Would a Fraud Bounty Have Exposed Madoff Years Ago?

Laura Goldman is a money manager who claims to have figured out back in the 1990’s, in the space of about 45 minutes, that Bernie Madoff was a fraud.

In this Fox Business interview, she discusses (very entertainingly) her encounters with Madoff. At the time, Goldman worked for Paine Webber (remember them?):

He was buying stocks and also trading options against the stocks, O.K.? And the thing is, my previous office had been in the Philadelphia Stock Exchange. I’m from Philadelphia, so I knew many of the market players in options in Philly. It’s too hard to track the trading of Microsoft, but it’s much easier for me to track the trading of the options. So I talked to the president of the Philadelphia Stock Exchange at that time, his name was Nick Giordano; I talked to big market makers like Susquehana, and none of them were doing business with Bernie Madoff. So I was a little curious about it. And then Bernie came back and told me that he was trading the options in Europe. Well, that didn’t really make sense to me, because trading in Europe is usually much more expensive than trading in the United States, especially for American stocks. So I said to myself, I don’t need this headache now. It basically took me 45 minutes to figure out something was wrong.

Now Goldman is agitating for regulatory change to lessen the chances of future frauds. “I am working with the S.E.C. to prevent another one,” she says. “One of my ideas is to pay a bounty for those that detect fraud. They already have one for insider trading. People on Wall Street are not Mother Teresas. They are not going to the S.E.C. unless there is something in it for them. Your friend James Altucher even says that in his Tech Ticker interview.”

Goldman is cited in this TIME article about fraud whistleblowing:

Goldman, who blew whistles on such notable investment frauds as First Jersey Securities, Bayou Hedge Fund, and Lydia Capital, among others, now has the full attention of S.E.C. Inspector Kotz‘s office. In all, Goldman says she has alerted the S.E.C. over 30 times and, despite its cold shoulder, through one means or another she has seen 25 of those tips lead to fraud charges being filed.

An S.E.C. whistleblower bounty is hardly a pipe dream; the I.R.S., among others, already pays for good info on frauds.


Kevin MN

If the problem with the SEC, why not offer the bounty to SEC employees? What if SEC investigators received a bonus for the amount of fraud they found and got convictions on? You wouldn't want to offer the actual prosecutors any bonus because it would give them a very dangerous incentive. However, if investigators could receive some sort of bonus or bounty it would give them incentive to find the biggest fraunds and a good reason to complain if legitmate fraud isn't prosecuted.

Hunter

#19 PaulK

I see "reputation" as perhaps a useful synonym (or replacement?) for "altruism." Avoiding prosecution, explaining inferior results, and being a hero are all reputational concerns. Mr. Markopolous might have viewed his position in relation to Madoff as a loss avoidance issue, rather than an potential gain in his standing as a member of the financial community.

The "safe" exploitation of an information advantage is just another cost that must be recovered. Additional transaction costs are incurred. For example, a less "reputationally motivated" trader might have uncovered the Madoff mess and chosen to exploit, rather than expose, the fraud. He simply could have chosen to join 'em instead of beat 'em. He could have invested, cashed out, invested again, cashed out again, and so on. According to his own hard-earned information advantage, this strategy had a guaranteed payoff - the books were cooked! The potential downside was that he could have failed to "cash out" when some "reputationally motivated" person finally managed to get the SEC's attention. But as you say, the additional pariah costs to any member of that community make it unlikely at best that anyone smart and connected enough to figure it out would sing.

My philosophy is that trying to make the unpredictable (i.e. not rationally maximizing) behavior of a whistleblower more predictable will likely lead to more distortions in an already distorted market for information.

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PaulK

Hunter, I agree with your overall premise. But, information asymmetrical situations have beneficiaries who keep it that way when it is useful and will rebalance the information when that is more useful to them. Whether insider tips (of upcoming events), someone who extracts information others miss, knowledge of wrongdoing, or knowledge of trades about to be made, the owners of the information tend to keep it for the advantage of themselves and their friends. But, as we have discussed, the advantage may be more in divulging it or reporting to authorities. Trying to change the value model will undoubtedly distort even more than now, and if the law of unintended consequences holds, it will distort in ways that are not wanted. For example, when their is more value in being a whistleblower, you are teaching the wrongdoers to keep the circle of insiders even smaller and more culpable, so they are less inclined to say anything (more to lose, less to gain). This would lessen the opportunities to discover such frauds. This is not a hypothetical - this kind of behavioral change has been noted in many criminal activities when authorities attempt to get some to turn on others. Sort of the prisoner's dilemma - the result has been that criminal gangs get better about making sure that all members are equally guilty so there is far less chance that one would be set free in exchange for information - too heinous a set of crimes means only lessening the sentence. I suppose it is a flattening of the normal hierarchy, where the analogue in information asymmetry is fewer people on the knowledge side and more of them equally involved/knowledgeable.

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armchairpunter

Paul K avers: "The average investor is just not sophisticated enough to tell the difference between a great fund manager and a fraud. This is why we have the SEC and other regulatory bodies by the way."

How's that working out for you? Or, I should say, us?

Should the "average investor" take comfort in the fact that the SEC is keeping an eye on things for them? If the SEC disappeared overnight, how would it really change things for the average investor? Would the NYSE, NASDAQ and other privately-owned exchanges relax their standards? Would private sector auditors and rating agencies be any less effective? (Which is not to suggest they're terribly effective.) Would private pension funds and institutional investors demand any less from the issuers they invest in?

Let's not forget that the government runs its own entitlement ponzi schemes that make Madoff 's look like a rigged cookie swap.

As for your home purchase comparison, there is a difference between the risk of fraud and the risk of unfavorable market movements. When I purchase a house, I have it inspected by a private inspector and I have title insured by a reputable private title agency. It so happens my private lenders require the same thing. Though I'll obtain an appraisal from a private appraiser for my lender, I know I am really on my own when it comes to assessing the value of the house and the probability of it increasing or decreasing over time.

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Nicholas Weaver

There is a bounty for insider trading...

If you read whats-his-names letters to the SEC, you see that a Ponzi scheme was one explanation, the other was front-running, and that if it was front-running, he wanted his whistleblower money for it.

ben famod

Bernie's blog says it best on the topic of bounties earned by government employees. This approach will simply increase the cost of corruption--the employees working towards a bonus/bounty will most likely engage in over zealous, and perhaps criminal activities themselves in order to "frame" potential defendants, and they'll simply ask for more in return for quashing their own investigations....massive inflation would be the result... great stuff at http://www.bernard-madoff-scam.blogspot.com

matt

Perhaps the easier solution is for the SEC to have a policy on not hiring former bankers and investment professionals for key investigation roles. My sense is that the problem is more based on having business connections at these firms more than anything else.

PaulK

armchairpunter, "How's that working out for you? Or, I should say, us?" - it is working out about as well as most us did the analysis on where house prices might go when buying. But, incompetency in the SEC should not be considered a permanent state. The SOX laws were added because of Enron and Worldcom - they are overkill and have unintended consequences, but they were the government's way of dealing with the problem.
Obviously the SEC is well aware of the fact that it screwed up big time with Madoff, and I suspect more effort will go into looking at such funds, at least for a while. But, your assumption that investors are able to determine fraud is just not realistic. You are no more equipped to detect fraudulent $20 bills or fraudulent artwork. It takes tools and expertise. If every one of us was expected to have both the tools and expertise, we would be back to the pre industrial revolution days. This is one of the services that the government is supposed to provide for good reason.

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Gareth plummer

Is there a potential for fraud bounty schemes to damage the reputation of legitimate investment schemes, a fraud bounty hunter would have to be paid massive amounts of money to make it worthwhile - the scarcity of fraudulent schemes could cause problems. Plus if a fraud bounty does find evidence of massive fraud what is to stop them asking for hush-hush from the fraudulent company. This could be to the tune of tens of millions of dollars.

Michael

I assume the bounty would only be paid to whistle blowers in the event that fraud was actually found to have occurred by the SEC. By all accounts, the SEC found no evidence of fraud in the decade or so that they were being warned about Madoff. The "bounty" then would do no as long as the SEC continues it's pattern of not aggressively pursuing credible allegations of misconduct. People may chose not to report crimes if they feel there is no personal gain however it would seem they are less likely to report anything if they knew they would be ignored.

David T

I'm afraid that the problem isn't just with the SEC. It is with Members of Congress interfering with investigations by putting pressure on the SEC to shut them down whenever one of their rich contributors complains that the SEC is after him. My insider information tells me that this is what really happens when the SEC starts to investigate some big whig on Wall Street. I would not be surprised to find out that Bernie Madhoff called some buddies on Capitol Hill to get the SEC off his back. But unless the SEC leadership has the guts to expose this pressure and fight it off, things will never change.

What we really need is an organization more independent of Congress and more ethics investigations into the improper use of influence by Congressmen. How independent is the SEC really? Is the Chairman as independent as the Fed Chairman? What about their budget?