Risk Management in the Post-Madoff Era of Fraud

Pat Huddleston


May 1, 2011

Madoff-Chips-Elway-BradyFrom 1977 to 1982, Larry Wilcox was a television star, playing officer Jon Baker opposite Eric Estrada in the hit NBC television series CHiPs. When he left the small screen, Wilcox branched out into other business ventures. He remained far out of the limelight until October 2010, when the U.S. Justice Department charged him with participating in a microcap stock scam that involved bribing pension plan employees. In November 2010, Wilcox pled guilty to one count of conspiracy to commit securities fraud.

Wilcox’s fraud was a classic “pump and dump” scheme, in which the fraudsters control worthless shares of small companies, pump up the price of those shares with rigged trading and false press releases and then sell the shares to innocent investors. The SEC will stop dozens of such scams this year (and every year). Luckily, no investors lost money in the Wilcox case; the corrupt pension fund employees were actually undercover FBI agents.

Most pump and dump stories don’t end so well. In the late 1990s, Russian mob boss Semion Mogilevich — now on the FBI’s Most Wanted list — made the Toronto Stock Exchange and prominent Canadian politicians unwitting players in a $150 million pump and dump scam involving shares in Pennsylvania-based sham company YBM Magnex International, Inc., which was purported to be a worldwide manufacturer of industrial magnets. After the FBI and other authorities raided the company’s headquarters in 1998, exposing the fraud, its shares fell to zero. The fraud victimized not only individual investors, but also institutions, including mutual funds and the Ontario Teacher’s Pension Fund.

Whether it is a pump and dump scheme or any other scam, avoiding professional investment fraud is not easy. Professional con artists are well funded and as skilled in their craft as world-class athletes. Not falling victim begins with admitting that you are vulnerable. Investors who believe that they are too smart to fall for a scam are easy marks. Smart risk managers will admit their vulnerability to professional scams, conduct a disciplined review of all possible points of entry and not only construct bulwarks against that entry but also systems to detect the fraudsters who do slip past them.

The Bad Report Card
As dangerous as the professional con artist is, a respectable financial adviser or fund manager can be more so. Former hedge fund manager Sean Mueller, who defrauded 65 investors, including NFL Hall of Famer John Elway, out of more than $71 million, described the typical scenario at his December 2010 sentencing hearing:

“At the end of a quarter, a position went against me extremely fast, and I panicked. I sent out a fictitious statement to start this off, thinking I could make this back. It was the wrong choice. So a stressful job became even more. So I tried working harder, I tried trading harder, researching harder — 60 to 70 hours a week trying to make this back. It didn't work.”

We call characters like Mueller “bad report card fraudsters” because they succumb to the universal human impulse to avoid the consequences of poor performance. If the fraud lasts until the scamster cannot raise enough new money to satisfy existing investors, the company will be that much poorer for it. Catching bad report card fraudsters early is the key to mitigating losses.

Mueller’s scheme lasted eight years. Would an audit have stopped it earlier? Perhaps. But the annals of investment fraud are full of characters who fooled auditors. Auditors have an important role, but the risk manager who studies the history of bad report card fraudsters is more effective than one who relies on auditors alone. Training on the characteristics and habits of those who have managed to cover up bad report card fraud for a decade or more can help risk managers know when an investigation of the adviser or manager is a necessary supplement to audits.

The Ultimate Fraud Detection Computer
Unlike other industries, the fraud business never slumps, and the SEC has already begun enforcement actions against scams that began after the financial crisis of 2008. Fortunately for smart risk managers, new discoveries in how the human brain works have emerged as the post-Madoff wave of scams has been building. Risk managers can use these discoveries to develop a new approach to due diligence that is grounded in new evidence about how humans think.

In his 2009 book, How We Decide, Jonah Lehrer reveals that — contrary to the age-old wisdom — emotions are essential to effective decision-making. Among Lehrer’s examples is Tom Brady, the quarterback of the New England Patriots. When Brady drops back to pass, he has, at most, four seconds to release the ball; not enough time for all the thinking required. Instead, Brady responds to his emotions, according to Lehrer. When he looks at his first option he gets a negative feeling. The same with the second. When he looks at the third, he gets a flood of positive emotion and releases the ball. Touchdown.

Of course, Tom Brady wasn’t born with a brain that could lead him to MVP awards, Super Bowl rings and a Hall of Fame career. Rather, the emotions his brain sends forth are reliable because they are informed by his training and experience; this includes all of his the film study, each practice since Pop Warner and every pass attempt he has every made. While Brady has a great arm, it’s his brain that makes him so impressive.

Having spent more than 20 years protecting investors, I can tell you that a well-educated and trained human brain is the most effective tool for preventing and detecting investment fraud. The good news is that risk managers can acquire that kind of tool.

Smart risk managers will battle the post-Madoff wave of fraud with a post-Madoff appreciation for how humans behave and make decisions. They will become students of investment fraud. They will use case-based training regimens in their organizations. They will stay current on the most advanced con artist tricks. By doing so, they will be able to protect their companies from the tragic loop of history that allows mob bosses and Madoffs to prosper in every economic climate.
Pat Huddleston served as the enforcement branch chief of the SEC’s enforcement division from 1992 to 1996. He currently lives in Atlanta as founder and CEO of Investor's Watchdog, an investor protection company. You can read more from Huddleston on his company’s blog, Investor's Watchblog.