Transparency and Disclosure: The Bernie Madoff Case
On the face of it, without referring to Alan Greenspan, I can simply say I think the markets needed more regulation and the banks needed more regulation.
New Yorker, April 12, 2011.
There is the issue of the opaque and secretive nature of hedge funds. Critics say opacity caused the Madoff crisis. When Bernard Madoff started his investment company, Bernard L. Madoff Investment Securities, LLC, he conducted business honestly. Around the early 1990s, he stopped trading and started fabricating returns. He issued false statements. A friend whose accounting office was in a strip mall verified these statements.
Madoff sold to his clients the idea of combining blue chip securities with derivatives to hedge risk. He provided investors with solid and steady returns even in down markets. He claimed his strategies were too difficult for investors to understand. Existing and potential clients meekly accepted this characterization of themselves because they were seduced by the alleged returns on investments. Madoff created a presence about himself and his fund. He was a great marketer who gave the illusion of exclusivity to credulous investors. These investors felt like they were a part of something special. Indeed, the exclusivity made many investors hesitant to pull funds for fear that they could not get back in later.
Sadly, all Madoff was doing was running a Ponzi scheme in which he would take funds from new investors, and pay dividends and redemption requests to older investors, pocketing a (large) portion for himself. These schemes fail eventually. An SEC official even said that the stated returns that Madoff was making were impossible, but the investigation was dismissed until Madoff was eventually turned in by his son.
This case raises the point about transparency in hedge funds. Had there been verification of assets, this fraud would have been detected and prosecuted earlier. Should investors be entitled to full transparency with regards to the strategies and investments their hedge fund managers are making? Hedge fund managers argue if their funds were forced to register with the SEC and be completely transparent, there would be nothing attractive about them. Hedge funds would simply be glorified mutual funds. Returns would return to the mean and there would be less benefit to hedge fund investors.
Needless to say, hedge funds are vigorously opposed to legislation that would require them to provide data to the government about their various investments and credit exposure. However, the need for secrecy and keeping their competitive advantage must be weighed against the rights of investors from being cheated. As in the spectacular case of Bernie Madoff, a hedge fund may make up its returns in order to steal as much money as it can from investors. Funds may also not give accurate performance data when the performance is poor in the hope that performance will improve in the following quarters.
Thomas Donaldson, an academic who works in the field of business ethics, thinks mandating hedge funds to disclose positions to regulators will have a deleterious effect on financial market innovation and destroy investment creativity. In addition, regulations are impossible to monitor and effect, mainly because of the large number of possible investment strategies that must be considered in writing up regulations. Instead he advocates the establishment of a norm by the hedge fund industry itself. Clients and managers should agree on a standard of transparency that meets at least the industry norm norm. Hedge fund managers should be encouraged to be ethical.
There are two problems with this solution. First, the hedge fund industry must be coaxed into publicly setting disclosure norms, and then enthusiastically encouraging their members to meet these levels of disclosure. What factors would push the industry to do such a thing? The industry is quite clear that proprietary strategy and trading is the key competitive advantage hedge fund managers believe they possess. Why would they make an honest and good effort towards developing disclosure standards when it seems clearly against their own economic interest?
One factor that may push them into setting disclosure standards will be the threat of regulation. If the threat proves always to be empty, as it has always seemed to be under the Greenspan/Bernanke leadership and world-view, then there is little incentive for the industry to establish disclosure standards.
The other factor that may push hedge funds to follow a self-designed disclosure standard will be the market. Chairman Bernanke believes the market provides strong corrective forces for dealing with hedge fund excesses. Thus, if clients leave the hedge fund industry by the droves because of a lack of trust in hedge funds, then the industry may be forced to act. This massive loss in trust can only be triggered by large scale fraud or financial meltdown caused by excessive hedge fund risk taking. However, by the time it gets to that dire stage, regulators will probably feel intense pressure from politicians to put in new regulations. Hence, we return to where we started – regulate hedge funds for a measure of transparency and disclosure. Otherwise, simply waiting for hedge funds to set disclosure and transparency norms will be like waiting for Godot.
If hedge funds were mandated to give credit exposures and investment holdings would this stymie financial innovation and creativity as Donaldson fears? The answer to this question may be in the form of two other questions. What constitutes financial innovation? Does most of it benefit society?
Paul Volcker, the former Federal Reserve Chairman, is of the opinion that the last great financial innovation was the ATM machine. Politicians, financial media, and business academics used to cheer financial innovations believing they made the economy function more efficiently. The cheers are fewer and more muted after the 2008 financial crisis. Shadow banking, collateralized debt obligations (CDOs), sub-prime lending, and credit default swaps (CDS), magnified and multiplied risks and as well as the effects of a collapse in U.S. housing prices. These financial vehicles and instruments were all recent innovations. One suspects they were developed for bankers and financial players, but not to benefit society.
Indeed, Lord Adair Turner, Chairman of the United Kingdom’s Financial Services Authority is quoted as saying, “Some financial activities which proliferated over the last 10 years were socially useless, and some parts of the system were swollen beyond their optimal size.” Stephen Green, the former Chairman of HSBC Bank, PLC, and the British Bankers’ Association, said, “In recent years, banks have chased short-term profits by introducing complex products of no real use to humanity.” Thus, experience in the past decade or so has shown that left unchecked, financial institutions will likely innovate, but the value of these innovations is highly questionable.
What Donaldson wants is for hedge funds to be naturally ethical. This cannot happen unless ethics is brought back into finance. If the prevailing economic culture and zeitgeist is one in which, ethics is a part of finance and not separated from finance (as it currently is), then there will be little resistance to voluntary disclosure standards. Academics, financial media, industry, and politicians view as unshakeable and unassailable truth that economics and its stepchild, finance, is a positive science. In other words, finance deals only with facts, not with values. Ethics deals with values. Therefore, the two are separate domains. This pernicious view has almost completely permeated Anglo-Saxon thinking and approach to finance and economics. It is the task of this Institute to replace this prevailing zeitgeist with one that brings ethics back into finance as normal practice.
 Tavakoli, Janet. Madoff Deserves Lots of Company. Tavakoli Structured Finance, Inc. December 13, 2008. http://www.tavakolistructuredfinance.com/TSF11.html.
 Lieberman, David, Gogoi, Pallavi, Howard, Theresa, McCoy, Kevin. Investors remain amazed over Madoff’s Sudden Downfall. USA Today. December 15, 2008. www.usatoday.com.
 Thomas Donaldson, “Hedge Fund Ethics” in Business Ethics Quarterly, Volume 18, Issue 3 (2008), pp. 405-416.