How Bernie Made Basket Cases of His Customers' Accounts

November 2, 2009
John Dodge

Two years ago, Bob McMahon wondered why antiquated systems at Bernard L. Madoff Investment Services weren't replaced with more modern and efficient off-the-shelf systems.

The Madoff systems were expensive to maintain and made it difficult to grow the business by expanding into new classes of securities. McMahon's job: To organize and document projects that would create custom technology for the firm's trading operations.

On Dec. 11, 2008, he got his answer.

That day, Bernie Madoff was arrested and charged with stealing tens of billions of his clients' money over decades. McMahon knew if "technologists" replaced the proprietary systems with more modern and open computers, they would have invariably found the absence of data on countless stock trades that supposedly took place. In a sense, the preservation of old computer technology helped Madoff successfully go undetected for years until his massive Ponzi scheme collapsed that day.

Over the past six weeks, Securities Industry News has dug into and beyond the court records to construct the most extensive report yet on how Madoff actually operated: The systems and technology he and underlings used to create-or fake-the most detailed set of customer accounts underlying a fraud in the history of the securities industry.

Included are the first details of a declaration filed Oct. 16 on behalf of the court-appointed trustee, Irving Picard, investigating the case, which describes how the real and the fake trading floors worked. And why the securities investors believed they owned are never going to be declared "missing." The answer: Because they never existed in the first place.

On the eve of the first anniversary of Madoff's arrest, this then is the story of how the legitimacy of his House 5 was turned into the bastard product of House 17-used solely to create and maintain an alternate reality of trades never made.

But it's more than that. It's also a cautionary tale to information technology managers and executives at shops up and down Wall Street. If you think something is amiss, don't let it rest. Do your own investigation. Before the company you work for turns out to be missing as well.

LEGITIMATE AND ILLEGITIMATE

"I asked myself how Bernie could have hidden and maintained this for so long. A lot of it was done because he had proprietary and legacy systems. And he relied on IT people he hired and paid," to not upset the status quo, says McMahon.

As a project manager, he always felt like an odd duck at Bernard L. Madoff Investment Services (BLMIS), an outfit which seemed to lack standards and procedures routine at former employers of his such as the International Securities Exchange and CheckFree Investment Services (now Fiserv, Inc.). Little was documented and the company seemed to be overwhelmed keeping the older systems from breaking down.

"I immediately recognized there was massive institutional chaos in the way the place was managed. No one found value in participating in project management meetings or in writing things down. There was no documentation," says McMahon, today an operational performance consultant for Standard & Poors.

McMahon lasted less than a year at Madoff's firm. He was hired in February 2007, by long-time BLMIS chief information officer Elizabeth Weintraub. She died in September of that year.

Differences over updating the systems and formalizing procedures with Weintraub's two successors led to his dismissal the following January, by McMahon's account.

Nader Ibrahim, who was on the support desk from 2000 to 2003, confirmed that the atmosphere in the BLMIS IT department was often tense and unusual.

"We did not have titles, which was definitely suspicious to me. We all knew who each other worked for, but nobody knew what the other person was doing," he said. "Everything was on a need-to-know basis. There was a lot of secrecy."

But there were no real secrets about Madoff's purported trading for thousands of investment advisory clients because investigators say they have discovered it never happened.

It's not as if Madoff didn't have a real trading floor. Madoff's legitimate market-making business was located on the 19th floor of 885 Third Ave., in New York, using one IBM Application System/400 computer IBM Application System/400 computer, known within the firm as "House 5.'' BLMIS' information technology operation was located on the 18th floor, where McMahon had his cube and was supposed to organize and document projects involving custom technology for the trading operation.

On the 17th floor? The fake trading floor where a second IBM AS/400 known internally as "House 17" processed historical price information on securities allegedly bought for clients. The end result was phony trade confirmations and wholly manufactured - but official-looking - statements for 4,903 investment advisory clients.

OPEN AND CLOSED

Madoff's legitimate traders used a mix of green-screen and "M2" Windows-based desktop computers. These ran in-house trading software referred to as MISS, which McMahon recalled standing for something like Madoff Investment Systems and Services. The internally-named and developed M2s ran MISS as a Windows application and were used by younger traders who wanted familiar software instead of the rigid green screen system, developed around 1985, where only text appeared on screen and instructions were in almost cryptic codes entered into command lines.

Support for House 5 was almost like that of a large investment bank's support of its trading operations. Nothing was too good, in theory, for the Madoff trading operation on the 19th floor. Even if it was not necessary.

"Madoff did not buy anything off the shelf. The IT team was doing proprietary software development. Maybe J.P. Morgan Chase needs all this heavy technology, but a hedge fund with 120 people doesn't have to be in systems development," said McMahon, adding that a similarly-sized firm might have a half dozen IT people. Both McMahon and Ibrahim pegged the number of people actively supporting technology at BLMIS at between 40 and 50.

But large staff and support for House 5 has not thrown off investigators. Court-appointed trustee Irving Picard, who is charged with liquidating Madoff's remaining assets, has instead focused on "House 17,'' where the daily administration of the Ponzi scheme was executed.

Picard hired an investigator, Joseph Looby, an accounting forensics expert who probably knows the most about the technology that aided Madoff in stealing client funds other than former members of Madoff's staff. Looby is an expert in electronic fraud and senior managing partner with FTI Consulting Inc. in New York.

Looby's 20-page declaration on Picard's behalf with the U.S. Bankruptcy Court for Southern District of New York on Oct. 16 amounts to the deepest examination yet of the foundational technology behind Madoff's fraud. The declaration seeks to deny paying Madoff's victims based on their last statements, dated Nov. 30, 2008, because the values stated were based on investments that were allegedly never bought or sold (see graphic, below).

Reached in his Times Square office, Looby, like Picard, said he could not elaborate on his examination of "House 17. "I'd love to, but it's an active investigation," he said, after filing the affidavit.

But in the declaration, he reported that "House 5" supported Madoff's market-making operation and was networked to third parties outside the firm that would logically support a trading operation. One, for example, was the depository and clearing firm Depository Trust Clearing Corp. (DTCC).

"[House 5] was an AS/400, consistent with a legitimate securities trading business," Looby wrote. In the declaration, he often compares House 5's legitimacy to House 17's illegitimacy.

House 17, for reasons that are now obvious, was shut off to anyone but Madoff's former chief finance officer and right-hand-man Frank DiPascali Jr. as well as any accomplices. DiPascali sits in a New York jail awaiting sentencing after pleading guilty to 10 felony counts on Aug. 11. He faces 125 years and his sentencing is scheduled for May 2010. In the interim, investigators are hoping to get his cooperation to implicate others.

"They want to squeeze him for more than what he's giving now so he can avoid 125 years in prison," said Erin Arvedlund, author of "Too Good to be True: The Rise and Fall of Bernie Madoff." The former reporter for Barron's in a widely-cited 2001 story challenged Madoff's implausible if not impossible returns and asked why hundreds of millions in uncollected commissions were left on the table. It appears now there were no trades made, from which to derive commissions.

"[House 17] was a closed system, separate and distinct from any computer system utilized by the other BLMIS business units; consistent with one designed to mass produce fictitious customer statements," according to Looby's declaration. House 17's expressed purpose was to maintain phony records and crank out millions of phony IRS 1099s on capital gains and dividends, trade confirmations, management reports and customer statements.

"The AS/400 was like a giant Selectric typewriter. When you're making up numbers like that, you're using your computer as a typewriter," said computer consultant Judith Hurwitz, president of Hurwitz & Associates in Newton, Mass.

Indeed, the Application System/400 is a multipurpose server that's very good at printing. IBM publishes several technical overviews for IT professionals known as "RedBooks" on the AS/400's extensive printing capabilities and also offers printing and forms design software for it.

The AS/400, launched in 1988, is one of IBM's most popular servers ever. Over the years, it has morphed into the iSeries, then the System i and has since been merged into the Power Systems line, which provides servers to companies "of all sizes." At IBM, the AS/400 "is like the Energizer Bunny," said a spokesman.

ON THE HOUSE

House 17 held 4,659 active accounts overseen by DiPascali where Madoff purportedly executed a “split strike conversion” strategy on large cap stocks. In basic terms, it’s a “collar,” putting a floor and a ceiling on returns. A floor on potential losses is created by purchasing a put on a stock. The sale of a call then puts a ceiling on the returns. The “split” in “strike” prices is considered a “vacation trade.’’ The trader doesn’t worry about what happens until the expiration dates on the put or call options arrive.

The strategy was allegedly applied for the thousands of customers on “baskets” of large cap stocks. According to the faked BLMIS statements, these accounts typically yielded 11 to 17 percent returns annually.

Another 244 “non-split strike” accounts produced phony returns in excess of 100 percent and were managed by BLMIS employees other than DiPascali.

The phrase “Managed by BLMIS employees” discovered and used by investigators is one of many strong indications that more were in on the fraud than just Madoff, DiPascali and BLMIS auditor David G. Friehling, the only ones charged so far. Friehling has pled not guilty. Meanwhile, Looby notes that 25 individuals worked for the investment advisory arm of BLMIS.

The “non-split strike” accounts included many “long time” Madoff customers and feeder funds such as those operated by Stanley Chais or Jeffry Picower and against whom Picard has filed civil suits to reclaim billions in profits alleged to be illegal. Picower of Palm Beach was found dead in his pool Oct. 25. Chais maintains he’s innocent.

In the declaration, Looby repeatedly asserts that no securities were ever bought for BLMIS investment advisory customers.

Proceeds sent in by clients for that purpose were “instead primarily used to make distributions to or payments on behalf of, other investors as well as withdrawals and payments to Madoff family members and employees,” the declaration states.

Here’s how it worked: BLMIS employees fed the AS/400 constantly with stock data, enough to support trades that would satisfy the expectations promised to Madoff’s thousands of eventual victims.

To support the fantasy returns, so-called “baskets” of S&P100 stocks would be bought and sold, on behalf of clients. Looby did not specify the typical size of a basket, but they were proportional to the proceeds a client had remitted to BLMIS.

“If a basket was $400,000 and a customer had $800,000 available, two baskets of securities and options would be purportedly “purchased” for the account,” Looby wrote. The types of stocks can be seen in a Madoff statement (p. 17).

Proceeds from purported basket sales existed only on “House 17” and on the paper it put out, which indicated the funds were put into safe U.S. Treasury bonds. Meanwhile, funds remitted by clients were being diverted to a JPMorgan Chase & Co. bank account known as “703.”

A sharp eye could have detected that funds weren’t where they were supposed to be: 2008 customer statements showed funds in a “Fidelity Spartan U.S. Treasury Money Market Fund” that hadn’t been offered since 2005. The fabulous returns had lulled BLMIS clients to sleep. “You don’t ask questions when you’re up,” said McMahon.

While some trading data was input by hand, DiPascali cleverly used “essentially a mail merge program” to replicate the same stock trading information across multiple accounts, according to the declaration.

Stocks in a basket were “priced” after the market closed (i.e., with the knowledge of the prior published price history). Customer statements were then fabricated by BLMIS staff on House 17 which appeared to outsiders to keep track of customer investments and funds in a manner typical of any investment advisor. “BLMIS staff confirmed it, the system facilitated it and consistent returns could not have been achieved without it,” Looby’s declaration states.

Indeed, the customer statements had been perfected as an instrument in the deception. Madoff investor Ronnie Sue Ambrosino, a former computer analyst who ironically had worked on an AS/400, told Securities Industry News that she never suspected a thing. After all, the Securities and Exchange Commission had given Madoff a clean bill of health on several occasions since 1992 by not digging deeply into his operations or just plain neglect.

“The statements were always perfect, neat and immaculately presented. They came on time and everything was like clockwork,” said Ambrosino, 56, a victim and now activist representing a group of about 400 Madoff investors. She bristles when the AS/400 is called old or outdated. “I know the 400 and it’s a pretty powerful machine.”

99.9 PERCENT FAKE

It was powerful enough to convince investors that whatever proceeds they sent to Madoff were being invested in the stocks cited on their statements.

“Key punch operators were provided with the relevant basket information that they manually entered into House 17. The basket trade was then routinely replicated in selected BLMIS split strike customer accounts automatically and proportionally according to each customer’s purported net equity,” Looby’s declaration says.

The situation was largely the same for non-split strike clients except that the purported trades were in single equities, not baskets. “Thousands of documents including customer statements, IA (investment advisory) staff notes, account folders and programs in the AS/400 were reviewed, and these documents confirm the fact that such statements were prepared on an account-by-account basis (i.e. not basket trading),” Looby wrote.

Looby verified that trades between 2002 and 2008 were phantom by cross-checking with various clearing houses such as DTCC, Clearstream Banking S.A. in Luxembourg, the Chicago Board of Options Exchange (CBOE) and four other clearing firms.

He also compared the cleared trades on the AS/400 “House 5” and “99.9 percent” of the fake trades on “House 17” did not match. The only connection he found is what looked like a small portion of a single client’s trades, which were directed by the client and recorded on House 5.

Madoff employees monitored the “baskets” for split strike accounts in an Excel spreadsheet to make sure “the prices chosen after-the-fact obtained returns that were neither too high or low.”

However, such monitoring was far from perfect. Looby cited several examples where daily trading volumes at BLMIS exceeded the entire daily volume for several stocks.

For instance, Madoff reported the purchase of 17.8 million shares of Exxon Mobil on Oct. 16, 2002. This amounted to 131 percent of the company’s trading volume for that day. BLMIS’s actual Exxon Mobil holdings that October were verified by the DTCC at 5,730 shares. Similar discrepancies for Amgen, Microsoft and Hewlett Packard were found on Nov. 30, 2008, the date for the final batch of BLMIS customer statements, as it turned out.

BLMIS data for options puts and calls was even more blatantly unreal. On Oct. 11, 2002, Looby found that BLMIS “applied an imaginary basket to 279 accounts with a volume of 82,959 OEX(S&P 100 options) calls and 82,959 puts.” That amounted to 13 times the OEX volume at the CBOE that day.

Many following the case speculate that other criminal defendants will be named. Arvedlund says prosecutors from the U.S. Attorney for the Southern District of New York (Lev Dassin) office have to assemble strong cases and that takes time.

“Prosecutors don’t want to get it wrong, indict other family members and then have them found not guilty,” says Arvedlund. A spokeswoman for the U.S. Attorney for the Southern District of New York declined comment.

However, it’s looking increasingly likely that others beyond the first three will eventually be hauled into criminal court. Picard has already tightened the noose in civil court, attempting to reclaim billions from Madoff family members and close associates.

Recent legal documents in the case tangentially and directly implicate others, either talking about yet-to-be-named “co-conspirators” or identifying them outright. A 264-page lawsuit filed by investor Jay Wexler on Oct. 20 accuses Bernard Madoff’s assistant and recruiter Annette Bongiorno and her staff with researching stock and options data “to generate tickets showing fictitious trades.” No response from Bongiorno could be obtained or found by press time.

Also surfacing in Wexler’s lawsuit are explosive allegations about decades of “rampant” drug use and wild parties in the BLMIS offices.

They are not far off the mark, according to Ibrahim. “I saw it all around me. Once a month, Bernie would throw a party for the systems guys and things would get a little out of bounds,” he said, adding that most of the alleged partying was after work. But “it was still a normal work environment” during the day, Ibrahim told Securities Industry News.

In his expansive lawsuit for which he demands a jury trial, Wexler identifies 19 defendants including banks, auditors, former feeder funds, several Madoff family members and associates, former BLMIS employees and even an insurance company.

Looby’s declaration has several references to unnamed accomplices that would seem to dovetail with Wexler’s accusations. “To create the illusion that these stocks had been purchased or sold, BLMIS employees would use the AS/400 and its software programs to fabricate customer statements.”

Prosecutors have a mountain of evidence and they have leverage with the 52-year-old DiPascali. “We know he did not do it alone,” says Arvedlund, the author. And he has expressed a willingness to help.

His confession in court Aug. 11 began “…I helped Bernie Madoff, and other people, carry out the fraud that hurt thousands of people.” At the end of his confession and just prior to pleading to be released on bail, he said: “I hope my help will bring some small measure of comfort to those who have been harmed. I apologize for this catastrophe…”

Prosecutors argued for DiPascali’s release so he could help them sort through the AS/400 and 6,000 boxes of evidence that occupy a half a floor in a New York building. They failed and he was sent to jail to await sentencing.

As for Bernie Madoff, the fraud’s chief architect, he’s not talking and could take his secrets to his grave. “Boy, that would be a shame,” says Arvedlund.