By Pam Martens: October 17, 2013
Five employees of Bernard Madoff are currently on trial for assisting in the perpetration of the largest Ponzi scheme in history; a multi-decade fraud that has resulted in suicides, destroyed retirement dreams, and increased skepticism about the thoroughness of regulators when a Wall Street crony is involved. Madoff was formerly Chairman of the Nasdaq stock market. Both Madoff, and his brother, Peter, who worked together for more than 40 years, are serving prison terms.
Two of those currently on trial are Jerome O’Hara and George Perez, former computer programmers who worked at the firm from the early 90s. Both the Securities and Exchange Commission and the U.S. Attorney’s office describe in their respective complaints the intricate level of programming that O’Hara and Perez had to perform to keep the fraud alive. That included programming to generate highly sophisticated account statements, showing stock and option trading that did not actually occur.
The fictitious investment strategy that Madoff told investors and inquiring regulators that he was using to deliver his steady, outsized returns was dubbed a split-strike conversion. It meant simply that Madoff would purchase a group of stocks that correlate as closely as possible to those found in the Standard and Poor’s 100 (S&P 100); for example, purchasing blue chip names in telecommunications, finance, energy, pharmaceutical, etc. To attempt to put a collar on how much one can lose, one buys some OEX (S&P 100) put options. To collect a little extra income to supplement stock dividends, one sells (collect premiums on) OEX call options. Could this generate the kind of consistent, positive returns Madoff was reporting? The simple answer is that if it worked, we’d all be doing it, we’d all be rich, and no one would need a portfolio manager.
Another problem is that the transaction costs would eat up the profits and deliver a minuscule or negative return. And, that’s why Madoff was not actually doing any trades with his clients’ money.
For the past five years, two things have troubled me about the official story line for this fraud. They are two missing words that I can’t find in the civil or criminal complaints: dividends and sweep.
On a legitimate investment account statement, when a stock that is owned by the client pays a dividend, one of two things happen based on the client’s instructions. The dividend is either reinvested into more shares of the same stock or the cash payment is “swept” into an interest bearing account. Now, there are some firms that just let the cash sit idle earning no interest, but the dividend still has to show a payment on the statement.
There were two mainframes in Madoff’s operation according to both the SEC and the U.S. Attorney’s office. A mainframe known as House 5 carried out real trades for the market making and proprietary trading operations; the House 17 mainframe carried out all the fictitious trades to generate fraudulent account statements. The House 17 computer did not interface with any of the clearinghouse computers, for obvious reasons.
Did O’Hara and Perez actually sit there and program into their House 17 mainframe the quarterly sequence for dividend payments on the thousands of stocks traded on multiple exchanges. Those dates are different for most stocks. And the amounts change. Sometimes they’re eliminated when a company’s in trouble. Sometimes there’s the payment of a one-time special dividend. What about stock splits? When a stock splits two for one or three for one or what have you, the dividend is adjusted accordingly. Did these two computer programmers know enough to catch all of this?
I’ll ask the SEC and the U.S. Attorney’s office what they know about this aspect and update this report. My curiosity is this: if the dividend payments were not being reported as they are on legitimate statements, why didn’t some client’s accountant notice that over all those decades?
Update: As promised, we’ve researched the issue of dividends and sweep fund on the Madoff statements and filed a detailed report here.