CORPORATE CRIME REPORTER
Tide
Runs Out on Wall Street – Who Was Swimming Naked?
23 Corporate Crime Reporter 5, January 29, 2009
The tide has run out on Wall Street and the question becomes – who was
swimming naked?
Answer – hedge funds and other unregulated vehicles.
Who was swimming with their clothes on and therefore was immune from ponzi schemes like Madoff’s?
The mutual fund industry.
“A marked disparity exists between the seeming immunity of mutual funds and the relative vulnerability of other collective investment vehicles,” Columbia University Law Professor John Coffee testified before the Senate Banking Committee earlier this week. “Mutual funds have not experienced Ponzi schemes, while hedge funds, other pooled investments like real estate investment trusts and investment advisers have.”
What distinguishes mutual funds from hedge funds and investment advisers that may explain this disparity?
Coffee said two differences stand out: independent custodians and Public Company Accounting Oversight Board (PCAOB) registered auditors.
Coffee, the author of, most recently, Gatekeepers: The Role of the Professions and Corporate Governance (Oxford University Press, 2006) fingered two basic failures of internal controls in the Madoff case.
“First, Madoff cleared his own trades and did not use either an independent custodian or a clearing broker to execute and clear his trades,” Coffee told the Committee.
“Second, Madoff was audited by a small auditing firm, Friehling & Horowitz, which only had three employees. Of these three, one was a secretary; another was Jerome Horowitz, an 80 year old, semi-retired partner, living in Florida, and the third was David Friehling, who was not subject to even the peer review process mandated by New York State because he claimed not to conduct audits (ironically, this may have truer than regulators realized).”
Coffee said that the Friehling & Horowitz firm was not registered with the Public Company Accounting Oversight Board, because of an overbroad exemptive rule that the SEC repeatedly adopted in the wake of Sarbanes-Oxley to spare broker-dealers that were not publicly held from the oversight of a PCAOB-registered auditor.
Coffee said that Ponzi schemes occur in all societies, and there have been similar scandals in Russia, Eastern Europe (particularly in Albania where one helped cause the fall of a government), India and, very recently, the U.K.
In the U.S., although Ponzi schemes are infrequent and represent only a tiny minority of alternative investments, they do produce substantial losses on a recurring basis, Coffee said.
Other scholars have computed the losses from Ponzi schemes, as shown by litigated court cases, and concluded that the prior record year was 2002 when over $9.6 billion was lost.
But Coffee said that annual losses of over $1 billion are frequent, with over $1.6 billion lost in 1995 and 1997 and over $1 billion in 1996, 1990, and 1976.
The amount lost varies radically from year to year largely because Ponzi schemes tend to be uncovered only in periods of market stress – “when the tide goes out on Wall Street.”
Coffee reviewed a number of recent major American ponzi schemes – Madoff, Bayou Group, Arthur Nadel and Scoop Management, Martin Armstrong and Princeton Economics International, Pinnacle Development Partners, John Bennett Jr. and the Foundation for Era Philanthropy, Martin Frankel, Reed Slatkin.
He concluded that “both the scale and frequency of Ponzi schemes seems to be increasing.”
Federal officials alleged that Madoff inflicted losses totaling $50 billion.
“Although Madoff is in a class by himself, the increase in the size of the typical Ponzi scheme appears to be the product of the growth of the hedge fund industry and the new popularity of alternative investment schemes,” Coffee said. “The increased frequency of Ponzi schemes contrasts sharply with the fact that no mutual fund registered under the Investment Company Act of 1940 has ever collapsed and been exposed as a Ponzi scheme. In fairness, the relevant contrast here is not between mutual funds and hedge funds – for example, Mr. Madoff was not running a hedge fund, but was an investment adviser. Rather, it is between mutual funds, which seem immune to Ponzi schemes, and other investment vehicles, which are less regulated and seem more vulnerable to fraud.”
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