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Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

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Page 1: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Finding Bernie Madoff: Detecting Fraud by Investment Managers

Stephen G. Dimmock and William C. Gerken

Page 2: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Fraud

On December 11, 2008 Bernie Madoff was charged with a $65 billion investment fraud.

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Page 3: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

The Questions

We test if fraud is ex ante predictable. If so, what predicts fraud?

Is it possible to improve the disclosure requirements mandated by the SEC?

Are there real economic consequences to fraud?

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Page 4: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Our Study

The main disclosure requirement in U.S. securities law is that investment advisors with more than $25 million in assets must file Form ADV with the SEC.

We use a panel of all ADV filings from 2000-2006.

13,579 distinct investment managersOver 20 million investorsMore than $32 trillion in assets under management

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Page 5: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Data

Panel of all Form ADV filings from 2000 through 2006. We also have disclosure reporting pages (DRP) which list all criminal violations in detail through 2007.

Current forms are available at: http://www.adviserinfo.sec.gov

Firms must file annually or in the event of a material change.

Measure variables as of August 1st and DRP filings over subsequent year

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Page 6: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Data: Filings and Removal

Aug-03 Aug-05Nov-03 Feb-04 May-04 Aug-04 Nov-04 Feb-05 May-05

1-Apr-04File AnnualForm ADV

15-Jan-05File Amended Form ADV and DRP

Disclosing Employee Conviction

18-Feb-05File Amended Form ADV and

DRP after Firing Employee

24-Mar-05File New Form ADV: No Crime Disclosed

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Page 7: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Internal Policies and Fraud

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

All No DRP ≥ 1 DRP Difference

Interest in Client Transaction 31.6% 30.9% 74.6% 43.7%***

Soft Dollars 58.9% 58.1% 74.1% 16.0%***

Custody of Assets 26.1% 25.6% 64.6% 39.0%***

Broker/Dealer 40.5% 39.0% 85.7% 46.7%***

Other Affiliation 56.1% 54.3% 92.1% 37.8%***

Small Client Focus 23.9% 22.7% 42.9% 20.1%***

Separate CCO 16.0% 14.6% 31.2% 16.6%***

History of Violations 16.4% 16.2% 84.5% 68.3%***

Page 8: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Predicting Fraud: Table 4 Part 1

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

All Fraud All Fraud Felonies Rand Eff Neg Bin

History of Violations 0.416*** 0.461*** 1.438***

[3.29] [3.20] [3.58]

History of Crime 0.757*** 0.764***

[5.62] [5.24]

History of Reg. 0.379*** 0.453***

[2.94] [3.15]

History of Civil 0.022 0.053

[0.17] [0.36]

Page 9: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Predicting Fraud: Table 4 Part 2

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Interest in Transactions 0.263** 0.239** 0.153 0.285* 0.693*

[2.29] [2.03] [1.19] [1.79] [1.89]

Soft Dollars 0.293** 0.259** 0.247** 0.307** 1.15***

[2.45] [2.28] [2.03] [2.15] [3.02]

Broker/Dealer 0.392** 0.394** 0.268* 0.454** 1.46***

[2.55] [2.56] [1.92] [2.14] [2.67]

Log(Account Size) -0.09*** -0.08*** -0.07*** -0.10*** -0.21***

[3.84] [3.43] [2.91] [3.58] [2.91]

Page 10: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Robustness

Fraud and number of employees is highly correlated. We control for this but want to be sure this does not inadvertently drive our results.

We estimate a placebo model, where the dependent variable equals one if the firm reports a non-investment crime such as drunk driving.

Also, we split the sample into small and large firms.

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Page 11: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Predicting Fraud: Tradeoff

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

73.3% identified at 5% false positive rate

59.3% identified at 1% false positive rate

33.2% identified at 0.2% false positive rate

Page 12: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Alpha and Fees

Using data from PSN (institutional funds) and CRSP MF (mutual funds), we determine if fraud risk is compensated.

No relation between fraud risk and alpha

No relation between fraud risk and fees

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Page 13: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Hidden Information

Firms are required to disclose crimes and regulator violations for 10 years, unless the offender leaves the firm.

If the offender leaves, the violation disappears.

Many violations disappear without explanation.

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Page 14: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Predicting Fraud with Hidden Information

Can removed information predict fraud?

Can information that is difficult to observe due to the format of Form ADV predict fraud?

Include the same controls as in Table 4, but do not show them in the interest of brevity.

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Page 15: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Predicting Fraud with Hidden Information

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

History of Investment Crime 0.687*

[1.76]

Number of Investment Crimes 0.027**

[2.54]

Removed DRP 0.433**

[2.09]

Unexplained Missing DRP 0.029**

[2.10]

Repeat Crime 0.80***

[3.87]

History of Crime 0.176 0.57*** 0.59*** 0.62*** 0.61***

[0.46] [3.96] [4.11] [4.01] [4.94]

Page 16: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Predicting Fraud with Hidden Information

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

False Positive RateNo Hidden

InfoRemoved

UnexplainedMissing DRP

RepeatCrimes

0.05% 13.4% 19.8% 21.7% 22.1%

0.10% 17.4% 30.2% 34.8% 28.5%

0.20% 27.9% 39.5% 40.6% 38.4%

0.50% 46.5% 50.0% 50.7% 53.3%

1% 59.3% 61.6% 60.9% 61.6%

5% 73.3% 73.3% 72.5% 73.3%

10% 88.4% 87.2% 88.4% 86.0%

20% 91.9% 94.2% 97.1% 94.2%

Page 17: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Consequences: Firm Death

Does fraud kill firms?

Estimate a survival hazard model of firms dying in the next year

Report hazard ratios – show the relative probability of firm death compared to other firms

Include controls used in previous regressions

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Page 18: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Consequences: Firm Death

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

New DRP Last Year 2.454**

[2.02]

First Crime 5.490*** 5.323***

[3.28] [3.24]

Repeat Crime 1.177 0.546

[0.23] [-0.64]

Removed DRP 1.024

[0.82]

Unexplained Missing DRP 1.052***

[3.47]

New Felony 3.481***

[2.71]

Page 19: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Consequences: Flows

Do investors withdraw their money following the disclosure of fraud?

Estimate panel regressions with firm fixed-effects and controls for: returns, portfolio value, assets under management, firm age, # of employees, and time fixed-effects

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Page 20: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Consequences: Contemporaneous Flows

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

New DRP Last Year -0.29

[0.33]

First Crime -0.315** -0.317**

[1.98] [2.00]

Repeat Crime 0.090 0.083

[0.95] [0.87]

Removed DRP 0.003

[1.25]

Unexplained Missing DRP 0.004

[1.34]

New Felony 0.027

[0.31]

Page 21: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Conclusion

Fraud is predictablePredict 73.3% of frauds with public information

Conflicts of interest and history of violations

Improve predictions using hidden information for high fraud risk firms

Investors react to fraudTransparent disclosure: 549% increase in firm

death, 32% outflowsNon-transparent disclosure: No Effect

Page 22: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Conclusion

Four simple changes would improve investor welfare:

1. Report the number of past violations

2. Disclose investment and non-investment crimes separately

3. Force disclosure of violations in the past year even if removed

4. Require firms to disclose the number of violations removed before 10 years has passed

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Page 23: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

Conclusion

Since the SEC has this hidden information on record, and firms are required to report it, the marginal cost of disclosing this information to investors is essentially zero.

Disclosing this information would allow investors to avoid frauds and likely increase the market penalty for fraud.

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion

Page 24: Finding Bernie Madoff: Detecting Fraud by Investment Managers Stephen G. Dimmock and William C. Gerken

What happens if investors use our results?

Introduction Data Prediction Alpha and Fees Hidden Info Reaction Conclusion