Throughout the annals of the history of man, there has been a myriad of hoaxes. From practical jokes to Ponzi schemes the art of the bamboozle has proven to be an integral part of human nature. Merriam Webster defines a hoax as ‘an act intended to trick or dupe’ and ‘something accepted or established by fraud or fabrication.’ (Merriam Webster Dictionary)
The tale of fraud is as old as history itself. As the dawn of commerce brought on the personal accumulation of capital subsequent unscrupulous individuals inevitably sought to redistribute that capital by any means necessary.
The intrinsic human traits of ambition and greed have led to both the birth and death of empires and the minting and destruction of countless fortunes. There has been no greater driving force in history than greed. One of the greatest fraudsters of all time is Bernie Madoff. On March 12th, 2009 Madoff was found guilty of defrauding his investors of $65,000,000,000 through what is known as a Ponzi scheme.
For his crimes, Madoff was sentenced to 150 years in jail. Con-artists have always engaged in fraud to enrich themselves at the expense of others. Today the largest frauds tend to be perpetrated through Ponzi schemes. For decades Bernie Madoff leveraged his fame in the finance industry to take advantage of his investors; It was the confirmation biases held by his clients and Madoff’s appeals to investor emotions that allowed him to perpetrate the largest recorded fraud in history.
The written record of fraud begins in the year 300 BC.
Hegestratos, a Greek shipping merchant, took out an insurance policy against his vessel and its cargo, the policy was known then as a bottomry. Hegestratos’ scheme was a simple insurance scam. He planned to sink an empty ship, allowing him to keep both the corn and benefit from the insurance policy. Ultimately, his plan backfired. After being caught in the act of sinking his ship by his crew, Hegestratos has chased off the ship and drowned trying to escape them. (Beattie, Investopedia) Like Bernie Madoff, Hegestratos’ scheme did not pay off in the end.
Five hundred years later in the Roman Empire, the Praetorian Guard assassinated the very emperor that they swore to protect. They then held an auction to sell the Roman Empire to the highest bidder. The winner of that auction was a man by the name of Julianus who made the astronomical bid of 250 gold pieces for every soldier in the Roman Army. The guards had sold something that wasn’t theirs, effectively amounting to financial fraud. Julianus was never recognized as emperor and was quickly deposed, leading to a period of civil war in the empire. (Hammond, Experian). It is clear that fraud is nothing new and perpetrators of such hoaxes do so for the express purpose of enriching themselves. As civilization progressed commerce flourished and equity markets emerged. The growth of equity markets allowed retail investors to participate in financial speculation and propagated fraud on a larger scale than ever seen before. Excited investors eager at a chance to stake a small fortune for themselves but without experience in the market often allow others to invest for them. This created even more opportunities for unethical money managers and executives to embezzle and defraud their investors.
One flavor of fraud that has been made possible by the relative ease of access to capital and new investors is known as the Ponzi scheme. Like most successful scams the Ponzi scheme isn’t very complex. It is nothing more than the age-old game of borrowing from Peter to pay Paul. In any Ponzi scheme money that is taken from today’s investors is used to pay off debts to yesterday’s investors. Typically, these investors are lured by promises of exorbitant profits. The problem that arises in a classic Ponzi scheme is that there is no actual investment occurring; the only activity is the shuffling of money from new investors to old ones. This scheme can go on as long as new investors are lining up to sink their money into the scheme. When these new investors run out or a large number of the investors choose to withdraw their funds at the same time the house of cards comes tumbling down. Investors often find that their principal has been distributed to other investors, their returns were fabricated, and they are left with nothing. This is precisely what happened when Bernie Madoff’s scheme imploded. (Darby, Smithsonian, 1998)
It was Mr. Madoff’s reputation on Wall Street that allowed him to swindle people so effectively. In the years before Bernie Madoff’s downfall, he was regarded as a master of finance. Madoff began his career by founding his firm on Wall Street in 1960. Originally, His company was primarily engaged as market makers in OTC securities such as penny stocks. Madoff was able to grow his business by integrating electronic trading capabilities which eliminated market inefficiencies and increased order flow through Madoff’s firm. Through his success, Madoff’s firm was legitimized and he was able to establish himself as a pillar in finance. In the early 1990s, Madoff was even appointed as the chairman of NASDAQ. (“Who is Bernie Madoff”, Investopedia) The majority of Madoff’s victims were wealthy and educated but most were not financial experts. Many of his victims were members of the Jewish community in Palm Beach and Long Island who had become acquainted with Madoff through country clubs and social networks. There were charities, benefactors, and celebrities such as Stephen Spielberg and Sandy Koufax. It was Madoff’s track record of success combined with what appeared to be a safe and unusually profitable investment strategy that made it easy for people to trust him with the management of their money. (Mathiason, The Guardian, 2009) The ethos that Bernie Madoff established during his years on Wall Street is what allowed him to take advantage of his clients who were almost exclusively successful and educated people.
One of the key logical fallacies at play in Madoff’s scheme was the confirmation bias. Psychology Today states that,
‘[a] Confirmation bias occurs from the direct influence of desire on beliefs. When people would like a certain idea/concept to be true, they end up believing it to be true. They are motivated by wishful thinking. This error leads the individual to stop gathering information when the evidence gathered so far confirms the views (prejudices) one would like to be true.’ (Heshmatt, Psychology Today)
Madoff cultivated close friendships with wealthy, influential businessmen in New York City and Palm Beach, Florida, signed them as investors, paid them handsome returns, and used their positive recommendations to attract more investors. (Loney, Reuters, 2008) He also bolstered his reputation by developing relationships with financial regulators. He exploited an air of exclusivity to attract serious, moneyed investors; Not everyone was accepted into his funds, and it became a mark of prestige to be admitted as a Madoff investor. As more investors joined, their money was used to fund payouts to existing investors as well as fee payments to Madoff’s firm. By believing in his power of confidence and leveraging his credibility in the world of finance, Bernie Madoff convinced additional targets that he was rich, powerful, and intelligent, and through these virtues, he could make them even wealthier. These traits exhibited by Madoff were all that most investors needed to confirm their biases that Madoff could make them obscenely wealthy. This confirmation bias created within the minds of his clients was a direct result of their wishful thinking that Madoff himself held the key to wealth creation. By securing the image of himself as an extremely successful investor in the minds of his would beSecuringwould-be clients made it possible for him to receive large sums of money from them in good faith which fed into his scheme and allowed him to live a lavish lifestyle funded by his the investors.
Madoff carried out his scheme uninterrupted for decades. During the investigation following the collapse of Madoff’s venture Amit Vijayvergiya, Chief Risk Officer for one of the largest feeder funds into Bernie Madoff’s scheme stated, ‘Madoff, after, you know, 18 years of a very lengthy and trusted relationship, an individual who had a stellar reputation and great credibility in the industry, provided us with this information, so we had every reason to believe it was true.” (Clark, 2009) This is a direct example of the confirmation biases that were at play when choosing to invest with Bernie Madoff.
Another contributing logical fallacy that may have helped Bernie Madoff in his quest to secure new investors was an appeal to emotion. An appeal to emotion is defined as fallacy that uses emotion in place of reality, to attempt to win the argument. It is a type of manipulation used in place of valid logic.” (Appeal to Emotion, LogicallyFallacious.com)
At the peak of his scheme Bernie Madoff was considered a financial wizard. By nature, investors seek to grow their capital as much as possible but also have a strong desire to preserve their principal investment. By promising above average above-average returns through conservative investments Madoff could have triggered an emotional response in the investors that chose to buy into Madoff’s fund. Another contributing emotional factor that allowed this Ponzi scheme to go on for so long was contentment. Year after year Madoff showed tohis investors that their money was growing. Because of this constant growth, they saw no need to remove money from the fund and allocate it elsewhere. By falsifying account statements and creating a verifiable narrative that showed constant value growth Madoff appealed to his investors in emotions and by doing so he kept those investments at his fund.
Another evident appeal to emotion made by Bernie Madoff to potential investors was the fact that many of Madoff’s closest relatives and business partners invested in the fund. This created a false sense of security and trust that Madoff took advantage of. Forbes magazine states, “Our research suggests that Madoff may have deliberately or inadvertently taken advantage of the automatic trust process regardless of whether his family members and business associates were victims or confederates. Even if he didn’t seem trustworthy, the fact that his closest relatives and associates invested with him could have provided a subtle, non-conscious signal that he was trustworthy. After all, foxes never prey near their dens, and thieves only steal far from their homes. Additionally, the constant associations of Madoff’s name with all sorts of philanthropic works, and other subtle cues, may also have encouraged people to trust when they shouldn’t have.” (Murnighan, Forbes)
Many of his prospective investors could have emotionally reasoned that the fund was legitimate because of the fact tha Madoff’s close relatives, friends, and business partners were supposedly heavily invested. It would be a reasonable emotional conclusion that such a well established well-established and seemingly professional man of high standing would not dare to steal from his family and friends.
When the 2008 recession began to unfold Madoff’s clients attempted to liquidate a $7,000,000,000 aggregate position in the fund. Unfortunately for them Madoff only held $200,000,000 in assets at the time. He broke down and revealed the scheme to his sons who promptly reported him to the SEC. Madoff was soon found guilty of his crimes and sentenced to prison, years in Prison. Today he lives behind bars in a federal corrections institute located in North Carolina. (David, Investopedia)
Ten years after his downfall Bernie Madoff’s victims are still yet to be made whole.
When looking back at Madoff’s scheme it is clear why the logical fallacies that contributed to the success of his scheme are so dangerous. Investors trusted Madoff because of their confirmation biases and allowed him to play on their emotional desire for greater wealth. Because of this they were swindled out of $65,000,000,000. Since the collapse of the firm, there have been over 39,000 petitions for compensation filed with the Justice Department and 11 Billion dollars returned to investors. (Benner, NYT, 2018) Madoff’s scheme still holds the crown for the there may be the largest fraud in recent history, but it is entirely possible that there is an even larger fraud lurking in the shadows that havethat yet to surface into the realm of public knowledge.