Fraud and the Madoff Case or The Truth Behind the Madoff Scandal and the Lessons We Can All Learn From the Largest

Fraud in History

H. David Kotz

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H. David Kotz, Managing Director

Berkeley Research Group

Background

• Legal Experience – Worked in private practice at major law firms for nearly 10 years.

• Joined United States Government in 1999; Worked at USAID and Peace Corps in legal and human resource capacities.

• Conducted fraud and disciplinary investigations as head of discipline for USAID and Inspector General of the Peace Corps.

I Joined SEC As Inspector General in December 2007

• In mid-March 2008, Bear Stearns collapsed and was sold to JP Morgan with financing support from USG.

• In early April 2008, Senator Grassley asked my office to examine SEC’s oversight of Bear Stearns.

Question on Everyone’s Mind at That Time

Voluntary Program

• SEC had oversight through a voluntary program called the Consolidated Supervised Entity (CSE) program made up of Bear Stearns, Lehman Brothers, Goldman Sachs, Morgan Stanley, Merrill Lynch, Citigroup and JP Morgan.

• Mission of CSE program was to allow the SEC to monitor for, and act quickly in response to, financial or operational weakness in a CSE company that might place it or the broader financial system at risk.

Findings in Audit of SEC’s Oversight of Bear Stearns (Part I)

• SEC was aware that:

• Bear Stearns’ concentration of mortgage securities was increasing;

• Bear Stearns had a 33:1 gross leverage ratio;

• Bear Stearns’ risk managers were not focused on its increasing concentrations in mortgage securities;

• Bear Stearns’ risk managers lacked expertise and independence and there was a lack of review of mortgage models.

Findings in Audit of SEC’s Oversight of Bear Stearns (Part II)

• Bear Stearns did not comply with the very few requirements of the CSE program as:

• SEC allowed Bear Stearns to use internal rather than external auditors issue report on the firm’s risk management control systems;

• SEC did not track its recommendations to Bear Stearns to ensure that they have been resolved;

• SEC approved the firms to be part of CSE program before reviewing their applications.

Findings in Audit of SEC’s Oversight of Bear Stearns (Part III)

• In June 2007, 2 of Bear Stearns’ managed hedge funds collapsed, yet the SEC made no efforts to review Bear Stearns’ strategies or analyze how Bear Stearns reacted to the crisis or reassess Bear Stearns’ viability in light of this collapse.

Collapse or Acquisition of Other CSE Firms

• By the time we issued our report on Bear Stearns, Lehman had filed for bankruptcy, Bank of America acquired Merrill Lynch, and Morgan Stanley and Goldman Sachs became bank holding companies. Therefore, all 7 entities (including Citigroup and JP Morgan) were no longer under SEC supervision.

Organizing the Madoff Investigation

• Challenges of Conducting Madoff Investigation:

• Staffing;

• Being able to conduct an independent investigation;

• Congressional pressure;

• E-mail issues;

• Not given access to information;

• Getting witnesses outside of SEC to cooperate.

Conducting the Madoff Investigation

• Interview with Bernie Madoff

Completing the Madoff Investigation

• Conducting the investigation and writing the 457-page report with 550 exhibits took 9 months and involved:

• Interviews of 122 people; • Review of 3.7 million e-mails; • Review of examinations and investigations

of Madoff over a 20-year period.

Findings in Madoff Report (Part I)

• SEC had 10 different opportunities to uncover the Ponzi scheme (8 substantive complaints, and 2 journal articles).

• SEC investigated Madoff in 1992, 2000 and 2001, examined his operations in 2003 and 2004, and investigated him again in 2006.

• SEC caught Madoff in numerous lies and discrepancies, but never followed up.

Findings in Madoff Report (Part II)

• SEC accepted Madoff’s answers at face value;

• SEC never sought verification of his trading with third parties;

• SEC examiners and investigators did not understand how a Ponzi scheme worked or how to determine whether any trading had occurred;

• SEC never really believed that Madoff could be operating a Ponzi scheme.

Conducting the Stanford Investigation

• Tasked by Congress with investigating how the SEC failed to uncover Robert Allen Stanford’s $7 billion Ponzi Scheme:

• The investigation involved:

• Interviews of 48 individuals.

• Review of 2.7 million e-mails.

• Thousands of pages of examination files and other documentary evidence.

Stanford Investigation Findings

• We found that SEC examiners were aware since 1997 that Stanford was likely operating a Ponzi scheme.

• We found that over the next 8 years, the SEC conducted four examinations of Stanford’s operations, finding in each examination that Stanford’s CDs could not have been “legitimate.” The only significant difference in the findings over the years was that the fraud grew exponentially, from $250 million to $1.5 billion.

• Internal influences with the SEC which favored number of cases and disfavored complex cases led to Enforcement decisions not to bring Stanford case earlier.

Wasendorf Investigation

Russell Wasendorf’s Multimillion-Dollar Ponzi Scheme

• July 2012: FBI discovered suicide note of Wasendorf, the chairman and CEO of Peregrine Financial Group (PFG), an Iowa-based financial firm, admitting to perpetrating a 20-year old fraud.

• Wasendorf embezzled millions of dollars from customer accounts by forging bank statements using Photoshop.

• Wasendorf set up a fake P.O. Box, which he used as the address for the counterfeit bank statements.

Wasendorf Investigation

• BRG experts were retained by the National Futures Association (NFA), the self-regulatory organization (SRO) for the futures industry, to investigate how the regulators failed to uncover Wasendorf’s fraud.

• In our investigation, we: • Examined over 190,000 NFA documents containing over 3

million pages • Conducted interviews of 32 individuals, including 25 current

or former NFA employees and 5 former PFG officials (including Wasendorf himself while he was in prison).

• The effort culminated with a 90-page report of investigation with hundreds of appendices and exhibits, and a 30-page recommendations report providing 21 specific and concrete recommendations designed to improve NFA’s policies and procedures.

Wasendorf Investigation Findings

In our investigation, we found that:

• The NFA had conducted 27 audits of PFG between 1995 and 2012.

• The CFTC conducted several reviews and audits of PFG as well.

• In a 2011 audit, NFA auditors sent a request for PFG customer bank account information directly to the bank and found that there was only a little over $7 million in the customer accounts when there should have been over $218 million in those accounts.

Wasendorf Investigation Findings

In our investigation, we also found that:

• PFG lost a total of $20 million over ten years. It reported small profits in only four out of its ten years and even in those years, the firm would not have been profitable without Wasendorf’s capital contributions.

• Wasendorf made close to $70 million of capital contributions into such an enterprise over the same time period.

Yet they all still failed to uncover the fraud.

Psychology of the Fraudsters

• What do Bernie Madoff, Allen Stanford and Russell Wasendorf have in common? • Giant egos

• Bernie Madoff was even jealous of Harry Markopolos.

• No remorse • In interviews, neither Madoff nor Wasendorf expressed any

concern for their victims.

• Blaming others for their illegal conduct • Madoff, Stanford and Wasendorf all blamed the regulators.

• Did not spare their families • Madoff and Wasendorf defrauded even those closest to them.

Lessons Learned From Similar Findings in Many Investigations

• Lack of Aggressive Enforcement;

• Lack of Skills and Competence;

• Lack of Accountability;

• Greater than Achievable Mandates.

Application of Lessons Learned to Corporate Fraud Investigations

• Effective fraud prevention is achieved by establishing:

• Aggressive culture of ethics and compliance, including:

• Enforceable code of conduct;

• Strong internal controls, which should include:

• Conducting an internal control review;

• Ensuring that internal controls are not solely responsibility of audit department.

• Segregation of duties.

Application of Lessons Learned (continued)

•Fraud may also be prevented through ensuring competent and skilled employees, which can be achieved through: • Initial and ongoing training; •Regular communication; and •Emphasizing corporate values.

Application of Lessons Learned (continued)

•Accountability is crucial for fraud prevention. •Companies must be willing to take

necessary actions to enforce the code of conduct. •Companies should also recognize and

reward employees that help to establish an ethical culture.

Application of Lessons Learned (continued)

• Ensure mandates are achievable by: • Fully funding compliance systems; • Testing key systems and controls; •Applying lessons learned from

internal or external fraud events.

Fraud Indicators

• Secretive Behavior;

• Refusal to Answer Questions;

• Working Constantly;

• Spending Lavishly;

• Overriding Controls;

• Unusual Transactions.

Responding to a Fraud Incident – Forensic Accounting

• Who should conduct investigations: • retaining an outside firm with no prior ties to the

company will substantially bolster the credibility of the investigation.

• Although all investigations should be conducted under the direction of legal counsel, retaining an independent firm with specialized experience may be the most cost-effective and efficient option.

• I have seen numerous instances where governmental officials conducting investigations of private companies decided not to even consider internal investigatory work where the investigation was conducted in-house or even by outside counsel.

Evidence Gathering

• Before the evidence gathering process commences, the investigator must consider: • The nature of what needs to be

investigated; • The evidence required to prove or disprove

the allegation; and • The most effective means of gathering the

evidence.

Systematic Collection of Documents

• Document collection must done carefully and systematically:

• Losing or destroying documents, even inadvertently, may have dire consequences.

• Once the universe of documents has been isolated, it must be preserved by photocopying, imaging or otherwise.

• The documents should then be marked for identification and privilege, and organized in a manner that permits them to be processed logically.

• Documents must be handled in such a way that preserves all applicable privileges.

Collecting Electronic Documents

• Electronic documents must be gathered carefully. It is critical to:

• secure back-up tapes.

• preserve data in the possession of departing employees.

• make copies of the computer hard drives of all employees at the core of the investigation.

Interviews – Background Information

• Before beginning interviews, it may be possible to gather background information concerning certain aspects of an individual’s financial circumstances (for example, mortgages, other secured debts and old court judgments), educational and employment references, professional qualifications, and other details such as whether he or she has taken his or her annual vacation.

• Other information available includes corporate information such as jurisdiction of incorporation, authorized share capital, and shareholder identities.

• Public domain information may also provide critical clues or evidence. For example, comparison of a company's statistics and trends to others in its industry may identify unexplained variances that alert the investigator to possible questionable activities or that warrant further investigation.

Conducting Witness Interviews

• Ideally, witness interviews should only be conducted by investigators with extensive experience and success in the interviewing process.

• At the outset of any interview, it should be made clear that the investigator or counsel represents the organization, not the employee, and that the interests of the organization and employee may be adverse.

• Employees being interviewed should be told about the investigation only on a need-to-know basis.

• The interviews should be documented appropriately to protect their contents.

Interview Challenges

• Witness obviously lying. • Rehearsed interview answers.

• Aggressive attorneys interrupting questions. • Witness taking frequent breaks to consult with attorney.

• Witness offended by answers.

• Interview takes an adversarial turn.

• Witness becomes very emotional and begins crying.

• Witness attempting to take back confession or admission.

Preparing Report of Investigation

• Report must be:

• Thorough;

• Comprehensive;

• Readable;

• Simple and straightforward;

• Detailed;

• Persuasive;

• Conclusions must be demonstrated through text; • But exculpatory evidence must also be included.

Completing Investigation

• Ensure accountability after investigations are concluded;

• Be prepared to deal with findings of investigation in advance of completion; and

• Undertake specific and concrete remedial measures.

• Goal is “put matter behind you and learn from incident.”

Contact Information

H. David Kotz, Managing Director

Berkeley Research Group

hdkotz@thinkbrg.com

202.480.2752