Key Concept

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.

Idea Summary

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’:

• Process-based trust: He was a ‘known quantity’ in the world of finance, associated with NASDAQ and with big names such as Merrill Lynch and Goldman Sachs, and he had a track record of providing good returns; the spread of historic information about him worked in his favour.
• Institution-based trust: The backing, over many years, of respected US regulator SEC reinforced his credibility.
• Characteristic-based trust: He used his links with the Jewish and South American communities, with Hollywood and with some of France’s leading families, to recruit his clients. (In what’s termed ‘affinity fraud’, he was able to convince people that his funds were exclusive, open only to the ‘privileged few’.)

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.

Business Application

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:

• Making attempts to reduce affinity fraud. (One of the institutions interviewed was saved by its policy of never investing in a body linked to a member of its board.)
• Granting institutions the resources to introduce independent controls — and emphasizing the need to take the concerns of third parties seriously.
• Restricting the size of portfolios managed by a single investment fund.

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:

• Good reputations aren’t always deserved. (Sometimes the emperor has no clothes.)
• If a deal sounds too good to be true, it usually is. (Unusually high returns — a feature of Ponzi schemes — should always ring alarm bells with investors.)  It should however be noted that in the case of the Madoff fraud, the returns were not unusually high. Many investors were attracted by the stability of returns.

Put simply, accurate assessments of trustworthiness depend on an ‘enquiring mind’.