Strategic Integration of Positive Social Change

By Craig Wright | 25 Oct 2022 | Alternative Coins & Systems

In Finding Bernie Madoff, Stephen Dimmock and William Gerkin (2009) demonstrated that methodologies based on the detailed statistical analysis of financial filings might be utilised in the detection of corporate fraud. The authors note that very little research has been conducted into the detection of fraud that is committed by investment managers. Such lack of concern has been somewhat problematic in the past. As a result, financial frauds have occurred in respect of Enron, WorldCom, and, previously, Bernie Madoff Investment Securities LLC. On Dec 11, 2008, Bernie Madoff and the firm he ran were charged with securities fraud over the creation of an $18-billion Ponzi scheme (SEC).

Accurate disclosure presents a critical component of protecting investor rights. The industry has implemented methodologies that would allow for the integration of regulatory review (e.g. XBRL, or eXtensible Business Reporting Language). Yet the use of such techniques for integrated reporting remains low (Gunn, 2007). While the standards allow for the integration of financial and non-financial reporting tools (Efimova, Rozhnova, & Gorodetskaya, 2019), and it is well reported that such tools provide significant benefits within the organisation (Joshi, 2019), the integration with regulators remains low. Of particular concern is the fact that even with an SEC mandate for the implementation of such reporting tools, the return of audited financial reports has been lagging (Hwang, No, & Kim, 2020).

In the past twelve years, the United States SEC (Securities and Exchange Commission) has consistently sought the implementation of enhanced investigatory powers. Yet, researchers such as Zitzewitz (2006) have consistently argued that international stock markets are highly correlated, linking directly to United States foreign markets. Such correlation is essential as it fundamentally validates the work of Bollen and Pool (2008). Recently, further scholarship enhancing earlier work by the same authors (Bollen & Pool, 2009) has increased, leading to the creation of many computer-assisted audit tools (CAATs). Yet, even though some researchers, such as Boritz, Datardina, & Boritz (2014), have made preliminary forays into the use and teaching of both CAATs and generalized audit software (GAS) within a classroom, usage remains limited.

As with previous scandals such as the Enron scandal, the Madoff financial scandal could have been avoided. The purchase and sale of shares in the United States are all recorded. Consequently, when large financial frauds such as the Madoff scandal occur, they demonstrate a problem with the audit and monitoring process. The argument put forward was that it was more challenging to follow the trades because they were done through over-the-counter retail brokers. But with the ability to follow tick size and monitor the trading environment, even high-frequency trading (HFT) is monitored and analysed by academic researchers (O’Hara, Saar, & Zhong, 2019). Researchers such as Myklebust (2020) use such information in their evaluations of European regulatory approaches in high-frequency markets. With advances in artificial intelligence and blockchain technologies, authors have noted that data analytics is becoming easier (Malinova, 2019).

The Madoff firm acted as a third market provider. Its strategy allowed Madoff’s firm to bypass exchange specialist firms and to leverage over-the-counter retail brokers that would act outside of the monitored trades. Registries of listed shares are dematerialised or maintained using electronic records. Madoff started the practice of payment for order flow (PFOF). The practice allows the dealer to pay a broker for the right to execute a customer order. In effect, it is a form of kickback that is questionable but still considered inside the law. Allen Ferrell had noted the problems with such processes and practices well before the Madoff fraud. The author considered it one of the most intractable and pressing issues in the securities regulation environment (Ferrel, 2000). In a typical arrangement, the securities market pays a broker anywhere from $0.01 to $0.03 each buy or sell order. Such an amount may seem insignificant, but in high-frequency and high-volume trading, it can add up to millions of dollars in kickbacks per year for the issuing party.

In part, such a kickback scheme provides an incentive for the broker to overlook any incongruity that may exist. The broker earning millions of dollars in overpayments has an incentive not to look too deeply into the transactions. If the broker were to complain, much of their income would disappear. As a result, the Madoff firm continued dealing with a select number of brokers who they groomed into accepting money to process problematic orders where the broker would not look too closely at the quantities or losses.

There is a social misalignment when it comes to how we look at people who are making a lot of money and investing publicly. Madoff was first investigated under allegations of fraud in 1992. Madoff was running a firm called Avellino & Bienes. When investigated, the firm returned the money to the people who had complained. The SEC then dropped the case. Later, in 2004, lawyers at the SEC Office of Compliance Inspections and Examinations (OCIE) found numerous inconsistencies and made recommendations for an investigation into the Madoff firms. Individuals formed personal relationships with the Madoff family, and one of the SEC officials ended up marrying Shana Madoff in 2007. Such entanglement ended the 2003 investigation (Quisenberry, 2017).

It had been noted that if the SEC had merely investigated the central securities depository, the stock records would not have checked out. In other words, Madoff and the firm were keeping multiple sets of records; the records reported publicly to investors did not match the sale records held at the depository trust company that managed the records (Heydenburg, 2015). The US securities market is highly automated. The same level of integration and automation was already the case well before the Madoff scandal (Domowitz & Steil, 1999). The integration of not only automated trading but the distribution of information concerning trading activity was well and truly entrenched in the New York markets two decades before the Madoff scandal (Ruder & Adkins, 1989). Such information was widely disseminated and accessible by the regulators and the clearing companies (Mooney, 1992).

The question must then be posed as to why regulators such as the SEC failed in their duty. The losses attributed to the Bernie Madoff case exceed US$20 billion. Thousands of individuals lost their pensions, and many organisations ended up going bankrupt. At one point, the Ponzi scheme meant investors were owed over US$50 billion, and if action had been taken earlier, the scandal would have resulted in only a fraction of the final losses (Henriques, 2018). In part, it stems from investor greed. When a firm makes unexplained excessive profits for decades on end, it must start to raise red flags; yet it did not. Although a few people had questioned the firm, very few acted or even moved their money.

As Ortner (2019) notes, one of the significant aspects of such fraud stems from kinship relations. When SEC officials get involved in personal relationships with individuals under investigation, it demonstrates a discernible conflict of interest and failure in regulatory governance. As Jackson (2010) rightly discerns, it was the actions of a zealous individual and whistle-blower that led to the collapse of this financial fraud when this occurred. Investigators had sought to demonstrate that an individual could not make consistent returns of over 20% above the market year in, year out for over a decade. Harry Markopolos had sought to promote an investigation into the Madoff firm for about a decade before the collapse.

The culture within the Madoff firms demonstrates how greed and a lack of accountability can twist entire corporate groups. Stolowy et al. (2011) detail how abuses of personal trust and promises of wealth can develop into an environment that promotes a toxic culture. In the analysis of the inner circle of the Madoff firms, Adair (2016) built the case on how the individuals and the firm were slowly groomed into sustaining the fraud. Here, the firm groomed individuals using promises of wealth and bonuses into completing more and more unethical actions. Those in the corporation maintained multiple sets of corporate books. With these multiple books, the Madoff firm had separate reporting to the SEC and investors and a secret set of books that would monitor the internal state of their Ponzi scheme. Consequently, it is easy to determine that the employees of the firm knew and understood what they were doing. As Mboga (2017) demonstrates, employees within the Madoff firm disguised US$50 billion of sales and loans in a Ponzi scheme that totalled over US$64.8 billion at one point.

Schwartz (2013) analyses multiple high-profile cases, including the Madoff firm. When unethical activity is both endemic within the firm and promoted from the top, it is unlikely to be addressed. To counter such activity, a firm must include a core set of ethical values that are infused throughout the organisation. They must be implemented within policies processes and practices. Next, organisations require a formal ethics programme, one that is based on a public code of ethics, ethics training, and the appointment of an individual acting as an ethics officer within the company, who has the power to act. Next, ethical leadership must be thorough and continuous. Without a comprehensive ethics programme and the appropriate tone from the top, the necessary elements that lead to the maintenance of an ethical corporate culture within a firm will not be developed.

Most critically, we are talking about an area where technology can help. In every significant financial fraud, the accounting systems have been inadequate. The Madoff firm had multiple sets of books. WorldCom had easily detected and invalid accounting-system breaches. As a result, it becomes simple to say that we need to stop relying on the mere actions of individuals and the placement of trust in regulators. The compromise of individuals associated with the SEC demonstrates the problem of placing reliance on humans when faced with excessive rewards.

It is possible to automate accounts. It is possible to publish a single auditable ledger. And if the IRS and SEC within the US environment had required a digitally signed master record of all transactions, it could have been publicly audited with the result that the discrepancy in the trades would have been instantly recognised and detected—decades before the scandal. The simple answer is to start utilising technology in the determination of financial fraud. Fraud relies on opportunity. If you remove opportunity, you minimise fraud.


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