How Madoff Made Off

So everyone has read about how Bernie Madoff has this 14+ year old Ponzi scheme and many have heard that for years now a money manager named Harry Markopolos has had a decade-long running battle to unveil the fraud. What you may not know is that Markopolos wrote a detailed memo outlining the case titled, “The World’s Largest Hedge Fund is a Fraud.”

In the memo, Markopolos posits two potential scenarios:

Madoff Securities is front-running clients. That is, he gets a client order for his normal (and large) brokerage business and then does a trade for his own account exploiting that inside information. This is, of course, illegal. Markolpolos cites this as the unlikely scenario. Madoff Securities is a Ponzi scheme. Markopolos cites this as the highly likely of the two scenarios.

Markopolos then lays out 29 “red flags” in excruiting detail in his 19-page memo to the SEC which I have embeded using Scribd below.

There are two big questions: it seems clear that a lot of people in the industry knew about this so why did no one (other than Markopolos) turn in Madoff? and why did the SEC not follow through? On the latter, I have no idea and an investigation into that is more than warranted. On the former question of why no one ratted Madoff out it’s basically because he used a big carrot and a big stick.

Let me explain. Madoff set up his “hedge fund” as an outsourced service. He just did the trading in managed accounts and only charged transaction fees (no 1% of assets under management and no 20% of profits). He then outsourced fundraising and client management to hedge fund-of-funds. A lot of the hedge FoF thought that Madoff was getting his returns by front running and figured they were in on the con, that Madoff wasn’t getting greedy and that left them to make a lot of money. A big carrot. On the flip side, Madoff held positions of great power (e.g. Chairman of NASDAQ) and could exact great retribution on anyone who crossed him (heck, just read the first page of Markopolos’ letter to the SEC to get a feel for how scared he was of being tagged as the informant). In short, Madoff ran the perfect con that exploited greed, fear and laziness.