Markets cannot function without relationships, and relationships cannot function without trust. But the mechanisms for building trust can be ‘faulty’. Bernard Madoff’s infamous Ponzi scheme, which ruined thousands of investors, depended on a series of ‘trust-producing’ factors that combined to conceal it from victims and the authorities. Understanding these mechanisms can help prevent similar frauds and abuses of trust.
Decision-making on the financial markets is driven by information and by trust. But trust can be flagrantly abused. This was amply demonstrated by the Bernard Madoff scandal, considered to be the biggest fraud in American history.
Madoff, a former non-executive chair of the NASDAQ stock exchange, used a ‘Ponzi scheme’ to defraud investors, paying returns out of invested money rather than profits. The scheme ran for many years [convicted in 2009, Madoff said it dated from the early 1990s] and left thousands of victims. How did it originate and develop — and remain undetected for so long? And what can be done to prevent similar crimes in the future? A recent analysis of the case helps answer these kinds of questions.
Researchers interviewed 11 of Madoff’s American victims, as well as the CFO of an organization that chose not to invest in the fund, and the CEO of a company representing the interests of minority shareholders. They also analysed the 113 ‘victim impact statements’ in the case — and relevant press articles, videos and books. They found that Madoff benefitted from three ‘trust mechanisms’:
These ‘trust-producing’ mechanisms were identified by sociologist Lynne Goodman Zucker in her 1986 article ‘Production of Trust: Institutional Sources of Economic Structure, 1840-1930’ as underpinning all market relationships. In the Madoff case, they operated in parallel — and they help explain why the scheme lasted for so long.
The researchers also found that credible account statements played a key role in concealing the fraud. Describing transactions with genuine, well-known companies carried out on the basis of actual prices, these statements were consistent with all available data. It wasn’t a case of investors being naïve — but a case of fraudsters being sophisticated.
What other factors played a part? At the time of Madoff, the regional regulatory offices did not communicate with each other. Six substantive complaints were received about Madoff, but in different locations that were not in contact with each other. A national database has since been set up by the SEC to co-ordinate the complaints system.
The research underlines the need for investors to diversify their portfolios (in terms of both assets and intermediaries) to limit their exposure to risk. In addition, the researchers advocate:
Fraud, of course, will never be completely eliminated — and deceptions based on false documents will always be difficult to uncover, even when auditing processes are robust. But the risks can be reduced. The research can be interpreted as pointing to two other ‘golden rules’ of business and finance:
Put simply, accurate assessments of trustworthiness depend on an ‘enquiring mind’.
This Idea is adapted from the article ‘Trust and financial markets: Lessons from the Madoff fraud’, authored by Business Digest and published in Research@HEC, No. 33, May-June, 2013, © HEC Paris.
The original was based on an interview with Hervé Stolowy and the Contemporary Accounting Research forthcoming article ‘The Construction of a Trustworthy Investment Opportunity: Insights from the Madoff Fraud’ co-written with Martin Messner, Thomas Jeanjean and C. Richard Baker.
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