Who Do You Trust?

For four decades, Bernard Madoff ran what appeared to be a money management powerhouse, an investment company that reliably increased the fortunes of banks, universities, and philanthropic foundations funded by such respected businessmen as Mort Zuckerman and Carl Shapiro.

Then, on December 12, when the social benefactor with homes in Manhattan, Palm Beach, and the Hamptons was arrested for fraud, he told authorities something that no one wanted to hear: there was no investment company — what he had built over 40 years was a Ponzi scheme of such magnitude that its inevitable unraveling could cost as much as $50 billion.

BU Today talked to Tamar Frankel, a School of Law professor of law, an author, and an expert on issues of trust and honesty in business, about Ponzi schemes (so named for the con man who bilked investors of millions in Boston in 1920), Madoff, and what might be done to reduce the likelihood of another Madoff-sized scam.

BU Today: What is a Ponzi scheme?
Frankel: A Ponzi scheme is a scheme in which the con artist offers notes or obligations that carry a high return. Then, because the con artist cannot meet the payments, he pays the promised returns to old investors from the money he gets from new investors.

It seems so simple. Why does no one catch on?
Number one, the personality of the con artist. He is charming, very nice, very accommodating. He looks wealthy, doesn’t care much about money. For example, in his autobiography, Charles Ponzi described a woman who came to demand her money before it was due. She was accompanied by a policeman. Ponzi took out his checkbook and said, “OK, here is your money.” The woman was so flabbergasted at this response that she hesitated and decided she would rather leave the money with Ponzi. But Ponzi then said, “No. Now that you don’t trust me, I don’t want to have you as an investor.” What happened next was, the policeman was so impressed that he invested with Charles Ponzi. It is a way to show that the Ponzi schemer doesn’t care about having more investors, doesn’t need any money, and can be trusted.

Did Bernard Madoff behave in similar ways?
One thing about Bernard Madoff, and the thing about other Ponzi schemers, is they are very, very generous. They are generous with other people’s money, but they are generous. They contribute to good causes, so people think they are good people.

How did people catch on to Madoff?
They asked for money and he couldn’t pay. With Ponzi schemes, when the payments stop, they stop altogether. They don’t dribble down as with legitimate investments.

Why did no one catch on before the payments stopped?
The cost of finding out the true source of the fraud is very high. There was no American custodian of the investments. The custodian was in the Virgin Islands. And people didn’t ask who, precisely, is your accountant. That was something that some people should have seen and some people may have seen.

One reason Ponzi schemes are so difficult to recognize is they look like an entrepreneurial enterprise. Most enterprises pay dividends and borrow at the same time. People borrow and buy stock. It is legitimate. There is nothing wrong with that. The difference is, with a Ponzi scheme, there is no source of income other than the money from new investors. But that is very hard to find out.

Con artists are also very optimistic. In many cases they think that things will work out somehow; something will come along and save their scheme. In his autobiography, Ponzi wrote that when he had collected investments of about $5 million, he realized that his scheme would not work. At that point, he said, he hoped that he would be able to buy a bank and slowly reduce the payment. As a matter of fact, he did buy control of a bank, and he received about $15 million in about six months. That was an enormous amount of money. He thought he could go legit. And if you think about other frauds, like Enron, they thought they could go legit. There is often that hope.

What happened to Charles Ponzi?
He was indicted and served a jail sentence and then was deported to Italy, where he came from. He died in South America a very poor man.

Do these people know that what they are doing is fraud? Or do they think that what they are doing is OK?
People disagree about that. Some people suggest that con artists are really of a certain kind, that they lack what most of us have that prevents us from hurting others. Most of us have an inbred sense of shame and empathy and guilt. The argument is that con artists don’t have these feelings or that they are very weak with them, and that they can dehumanize others and can view them as things. So they don’t identify with victims and do not suffer the pain they inflict.

What do we know about the people who tried to tip off authorities in the Madoff case?
Someone said there were as many as eight occasions in which the government was alerted to the possible Ponzi scheme. One problem was that one of the informants was a competitor and a bounty man looking for payment on tax avoidance. His argument was an economic argument — that Madoff could not possibly produce the returns he claimed to produce. But the Securities and Exchange Commission is not an economic evaluator. The SEC’s objective is to ensure true information.

There were also other concerns, like the fact that a person who worked at the SEC enforcement division married Madoff’s daughter. That is a conflict of interest. So the question is, when did that relationship start? But the main reason Madoff got away with it for so long is that he is a member of the elite financial leadership. It’s very hard to take a man like him and put him to the wall and interrogate him. He was treated with kid gloves. And it’s also true that no investors had complained and said, “I can’t get my money back.”

Where did his “investors” think their money was?
Madoff sent his investors lists of stocks in which he said he invested money. These were just copied from the newspapers’ lists. The investments didn’t exist, but he had enough money that once a month he could pay those people who asked for money. What he did was invest the money in government securities, so the amounts he held were off the radar screen of the broker-dealers’ supervisors. And when he had pools of funds, they were outside the definition of an investment company, which could have triggered regulation.

I know that you recently testified before Congress. What did you tell them?
I told them that the greatest danger right now is a lack of investors’ trust. Mind you, trust is not gullibility. Trust requires some reasonable belief. People have lost that reasonable belief. What we need most now is the ability to verify information. Investors cannot verify the information that is well hidden. It’s too costly. The private sector gatekeeper cannot or will not do that. We have had bad experiences with them. What remains is the government, and when I look at the government, I see that its examination resources are ridiculously small compared to what is needed. I don’t think it’s necessary to examine small enterprises. But we have allowed the emergence of enormous enterprises with huge pools of money. Madoff was one of them. If he lost $50 billion, he must have had $50 billion. The same applies to these enormous banks and hedge funds. I would like to see examinations of these mammoth pools of money that belong to people and are controlled by other people.

Do we need to create a new government agency to do that?
No. We have had examiners in the SEC for a long time. We have examiners in the Federal Deposit Insurance Corporation. I don’t suggest that we pull them together. What I do suggest is that they pool the information. There are a number of very knowledgeable people who really know the ins and outs of the market who are being laid off. This is a good time to hire them to find out what is really going on. Those people, of course, should be paid more, and they should also be given something that they may value apart from money. Those people who value only money shouldn’t be government examiners anyway. But there are people who value the power and the prestige that comes with being a government examiner and the satisfaction of doing the right thing. They should be hired and help clean the system.

Art Jahnke can be reached at jahnke@bu.edu.