Five signs your client may be running a Ponzi scheme

Bernard Madoff’s boxer shorts were sold to pay off his victims. Now, his bank will chip in.
Bernard Madoff’s boxer shorts were sold to pay off his victims. Now, his bank will chip in.
Image: REUTERS/Jessica Rinaldi
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It seems that another big fine is in the offing for JP Morgan: Leaks abound that the bank will sign a deferred prosecution agreement with the Justice Department, effectively admitting to wrongdoing and paying perhaps $2 billion in penalties and fines. (It agreed to pay $13 billion over its handling of mortgage-backed securities not two months ago.) The charges? Not noticing that its client Bernard Madoff, who paid the bank hundreds of millions of dollars, was running a Ponzi scheme and defrauding investors in his wealth management business. 

We thought it might be helpful to put together a brief list of five warning signs for other financial institutions that might run into similar problems. The DOJ hasn’t revealed its bill of particulars yet, but Irving Pickard, the trustee charged with recovering lost money for Madoff’s victims, obtained internal e-mails from JP Morgan when he sued the bank for damages, giving us a handy list of tell-tale signs that someone’s returns may be too good to be true:

  1. Your hedge fund client is using a retail checking account. Rather than use a business bank account, Madoff’s hedge fund put billions of dollars from thousands of investors into a retail account, and didn’t bother to segregate it with sub-accounts. His accounts “exhibited, on their face, a ‘glaring absence of securities activity.'”
  2. Millions of dollars of this money are transferred to one personal friend of the owner. Norman Levy, a friend of Madoff’s, was the largest single recipient of funds from the JP Morgan account in what has been described as a “check-kiting scheme.
  3. The fund doesn’t seem to bear any relationship to the investments it claims to make. Madoff’s investment strategy was supposedly buying S&P 100 stocks and hedging them with options. However, in 2006, three years before the fraud was revealed, JP Morgan’s due diligence found steady yields from Madoff’s “investments” even as the S&P 100 dropped 30%.
  4. Someone tells you your client is running a Ponzi scheme. In 2007, a JP Morgan money manager told the company’s chief risk officer, John Hogan, of speculation that Madoff was running a Ponzi scheme. Hogan asked a junior analyst to Google Madoff and, when internet searches resulted in no hard evidence, made no further inquiries.
  5. Your colleagues on the bank’s trading desk stop investing in your client’s fund because he’s a fraudster. In 2008, JP Morgan pulled $276 million out of Madoff’s funds due to suspicions of his fraud. Yet it told no regulators or other investors, nor did it close Madoff’s account with the bank.

Hopefully nobody will have to say “I told you so” to another large financial institution in the future.