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Apr 23, 2009

Bernie Madoff never got caught—and other mysteries from the biggest-ever Ponzi scheme.

By FORTUNE; Illustrations by Jeffrey Smith

The outlines of Bernie Madoff’s story are well known: a self-confessed, decades long, $65 billion investment scam, partially disguised by a respected, legitimate trading business.
What may never be known are the answers to two questions: how did he do it? And why wasn’t he caught?
Veritable armies of forensic accountants, lawyers and investigators are searching for clues to the puzzle that Bernie left when he pleaded guilty and moved from his 4,000 square foot New York penthouse into a 76 square foot jail cell. It could be years before all the pieces are found—or never. 
Here’s some of what’s known so far.

Ne’er the Twain Shall Meet

The Madoff empire, housed in Manhattan’s so called Lipstick building (it resembles a giant, cylindrical lipstick tube) consisted of two businesses.  
One was a large, respected Wall Street trading company that was a pioneer in electronic trading; the trading floor was on 19 and the software programmers worked on 18.
The other, on the 17th floor, was a mysterious investment company whose claim to fame—before Madoff confessed—was its ability to provide steady returns to investors, year-in and year-out.
The two were kept mostly separate.
Bernie and his brother Peter didn’t invent electronic trading, but they were among the first to design software that could trade stocks electronically in seconds. 
“If you have a brokerage firm that advertises they will get their trade done with you in five seconds,” says one longtime employee, “that’s because our system will get it back to them in two. That’s the innovation.”
Trading through Madoff was not only fast—it was cheap. The allure for customers was obvious. And these ultra-cheap, fast electronic trades were among the things that helped discount brokers, like Schwab and Fidelity, slash commissions and bring stock trading to the masses.
By the early 1990s, Madoff’s firm was handling 9 percent of the New York Stock Exchange’s daily trading volume.
However, growing competition and changing regulations gradually eroded the firm’s profit margins.
Indeed, among the charges to which Madoff pleaded guilty in March were three counts of illegally transferring at least $250 million from the fraudulent investment business to the legitimate trading business.

Bernie’s World

The investment operation, separated from the rest of the business by security that few employees could penetrate, seemed like a galaxy far removed from the rest of the company.
Employees in the rest of the firm knew there was a different, lucrative business on half of the 17th floor, but they didn’t know exactly what it did.
“We were all aware of this hedge fund that had great returns for 20 years,” recalls one trader. “We knew it was statistically impossible [to have the steady gains for which Madoff became famous]. We always kind of wondered, how the hell does he do it?”
Bob McMahon, a former Madoff tech consultant, dubbed the operation “Bernie’s World.” It could have been called  “Fantasy Island.”
The people who worked there were a different breed from the overachievers who worked in the trading operation. Many of the employees had been hired straight out of high school.
“This was the only world they ever knew,” says McMahon. “It was the old analogy of mushrooms: you keep them well fed and happy in the dark.”
In theory, Madoff’s investing genius consisted of knowing the best time to enter or leave the market.
Ostensibly, every so often Madoff’s team was “buying” or “selling” massive quantities of stocks and options. Each time that happened, the 17th floor team would spring into action and spend all-nighters churning out trade confirmations for thousands of customers.
Unfortunately for the investors, there were no trades behind those paper trails—at least for many years.

A Private Club

Madoff was able to perpetrate his fraud for so long in part because of his preference for marketing by word of mouth. It was a private club—one that became ever more desirable because of Madoff’s seeming reluctance to admit new investors.
One of the tacit conditions, as we know now, was an understanding that information about Madoff investments was to be held closely. Most investors complied: who would want to risk losing their privileges?
Not many. What had started decades before as a small-time recruiting effort at country clubs had long since gone global, lured by the call of steady 10 to 12 percent returns. Massive international institutions, such as Grupo Santander, Fortis Bank, and the Abu Dhabi Investment Authority, some unwittingly, ended up placing—and eventually losing—money with Bernie.
How much did he raise?
According to experts, the actual amount investors gave to Madoff over the years is probably around $20 billion.  That’s far less than the widely cited $65 billion, which is a tally of the stated value of all the statements of every Madoff account holder as of November 30.
That number, like so much else about Bernie Madoff, was fictional.

The End Game

For a time, Madoff seemed to defy the worst collapse since the Great Depression. While double-digit monthly drops suddenly became common, Madoff was somehow eking out a heroic positive return, ostensibly 4.5 percent through October 2008.
In November he sat down with members of the American Jewish Congress, one of the nation’s oldest Jewish philanthropic organizations. The group’s president, Richard Gordon, asked how Madoff could be making money in one of the worst markets in history.
“I could explain it to you, Richard, but it’s really complicated,” Madoff replied evenly. “I’m a steady and true investor.”
Of course, he wasn’t, and the Ponzi scheme he had built was having trouble withstanding the onslaught of redemption requests. By early December, investors had demanded the return of some $7 billion.
On December 11, Madoff confessed his entire crime—first to his sons and then to prosecutors. (In between, he coolly attended his company’s holiday party at a local Mexican restaurant.)
On March 12, he pleaded guilty to 11 charges of fraud, theft, money laundering and perjury and now awaits sentencing.
The federal investigation proceeds. Less than a week after Madoff’s plea, the firm’s outside accountant, David Friehling, was charged with criminal fraud for years of signing off on phony statements. The charges did not assert that he knew of the Ponzi scheme. No one else has been charged with any crime.  
Investigators continue to try to locate Madoff assets—a bit more than $1 billion has been discovered so far. In all likelihood, however, they aren’t going to find much.
There are two virtual certainties with Ponzi schemes. The first is that they always collapse. The second, that the money is generally long gone by that time.

Money for Nothing

In 1919, an Italian immigrant living in Boston had an idea: he could make money buying large quantities of postage stamps abroad and sell them at a mark-up in the United States. Then he had what he thought was a better idea: raise money from investors for the scheme, but don’t actually buy the stamps. Just pay returns out of the money he raised, keep on raising new money to pay off old investors—and pocket the difference.
Charles Ponzi’s scheme started in November and collapsed in August of 1920. The problem: he promised his investors that they would see a 50 percent return in 45 days—which meant he had to raise new money at an unsustainable pace.
The Boston Post uncovered the scheme and won the 1921 Pulitzer Prize Gold Medal for Meritorious Public Service.  For his troubles, Ponzi ended up serving more than 10 years in prison and was deported back to Italy in 1934.

Who was Bernie Madoff?

People believed in Bernie Madoff. Nasdaq made him its chairman; the Securities and Exchange Commission appointed him to industry panels; Congress invited him to testify.
Long before Madoff attained infamy as a criminal mastermind, he earned respect as a pioneer in electronic trading. The irony was that he didn’t even use email—he could barely turn his computer on.  But he and his brother built Bernard L. Madoff Investment Securities into what was long considered a charmed and important Wall Street player.
Madoff was a master talker and charmer. His role in the company was to glide in at the end and make peace, says Christopher Keith, a former chief technology officer of the New York Stock Exchange, who compares him to the biblical Solomon: “He was the type of person who was sort of above the fray—the wise man.”
He had his quirks, and to a startling extent they colored the firm—quite literally when it came to the décor. Virtually every piece of furniture, equipment, or decoration was black    or gray.
Madoff was even more obsessed, if that’s possible, with cleanliness. Even while he was responsible for billions of dollars, it was not uncommon to see him dusting his office or the two-foot sculpture of a screw behind his desk. A third Madoff fixation was that everything needed to be symmetrical and in straight lines.
Today, Madoff is a diminished figure, a sad version of the vital, regal person who for years could charm money out of seemingly everyone. Even if he doesn’t get the maximum 150 years when he is sentenced on June 16, whatever he does receive will effectively be a life sentence for the 71 year old.

Meet the Family

One of the most widely made assumptions is that various family members “had to know” what was going on. Representatives for all the family members have declared their innocence.
Peter Madoff, now 63, is Bernie’s brother. He was the head of compliance and de facto chief operating officer for the Madoffs’ original, legitimate trading business. A lawyer by training, he was the driving force behind the firm’s technological innovations. Though he couldn’t write code, he could discuss software algorithms with surprising facility.
He was the hands-on brother, the one immersed in detail, and most of all, the designated tough guy. “Peter was like five miles of bad road,” says Christopher Keith, a former chief technology officer of the New York Stock Exchange.
Ruth Madoff is Bernie’s wife of 50 years, and was an effervescent and gracious presence at a firm that cultivated a family feeling. Ruth has insisted her husband didn’t inform her of the fraud until the day before he was arrested.
Andy Madoff, 43, was considered the more cerebral of Bernie’s two sons, with a better understanding of complex technological issues. After a bout of lymphoma a few years ago, Andy ceased working on the firm’s original trading operation and focused on other projects, such as energy trading.
Mark Madoff, 45, was in charge of the main trading business at the time the firm collapsed. If he didn’t have his younger brother’s intellect, he had the people skills that marked him as heir to the Madoff throne. A frat boy, he was easygoing and low-key.


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