Bernie Madoff, The Wizard of Lies

by Diana B. Henriques

  The computer-generated records had already gotten Madoff through the impromptu due-diligence session with Fairfield Greenwich’s Jeffrey Tucker in 2001 and through earlier SEC examinations. He was sure they would quell any suspicion from the visiting sceptics now.

  But all the convincing computer charades in the world wouldn’t save him if his fraud ran out of real, hard cash. And by November 2, the balance in Madoff’s slush fund account at JPMorgan Chase was down to just $13 million—nowhere near enough to cover the $105 million in redemption cheques that had to be mailed in the next three days.

  Any hesitancy, any delay in payment, would surely trigger a panic. Everything now hung in the balance: the luxurious life, the nearly worshipful gratitude from his “investors”, the status and respect in the industry, the entire edifice of his life—a lie he had lived so long it probably seemed like reality by now.

  Since 1992, Madoff had survived each SEC examination and due-diligence visit unscathed. He had fooled regulators, hedge fund administrators, and auditors for years, conjuring up counterfeit records and bogus computer data that seemed to satisfy them. But you cannot conjure up a counterfeit bank balance and write cheques on it. The money is there or it isn’t—and it wasn’t.

  His Ponzi scheme was $92 million in the red. Madoff had just three days to find more money or his cheques would bounce, just as Bayou’s had.

  The cash crisis of November 2005 pushed Madoff’s fraud right to the brink. Only some timely cash transfers from his legitimate business accounts and an eleventh-hour bank loan to his firm forestalled immediate disaster. But the price of that bailout was that the border between Madoff’s fraud and his legitimate Wall Street business—his greatest pride, the lifelong occupation of his brother and sons—was blurred beyond repair.

  While the Ponzi scheme was nearly out of money, the Madoff brokerage firm wasn’t. Its bank accounts were healthy, its credit was good, and its business looked strong, at least from the outside. Indeed, under the direction of Madoff’s sons, the firm’s proprietary trading desk was generating profits for the firm and consistently outperforming the overall market. And it still handled an impressive share of the market’s trading volume. So, as a stopgap measure, Madoff moved some of his legitimate firm’s money into his Ponzi scheme’s bank account on November 3, 2005, to cover its outstanding cheques. The next day, as a longer-term lifeline, he appropriated some bonds that belonged to Carl Shapiro, one of his oldest customers, and used them as collateral to get a bank loan for $95 million. The proceeds, received ten days later, were supposedly for his legitimate business, but were promptly shifted into his Ponzi scheme’s dwindling account to cover continued withdrawal demands.

  A subsequent criminal indictment asserted that it was Dan Bonventre, who had worked at Madoff’s side for more than three decades, who actually carried out these rescue measures and hid them from regulators and from others at the firm. Bonventre denied that he knew anything about the fraud; the criminal case against him was still pending in February 2011. Bonventre had joined the Madoff firm in 1968, when he was still in his early twenties, after having worked briefly as a bank auditor, and he was mostly self-taught when it came to running the operational side of a midsize Wall Street brokerage business. He was a senior executive at the firm by 1975, when Frank DiPascali came on board, and by 1978 he was director of operations.

  Prosecutors and regulators at the SEC later claimed that Bonventre had been falsifying records for years to prevent any trace of the Ponzi scheme from showing up on the ledgers of the legitimate Madoff business, a charge Bonventre also denied. As that legitimate business faltered in the late 1990s, Madoff arranged to move as much as $750 million in stolen money into the brokerage firm’s accounts over the years by making the cash look like legal profits from his investment advisory business, according to federal prosecutors. When the cash crisis hit, prosecutors said, phoney ledger entries were created to explain why money was now moving in the opposite direction. Bonventre’s lawyers insisted he was “absolutely innocent” of any knowing role in Madoff’s fraud.

  Whether Bonventre acted knowingly or was hoodwinked by Madoff, hundreds of millions of dollars were in fact moved from the brokerage firm’s account to the Ponzi scheme during the cash crisis that struck in the autumn of 2005. The cash, much of it borrowed from the brokerage firm’s banks, would help keep the Ponzi scheme alive into the spring of 2006.

  It was a long and precarious season for Madoff—one that got much worse when he learned in mid-November 2005 that the SEC had opened yet another investigation of his hedge fund operation, just months after closing the last one. And this time, acting belatedly on yet another poorly understood tip, it was knocking on the door of his biggest feeder fund, Fairfield Greenwich.

  The source of the inquiry was once again an accusation from Harry Markopolos, the sceptical “quant” in Boston. In October 2005 he made his third attempt to persuade the SEC to open an investigation of Bernie Madoff. Deliberately looking to shock the regulators, he entitled his report “The World’s Largest Hedge Fund Is a Fraud”. Like his earlier efforts, the submission discussed all the red flags that Markopolos saw flying from Madoff’s operation: a consistency of return that was humanly impossible, stealth trading that left no trace in the stock or options markets, absurdly generous or inept counterparties who were always willing to be on the losing side of their Madoff trades. Like his earlier efforts, the report was complicated, arrogant, and dismissive of the SEC’s own quantitative abilities. “Very few people in the world have the mathematical background needed to manage these types of products but I am one of them,” Markopolos wrote. It was so clear to him that Madoff was running a Ponzi scheme; why didn’t everyone else see it?

  What happened to Markopolos’s third submission to the SEC is a textbook lesson in bureaucratic bungling. Animosity, arrogance, defensiveness, ignorance, stubbornness, inattention, simple laziness—all that “people-to-people stuff” of office life—were part of the equation. You didn’t need to be a quant to see how it would add up.

  But it started well enough.

  Members of the Boston enforcement staff read Markopolos’s latest memo and met with him in person for several hours on October 25, 2005. They were impressed—indeed, alarmed. While the memo acknowledged that front-running was a remotely possible explanation for Madoff’s success, it emphasized that a Ponzi scheme was far more likely. If Harry was right, the investor losses would be in the billions of dollars.

  But once again the Boston office was stuck with the bureaucratic reality: Madoff was in New York, so the SEC office in New York would have to investigate him. The Boston team tried hard to impress the New York office with the credibility of this informant and the urgency of his warning. In an uncommon move, the head of the Boston office personally made the referral to his counterpart in New York, to underscore how important he thought the tip was.

  The e-mail went out the day after the meeting with Markopolos and included an attachment summarizing Markopolos’s concerns: “The informant believes that Madoff may be running one giant Ponzi scheme, and there are signs that it may be close to crashing down on him. According to the informant, if that happens, it would have widespread ramifications, as a lot of people have placed a lot of money with Madoff.”

  A branch chief in Boston followed up the next day, October 27, with an e-mail to all three assistant enforcement directors in the New York office, offering to hook Markopolos up directly with the appropriate staffers in New York.

  The warning from Boston could not have been clearer: the SEC needed to find out if Madoff was running a Ponzi scheme.

  The team assigned to the task in New York had virtually no experience investigating Ponzi schemes. A key investigator there had very little experience at all, having been at the SEC for just nineteen months. The leader of the team would later say she had been “hamstrung by a lack of resources and personnel” and by the unresponsiveness of others within the agency who could have been helpful but weren’
t. The culture of the agency discouraged staff members from reaching outside their own “silo” for help, so staffers knowledgeable about Ponzi schemes were not consulted. And even those who thought they knew something about Ponzi schemes clearly didn’t. Despite the clarity of the warning, people on the team would later recall that they never truly thought it was credible that a man like Bernie Madoff could be a criminal—he simply didn’t fit their ill-informed image of the “typical” Ponzi scheme artist.

  Finally, Ed Manion’s prediction about people either instantly liking or disliking Harry Markopolos proved true. It seemed to Markopolos that the New York branch chief, Meaghan Cheung, the hands-on leader of the new investigation, had instantly taken a dislike to him. Even after Boston had vouched for Markopolos, Cheung seemed to remain distant and unreceptive—and her opinion spread to the other two women on the team. “I remember hearing that she thought he was kind of condescending to the SEC, in terms of SEC expertise and knowledge,” one of her subordinates recalled later.

  While some might say a little condescension was justified, given how the agency had handled his previous tips about Madoff, Markopolos didn’t help his cause with his approach to the women in New York. He later recalled that, in his first telephone conversation with Cheung, he questioned her inadequate knowledge of derivatives and dismissed some of her earlier successful accounting fraud cases. He said later that she seemed “offended” by this. In fact, his questions were totally irrelevant: No knowledge of derivatives is required to investigate a Ponzi scheme. If it’s truly a Ponzi scheme, there are no derivatives; there’s just a liar with a bank account. In fact, Cheung’s previous experience might have been more relevant, since accounting fraud investigations sometimes involve verifying whether the assets shown on the balance sheet actually exist, the precise question a Ponzi scheme investigation must answer.

  If Cheung had known more about Ponzi schemes, she would have known how to deal with Markopolos’s arrogant and misguided questions. But she didn’t. And if Markopolos had known more about dealing with people, he never would have asked those offensive questions in the first place. But he didn’t. For a quant, the human equation is often the most difficult to solve.

  In late 2005, Harry Markopolos made one last effort to expose Madoff by going, at last, to the media. On the advice of a friend at a Washington-based taxpayer advocacy group, he approached John Wilke in the Washington bureau of the Wall Street Journal. Wilke had spent most of his distinguished career in Washington, where he wrote about corrupt congressmen and the companies that corrupted them. When Markopolos first contacted him, Wilke was already at work on another significant project. While he listened to the tipster, he may have been unwilling to pursue a story that intruded on the turf of the Journal’s securities industry reporters in New York. Some of Markopolos’s allies urged him to approach other reporters—at the Journal or at other news organizations in New York—when Wilke did not pick up on the story, but Markopolos wanted to work only with Wilke. By February 2007, Markopolos was discouraged and chose to interpret Wilke’s reluctance to pursue the story as evidence of a conspiracy. “I was convinced,” he later wrote, “that someone high up at the Journal had decided it was too dangerous to go after Bernie Madoff.” Senior editors at the Wall Street Journal, which had tackled some of the most powerful figures on Wall Street and in Washington over the years, flatly denied that anything was behind Wilke’s decision not to investigate Madoff in 2006 except his own professional priorities.

  In the New York SEC team’s defence, they also were misled by their colleagues about the earlier Madoff investigations, none of which had actually addressed the question of whether he was running a Ponzi scheme. One man who supervised the 2005 examination claimed that Lamore and Ostrow had investigated “basically some of the same issues” and found nothing. Lamore agreed to meet with the new team, but his response was dismissive. “In short, these are basically the same allegations we have heard before. The author’s motives are to make money by uncovering the alleged fraud,” he said. Lamore was referring to a bounty that the SEC offered for tips about insider trading cases, a category of crimes that included front-running. “I think he is on a fishing expedition and doesn’t have the detailed understanding of Madoff’s operations that we do which refutes most of his allegations,” Lamore continued. Another supervisor agreed: “There is still a little mystery as to what Madoff does,” he said, but a Ponzi scheme or front-running didn’t seem likely “from what we’ve seen.”

  The impression the new team got was that the previous examiners hadn’t thought there was anything to Markopolos’s analysis suggesting a Ponzi scheme. No one bothered to go through the older case files carefully, so no one noticed the nearly identical complaint the hedge fund manager made in 2003 or the Renaissance e-mails found in 2004. And no one noticed that the earlier investigators never actually looked for a Ponzi scheme at all.

  Lamore did note that his team had not approached any of Madoff’s hedge fund clients, so the new team decided to cover that base at least. It sent a letter to the Fairfield Greenwich Group, asking for crates of documents relating to its dealings with Madoff. The plan apparently was to check whether Fairfield’s account statements (which DiPascali had fabricated) matched up with the account statements Madoff had given Lamore’s team (which DiPascali had also fabricated). If Madoff was operating a Ponzi scheme, this was a useless exercise.

  But it got Madoff’s attention. There he was with his cash balance hovering close to zero and suddenly his biggest, most reliable source of cash was receiving letters about him from the SEC.

  The danger to his fraud increased on December 13, when the junior member of the New York SEC team discovered an “odd discrepancy” between Fairfield’s documents and the previous team’s notes on its interview with Madoff in May. In the spring, Madoff had claimed that he hadn’t used options as part of his strategy for about a year. But the current Fairfield account statements still showed options trades. There did not seem to be any explanation, other than that Madoff was lying to someone. Since Madoff’s feeder funds all believed he was still buying options for them, it would be devastating if the SEC started suggesting that he wasn’t.

  Still, even the discrepancy over his use of options did not suggest to the SEC team that relying on Madoff as a source of truthful information was a bad idea. He remained an extremely reputable figure on Wall Street, as far as they knew. Reflecting on the case later, one investigator wrote a colleague that there wasn’t “any real reason to suspect some kind of wrongdoing.”

  In December 2005 the chief risk officer at Fairfield Greenwich confirmed in an SEC interview—conducted after the SEC gave him permission to consult with Madoff before testifying—that options remained part of the Madoff strategy. The investigative team decided it would be a good idea to track down some of the counterparties to these mysterious options trades before questioning Madoff about it. It would have been an excellent idea—indeed, if it had been diligently pursued, it would certainly have exposed Madoff’s crime. But this didn’t happen.

  Bernie Madoff and Frank DiPascali spent January 2006 producing documents in response to the SEC’s new demands—although the huge stacks of paper did not include any OTC options contracts. On January 26, DiPascali went downtown to the SEC’s offices to answer questions about the counterparties supposedly on the other side of Madoff’s trades, and his lies were sufficiently convincing to keep the investigators offtrack for a while longer.

  Regulators and prosecutors later accused Dan Bonventre of spending this perilous January dealing with the Ponzi scheme’s worsening cash crisis, using another $54 million in government bonds from Carl Shapiro’s account as collateral for a $50 million bank loan in mid-January. The loan proceeds were put into the Ponzi scheme account to cover continuing withdrawals. On at least four occasions, money from the legitimate firm’s bank accounts had to be tapped to cover giant withdrawals from the Ponzi scheme. It was not clear how long this could go on before the legitim
ate firm started suffering a cash squeeze as well—or someone working there picked up gossip about the curious transfers and loans.

  Meanwhile, SEC investigators continued to poke around at the feeder funds that Madoff relied on for the fresh cash he desperately needed. On January 30, 2006, they interviewed Jeffrey Tucker from Fairfield Greenwich. Two days later they sent a letter to Tremont Partners demanding the same list of documents they had sought from Fairfield in December.

  Then, in mid-February, the team asked Madoff for a piece of paper that he knew could send him to prison. They wanted a list of all the accounts through which he executed, cleared, or settled any trades, including the disputed options trades—trades they still believed he was making, despite his earlier testimony. Of course, he was not executing, clearing, or settling any trades at all, but he could not refuse the request without setting off all kinds of tripwires at the SEC. So, on February 23, Madoff gambled big and produced a six-page list of the financial entities through which he was allegedly conducting trades for his hedge fund clients, along with his account number at the DTCC clearinghouse.

  Then he waited for the sky to fall.

  9

  MADOFF’S WORLD

  It is hard to fathom how Bernie Madoff managed to handle the protracted liquidity crisis and SEC investigation of late 2005 and early 2006. Even on paper, the magnitude of the cash drain was shocking. Between April 2005 and June 2006, investors withdrew roughly $975 million from the Fairfield Sentry fund alone, nearly 20 percent of its assets. The situation looked so dire that it is hardly surprising that Dan Bonventre and two computer programmers who worked with Frank DiPascali on the seventeenth floor emptied their Madoff accounts in the spring of 2006 and moved the assets elsewhere—although all three have denied that they knew anything about the fraud or its teetering finances. Madoff could scarcely refuse to let them pull the money out. Even if they were not helping his Ponzi scheme stay afloat, and they flatly denied that they were, it would have raised alarms if they had not been able to make the withdrawals. On April 13, Madoff arranged to tap his brokerage firm’s operating account once again to cover another $120 million redemption request from the Sentry fund, which had withdrawn $150 million just a month earlier.