The Money Issue: The CFO & Spotting Fraud – We’re not as safe as we think we are

A At first Harry Markopolos couldn’t believe what he was seeing when he saw Bernie Madoff’s investment performance figures. They were too good to be true. Then no one else would believe what he was saying. It was too bad to be true.
The story of Harry Markopolos’ discovery of Bernie Madoff’s multibillion-dollar Ponzi scheme full eight years before it unravelled is cautionary tale. It contains many lessons for chief financial officers, regulators, investors and directors about how to detect and prevent fraud.
But mostly the Madoff fraud is story of group-think and how gatekeepers, managers and guardians failed repeatedly to challenge the status quo and declare the emperor had no clothes.
“If everybody is thinking alike, is anybody thinking?” Markopolos asked an audience of financial regulators, CFOs and accountants at Serious Fraud Office (SFO) conference in Auckland in February.
He was in New Zealand at the behest of the SFO to pass on those lessons about fraud detection and group-think. His comments are particularly topical for country where its business leadership community is relatively small and tightly interconnected, and where New Zealanders remain remarkably trusting of each other.
Markopolos also raised some uncomfortable questions about the roles of auditors, trustees and the sorts of financial controls most big companies and investors take for granted.
New Zealand has experienced its own versions of the Madoff Ponzi, most notably in the case of David Ross’ Ross Asset Management, Allan Hubbard’s interconnected web of finance companies and investment companies, and Jacqui Bradley’s B’On Financial Services. Combined losses to investors and taxpayers in these schemes of close to $1.5 billion make them about twice as big as the Madoff fraud relative to the size of the New Zealand and US economies.
KPMG’s Fraud Barometer for the six months to June last year showed record $1.7 billion worth of fraud in 33 cases put before the courts, up from $279.7 million in 24 cases in the same period year earlier.
Also speaking at the SFO conference, SFO Minister Anne Tolley said an SFO estimate of serious fraud in New Zealand is expected to be released later this year showing fraud worth “many billions of dollars per year”.
New Zealand may see itself as one of the safest, least corrupt and better regulated business destinations, but the events of the past five years should wipe out that complacency.
Here are five key questions Harry Markopolos says fraud investigators, financial managers and investors should ask to nip serious fraud in the bud.

Is it too good to be true?
The way Harry Markopolos stumbled across the Bernie Madoff fraud seems almost banal. Markopolos was fund manager at derivatives fund manager in 2000 trying to market to the same clients as Madoff. He and his colleagues kept hearing about shadowy figure with an amazing ‘black box’ investment strategy that regularly returned 16 percent annually year after year.
Markopolos, derivatives specialist with an eye for the maths to understand such trades, was told to go away and try to reverse engineer Madoff’s strategy so as to copy it and offer it to Madoff’s clients.
The Boston-based Army Reserve Officer became even more interested after meeting with minor member of European royalty, Thierry de la Villehuchet, who was feeding investments to Madoff. De la Villehuchet encouraged Markopolos to replicate Madoff’s strategy so as to offer some of his investors some ‘diversification’.
Madoff was reporting returns of about one percent per month compounding, or around 16 percent per year, year after year since the early 1990s. Sometimes Madoff’s performance was worse than the overall market, but mostly it was better. Madoff had made positive returns in 113 of the 118 months since his records began in December 1990.
The consistency of the returns was the warning sign for Markopolos.
“He was the slot machine that kept coming up cherries and I wanted to figure out how he was doing it,” he said.
Markopolos described the chances of this sort of consistency in way that resonated with his Auckland audience two days after the Black Caps had been thrashed by England in 20-20 match at Eden Park.
“It would be like the Black Caps playing 100 games and only losing four. It’s just not possible,” he said.
By early 2000 Markopolos was certain Madoff’s performance was fraudulent. He just wasn’t sure whether it was Ponzi scheme or whether Madoff was using his position as broker-dealer in the US stock market to ‘front-run’ the markets, which was also illegal.
Madoff’s returns had ‘Sharpe ratio’, which measures the returns from fund relative to the riskiness of that fund, which was nearly five times better than the performance of the underlying stocks Madoff said he was betting on. For 18 years in row.
By early 2000 Madoff appeared to have around US$7 billion in funds under management. By then Markopolos had ticked the box for ‘too good to be true’.

Have you checked the source documents?
By early 2000 Markopolos was worried enough about the scheme and frustrated enough with his own bosses’ demands to replicate it that he decided to dob Madoff in to the Securities and Exchange Commission (SEC).
And that’s where the fun started, or at least for Markopolos, where the fear started.
After some initial success in the SEC’s Boston office, Markopolos ran up against SEC lawyers who simply didn’t understand the nature of investing or didn’t have the numeracy skills to understand why Madoff’s returns were too good to be true.
“They just thought I was disgruntled competitor… because that’s what I was,” he said.
The SEC was also in awe of Madoff, who had been co-founder of NASDAQ and was very well connected in political and philanthropic circles in New York.
By mid 2000, Markopolos was like dog with bone. He just kept digging and looking for evidence to prove or disprove Madoff was Ponzi schemer. He did that for the following seven years.
Firstly, he looked for proof in the market that Madoff was actually making the trades he said he was. Madoff’s so-called ‘split-strike’ conversion strategy should have left footprints in the markets in the form of volume records, particularly at the scale he was operating at.
Markopolos used his Bloomberg terminal to track the volume records. Interestingly, he asked for show of hands in the audience of regulators, CFOs and accountants at the Auckland conference who had Bloomberg terminal for such investigations. Just one person in the audience of over 200 put up their hand.
Madoff kept asking the fund managers feeding money to Madoff, including the member of the French royalty, for proof of the underlying trades. To his amazement none of them could.
Every time Madoff was asked for the exchange ‘ticket’ records to prove the trades, he fudged the answer, citing his proprietary trading system, and then threatened to cut off the investor from using his funds.
He regularly told investors not to say where their money was invested, and that Madoff was only managing that client’s money. Amazingly, it turned out none of the ‘feeder’ funds, which included several major European banks, had checked that the funds were in custodian accounts at Bank of America, as Madoff declared they were. They weren’t.
Some funds had asked why Madoff used tiny three-person accounting firm called Friehling and Horowitz in suburban New York to audit his accounts and why Madoff wouldn’t show them the accounts. Madoff told them his accountant was his brother in law and was the only outside party allowed to see the accounts.
A simple check would have found that Madoff did not have brother in law and the accountant he used did not have licence to be an auditor.
Also, Madoff’s reports to clients as recently as 2004 were presented on dot matrix printed ‘green bar’ paper and trades were only reported to three decimal places when they should have been to eight places. His statements also showed

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