Kim's Comments

February 18, 2009

How did Bernie get away with it?

Few scandals are isolated acts by isolated individuals, and his case is no exception. By all accounts, Madoff cultivated his investors with charm, an air of exclusivity, and phenomenal (if indecipherable) financial returns. While there are scattered reports of investors who resisted or withdrew their funds due to suspicions about Madoff's integrity and solvency, few individuals were as visible and dogged as Harry Markopolos. Beginning in 1999, Markopolos scrupulously documented the red herrings inherent in Madoff's reported earnings and hectored the SEC to act on the allegations. In 2005, he declared that it was "highly likely" that "Madoff Securities is the world's largest Ponzi scheme" and he supplied data to support his contention. The autopsy on the Madoff case, to me, breaks down into two questions: Why didn't Markopolos' whistleblowing make a difference and why did so few others step up to resist or report Madoff's corruption?

I don't know Bernie Madoff, but I know enough about scandals to begin to put some of the pieces together to explain how he "made-off" with a lot of people's hard earned money. Let me suggest six causes: conflicts of interest, complexity, group think, misplaced loyalty, marginalizing the messenger, and fear.

• Conflicts of interests arise when roles or loyalties collide. For example, Madoff served on the board of Yeshiva University and as Chair of its investment committee. In those roles he arranged for foundation funds to be placed with his security company, clearly putting his fiduciary responsibilities as a board member at odds with his business interests. (Some might suggest that the interests were aligned in that Bernie was committed to making money for his company as well as for Yeshiva. The conflict arises, however, in his inability to carry out his fiduciary responsibilities for Yeshiva, given his self-interest in the investments). No doubt his presence and powerful positions affected fellow board members, who, sharing business and social relationships with Madoff, were likely loathe to question his dual role or object to his decisions (see loyalty and group think, below).
  
  Down the line from Madoff himself, we can imagine an array of similar conflicted roles and loyalties as fund managers, accountants and others who were responsible for rendering objecting financial advice were silenced by their own involvements with Madoff and the allure that he held for them.
• People utilize the services of professionals when they lack the expertise or interest to do the job themselves. The arena of investments and fund management is complex and ever-evolving—perfect for a paid expert. Is it only me, or is the reliance on such a professionals proportional to one's ignorance on the topic? We don't even know enough about the basics of finance to evaluate the credentials and integrity of the people we choose to hire to manage our funds! The ignorance and complexity combine to create two results: individuals and boards over-rely on word-of-mouth recommendations for experts, investments, appraisals, and an array of other financial decisions, and they are easily duped or dissuaded, even when they raise reasonable and well-articulated financial concerns. Should they have the wisdom and courage to press for answers or put forward a complaint, they may still be deterred by the complexity of the systems involved in running or regulating financial structures.
• The third cause of scandals is group think, the phenomenon by which dissent is discouraged in boards, committees, or communities. Peer pressure doesn't end at the childhood playground or adolescent hang out. It gets exerted in subtle and overt ways, as norms evolve to "be a team member", make the meeting go smoothly, respect authority, or otherwise avoid taking a contrarian stance. The more passive and "rubber stamping" the group, the less likely it is that any individual will break the silence to question decisions, press for more information, dispute reports, or vote in the minority.
  
  The Madoff scandal is populated by boards full of bright, successful and well-connected individuals. How did the make-up and processes on those boards serve to silence dissenting opinions and marginalize courageous members? Were similar dynamics in place at the New York office of the SEC, such that they failed to act on Markopolos' allegations of fraud?
• News accounts of the Madoff case are replete with references to the breach of trust his actions caused. For some in the Jewish community, this breach of faith perpetrated against fellow Jews, is perhaps the greatest crime of all. Trust (in him, in the people around him, in his desire to "do good" with investments and do good for investors) was the hook by which many clients were caught. Loyalty and trust are great virtues, but in cases like this, they can distort judgment, replace research, and derail due diligence. As Reagan once said of relations with the Soviet Union, "trust, but verify."
• Many factors can lead to deafness or blindness on the part of regulators, administrators, legislators, and others who hold the power to cease or correct wrongdoing. Sometimes, these people in power marginalize the messenger: "he doesn't understand how these things work", "she's a disgruntled employee", "that report is just sour grapes because they lost the contract." It is unclear as yet how many would-be whistleblowers were written off in the web of Madoff's activities. As a business rival, Harry Markopolos' research and complaints could easily have been construed as resentment, envy, a smear campaign, or simply excuses for his own fund's poorer performance.
• Fear is the ultimate deterrent of courage. Markopolos acted despite fear, of retribution by Madoff, and even of physical harm to family or friends. Many more were quelled by fear-- of being cast out of Madoff's wealth, power, and connections (or incurring the wrath each of those could create), of the loss of cache conferred by being a client of his exclusive group, of the loss of friends for taking an unpopular position, of being wrong, of losing out on the fabulous returns he generated, etc.

The boards and individuals victimized by Bernie Madoff may have more wealth and fame than the Average Joe, but the things that allowed the scandal to play out over decades should be familiar to us all. As my Grammy used to say, "We know better than we do". The Madoff scandal is a great example of what happens when that's true.