Accounting Fraud Examination
October 12, 2011
As we look back on the first decade of the 21st Century, we see that Corporate America and the Financial Markets were riddled with corruption and fraud. At the beginning of the decade we saw the likes of Enron and WorldCom become insolvent due to accounting frauds of epic proportions. The one case that stands out amongst all of them is the Bernard Madoff case, which is considered to be the largest fraud case of all time. “Madoff managed to lure billions of dollars away from huge charities, as well as wealthy individuals in both the United States and Europe by getting them to invest in his hedge fund. He did ...view middle of the document...
It was a broker-dealer firm that was engaged in three main types of businesses, market making, proprietary trading and investment advisory services. There was a subsidiary, Madoff Securities International Limited (MSIL), that was incorporated in the United Kingdom (Gregoriou et al, 2009).
In the beginning BMIS was a brokerage business, they paid brokers $0.01 per share to deliver their retail market orders. The NYSE was charging for order flows, which led others in the market to direct their share of trading to BMIS. This created what was known as the “third market” (Gregoriou et al, 2009). In 1989, BMIS was handling more than 5% of the trading going on on the NYSE. Competition was increasing and the margins were shrinking so Madoff created a separate investment advisory firm that was located one floor below the brokerage firm (Gregoriou et al, 2009). This was keep secret and separate from the floor above. By the beginning of 2008, BMIS had accumulated 200 employees that were divided between New York and London, 12 of whom were assigned to Madoffs’ infamous split-strike conversion strategy.
How The Fraud Was Executed
“In early 2008, according to its Form ADV, BMIS was managing twenty-three discretionary accounts for a total of $17 billion” (Gregoriou et al, 2009). Most of these accounts were the property of feeder funds and were marketed to investors from around the world by intermediaries. This meant that Madoffs last investors were not direct customers of BMIS. Instead they had to invest through an approved feeder that had to open a brokerage account that was delegated to BMIS for full trading authority of their portfolios. This being the case, investors could perform due diligence on the feeders but not on BMIS. This was an intregal part of Madoffs’ fraud scheme (Gregoriou et al, 2009). For the most part his investments posted positive results with no down years and almost no negitive months. Following is a diagram of one of Madoffs’ feeder funds which shows a track record of almost continuous high returns.
Exhibit 2: Track record of Fairfield Sentry Ltd, one of the Madoff split-strike conversion strategy feeder funds.
(Gregoriou et al, 2009). It is easy to see why people had no problem giving him their money to invest with returns like those.
Mr. Madoff had a surprising simplistic approch to investing, he called it a split-strike conversion, better know to some as a collar or bull spread.
1. “Buy a basket of stocks highly correlated to the S&P 100 index.
2. Sell out-of-the-money call options on the S&P 100 with a notional value similar to that of the long equity portfolio. This creates a ceiling value beyond which further gains in the basket of stocks are offset by the increasing liability of the short call options.
3. Buy out-of-the-money put options on the S&P 100 with a notional value similar to that of the long equity portfolio. This creates a floor value below which further declines in...