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December 18, 2008 4:58 PM

Madoff's Supposed Scheme: The Perfect Ponzi

Posted by Brian Baxter

Edward_davis

The alleged Ponzi scheme that federal prosecutors charge Bernard Madoff with running isn't the first and it won't be the last.

The scheme popularized by the likes of Charles Ponzi continues to nab unwitting investors even today.

The Am Law Daily caught up with Edward Davis, an international asset recovery lawyer with Miami boutique Astigarraga Davis, to discuss the sinister beauty of the Ponzi's design.

According to prosecutors, Madoff has been running this scheme for years. Why did it implode now?
It's pretty common that these Ponzis break during down economic times. It's like people stealing cars and dumping them in a lake. As long as the lake is at full level, you never see them. But when the level of the lake goes down, you start seeing cars pop out. And you've got all these rusted hulks that you didn't realize were stolen cars.

So we're going to see more of these?
Oh yes. We've already seen a huge one break in Colombia three weeks ago for hundreds of millions of dollars. We had another case down here in Miami where a guy named Andres Pimstein used the University of Miami as a credibility-builder for another Ponzi. Late last year we also had the Lou Pearlman case, another classic Ponzi scheme. And now we have [Madoff].

How widespread are Ponzis?
For everyone that we just talked about, there's probably ten more that we don't even know about. A lot of these things die a natural death because people are embarrassed and don't do anything about them. We actually just got a call about one where the money is in the Caribbean. It's an affinity case like [Madoff's] where the fraudsters prey on people of a particular religious group or organization. So they validate their own credentials through similar friends, relatives, or church or club members.

Are regulators doing enough to catch these guys?
That's what everyone wants to talk about right now. Personally I think you blame the fraudster first, the investor second, and then the cops. Ponzis are hard to find. I don't know what the SEC knew and didn't do [and vice-versa], but I believe from what I've read that [the Ponzi] part of [Madoff's] business was not the public part of his business. So it wouldn't have been easy to find.

Why are Ponzis difficult to uncover?
Because you need someone to tip you off. They're usually confined to a small group and are not public by their very nature. With [Madoff], apparently there was a legitimate piece of his business that was on the front side, but [the Ponzi] was run out of the back office. To me, the first person that needs to police the market is the investor, not the SEC. There's a fundamental investing rule: If it sounds too good to be true, it usually is. People forget about that and greed tends to take over.

What makes Madoff's scheme different from the average Ponzi?
It's unique in that it went on for so long and for such huge dollars. And also the quality and sophistication of the investors, who seem to have participated on both an individual and institutional level. That's pretty unique. Ponzis tend to be more affinity-based, local in nature, less visible, and for much smaller dollar amounts. In a way, the bigger it is, the more legitimate it seems, so the easier it is to perpetrate. Ironically, it's inversely proportional.

How is a Ponzi scheme structured?
Usually 25 to 35 percent of the 'take' goes to pay the front end of the Ponzi--those that come in first. So that means of the approximately $50 billion tied up [in Madoff], about $13 to $18 billion went to fund the front end. These folks are your de facto marketing force because they're getting great returns and telling all their buddies.

Are they complicit in the fraud?
No, most of the time they do so unwittingly. But in some Ponzi schemes there are shills within that talk up the Ponzi. In [the Madoff matter] it sounds as if he didn't need that because he got high-rollers and heavy-hitters to talk it up for him by paying them these relatively high, consistent returns in a market where other people weren't getting those returns.

What are the funds normally used for in a Ponzi scheme?
In most Ponzis, funds are not invested in the market or used to buy anything. Those running the scheme usually use them for their lifestyle. Wine, women, and song, right? You see this especially in places like Florida where people seek to avail themselves of our liberal debtor protection laws and make transfers to trusts and family members. Those are typical methodologies used by the fraudsters to make it difficult to go after the proceeds of the crime. Now some of [the Madoff funds] could have been lost in the market, but my guess is that a good chunk of it is offshore.

Assuming that's the case here, how do investors go about recovering those funds?
I specialize in representing victims in recovering offshore assets. I belong to a group under the International Chamber of Commerce in London called FraudNet, which is a group of lawyers that specialize in representing victims in transnational fraud. And we go after those kind of assets when people steal and secret proceeds of their crimes offshore. I've traced funds to the Isle of Man, Jersey, Guernsey, Hong Kong, [the British Virgin Islands], Switzerland, the Caymans, and the South Pacific to places like the Seychelles and Vanuatu. Panama is as popular as ever. And you see a lot of Russian money going to Cyprus and Israel.

Have you been approached by any potential Madoff victims?
I've been contacted by some lawyers who've been contacted, but not by [any victims]. Typically what happens is they tend to turn to a trusted lawyer they know and unfortunately by the time they get to me and they figure out that the money went offshore, they're already fatigued from spending a lot of money on lawyers. So many lose interest in going after their money.

The Ponzi scheme seems like such a classic formula for a fraud. Why does it keep recurring again and again?
Well, the concept is simple to understand and implement for the fraudsters. Generally speaking, you don't really handle products or true investments. They'll issue statements cranked out on word processors to make it look like your investments are doing well, and as long as you don't ask for your money back and are willing to roll it over, it works out just fine for them.

Unless of course, the economy goes bad.
That's right. The minute you hit a down economy and the back end falls out because you can't get anyone else to come in, that's when they fall apart. And you also get squeezed on the front end, because people need cash to meet other obligations. So they start calling to cash out. It's a tipping point. And there was nothing left in the middle because [Madoff] either lost it or squirreled it away and spent it. And [Madoff] got caught in the vice.

And investors get left in the lurch?
Yep. You see it more and more. People just assume it must be legitimate. [Madoff] just proves that it doesn't matter who you are, anyone can get taken.

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The thing is that Ponzi himself actually believed he could retrieve the money. Madoff was straight out fraud, deception and stealing.

Am I right in thinking that where a hedge fund holds non quoted assets and the valuations are "on the high side" on the basis of which new investors are coming in you have a quasi Ponzi scheme?

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