Rather than investors getting smarter, Ponzi schemes have actually become reasonably common since then. In 1985 it was revealed that a Ponzi scheme run by highly respected San Diego currency trader named David Dominelli had cheated more than a thousand investors out of more than $80 million. Greater Ministries International leader Gerald Payne claimed God was his investment adviser and would double the $500 million that 20,000 people invested in his fake precious metal business. Lou Pearlman, who created the boy bands *N Sync and the Backstreet Boys, swindled investors out of more than $300 million by showing them fake financial statements supposedly produced by nonexistent accounting firms to convince them to invest in the fictitious companies he created. In 2003, Reed Slatkin, cofounder of Internet service provider EarthLink, was sentenced to 14 years in prison for a Ponzi scheme that swindled investors out of approximately $250 million. In 2008, a Minnesota businessman named Tom Petters was accused by the government of swindling investors out of as much as $3.5 billion. Neil and his co-workers at Benchmark Plus had determined earlier that Petters was likely to be a fraud.
There were several reasons I believed almost right from the beginning that Madoff’s operation was a Ponzi scheme rather than front-running or even something more creative. We found out quickly that Madoff was continually on the prowl for new money—although obviously we had no idea of the full extent of that this early in our investigation—and by definition a Ponzi scheme requires a continuous flow of new money to pay old investors. If you’re front-running, you don’t need new money. In fact, raising additional cash cuts down on your own profit. Nor did it seem likely that Madoff was using the hedge fund as a vehicle for borrowing money from investors. Just like Charles Ponzi putting money in the bank at only 5 percent interest, why pay investors 1 to 2 percent a month or more for the use of their money when you can borrow it in the overnight markets much more cheaply? That made no sense to me, so I was pretty certain it was a Ponzi scheme.
Frank Casey disagreed completely with me. He felt just as strongly as I did about it, but he was certain Madoff was front-running. It has been my experience that front-running is common in the broker-dealer industry. It’s a form of insider trading, and the SEC allows it to go on because they know they can’t stop it. They would successfully catch two or three cases a year, and think they actually were accomplishing something. Meanwhile they let thousands of cases continue unmolested.
Front-running is the industry’s dirty open secret. Everybody knows it goes on. “Here’s what I think is really happening,” Frank said to me. “He wants to build the biggest, most powerful independent broker-dealer in the world. He wants to be the biggest market maker, and his biggest problem in doing that is a lack of capital. To take down the block trades, to handle 10 percent of the total volume of the stock market, he needs tremendous amounts of capital. So what he’s doing is putting out some fancy-ass story and he’s giving his investors some wild explanation of how he’s making money for them. What he’s really doing is using them to raise dumb equity.” That was a phrase Frank used to describe using investors’ money as equity on a highly leveraged basis to make a lot of money for himself. “He’s treating the equity as a loan. What does he care if he pays them one to two percent a month if he’s making one hundred percent or one hundred fifty percent annualized profit?”
What Frank was suggesting was that Madoff used the hedge fund investments over which he had complete discretion to produce profits from his broker-dealer. There were two ways we figured Bernie could have front-run his order flow. If a limit order came in to buy one million shares of IBM at a price of $100 or lower, Madoff could have put in his own order to buy the same number of shares at $100.01. He could then buy a million shares at $100.01 knowing that he had a firm order to buy those same shares at $100, so the most he could lose was a penny per share, or $10,000. However, if IBM went up, he could make unlimited profits. Of course, if a client came in and said, “Buy me one million shares of IBM at the market,” then Madoff could have a field day. For market orders all he had to do was buy one million shares of IBM first, which would drive the price of IBM up, and then sell the shares at a guaranteed profit to his trusting client.
Frank knew that as a broker-dealer Madoff printed his own trade tickets. Madoff could print phony tickets and use the cash as his capital base. That way he wouldn’t have to raise a lot of attention by continually going to the banks for short-term loans. And he needed the cash to build his broker-dealer. By 1999 most of the independent market makers had been sold to large firms, giving them tremendous cash resources. Madoff was pretty much the last of the large independent market makers. And while there were a lot of people wondering why he refused to sell his operation—he probably could have gotten more than a $100 million and he owned it by himself—he wouldn’t sell, so Frank argued that he needed
