—industry records show that he got his broker’s licence and joined the firm in June 1969—and he came to stay after getting his law degree. He arrived amid some of the most revolutionary changes since the invention of the ticker tape and telegraph a century before. And he put the Madoff firm on the technological map, spending a lot of its money to do so.
There was little agreement, in hindsight, about whether the Peter Madoff of those days was a warm, engaging man or a sharp-tongued, demanding one. Some former employees, burned by their losses, recalled Peter in less than flattering ways. But even after Bernie Madoff’s fall, the trade journals were full of comments from people who had known Bernie and his brother for years and genuinely liked them. Peter Chapman, of Traders Magazine, found that Peter, like Bernie and his sons, “was almost universally liked” on the Street. The Madoff brothers “were just great, great people,” said one of their institutional clients.
There were two vivid threads of agreement weaving through these differing recollections.
First, there was a common perception that Bernie subtly and humorously, but persistently, belittled his younger brother. There may have been nothing more to it than the age-old
friction between a successful man and a promising younger brother trying to find his place at the table. Despite Peter’s law degree—a credential that Bernie had decided wasn’t worth his own time—he started out as a salaried employee of his brother’s brokerage firm, albeit an increasingly well-paid one. Nearly forty years later, he would still be only a salaried employee, working for a brother who never made him a partner in the primary business to which he had devoted his entire working life. For decades, his only ownership stake in the primary Madoff firm was a sliver of equity in the firm’s London subsidiary, formed in 1983, with his brother retaining an ownership stake of more than 88 percent of that unit.
It is possible that Bernie’s treatment of Peter simply echoed the dynamics of their childhood. By 1970, their father, Ralph Madoff, had taken an interest in Bernie’s firm, and he and Sylvia would sometimes help Bernie by riding out to inspect some company he was considering as an investment. Ralph’s occasional presence at the firm could have reinforced Bernie’s and Peter’s childhood roles of Big Brother and Baby Brother. If so, the influence did not last long. In July 1972, Ralph Madoff died of a heart attack at age sixty-two. Two and half years later, in December 1974, Sylvia Madoff died suddenly as well, after suffering an asthma attack during a holiday cruise in the Caribbean. She was just weeks shy of her sixty-third birthday.
Even with the lower actuarial expectations of the early 1970s, it was a shock to the Madoff brothers to lose both parents so early and so young. Friends from that era would recall that Bernie became more fatherly towards his younger brother, stepping into Ralph’s shoes as the family patriarch.
The second common perception from those who knew him well is that Peter Madoff was the essential force that propelled his brother’s firm into the vanguard of marketplace computer technology, keeping it competitive and drawing favourable regulatory attention. In one account of Wall Street’s automation, the authors introduced the Madoff brothers like this: “Bernard (who founded the firm) and Peter (the company’s computer genius)”. Even one of the lawsuits filed against him after his brother’s fall credited Peter with developing the trading technology on which the firm’s trading desk relied.
Bernie Madoff embraced the larger idea that technology was clearly going to reshape the stock market and had to reshape the Madoff firm, too. But his brother grasped all the nuts and bolts it would take to get there. As Peter’s expertise grew, he took a larger role in overseeing the firm’s trading operation, where the new technology hit the road every day.
If some insider accounts are right, Peter’s contribution to his brother’s firm was even more significant. These chronicles credit Peter as the one who saw the potential for making a market in stocks that normally traded on the New York Stock Exchange. “And it was that decision,” one report noted, “that catapulted the firm into the big leagues of wholesaling.”
The over-the-counter trading of exchange-listed stocks was called the “third market”, a name that some scholars said was derived from Wall Street’s view that the Big Board and other traditional stock exchanges were the “first market” and the OTC market was the “second market”. The big Wall Street firms that were members of the New York Stock Exchange were obligated by its rules to trade the shares of NYSE-listed stocks only on the Big Board. So the third market—the trading of NYSE-listed stocks among dealers in the over-the-counter market—was a niche that smaller non-NYSE firms could exploit easily without being jostled by giants. As institutional investors flocked to the third market, where commissions were lower than on the Big Board, the increased trading volume generated new revenues for the smaller firms handling third-market trades. It was here that the Madoff firm first began to increase its share of Wall Street trading volume and build its reputation with other Wall Street leaders. And getting into the third market, according to many, was Peter Madoff’s idea.
Peter’s role during this turbulent decade of cascading technological change made him as influential in regulatory circles as his brother. He also became an increasingly important figure within the firm itself, taking on a host of important duties, including regulatory compliance.
It is beyond the world of trading technology that the mysteries arise. As chief compliance officer, how much did Peter know about what was going on in the private customer accounts opened at the firm? How much did Peter learn about what Bernie did with all the money that Ruth Madoff’s relatives were sending to him through her father’s old accounting firm? How much did Bernie share with him about the financial condition of those parts of the firm that Peter didn’t see? In short, how much did Bernie tell Peter about his evolving fraud?
Absolutely nothing, according to Madoff himself and Peter’s lawyer, commenting after Bernie’s arrest and responding to questions in the years that followed—years in which Peter remained under investigation but was not arrested or charged with any crime.
Peter Madoff had his own investment accounts, managed by his brother, and those accounts would generate millions in profits for him and other members of his family over the years. Didn’t he ever suspect that his returns were too good to be true? Records would later show a number of backdated trades in those accounts that had enriched him enormously. Didn’t Peter ever sit down and check the paperwork on those accounts with Bernie to see how such remarkable profits were possible?
His answer, from the day of his brother’s arrest, was “no.” His legal defence in a string of lawsuits was that he, like thousands of other people, believed he could trust his spectacularly talented brother to manage the family’s personal money—just as his brother trusted him to run the firm’s core stock trading business and keep it ahead of the technology curve.
If Bernie entrusted Peter with anything beyond the firm’s high-tech trading business, there was little on paper to publicly document it.
By the late 1970s, Frank Avellino and Michael Bienes realized that they simply had to do something about their arrangement with Bernie Madoff.
The process that Saul Alpern had begun a decade earlier—receiving cheques from investors, logging in the individual profits, mailing out cheques for the withdrawals, noting when the money was reinvested—had gotten far too cumbersome, according to Bienes. The accountants were suffering under the same sort of paperwork crunch that had bedevilled Wall Street a decade earlier, but they did not have access to the mainframe computers that would have solved their problems, and personal computers were still a few years away. Besides, the partners still had an accounting firm to run.
Avellino & Bienes had inherited nearly all of Saul Alpern’s accounting clients after the older man’s retirement, but one important account did not make the trip: Bernard L. Madoff Investment Securities. The Madoff firm’s books had been handled by Jerome Horowitz, another accountant in the Alpern firm who was sufficiently well-established that Bienes expected he would soon break off to set up his own practice—as he did. Despite the Alpern family connection, it actually was Horowitz who handled the annual tax accounting and audit chores for Madoff’s brokerage firm. When Horowitz left the Alpern firm to strike out on his own in the late 1960s, he took Madoff’s accounting business with him.
There were apparently no hard feelings about the move, as Bernie Madoff continued to invest money for the clients of Avellino & Bienes after his father-in-law retired. The number of accounts grew slightly “to accommodate [private retirement] accounts and family members of their accounting clients,” Madoff said in a letter from prison, but never exceeded a half-dozen accounts, all of which he said were involved in his hallmark arbitrage trading.
“It was my understanding that all of these Avellino & Bienes [accounts] would operate in the identical manner as the original account of my father-in-law,” he said—in other words, money from many investors would be pooled in a few accounts at the Madoff firm, and the profits would be allocated appropriately by the accounting firm. He claimed to have warned the two accountants to keep the number of investors below the level that would require them to regis
ter as a public mutual fund—a claim Michael Bienes stoutly disputed in his public account of these years.
While the returns were attractive for Avellino, Bienes, and their clients—regulators would later say they ranged in the high teens, but there is no firm evidence of Madoff’s track records in these years—the paperwork logjam was threatening to bury them. Bienes credits Avellino with the breakthrough idea: “Four words: Let’s pay them interest. It’s simple. You give them a stated rate. You pay it to them calendar-quarterly. They can roll it over if they want, or they can take a cheque if they want.”
This step was noteworthy because it was the first big change in the way Avellino & Bienes handled the money invested with Madoff, a change that Madoff said was made without his knowledge or approval. It was also one that simplified the process enough so that the tiny accounting firm could handle an enormous number of customers and a stunning amount of money. There was no formal partnership structure or separate business unit created to mark this new approach by the two accounting partners. It was all very casual, but the accounting firm “always stood behind it,” Michael Bienes said years later.
“That’s how much we believed in Bernie,” he stated.
It was an era when people desperately wanted something solid to believe in. The 1970s seemed like the decade that would ruin Wall Street. The contrast between Wall Street’s dismal state and Madoff’s apparent success with his arbitrage trading only enhanced his reputation.
“The stock market crashed in the 1970s, and no one noticed,” the financial writer Jerry Goodman observed. Unlike the crash of 1929, the 1970s crash occurred in slow motion. As Goodman memorably summed up, “If the first crash was a dramatic leap from a sixty-storey building, the second was like drowning in a bubble bath. The bubble-bath drowning sounds less scary, but you end up just as dead.”
Bernie Madoff, The Wizard of Lies Page 8