Insights & Reports > Kroll Global Fraud Report

Using IRS-type reporting mechanisms, Ponzi schemes such as Madoff’s could have been uncovered sooner.

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Dr. Marcia Kramer Mayer

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How does $65 billion in assets purportedly under management go missing? That was the sum of the account values that Bernard Madoff Investment Securities (BMIS) reported to clients throughout North America, Europe, and Latin America on their November 2008 statements. Virtually none was real, as the world learned days later when the biggestever Ponzi scheme came to light. Some 5,000 direct investors and untold thousands with money in feeder funds saw their supposed net worth collapse in an instant.

An exhaustive report issued on 31 August 2009 by the SEC Office of the Inspector General (OIG) tells the story of how the SEC was fooled by Madoff’s machinations despite the creditable and detailed complaints and significant red flags that whistleblowers and journalists brought to its attention as early as 1992, and the two investigations and three examinations that ensued. The OIG report rules out inappropriate connections or influence as factors in the bungled investigation. Rather it finds the problem to have been inexperience and financially naive staff, misplaced priorities, internal communication failures, and lack of appropriate follow-up and the repeated failure to seek third-party corroboration of Madoff’s claims.

Clearly, we need a better way. From the standpoint of early monitoring rather than probable-cause investigation, the current regulatory regime for investor advisor fraud detection falls short on four counts.

First, most investment advisors are not required to register with the SEC. Some are exempt because they manage less than $25 million, but a significant number are exempt because they have fewer than 15 clients, as each hedge fund advisee counts as just one client for registration purposes.

Second, SEC registration is not a game-ender for Ponzi operators. Madoff was registered but lied in his disclosures. On his last Form ADV, filed January 7, 2008, he reported $17 billion in assets under management: far below the $65 billion he told investors later that year – even though markets had crashed in the interim – but higher than the negligible amount he actually held on their behalf. Another huge falsehood was his reported client count: 23, versus the 4,903 active accounts that administrators found upon the firm’s demise. The SEC simply has no ready way to validate the representations of registered investment advisors or even to know when they are giving contradictory stories to customers and regulators.

Third, the current system has no requirement for investment advisors to use an independent custodian. BMIS truthfully disclosed that it did not do so. By permitting advisers to provide self-custody, current law facilitates misrepresentations about assets under management. The danger is compounded if the advisor uses a captive, no-name auditor, as did BMIS.

Finally, in the current system oversight is resource-intensive. Large numbers of financially sophisticated inspectors would be needed to conduct routine, comprehensive reviews competently. Budget constraints preclude such an approach.

Two proposals of note try to address the problem. The Obama Administration’s regulatory reform bill would require hedge fund advisors to register with the SEC if they managed at least $30 million in assets. A pending SEC proposal would effectively mandate a qualified independent custodian. Both measures would help in Ponzi scheme detection, but they do not go far enough.

One concern about the SEC plan is that a supposedly independent custodian might be complicit with a scheming advisor. Another is that a Ponzi artist might direct substantial incoming customer assets in such a way that the custodian never learned of them, and so could not see them getting siphoned off.

As for the Administration bill, investment advisors to funds are covered but those with discretion over non-pooled monies are not. Madoff did not operate a hedge fund; he purported to invest on behalf of clients individually. Another weakness is that the bill gives the SEC no means to test the veracity of a registrant’s disclosures. If a custodian were complicit with or deceived by an advisor client, the task of asset validation would fall to the SEC.

The law should better equip the agency to perform its investigations. If Congress and the SEC are serious about protecting investors from Ponzi schemes, they need look no further than the Internal Revenue Service (IRS) for an approach that is both simple and well tested: multiple-source reporting of entity-specific data. Rather than accept at face value the income components that taxpayers report on their personal tax returns, the IRS comprehensively cross-checks those claims against statements of wages, interest, dividends, and gross sale proceeds submitted by employers, financial institutions, and other income payers. It then attempts to reconcile any identified discrepancies. Routine crosschecking improves the accuracy of the final numbers not only by correctingerrors but also by motivating honest reporting in the first place.

The SEC must be similarly empowered to routinely and cost-effectively validate the data that it needs to police investment advisors. Instead of having it rely exclusively on the most self-interested party – the advisor – for routine information on assets under management, a system under which multiple organizations would be required, and individual investors encouraged, to provide the SEC with data about each advisor’s managed assets, would be preferable.

Investment advisors with at least $30 million under management would be required to report quarter-end assets by account – identified by code, not name.

Custodians would have to report quarterend assets under management for each advisor-client. To give teeth to this mandate, advisors would be required to use an independent custodian.

Investors would be invited – but not required – to report quarter-end assets under management by advisor and account.

This data would be fed into software that made comprehensive comparisons efficiently, checking whether the total assets under management per an advisor’s aggregate reported account-level assets matched the overall sum given by the custodian, and whether account-level assets as per the advisor agreed with those reported by participating investors.

For any given date and level of aggregation, the values should agree. If there were large, numerous, or recurrent discrepancies for an advisor, a well-focused SEC inquiry could be launched to determine whether any claimed assets were missing.

The involvement of individual investors is the linchpin of this plan. Even with a truly independent custodian, an advisor could run a Ponzi scheme by having some investment monies deposited into accounts of which the custodian was unaware, while the firm ran a legitimate operation with assets that the custodian did see. An advisor engaged in such asset diversion would report to the SEC only those assets under management to which its custodian was privy. If the SEC had no ready means of learning that the advisor was reporting larger numbers to investors, the scheme might go undetected. An asset-diverting advisor, however, would have no protection under this plan from random investors reporting their individual account asset values. Unless the advisor informed the SEC of all account-level assets, any one investor report could trip it up.

In the end, Ponzi scheme prevention and detection requires keeping an eye on customer assets. If investor self-interest can be harnessed to motivate at least some advisory clients to report their assets under management. And if advisors can be made to fund the system, securities regulators who adopt a multiple-source reporting system such as the one proposed here can tackle the Ponzi problem quickly, effectively, and at minimal cost to tax payers.