A Ponzi scheme occurs when a fraudster uses deposits of new investors to payoff previous investors; no real investing is happening. A Ponzi scheme will collapse if new clients don’t invest, or their investments are too small to fund a decent return to previous investors.
Ponzi schemes are based on trust and greed. The fraudster develops trust by building a relationship with the investors. The fraudster usually gains trust through their actions, their professional, social, or religious affiliations, and personal references. Fraudsters exploit the greed of their investors, who see a chance to obtain higher returns than usual. Because the investors trust the fraudster, they do not perform their normal due diligence.
In March 2009, Madoff pled guilty to 11 federal crimes and acknowledged turning his broker-dealer business into a substantial Ponzi scheme that defrauded investors out of billions. Federal investigators believe that the fraud began as early as the 1980s and the whole things was possibly never legitimate. The fraud totaled almost $65. On June 29, 2009, Madoff was sentenced to the maximum 150 years. He is still in prison.
Madoff was once the chair of NASDAQ and often spoke about the securities industry on CNBC. Madoff took advantage of his connections in the investment community and made it seem like it was an honor to invest with him. A Ponzi scheme can only work if plenty of funds are brought in year after year to pay off previous past investors; as such, Ponzi schemes grow exponentially until they collapse. Until that collapse, Madoff had a luxurious lifestyle.
Madoff pulled this off by omitting all the transactions from his formal books. He hired a CPA firm to audit the books, but that audit didn’t really occur. In fact, the CPA was violating independence requirements by being an investor in the fund himself. For a fund of its size, it would normally be audited by a very large, high-quality audit firm. The investors were greedy and enjoyed the higher returns instead. They trusted Madoff, so they didn’t perform the typical due diligence with a verifiable external audit.
It is alleged (as reported on a CNBC Primetime Special) that one of Madoff’s investors was with the Russian mob and Madoff chose to turn himself in and plead guilty because he feared for both his life and that of his sons. Many have speculated that his sons helped him orchestrate the fraud: both died within a few years of the fraud being revealed. As a result of this fraud, the Public Company Accounting Oversight Board (PCAOB) began requiring broker- dealers to obtain audits using firms registered with the PCAOB, and the PCAOB now sets standards for audits of broker-dealers.
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