Market Scams

Bernard Madoff – Ponzi Scheme

Incident:

It was in December 2008 that the biggest financial fraud in the history of the US came to light, this happened when Bernard Madoff, former Chairman of NASDAQ confessed to have been operating a 'Ponzi Scheme'. This affected a large number of investors, banks and had a huge impact on the already reeling US economy.

Analysis:

How Did The Fraud Happen?

Madoff confessed to having operated the Ponzi scheme through the investment management and advisory division of his firm, Bernard L. Madoff Investment Securities LLC (BLMIS).

The division was supposed to invest client’s money in shares of common stock, options, and other securities. It was also promised that whenever clients wanted it, the principal amount of the investment and the profits earned till date would be returned to them. However, instead of investing the money in the securities market, the investment management and advisory division of BLMIS deposited the entire amount in a bank account in Chase Manhattan. Moreover whenever a redemption request was made, it was fulfilled using the pooled money kept in the bank account. However the fund did not receive many redemption requests because of the steady returns that it delivered.

Strategy?

Rather than offer high returns to all, Madoff offered modest but steady returns (10%). The investment method was marketed as "too complicated for outsiders to understand". He was secretive about the firm’s business, and kept his financial statements closely guarded. Madoff was a "master marketer" and his fund was considered exclusive, giving the appearance of a "velvet rope". He generally refused to meet directly with investors, which gave him an "Oz" aura and increased the allure of the investment. Some of Madoff investors were wary of removing their money from his fund, in case they could not get back in later.

Madoff sales pitch, an investment strategy consisted of purchasing blue-chip stocks and taking options contracts on them, sometimes called a split-strike conversion or a collar. Typically, a position will consist of the ownership of 30–35 S&P 100 stocks, most correlated to that index, the sale of out-of-the-money 'calls' on the index and the purchase of out-of-the-money 'puts' on the index. The sale of the 'calls' is designed to increase the rate of return, while allowing upward movement of the stock portfolio to the strike price of the 'calls'. The 'puts', funded in large part by the sales of the 'calls', limit the portfolio's downside.

In 1982, he began using futures contracts on the stock index, and then placed put options on futures during the 1987 stock market crash.

Red Flags:

A few analysts performing due diligence had been unable to replicate the Madoff fund's past returns using historic price data for U.S. stocks. The only conclusion that they could arrive on was that the scheme was either front running or a ponzi scheme.

**Front Running – Illegal practice of a stock broker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers. When orders previously submitted by its customers will predictably affect the price of the security, purchasing first for its own account gives the broker an unfair advantage, since it can expect to close out its position at a profit based on the new price level.

**Ponzi - Fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned.

According to the industry experts, both regulators and investors neglected some important facts which enabled Madoff to carry on with this fraud for a long time. His fund had proved to be a consistent performer over decades. The fund had had only five losing months since 1996.

One Madoff fund, which described its "strategy" as focusing on shares in the Standard & Poor's 100-stock index, reported a 10.5% annual return during the previous 17 years. Even at the end of November 2008, amid a general market collapse, the same fund reported that it was up 5.6%, while the same year-to-date total return on the S&P stock index had been negative 38%.

Complaint:

Financial analyst and whistleblower Harry Markopolos complained to the SEC's Boston office in May 1999, telling the SEC staff they should investigate Madoff because it was impossible to legally make the profits Madoff claimed using the investment strategies that he claimed to use. In 2005, Markopolos sent a detailed 17-page memo to the SEC, entitled “The World's Largest Hedge Fund is a Fraud”.

Aftermath:

The scheme began to unravel in December 2008, as the stock market continued to plunge. Subsequently, as the general market downturn accelerated, investors tried to withdraw $7 billion from the firm, and in the weeks prior to his arrest, Madoff struggled to keep the scheme afloat. To pay off those investors, Madoff needed new money from other investors.

As a last ditched effort Madoff approached several high profile clients saying that he was raising money for a new investment vehicle & needed ($500 million -$1 billion). Finally he decided that the firm pay out 170 million dollars in bonuses from $200 million in assets that the firm still had. He was asked to explain how he could pay bonuses if he was having trouble paying clients & this was when he confessed to have been operating a “Ponzi scheme” which was “one big lie”

There has been no bailout for Madoff’s investors & he has been sentenced to 150 years in prison.

Sumitomo Corporation – The story of Copper derivatives

Incident:

This study is a classic example of – ‘Running on the top of the tiger not knowing how to get off without being eaten.’

Yasuo Hamanaka, the chief copper trader at Japan's Sumitomo Corporation caused $2.6 billion losses to the company through his unauthorized trading activities in the physical and futures market in copper at the London Metal Exchange. It was the largest unauthorized trading-related loss incurred by any Japanese company during that time.

Analysis:

Initial Profits – Result of Manipulation

Yasuo Hamanaka the head trader of Sumitomo Corporation manipulated the world copper prices through his operations on the LME (London Metal Exchange) copper futures market over the period of 1991-95. This artificial increase in copper price resulted in increased profits for Sumitomo Corporation from selling copper. Moreover Hamanaka was reporting inflated trading profits to the top management by showing invoices of fictitious option trades, which he had created through a nexus with some brokers. Whenever any hedge fund or speculator who was aware of manipulation tried to take short positions, Hamanaka invested more money into his positions thus sustaining the high price. However despite these faulty practices no action was taken against Hamanaka because of the profits he generated for the company.

Lack Of Transparency

Successful manipulation of the copper prices was possible due to lack of transparency in the reporting positions of large clients at LME.

Action Taken Too Late

During late 1995, due to increased copper production facilities particularly in China, copper prices started declining. This was ominous for Sumitomo as they had long positions in the futures market. Hamanaka failed to get rid of his positions. He tried to recover the losses by taking huge positions in copper commodity futures on the London Metal Exchange. However the huge volume of trading attracted the attention of the exchange and it gave a warning to Hamanaka. Hamanaka then struck a deal with Merrill Lynch for US $150 Mn, which enabled him to trade via Merrill at LME. Later however when LME started investigating on the alleged manipulation of copper prices Hamanaka was taken off from his position of head trader. This brought the short traders and hedge funds into the act causing the copper prices to fall further on LME.

Lack of Proper Managerial Supervision and Operational Control Systems

Transactions were made solely by Yasuo Hamanaka himself. He abused Sumitomo's name, and continued on with unauthorized trading and even borrowed money from several banks without any authorization from his seniors. Hamanaka a middle-level manager got so much power only because of the fact that he had helped Sumitomo garner a lot of profits in the past. He was given a great deal of responsibility by the company, a star trader status and his only regulators were overseas, far from Tokyo.

Lack of Monitoring

Trading in commodities and financial instruments was not being properly monitored by the government regulatory agencies and by the companies undertaking these transactions. This conclusion can be derived from the fact that in a short span of 16 months three major derivative disasters were seen:

· UK's 233-year-old Barings Bank, which lost $ 1.4 bn in February 1995 due to Nick Leeson's unauthorized trading activities in the Singapore futures market

· Japanese bank Daiwa which lost $1.1 bn in America's Treasury bond market in September 1995 due to the unauthorized trading activities of Toshihide Iguchi.

· Japan's Sumitomo Corporation $2.6 billion losses due to unauthorized trading activities in the physical and futures market in copper at the London Metal Exchange.

The debacle was the result of Sumitomo's poor managerial, financial and operational control systems. Due to this, Hamanaka was able to carry on unauthorized trading activities undetected by the top management. The vesting of excessive decision power on a single employee and failure to implement the job rotation policy were the other reasons cited.

Damage Control Measures

In order to control mounting losses, Sumitomo began aggressive liquidation of its uncovered positions in the copper physical and futures market under its new president Kenji Miyahara. It cancelled its plans to buy back 20 million of its shares and award Yen 120 million ($1.1 million) of bonuses to its senior managers. Sumitomo was able to overcome the losses since it had a net worth of $6 bn and another $8 bn in hidden reserves. The losses estimated to be $2.6 bn amounted to only 10 per cent of Sumitomo's annual sales.

Crazy Eddie-The Series of Frauds

Incident:

By June 1988, Crazy Eddie's suppliers were demanding the liquidation of the company, so they could recover money owed to them. In 1989 they would get their wish. The closing of Crazy Eddie began in March 1989, as the company shuttered 17 of its 43 stores. On June 6, 1989 Crazy Eddie was served with a petition by five of its creditors, who had not been paid a total of $860,000 they were owed, which sought to have the company forced into bankruptcy. The company originally planned to fight the petition and file for dismissal, but fifteen days later Crazy Eddie voluntarily filed for Chapter 11 bankruptcy protection. Company president and CEO Peter Martosella cited problems created by the creditors' position (which he termed "ill-advised"), but said business would be conducted as usual at the remaining 26 stores and that Crazy Eddie was still a strong franchise. The company vowed to stay in business but despite Martosella's assertions Crazy Eddie continued to falter.

How did frauds happen?

Almost from the beginning, Crazy Eddie's management was engaged in various forms of fraud. The Antars deliberately falsified their books to reduce (or eliminate) their taxable income. They also paid employees off the books, and regularly skimmed thousands of dollars earned at the stores. For every $5 Crazy Eddie reported as income, $1 was taken by the Antars. In 1979, the Antars began depositing much of this money (hundreds of thousands of dollars) in Israeli bank accounts. The Antar family skimmed an estimated $3 million to $4 million (US) per year at the height of their fraud. In one offshore bank account, the family deposited more than $6 million between 1980 and 1983.

By 1983, it was becoming more and more difficult to hide the millions of illicit dollars. The Antars discovered the way to cover up their growing fraud was to take the company public. In preparation, Eddie Antar initiated a scheme in 1979 to skim less each year. Since more income was actually being reported, this had the effect of showing drastically increasing profit margins. While company's actual profits (taking into account skimmed profits increased approximately 13%, reported profits rose nearly 171%) from 1980 to 1983.

A district manager who was paid $5,200 per year "on the books" and $50,000 per year "off the books" was now paid "on the books" over $75,000 per year on the books, instead of receiving any "off the books" compensation. Therefore, according to Crazy Eddie's books and records such a person's annual salary suddenly went from $5,200 per year to $75,000 per year.

Despite the misgivings of people closely associated with Crazy Eddie, the company held its initial public offering on September 13, 1984 (symbol: CRZY). Shares of the company sold initially for $8. By early 1986, Crazy Eddie stock was trading at more than $75 per share (split adjusted).

Eddie recruited his cousin, Sam E. Antar (known as Sammy), to assist the company with its fraud. In 1986, he was named CFO of the company. Sammy was informed that there was a $3 million deficit from the previous year's inventory fraud that needed to be hidden. Additionally, he was instructed to find ways to show a 10% growth in sales.

One of Sammy's major schemes was a money laundering operation later known as the Panama Pump — money that the Antars had deposited in Israeli banks was transferred to bank accounts in Panama. These accounts, opened under false names, then drafted payments to Crazy Eddie. This money was largely used to inflate same-store sales figures for the company.

As a public company, Eddie, Sammy, and others engaged in increasing amounts of inventory fraud to increase reported profits and inflate the value of Crazy Eddie stock. For the fiscal year ended March 1, 1985, Crazy Eddie falsified inventories by $3 million. The next fiscal year, that amount increased to between $10 and $12 million.

Eddie Antar and his father Sam M. Antar wanted to sell over $30 million in stock by the first week of March 1986 at the highest possible price. Therefore, to meet analysts' sales expectations, Sammy conceived of a plan known as the "Panama Pump."

Eddie Antar and other family members advanced $1,500,000 to Crazy Eddie from their secret bank accounts in Israel which contained funds skimmed while Crazy Eddie was a private company. Those funds were first wired from Bank Leumi Israel to Bank Leumi Panama (both countries were bank secrecy jurisdictions).

After the funds were transferred to Panama, another family member withdrew those funds from Bank Leumi in the form of drafts or non-negotiable instruments, to avoid violating disclosure laws on the movement of funds into the country.

The bank drafts were issued in amounts ranging from $25,000 to $100,000 in order to make it easier to deposit such drafts in each comparable store bank account and conceal the phony sales.

Since Crazy Eddie’s weekend checks from sales to customers were deposited on Monday anyway, there was no problem including such bank drafts with the weekend sales proceeds. The bank drafts were dated before the fiscal year ended.

Also, another $500,000 in currency from Antar family mattresses that did not make its way to Israel was deposited in the same store sales.

Finally, a sale of $200,000 to another retailer called “trans-shipping” was counted as a retail sale and included in same store sales.

The sum total of $1.5 million in bank drafts, $500k in currency, and $200k from counting a trans-shipping sale as a same store sale, artificially increased same store sales in total by $2,200,000 for fiscal year 1986 and reported profits by $2 million.

In Q4 1986, Crazy Eddie reported a 14% same store sales increase, instead of a 9% same store sales increase, due to the "Panama Pump" and other schemes described above. Likewise, Crazy Eddie reported a 10% same store sales increase for January and February 1986, instead of the 4% same store sales increase due to the “Panama Pump.” As a result of the “Panama Pump” fraud, Crazy Eddie’s reported same store sales for January February 1986, met analysts’ expectations for that period.

To continue the same store sales inflation, a scheme to sell (trans-ship) merchandise to non-retail customers who were not end users, such as other retailers and wholesalers, was advised and such sales were counted as if they originated from those comparable stores. That scheme is known as "channel switching."

Those trans-shipping sales originated from the main office. However, such sales were counted as if they originated from comparable stores as retail end user sales.

The trans-shipper issued a series of checks in small denominations for their purchase of merchandise from Crazy Eddie instead of issuing one large check per order. The small checks (usually in denominations of $10,000 - $20,000) were deposited into the bank accounts of the comparable store sales and treated as a regular “off the street” customer retail channel sale.

Analysis:

Methods of doing the frauds:

Fictitious revenues: The most common way companies create fictitious revenues is to dummy up sales that did not occur. The accounting transaction created is a credit to sales with an offsetting debit to accounts receivable, which boosts both assets and income. In the Crazy Eddie’s case, the audit trail was easy to fake. Antar’s underlings prepared phony invoices showing merchandise sales. Three major suppliers, beholden to Crazy Eddie’s for large volumes of business, cooperated. When auditors attempted to confirm some of these receivables, the vendors would—at Antar’s behest—lie. Obviously, with such a conspiracy, it would have been difficult—if not impossible—for the auditors to easily uncover such a scheme.

Fraudulent asset valuations: Although any asset can be fraudulently valued, the most frequent manipulations occur in inventory. In the Crazy Eddie’s fraud, Antar overvalued inventory by $80 million, and employed some pretty outrageous tricks to get there. He and his conspirators “borrowed” merchandise from suppliers to boost the ending inventory count. These were the same suppliers who confirmed Crazy Eddie’s phony receivables. Eddie convinced the suppliers to simply ship merchandise to the Crazy Eddie’s stores, and hold the billing until after the end of the accounting period. They also shipped stock from one store to another so it could be double-counted. And, most outrageous of all, they got into the auditors’ desk and altered inventory count sheets in the work papers to increase the numbers.

Timing differences: Another way companies overstate assets and income is by taking advantage of the accounting cutoff period to either boost sales and/or reduce liabilities and expenses. Antar routinely told his stores to hold the books open past the end of an accounting period to falsely inflate sales revenues. Conversely, as detailed below, the liabilities for any given period were normally not recorded until the next period.

Concealed liabilities and expenses: Unfortunately for the CPA (Certified Public Accountant), it is all too easy for a client to conceal liabilities. After all, it is easier to audit something that is there rather than something that isn’t. In the Crazy Eddie’s case, Sam E. Antar, the CFO (and Eddie’s nephew), regularly stashed unpaid bills in his desk. The liabilities would be either entered after the yearend or held for long periods without being recorded. As a result, Crazy Eddie’s never did know what it really owed, and neither did the auditors.

Improper disclosures: Generally accepted accounting principles (GAAP) require adequate disclosure in the financial statements. Any material fact not covered in the financials should be disclosed in accompanying footnotes. Sam Antar—a former CPA and auditor—managed to change accounting methods simply by altering two words. In one year, the footnotes stated that certain income was recognized when received (cash basis). The following year, Sam removed “received” and substituted earned (accrual basis). The deception went unnoticed by the auditors, and it had the intended effect of boosting income. A careful review of the footnotes from year to year would normally detect such a simple—but in this case, effective—scheme.

The rationale behind the fraud:

Greed

The whole purpose of the establishment of this electronic consumer products chain was to achieve maximum wealth by all the possible means. The entire Antar family was involved in the frauds and till the company went into bankruptcy, there were lots of frauds which became evident and CEO was sentenced with 8 years of imprisonment and fined to the tunes of $150m.

Incentives and opportunities

Crazy Eddie committed crimes simply because they could. Criminologists like to analyze white collar crime in terms of the 'fraud triangle' - incentive, opportunity, and rationalization. They had no rationalization. Simply put, the incentive and opportunity was there, but the morality and excuses were lacking. They never had one conversation about morality during the 18 years that the fraud was going on.

Lack of Policy Control

Unfortunately, policy makers in Washington and even Crazy Eddie's former auditors apparently have not learned any lessons from the past and continue to make white-collar crime easy for the criminals. For example, the Dodd-Frank Act watered down Sarbanes-Oxely by exempting small companies from internal control audits. Crazy Eddie would have been exempted under those provisions, too. KPMG (Crazy Eddie's former auditors) was cited by the United Kingdom’s Financial Reporting Council for signing off on audits too early, the same mistake they made at Crazy Eddie.

Amaranth Advisors

Background

Amaranth Advisors LLC (Amaranth) was a US based hedge fund incorporated in 2000 by Nick Maounis (Maounis). Initially, Amaranth used conservative investment strategies like arbitrage. When several hedge funds started using similar investment strategies, the resulting profitability came down. Maounis then shifted Amaranth's focus to energy trading. In mid 2004, Maounis hired Brian Hunter (Hunter), an energy trader who was working for Deutsche Bank energy trading desk. Hunter started generating good profits in energy trading. He generated US$ 1 billion profits in 2005. Hunter's trading strategy in 2005 was believed to be based on historical returns as well as on weather predictions. He used excessive leverage and invested in natural gas derivatives on NYMEX and ICE in 2006. However, his strategy went wrong and prices of natural gas contracts moved in opposite direction to his estimates. That led to margin calls from Amaranth's lenders which it could not meet and eventually had to windup with US$ 6.6 billion losses.

Trading Strategy

Amaranth’s trading strategy followed by Hunter was long winter and short non-winter natural gas futures contracts. Hunter repeatedly used borrowed money to double up his bets. Buying more futures contracts of the kind his fund already owned supported their price by increasing demand, propping up paper gains. But that support only lasted as long as Amaranth and its lenders were willing to spend cash to buy more contracts.

( Refer Annexure I ,Amaranth’s Positions )

Historical returns from similar positions held by Amaranth in previous years yielded profits as natural gas supplies were disrupted due to hurricanes like Rita and Katrina and natural gas prices went through the roof. This earned Amaranth USD 1 billion profits and Hunter was labelled as star trader. Hoping for the repeat performance Hunter again took went long on the natural gas contracts leveraging their position 8:1. Hunter had put 50% of the USD 9 billion hedge fund at stake on natural gas. But that year US did not experience any major storm and on the back of increased supplier the natural gas prices plummeted. This gave a body blow to the hedge fund and the firm shed USD 6 billion in losses.

Risk Management:

Amaranth’s risk exposure can examined in two dimensions of risk - liquidity risk and market

Risk.

§ Market Risk

It is found that Amaranth may have been chasing a potential expected profit of about $1B in September, 2006 for a market risk VaR of about $3.781B with a leverage of about 7.28. That is, although the trade was a reasonable one to make, Amaranth leveraged the position significantly and was taking on a lot of market risk. Even with simple market risk measures, they were implicitly prepared to lose about 56% of their fund ($3.781B) in a “worst” case scenario (less than 1% of the time) for an expected profit of about $1B. They were taking a too risky position.

§ Liquidity Risk

In the simulated spread trades, the only way to generate such huge losses in September 2006 would have been to hold natural gas futures positions and/or options that represented up to 80% of the total open interest on the NYMEX. While these positions could have been held in a combination of OTC deals, NYMEX positions, and ICE positions, they still represent much too large a position with respect to total open interest on the NYMEX exchange. In some senses, Amaranth would have been near to the sole owner of one side of these futures positions. Thus, the positions of Amaranth were irresponsible and massively excessive from a liquidity perspective, which may have explained the additional $2.07B losses in excess of a simple VaR measure. This also raises important questions for regulators about more transparency in the context of hedge funds’ trading positions.

Reasons for the collapse and Lessons:

· One of the strong reasons was the lack of stringent trading limits on ICE. ICE, which was an unregulated exchange, had helped Hunter to place bets without any position limits.

· Concentration Risk: Close to 50 % of hedge fund stake was on a single underlying asset natural gas.

· Deviation from core competency: Amaranth had traded energy for several years their roots lay in convertible-bond trading, a different, less-volatile market.

· Portfolio diversification as a risk mitigation strategy was ignored by a hedge fund which is supposed to follow superior risk management practices.

· Relied on the past success of their star energy trader Brian Hunter.

· Excessive use of leverage.

· Firm ignored statistical computations of Value at Risk.( Annexure III )

· Flaws in debt and liquidity management.

Aftermath

The Commodity Futures Trading Commission (CFTC) and Federal Energy Regulatory Commission (FERC) had filed the lawsuit against Amaranth and two of its traders - Matthew Donhoe (Donhoe) and Brian Hunter (Hunter), alleging that they had manipulated natural gas market prices through their trading activities in February and April, 2006. CFTC had originally sought US$ 20 million and FERC had sought US$ 291 million in fines from Amaranth and its traders. However, they later agreed to settle the charges against Amaranth and Donhoe for a total of US$ 7.5 million as they felt that the defunct Amaranth would not be able to pay such high penalties with its assets already having been liquidated. The charges against Hunter, however, continued with CFTC and FERC complaining that the bets placed by him had been huge and had led to the collapse of Amaranth

“Major crises are major opportunities for change”