From Ponzi to Madoff: the six biggest market scams in history

With investing, I suggest looking for clear investment strategies and realistic returns rather than “smart”  and exclusive opportunities. Once you get burned by a market scam, it is often too late.

In this spirit, I like Warren Buffett’s two rules of investing:

“Rule number one: never lose money. Rule number two: don’t forget rule number one”.

Buffett’s rule fits perfectly with his historical partner Charlee Munger’s statement:

“It’s remarkable how people like us have gained a long-term advantage by trying to be consistently not stupid instead of trying to be very smart”.

To decrease the chances of doing anything stupid with investments, let’s learn more about historical financial frauds caused by criminals but facilitated by:

A) weak financial controls (within a company, financial institutions or regulators)

B) investors’ greed

C) general lack of financial education

Top Financial Frauds of All times

Check out my TOP 6 Financial Frauds of all time, from Ponzi to Madoff! It is fair to assume we will witness more to come. So, bulletproof yourself with these two key rules:

1) If it sounds too good to be true, it is probably so! Please stay away from it!

2) Don’t invest in what you don’t understand

Charles Ponzi & The Ponzi Pyramid, 1920

The ancestor of the financial and stock market scam, the reference, not to say the icon of financial scammers, is Charles Ponzi. In the 1920s, this Italian immigrant managed to convince more than 40,000 investors, part of his own Italian community in Boston, to give him up to $15 million (the equivalent of several tens of billions today) by offering them miraculous interest rates: up to 50% in 45 days.

His “scheme” was simple: he paid interest to the first arrivals by distributing to them the money deposited by the new savers.

Charles Ponzi’s scheme focused on a real business opportunity within the US Postal Service. The postal service, at that time, had developed international reply coupons that allowed a sender to pre-purchase postage and include it in their correspondence. The receiver would take the coupon to a local post office and exchange it for the priority airmail postage stamps needed to send a reply. This type of exchange is known as arbitrage, which is not an illegal practice.

After exploiting this business opportunity, Ponzi became greedy and expanded his efforts. He promised returns of 50% in 45 days or 100% in 90 days. Due to his early success in the postage stamp scheme, investors were immediately attracted.

However, Instead of investing the money deposited by investors, Ponzi just redistributed it and told the investors they made a profit. The scheme lasted until August 1920, when The Boston Post began investigating the Securities Exchange Company. As a result of the newspaper’s investigation, Ponzi was arrested.

Accused of 86 crimes and misdemeanours, he was imprisoned from 1926 to 1934 and died a few years later, paralysed and half-blind, in a hospice for the needy in Brazil, without a penny to his name. But he became famous, even giving his name to a system, the “Ponzi scheme”, which has been taken up by many “financiers”. In fact, this fraudulent investing scam promising high rates of return with little risk to investors has become the benchmark for most international financial frauds.

However, the Ponzi scheme is similar to a classic pyramid scheme because both are based on using new investors’ funds to pay the earlier backers. Pyramid schemes are so named because their compensation structures resemble a pyramid. The scheme starts with a single point on top where the original members exist and becomes progressively wider toward the bottom as every level recruits new people.

Ponzi and pyramid schemes eventually bottom out when the flood of new investors dries up and there isn’t enough money to repay investors. At that point, the schemes unravel.

Written evidence of similar fraudulent methods was even described in two separate novels by Charles Dickens, Martin Chuzzlewit, published in 1844 and Little Dorrit in 1857.

 

Nick Leeson and Barings, 1995

It is always dangerous to put in the same hands the three essential functions in finance of trader, product designer and controller. But that’s what Nicholas Leeson, known as Nick Leeson, a financial whiz kid, managed to do, giving wings to a venerable London institution, Barings Bank, a British merchant bank based in London, which was over 400 years old (funded in 1762 by Sir Francis Baring).

While in his Asian office in Singapore to oversee derivates operations, Nick Leeson began to multiply risky operations. Leeson was supposed to be arbitraging, seeking to profit from differences in the prices of Nikkei 225 futures contracts listed on the Osaka Securities Exchange in Japan and the Singapore International Monetary Exchange (SIMEX). However, instead of buying on behalf of clients on one market and immediately selling on another market for a small profit, using the strategy approved by his superiors, Leeson started undertaking such trades using the bank’s own money, gambling on the future direction of the Japanese markets.

At first, he was successful until he started to lose a lot. He created a fake account to hide his losses, which allowed him to be considered the most successful trader in his bank.

How did it happen?

Leeson was general manager for Barings’ trading on SIMEX. Barings circumvented standard accounting and internal control safeguards by making Leeson head of settlement operations for SIMEX. He was charged with ensuring accurate accounting for the unit! Different employees would have normally held these positions. With authority to settle his own trades, Leeson could operate without supervision from London—an arrangement that made it easier for him to hide his losses. After the collapse, several observers placed much of the blame on the bank’s own deficient internal control and risk management practices. 

Because of the absence of oversight, Leeson was able to make seemingly small gambles in the futures arbitrage market at Barings Futures Singapore and cover up his shortfalls by reporting losses as gains to Barings in London. Specifically, Leeson altered the branch’s error account, subsequently known by its account number 88888 as the “five-eights account”, to prevent the London office from receiving the standard daily reports on trading, price and status.

By December 1994, Leeson had cost Barings £200 million. He reported to British tax authorities a £102 million profit. Using the hidden five-eight account, Leeson began to trade aggressively in futures and options on SIMEX. His decisions routinely resulted in losses of substantial sums, and he used money entrusted to the bank by subsidiaries for use in their own accounts. He falsified trading records in the bank’s computer systems and used money for margin payments on other tradings. As a result, he appeared to be making substantial profits. However, his luck ran out when the Kobe earthquake upset the Asian financial markets—and with them, Leeson’s investments. Leeson bet on a rapid recovery by the Nikkei, which failed to materialise.

On 23 February 1995, Leeson left Singapore to fly to Kuala Lumpur. Barings Bank auditors discovered the fraud around the time that Barings’ chairman Peter Baring received a confession note from Leeson.

Leeson’s activities had generated losses totalling £827 million ($1.3 billion), twice the bank’s available trading capital. The collapse cost another £100 million. The Bank of England attempted an unsuccessful weekend bailout, and employees around the world did not receive their bonuses. Barings was declared insolvent on 26 February 1995, and administrators began managing the finances of Barings Group and its subsidiaries. The same day, the Board of Banking Supervision of the Bank of England launched an investigation led by Britain’s Chancellor of the Exchequer; its report was released on 18 July 1995. Leeson was captured after spending 272 days on the run and sentenced to six years and six months imprisonment, served in Singapore’s Changi Prison for his wrongdoings.

Dutch bank ING purchased Barings Bank in 1995 for the nominal sum of £1 and took over all of Barings’ liabilities, forming the subsidiary ING Barings.

In 1999, this young financial wizard’s incredible story became the blockbuster Rogue Trader, featuring Ewan McGregor. He was ultimately able to rise from the ashes. He now trades with his own money and performs speaking engagements. He has a Net Worth of 3 million dollars.

Jeffrey Skilling and Enron, 2001

The two directors of Enron Corporation, Kenneth Lay and Jeffrey Skilling led this Texas-based commodities and energy trading group, which in the 2000s was the 7th largest US company with 20,000 employees, into the grave. In 2000, Enron had over $100 billion in sales, was worth $90 billion on the stock market and was voted “America’s most innovative company” by Fortune magazine.  But no one at Fortune or anywhere else could have imagined the imagination of the two executives in creating a smokescreen around their group’s accounts!

Yet in 2001, Enron was bankrupt and disappeared. The price of Enron’s shares went from $90.75 at its peak to $0.26 at bankruptcy

How did this happen? Very simple: the two men diversified their group into climate futures and other exotic/toxic investments that ultimately cost them a lot of money. They also totally disguised their accounts, using what is known as ‘creative accounting‘. Thanks to it, they could hide huge liabilities and endless debts in empty shells. Like in the case of Barings, a market downturn in 2001 tore down their entire edifice, throwing tens of thousands of people out of work and wiping out even the funds intended to provide for former employees’ retirement. Cyclical market downturns, often following moments of extreme optimism and euphoria, pull up the curtains over bad management. This reminds me of Warren Buffett’s quote:

Only when the tide goes out do you discover who’s swimming naked.

The two directors were not simply bad managers. They did not lose control of the situation, as could be with the young kid Nick Leeson. The two directors profited from early sales of Enron stock many months before the company imploded. Combined, Lay and Skilling cashed out roughly $33.5 million worth of Enron shares in 2001.

Initially sentenced to 24 years in prison, he reached a deal with the court to reduce it to 14 years. He was released from custody in 2019, after serving 12 years. In June 2020, Skilling was reported by Reuters to be fundraising for the launch of an online oil and gas trading platform named Shalemetrics

Calisto Tanzi and Parmalat, 2003

It is a European Enron. For a long time, the food group was the largest company in the Italian peninsula sector, employing more than 36,000 people. Here again, the same mix of concealment and ‘creative accounting‘ lies at the root of the scandal: in the early 2000s, the equivalent of 8 billion euros disappeared from the group’s accounts without being found. Until December 2003, the group was forced to admit to a hole of €4 billion in its accounts. Inspectors examining the group’s books discovered more than €14 billion in debts, most undeclared. The group’s founder, Calisto Tanzi, and its financial director, Fausto Tonna, had set up six shell companies in the Grand Duchy of Luxembourg, using nominees to conceal the falsified accounts and losses.

Investigators concluded that over a dozen billion euros had disappeared from the company! The group had to be put into bankruptcy, swallowing the savings of about 135,000 Italian savers. This makes it the biggest financial scandal in Europe. The group, on its knees and unable to stand up on its own, was forced to accept the takeover offer launched in 2011 by the European number one in the sector, Besnier, which has since put it back on its feet.

Like in the case of Burns and Enron, even with Parmalat, the old adage – too big to fail! – did not hold. While the company is still in existence, it is now a subsidiary of the French company Lactalis.

I have clear memories of the case, the terrible atmosphere all over Italy due to the collapse of a giant local champion, and the desperation among thousands of workers and small investors. Investments in a food giant like Parmalat were proposed as “safe and sound”. After all, it was all about dairy products. How could Parmalat go sour?

Jerome Kerviel and Société Générale, 2008

2008 was a fruitful year for financial crises and market scams. Back in 2008, Jerome Kerviel almost brought down the French bank that employed him: Société Générale. His scam? To have carried out operations under the nose of his hierarchy (at least that’s what he was able to prove in court), which led the bank to post a colossal loss of 4.9 billion euros. How did it happen? His business involved very large volumes at very low risk. Sounds familiar already?

He kept the volumes but took increasingly bold bets over time that eventually backfired on his bank. Jérôme Kerviel, in his book published in 2010 and entitled “L’Engranage” (French edition), claims that his operations were known to his superiors, who turned a blind eye to their success.  Sounds familiar?

Jerome was an employee that reported to his line managers. I bet the greed or love of performance of his supervisors increased the risk appetite of the unit by passing all compliance and risk management protocols. Again, another case of a Financial Institution shaking the trust in the financial ecosystem.

Bernard Madoff, 2008

Bernard Madoff, or Bernie, as those who knew him liked to call him, was a New York hedge fund manager. Forgive me,  I also refer to him as Bernie because he holds a special place in my…journal for having managed for decades the biggest financial scam in history without being caught! He collected up to 19 million USD of deposits for an alleged investment of 65 billion USD. This “financial serial killer”  never invested a dollar! Quite shocking information for investors worldwide that would have expected due diligence from investment firms and controls for regulators.

The scariest thing in Madoff’s story is that nobody brought him down. Regulators missed it. Sophisticated investors, who should have known better that a conservative options strategy can’t produce those results, didn’t ask the right questions.

None of that brought Bernie down. What brought Bernie down was a black swan event – the subprime financial crisis. Without a crisis of that magnitude, Madoff might still be doing it today.

Not surprisingly, there are several great books and movies about him. (The Wizard of Lies: Bernie Madoff and the Death of Trust; Chasing Madoff, or Madoff: the Monster of Wall Street.

The beginning

As with all the most beautiful stories, we should start from the beginning. Once upon a time, a young Jewish kid from a humble family was determined to make a name for himself. He had a chip on his shoulder and wanted to show his family, himself, and his wealthy father-in-law that he was “the guy”. Initially, he was moved less by greed and more by status and position.

Bernie’s first steps in the business were thanks to his father-in-law. He provided the first wealthy clients to the young Bernie. Bernie was bright and ready to take risks with OPM (other people’s money). His penny-stock brokerage firm – Bernard L. Madoff Investment Securities LLC – grew.

Real big money and success came in the ’80s when he and his brother Peter began to build electronic trading capabilities—”artificial intelligence” in Madoff’s words—that attracted massive order flow and boosted the business by providing insights into market activity.

He and four other Wall Street mainstays processed half of the New York Stock Exchange’s order flow, and by the late 1980s, Madoff was making in the vicinity of $100 million a year.

His remarkable role in the NASDAQ, advising the SEC (Securities and Exchange Commission) along the process, granted him wealth and prestige. He was respected and considered a genius. Madoff would become chair of the Nasdaq from 1990 until 1993.

Two businesses

In 1993 he moved to the Lipstick building, running a legit trading business as a market maker / Stock brokerage with 200 employees on the 19th floor. The office was top-notch; the service was excellent and well-regarded by the regulatory authorities and market players. He moved 10% of daily trades at the New York Stock exchange and became the 6th largest market maker in the S&P500.

However, he also kept a second office on the 17th floor. His opaque “investment advisory firm” was highly secluded from the main office, with different staff (Frank Di Pascali above all), different management and operations. It was operating an asset management firm. With this service, he promised his clients stable and safe returns of around 10-12-15 % per year.

How? He reported that his firm used a split-strike conversion strategy, which involved investing in a basket of stocks while simultaneously buying and selling options to hedge risk. His Investment Advisory firm promised slightly higher performances than the average annualised returns of the S&P500 (8-10%).

Nothing extravagant nor wildly exciting. However, his appeal was the guarantee of stable returns and no volatility – no matter the market conditions! This was something never heard before!

The clients

The promise of good returns without downside risk was a blessing for wealthy private investors and top fund managers and pension fund managers who flocked to Madoff’s fund to get some performance when the markets were sluggish.

• Hollywood stars like Steven Spielberg, John Malkovich, and Kevin Bacon invested with him.
• Elie Wiezel, Nobel for Peace, had invested all the budget of his foundation (15 million USD) to the memory of the Shoah to Madoff.
• Former L’Oreal owner and richest woman in the world  – Liliane  Bettencourt, was the first major french investor (she lost 22 million EURs)
• Carl Shapiro, a “close friend” of Madoff, lost 250 million USD. (However, he was later judged as a net gainer from the Ponzi scheme over the years, and settled for 625 million USD)
• As a classic feature of pyramid schemes, he largely targeted his community, which was the Jewish community in the case of Madoff.

Because no purchases or sales of securities were taking place, he was collecting money from new clients and depositing redemptions to older ones (secretly robbing Paul to pay Peter). No real investment was truly taking place. Like the pyramid scheme, he had to find new clients to keep the scheme “alive” desperately.

It was easy for him to attract fund managers because he offered a unique profit split. As long as partners were funnelling money, they took the biggest profit cut. It was an incredible and unique deal for hedge funds/private banks alike.

He attracted family bankers and institutions from all over the world. He had over 40 “feeders” in the US. Still, European investors had significant exposure to Madoff’s scheme, with over 200 feeders. Partners such as HSBC, Royal Bank of Scotland, Spain’s Santander, France’s BNP Paribas, and Japan’s Nomura invested money in Madoff’s scheme.

Thanks to its longevity and capacity to expand accessing new clients and deposits, Madoff’s scheme secretly became the biggest investment fund in the world, with a value of 65 billion dollars.

And that worked like a charm until it did not!

This time was different

I vividly remember his arrest on the 11th of December 2008 and the subsequent investigations. Even the story behind his arrest is unique and surprising.  He was not caught! Madoff denounced himself, first to his family and then to the authorities.

The Subprime crisis of 2008 triggered his confession. When most private and institutional investors reported losses up to 40%, they decided to withdraw some money from the ONLY fund still stable: Madoff’s fund. In a few weeks, Madoff saw requests for up to 8 billion dollars of withdrawals for money he did not have. While his books said his fund was worth $64bn, most of that money did not exist.

When his first business burst in the ’80s after recklessly investing money, he was saved by the money he borrowed from his father-in-law to “cover the losses”. By secretly covering the losses, he looked to clients as a genius, became his investment did not lose during the market downturn! This was a turning moment for Madoff. The model was tested:

1) Cover losses

2) Lie to the clients with fake documents and reports

3) Borrow money from friends when needed

During the nineties, he was once again saved by the money he borrowed. This time, he borrowed it from his closest wealthy clients (Normal Levy, Jeffry Picower, Stanley Chase, Carl Shapiro). The liquidity was needed to cover the withdrawals caused by the request of the SEC to close the unregulated investment fund developed by his accountants.

On this occasion, there is another turning point in Madoff’s business model.  Once clients saw he had liquidity, that he allowed money to be withdrawn, and that “on paper”, the investments were still positive, most clients decided to keep investing with Madoff. The cult of Madoff was raised to another level. Clients wanted Madoff’s stable and safe returns! 

However, in 2008 the market downturn was unprecedented. This time was different. The Madoff’s hole was too big to cover!

On 29 June 2009, Bernie Madoff was sentenced to the maximum prison term in the US: 150 years! He took full individual charge for everything. For a while, Madoff appeared to be the only person found responsible for the 65 Billion scam!   Another extraordinary fact about Madoff’s case. After a while, authorities charged several of his closest employees (the Madoff’s five). Bernie died in prison in 2021. Unfortunately, a fraud of this size brought dramatic consequences:

1) Renè Thierry Mahon de La Villehuchet, french aristocrat and fund manager among the founders of Access International Advisors (AIA), lost his life – apparently by his own hands, after losing an estimated 1.4 billion dollars in the Madoff scheme. He was the french connection of Madoff, able to attract French / Swiss / Italian fortunes – those who give names to streets and parks in Europe – into Madoff’s fund. The big name among the client that Thierry brought to Madoff was Liliane Bettencourt (L’Oreal). Due to the high exposure of his clients, family members, and himself to Madoff’s fund, feeling extremely guilty, he became “the first physical victim” of the Madoff Investment scandal.

2) His old client Picower was found dead in a swimming pool at his mansion in Palm Beach in 2009. His widow, acknowledging he was reported as a co-conspirator of the Pyramid Scheme and the one who benefitted the most from it, returned to the victims $7.2bn.

3) Bernie’s first son – Mark Madoff – committed suicide on the second anniversary of his father’s arrest (2010)

4) Bernie’s second son – Andrew Madoff – died of cancer at age 48. (2014), after a long battle with mantle cell lymphoma, rare cancer that typically strikes men over 60. He had improved in 2003 but blamed the stress of his father’s crimes for its return.

5) Thousands of wealthy investors were highly exposed to Madoff’s fund.

6) Somehow, among the wealthy victims, some middle-class investors had allocated all their family savings to Madoff’s fund. Thousands lost their retirement money.

7) The ultimate drama of the Ponzi scheme was that to refund the clients of Madoff’s scheme (download the complete list here), the government somehow chased money from innocent victims themselves.

HOW BERNIE MANAGED SUCH A SCAM?

1) With high net worth individuals, he had great social skills and could present himself as a friend. He was also referred to as “uncle Bernie“. As such, none could believe he would betray them, their friends!

2) Everyone – even among many professional investors – thought he was a genius, a Wall Street financial genius, a master of the market. Family Bankers, Pension funds, and the like were begging to do business with him for “safe” and stable returns

3) He had built a sense of exclusivity among his clients. Clients felt lucky to have been accepted as clients. He made the fund appear closed to new clients to keep this exclusivity. It was necessary a lot of money and the right network to be able to access it

4) Investors were complacent out of greed or ignorance. Those clients that could smell something fishy thought the eventual victim would have been other traders or clients. However, they were the first victims of Madoff’s Investment scheme. Some money managers reported “red flags” on Madoff’s fund because they could not look at the books or do any due diligence. Still, any reported attempt to change the investment fund was met with high resistance by clients. Money managers had no incentive to fight clients’ preferences.

5) Madoff was protected by his power, experience, and probably the investment community’s interest in keeping the ball rolling as long as possible.

5.1) For instance, JP Morgan Chase, the bank holding the accounts of Madoff Fund, Madoff’s private accounts, and those of his biggest clients, could easily monitor inappropriate transfers but never report them! Look at the incentive, and you will understand the behaviour, right? The bank settles for $2 Billion for its Role in Bernard Madoff Ponzi Scheme. Just enough to admit its responsibility for “lack of oversight”.

5.2) For decades, some of his feeders’ funds made millions thanks to Madoff. They wanted to keep going!

5.3) Despite losing their principal (money deposited in the fund), some of his early clients often received and spent 3-4 times the investment amount.  As such, those early investors of the Ponzi scheme who did not re-invest all their profits into Madoff’s fund made money out of it.

5.4) There are claims that some of his biggest four clients and “friends” with who he had unique relations played Madoff by depositing money in the fund for very high returns (up to 950%!). They were ultimately sponsoring and keeping the Ponzi Scheme alive during times of crisis while safely withdrawing money and immense profits afterwards. Jiffy Picower was Maddof’s mystery man, accused of being the largest beneficiary of the biggest financial crime in U.S. history.

6) The SEC (The Securities and Exchange Commission –  a U.S. government oversight agency responsible for regulating the securities markets and protecting investors) completely failed its supervisory duties, despite several opportunities and ref glad reported by external journalists and investigators.

• Back in 2001, the journalist Erin  Arvedlund raised scepticism on Madoff’s Don’t ask, don’t tell business model (download it).
• Michael Ocrant published his investigative article in 2001: Madoff Top Charts. Skeptics Asks How (download it)  
• Back in 2005, Harry Markopolos wrote to the SEC The World Largest Hedge Fund is a fraud (download it). In his view, it was clear that Madoff’s model was impossible: “the returns were a straight line of 45 degrees, something impossible in finance, where returns are cyclical. The number of positive months in Madoff’s track record was 95%: something never seen before!

Why He Did it?

It is challenging to reach a clear understanding of why Madoff carried out the scheme at all. “I had more than enough money to support any of my lifestyle and my family’s lifestyle. I didn’t need to do this for that,” he once reported, adding, “I don’t know why.”

Indeed, for a long period of time, the legit business was lucrative, and Madoff could have earned the Wall Street elites’ respect solely as a market maker and electronic trading pioneer. However, it was also discovered that in the last years of operation, the market maker was working at a loss due to higher competition and high overhead costs (too many employees and wild expenditures). Madoff arrived to shift 800 million USD from the scheme to pretend the legit business was still profitable.

“I just allowed myself to be talked into something and that’s my fault,” he said, without making it clear who talked him into it. “I thought I could extricate myself after a period of time. I thought it would be a very short period of time, but I just couldn’t.”

Madoff’s relationship with the Big Four—Carl Shapiro, Jeffry Picower, Stanley Chais, and Norm Levy might have added extra motivation. The Madoff scheme netted them hundreds of millions of dollars each: “Everybody was greedy, everybody wanted to go on, and I just went along with it,” Madoff said.

For the individual investor, there is a lot to learn from Bernie’s scheme:

Investors were eager to find the holy grail of good and safe returns without volatility or risk. However:

1) An equity portfolio with stable returns does not make any financial sense. Markets have cycles. It comes with the territory. If someone promises you safe and stable returns, it is a scam!

2) If you look for returns higher than the S&P500 – the most common market benchmark – try to understand the risk profile and characteristics of the Investment proposal. If it is too good to be true, it is probably too good!

3) Financial scholars theorised that Mr. Madoff’s Ponzi scheme lasted so long because it had appealed more to his clients’ fears than to their greed. You can lose a lot not only out of greed but also out of unrealistic security and safety.

4) Diversify your investments. It does not matter how old or prestigious the bank is, or how popular the money manager. Don’t put all your eggs in one basket.

5) If you don’t understand the investment, don’t invest. If you don’t know the game and the players, learn it or run away. As Warren Buffett and a million other card players have said,

“If you can’t find the sucker at the table, you’re it.”

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