Page last updated at 15:13 GMT, Tuesday, 16 December 2008

False security led to Madoff scandal

By Neill Blundell
Head of financial crime, Eversheds

The financial services world has been rocked by a fraud of spectacular dimension.

Neill Blundell
Neill Blundell of Eversheds law firm

One of the most highly-regarded hedge fund managers, Bernard Madoff, has allegedly cheated his hedge fund and investment banking businesses out of an estimated $50bn.

What effect does this have on companies and investors on this side of the Atlantic?

In the global marketplace that we live in, the institutions that we bank with and invest our savings with may have invested in Mr Madoff's fund.

Hedge funds work by allowing investors to deposit a set amount for a defined period. Usually there will be a "lock-in" for about six or 12 months, during which time investors cannot withdraw their money, but can monitor how their investment is performing.

However, the fund can perform positively or negatively, meaning that there can be a loss. That is the risk.

A good hedge fund will buck trends and make money even when business within the market place is declining.

This is known as making "absolute money". Funds that can do this are very successful and will attract further investors wanting a slice of the action.

'False security'

In Mr Madoff's case, it appeared to investors and the market that his hedge fund was successful.

Investors were receiving up to 12% in promised returns and this, combined with Mr Madoff's reputation as a highly respected businessman, gave investors a sense of security.

But it has proved to have been a false sense of security. The truth is that Mr Madoff was misrepresenting the success of his hedge fund. He was sending fraudulent paper copies of his trading records to show false returns.

In fact, the fund was not profitable at all - and had not been for some time - but Mr Madoff was using money from new investors to pay current investors, so maintaining the image of a successful fund.

While the wholesale financial markets were buoyant, it appeared not to matter. Investors were getting their money.

However, as the wholesale funding market dried up, there were no longer any new investors, Mr Madoff could not pay his old investors and the fraud was discovered.

In essence, this was a pyramid scheme, in which new investors were essential to fuel the fraud.

Due diligence

What is shocking is that such a huge fraud has been committed and that it went undetected for so long.

The US authorities are not known for a lax approach and it appears that the Securities and Exchange Commission investigated Mr Madoff's businesses twice, once in 2005 and once in 2007. During these investigations, no fraud was discovered.

UK banks and financial institutions are among those that "bet" on Mr Madoff's fraudulent scheme and, so, lost billions of "our money".

These institutions' liquidity could be seriously affected by such losses and the impact of this will reverberate through the UK market place. We will have to see whether the fall-out leads to direct losses for UK investors and leads to any financial institutions becoming insolvent.

This is clearly a US-led investigation, but our UK authorities are entitled to review the conduct of any UK citizens or institutions. The Serious Fraud Office will, therefore, be looking very closely at Mr Madoff's fund and working with its US counterpart to discover the extent of the fraud.

In difficult economic times, as in any others, we expect our banks and financial institutions to do adequate due diligence. One question that needs to be answered is, how did they get it so wrong?

In the future, investors will want to ramp their checks on those that manage such funds, as well as the accounting practices that underlie them, if they want to protect themselves from such frauds.

Independent verification may also become necessary, as well as imposing strict conditions on fee arrangements.

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