Pamintuan, Laurenz D.

June 28, 2017

BAT 411 BFG Prof. Fernandez

Case 1: The Enron Bankruptcy

Enron Corp. is a company that reached dramatic heights, only to face a dizzying collapse. The story
ends with the bankruptcy of one of America's largest corporations. Enron's collapse affected the
lives of thousands of employees and shook Wall Street to its core. At Enron's peak, its shares were
worth $90.75, but after the company declared bankruptcy on December 2, 2001, they plummeted to
$0.67 by January 2002. To this day, many wonder how such a powerful business disintegrated
almost overnight and how it managed to fool the regulators with fake, off-the-books corporations
for so long.

Enron Named America's Most Innovative Company

Enron was formed in 1985 following a merger between Houston Natural Gas Co. and Omaha-based
InterNorth Inc. Following the merger, Kenneth Lay, who had been the chief executive officer (CEO)
of Houston Natural Gas, became Enron's CEO and chairman and quickly rebranded Enron into an
energy trader and supplier. Deregulation of the energy markets allowed companies to place bets on
future prices, and Enron was poised to take advantage.
The era's regulatory environment also allowed Enron to flourish. At the end of the 1990s, the dot-
com bubble was in full swing, and the Nasdaq hit 5,000. Revolutionary internet stocks were being
valued at preposterous levels and consequently, most investors and regulators simply accepted
spiking share prices as the new normal.
Enron participated by creating Enron Online (EOL), an electronic trading website that focused on
commodities in Oct. 1999. Enron was the counterparty to every transaction on EOL; it was either
the buyer or the seller. To entice participants and trading partners, Enron offered up its reputation,
credit, and expertise in the energy sector. Enron was praised for its expansions and ambitious
projects and named "America's Most Innovative Company" by Fortune for six consecutive years
between 1996 and 2001.
By mid-2000, EOL was executing nearly $350 billion in trades. At the outset of the bursting of
the dot-com bubble, Enron decided to build high-speed broadband telecom networks. Hundreds of
millions of dollars were spent on this project, but the company ended up realizing almost no return.

When the recession began to hit in 2000, Enron had significant exposure to the most volatile parts
of the market. As a result, many trusting investors and creditors found themselves on the losing end
of a vanishing market cap.

The Collapse of a Wall Street Darling

By the fall of 2000, Enron was starting to crumble under its own weight. CEO Jeffrey Skilling had a
way of hiding the financial losses of the trading business and other operations of the company; it
was called mark-to-market accounting. This is a technique used when trading securities where you
measure the value of a security based on its current market value, instead of its book value. This can
work well for securities, but it can be disastrous for other businesses.
In Enron's case, the company would build an asset, such as a power plant, and immediately claim
the projected profit on its books, even though it hadn't made one dime from it. If the revenue from
the power plant were less than the projected amount, instead of taking the loss, the company would
then transfer these assets to an off-the-books corporation, where the loss would go unreported.
This type of accounting enabled Enron to write off losses without hurting the company's bottom
line.
The mark-to-market practice led to schemes that were designed to hide the losses and make the
company appear to be more profitable than it really was. To cope with the mounting losses, Andrew
Fastow, a rising star who was promoted to CFO in 1998, came up with a devious plan to make the
company appear to be in great shape, despite the fact that many of its subsidiaries were losing
money.

How Did Enron Use SPVs to Hide its Debt?

Fastow and others at
Enron orchestrated a
scheme to use off-
balance-sheet special
purpose vehicles (SPVs),
also know as special
purposes entities (SPEs)
to hide mountains of
debt and toxic assets
from investors and
creditors. The primary
aim of these SPVs was to
hide accounting realities,
rather than operating
results.

The standard Enron-to-

SPV transaction
occurred when Enron
transferred some of its
rapidly rising stock to
the SPV in exchange for
cash or a note. The SPV
would subsequently use
the stock to hedge an
asset listed on Enron's
balance sheet. In turn,
Enron would guarantee
the SPV's value to reduce
apparent counterparty
risk.

Enron believed that its

stock price would
keep appreciating a belief similar to that embodied by Long-Term Capital Management before its
collapse. Eventually, Enron's stock declined. The values of the SPVs also fell, forcing Enron's
guarantees to take effect. One major difference between Enron's use of SPVs and standard debt
securitization is that its SPVs were capitalized entirely with Enron stock. This directly compromised
the ability of the SPVs to hedge if Enron's share prices fell. Just as dangerous and culpable was the
second significant difference: Enron's failure to disclose conflicts of interest. Enron disclosed the
SPVs to the investing publicalthough it's certainly likely that few understood even that much
but it failed to adequately disclose the non-arm's length deals between the company and the SPVs.
Arthur Andersen and Enron: Risky Business
In addition to Andrew Fastow, a major player in the Enron scandal was Enron's accounting firm
Arthur Andersen LLP and its partner David B. Duncan, who oversaw Enron's accounts. As one of the
five largest accounting firms in the United States at the time, it had a reputation for high standards
and quality risk management.

However, despite Enron's poor practices, Arthur Andersen offered its stamp of approval, which was
enough for investors and regulators alike, for a while. This game couldn't go on forever, however,
and by April 2001, many analysts started to question the transparency of Enron's earnings, and
Andersen and Eron were ultimately prosecuted for their reckless behavior.
The Shock Felt Around Wall Street

By the summer of 2001, Enron was in a free fall. CEO Ken Lay had retired in February, turning over
the position to Skilling, and that August, Jeff Skilling resigned as CEO for "personal reasons." Around
the same time, analysts began to downgrade their rating for Enron's stock, and the stock descended
to a 52-week low of $39.95. By Oct.16, the company reported its first quarterly loss and closed its
"Raptor" SPE, so that it would not have to distribute 58 million shares of stock, which would further
reduce earnings. This action caught the attention of the SEC.

A few days later, Enron changed pension plan administrators, essentially forbidding employees
from selling their shares, for at least 30 days. Shortly after, the SEC announced it was investigating
Enron and the SPVs created by Fastow. Fastow was fired from the company that day. Also, the
company restated earnings going back to 1997. Enron had losses of $591 million and had $628
million in debt by the end of 2000. The final blow was dealt when Dynegy (NYSE: DYN
Dynegy Inc),

a company that had previously announced would merge with the Enron, backed out of its offer on
Nov. 28. By Dec. 2, 2001, Enron had filed for bankruptcy.
Enron Gets a New Name
Once Enron's Plan of Reorganization was approved by the U.S. Bankruptcy Court, the new board of
directors changed Enron's name to Enron Creditors Recovery Corp. (ECRC). The company's new
sole mission was "to reorganize and liquidate certain of the operations and assets of the 'pre-
bankruptcy' Enron for the benefit of creditors." The company paid its creditors more than 21.7
billion from 2004-2011. Its last payout was in May 2011.

Enron Execs and Accountants Prosecuted

Once the fraud was discovered, two of the preeminent institutions in U.S. business, Arthur
Andersen LLP, and Enron Corp. found themselves facing federal prosecution. Arthur Andersen was
one of the first casualties of Enron's prolific demise. In June 2002, the firm was found guilty of
obstructing justice for shredding Enron's financial documents to conceal them from the SEC. The
conviction was overturned later, on appeal; however, despite the appeal, like Enron, the firm was
deeply disgraced by the scandal.

Several of Enron's execs were charged with a slew of charges, including conspiracy, insider trading,
and securities fraud. Enron's founder and former CEO Kenneth Lay was convicted of six counts of
fraud and conspiracy and four counts of bank fraud. Prior to sentencing, though, he died of a heart
attack in Colorado.
Enron's former star CFO Andrew Fastow plead guilty to two counts of wire fraud and securities
fraud for facilitating Enron's corrupt business practices. He ultimately cut a deal for cooperating
with federal authorities and served a four-year sentence, which ended in 2011.
Ultimately, though, former Enron CEO Jeffrey Skilling received the harshest sentence of anyone
involved in the Enron scandal. In 2006, Skilling was convicted of conspiracy, fraud, and insider
trading. Skilling originally received a 24-year sentence, but in 2013 his sentence was reduced by ten
years. As a part of the new deal, Skilling was required to give $42 million to the victims of the Enron
fraud and to cease challenging his conviction. Skilling remains in prison and is scheduled for release
on Feb. 21, 2028.

New Regulations As a Result of the Enron Scandal

Enron's collapse and the financial havoc it wreaked on its shareholders and employees led to new
regulations and legislation to promote the accuracy of financial reporting for publicly-held
companies. In July of 2002, then-President George W. Bush signed into law the Sarbanes-Oxley Act.
The Act heightened the consequences for destroying, altering or fabricating financial records, and
for trying to defraud shareholders. (For more on the 2002 Act, read: How The Sarbanes-Oxley Act
Era Affected IPOs.)

The Enron scandal resulted in other new compliance measures. Additionally, the Financial
Accounting Standards Board (FASB) substantially raised its levels of ethical conduct. Moreover,
company's boards of directors became more independent, monitoring the audit companies and
quickly replacing bad managers. These new measures are important mechanisms to spot and close
the loopholes that companies have used, as a way to avoid accountability.

The Bottom Line

At the time, Enron's collapse was the biggest corporate bankruptcy to ever hit the financial world.
Since then, WorldCom, Lehman Brothers, and Washington Mutual have surpassed Enron as the
largest corporate bankruptcies. The Enron scandal drew attention to accounting and corporate
fraud, as its shareholders lost $74 billion in the four years leading up to its bankruptcy, and its
employees lost billions in pension benefits. As one researcher states, the Sarbanes-Oxley Act is a
"mirror image of Enron: the company's perceived corporate governance failings are matched
virtually point for point in the principal provisions of the Act." (Deakin and Konzelmann, 2003).
Increased regulation and oversight have been enacted to help prevent corporate scandals of
Enron's magnitude. However, some companies are still reeling from the damage caused by Enron.
Most recently, in March 2017, a Toronto-based investment firm was granted the okay by a judge to
sue former Enron CEO Jeffery Skilling, Credit Suisse Group AG, Deutsche Bank AG, Bank of
America's Merrill Lynch unit over losses incurred by purchasing Enron shares.
Case 2: The Madoff Pyramid: Investment Fraud
In 1992, Bernard Madoff explained his purported strategy to The Wall Street Journal. He said the
returns were really nothing special, given that the Standard & Poors 500-stock index generated an
average annual return of 16.3% between November 1982 and November 1992. "I would be
surprised if anybody thought that matching the S&P over 10 years was anything outstanding." The
majority of money managers actually trailed the S&P 500 during the 1980s. The Journal concluded
Madoff's use of futures and options helped cushion the returns against the market's ups and downs.
Madoff said he made up for the cost of the hedges, which could have caused him to trail the stock
market's returns, with stock-picking and market timing.
Purported strategy
Madoff's sales pitch was an investment strategy consisting 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 3035 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 his 1992 "Avellino and Bienes" interview with The Wall Street Journal, Madoff discussed his
supposed methods: In the 1970s, he had placed invested funds in "convertible arbitrage positions
in large-cap stocks, with promised investment returns of 18% to 20%", and in 1982, he began
using futures contracts on the stock index, and then placed put options on futures during the 1987
stock market crash. 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 and options on the
indexes. Barron's raised the possibility that Madoff's returns were most likely due to front
running his firm's brokerage clients.
Mitchell Zuckoff, professor of journalism at Boston University and author of Ponzi's Scheme: The
True Story of a Financial Legend, says that "the 5% payout rule", a federal law requiring private
foundations to pay out 5% of their funds each year, allowed Madoff's Ponzi scheme to go
undetected for a long period since he managed money mainly for charities. Zuckoff notes, "For
every $1 billion in foundation investment, Madoff was effectively on the hook for about $50 million
in withdrawals a year. If he was not making real investments, at that rate the principal would last
20 years. By targeting charities, Madoff could avoid the threat of sudden or unexpected
withdrawals.
In his guilty plea, Madoff admitted that he hadn't actually traded since the early 1990s, and all of his
returns since then had been fabricated. However, David Sheehan, principal investigator for Picard,
believes the wealth management arm of Madoff's business had been a fraud from the start.
Madoff's operation differed from a typical Ponzi scheme. While most Ponzis are based on
nonexistent businesses, Madoff's brokerage operation was very real.
Sales methods
Rather than offer high returns to all comers, Madoff offered modest but steady returns to an
exclusive clientele. The investment method was marketed as "too complicated for outsiders to
understand." He was secretive about the firms business, and kept his financial statements closely
guarded. The New York Post reported that Madoff "worked the so-called 'Jewish circuit' of well-
heeled Jews he met at country clubs on Long Island and in Palm Beach." (The scandal so affected
Palm Beach that, according to The Globe and Mail, residents "stopped talking about the local
destruction the Madoff storm caused only when Hurricane Trump came along" in 2016.) The New
York Times reported that Madoff courted many prominent Jewish executives and organizations;
according to the Associated Press, they "trusted [Madoff] because he is Jewish. One of the most
prominent promoters was J. Ezra Merkin, whose fund Ascot Partners steered $1.8 billion towards
Madoff's firm. A scheme that targets members of a particular religious or ethnic community is a
type of affinity fraud, and a Newsweek article identified Madoff's scheme as "an affinity Ponzi."
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 Madoff investors were wary of removing their
money from his fund, in case they could not get back in later.
Madoff's annual returns were "unusually consistent," around 10%, and were a key factor in
perpetuating the fraud. Ponzi schemes typically pay returns of 20% or higher, and collapse quickly.
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 500-stock index had been negative 38%. An unnamed
investor remarked, "The returns were just amazing and we trusted this guy for decades if you
wanted to take money out, you always got your check in a few days. Thats why we were all so
stunned.
The Swiss bank Union Bancaire Prive explained that because of Madoff's huge volume as a broker-
dealer, the bank believed he had a perceived edge on the market because his trades were timed
well, suggesting they believed he was front running.
Access to Washington
The Madoff family gained unusual access to Washington's lawmakers and regulators through the
industry's top trade group. The Madoff family has long-standing, high-level ties to the Securities
Industry and Financial Markets Association (SIFMA), the primary securities industry organization.
Bernard Madoff sat on the Board of Directors of the Securities Industry Association, which merged
with the Bond Market Association in 2006 to form SIFMA. Madoff's brother Peter then served two
terms as a member of SIFMAs Board of Directors. Peter's resignation as the scandal broke in
December 2008 came amid growing criticism of the Madoff firms links to Washington, and how
those relationships may have contributed to the Madoff fraud. Over the years 200008, the two
Madoff brothers gave $56,000 to SIFMA and tens of thousands of dollars more to sponsor SIFMA
industry meetings.
In addition, Bernard Madoff's niece Shana Madoff was active on the Executive Committee of
SIFMA's Compliance & Legal Division, but resigned her SIFMA position shortly after her uncle's
arrest. She married former Assistant Director of the SEC's OCIE Eric Swanson, whom she had met in
2003 while he was investigating her uncle Bernie Madoff and his firm. The investigation concluded
in 2005. In 2006 Swanson left the SEC and became engaged to Shana Madoff, and in 2007 the two
married. A spokesman for Swanson said he "did not participate in any inquiry of Bernard Madoff
Securities or its affiliates while involved in a relationship" with Shana Madoff.
Previous investigations
Madoff Securities LLC was investigated at least eight times over a 16-year period by the U.S.
Securities and Exchange Commission (SEC) and other regulatory authorities.
Avellino and Bienes
In 1992, the SEC investigated one of Madoff's feeder funds, Avellino & Bienes, the principals being
Frank Avellino, Michael Bienes and his wife Dianne Bienes. Bienes began his career working as an
accountant for Madoff's father-in-law, Saul Alpern. Then, he became a partner in the accounting
firm Alpern, Avellino and Bienes. In 1962, the firm began advising its clients about investing all of
their money with a mystery man, a highly successful and controversial figure on Wall Streetbut
until this episode, not known as an ace money managerMadoff. When Alpern retired at the end of
1974, the firm became Avellino and Bienes and continued to invest solely with Madoff.
Avellino & Bienes, represented by Ira Sorkin, Madoff's former attorney, were accused of selling
unregistered securities. In a report to the SEC they mentioned the fund's "curiously steady" yearly
returns to investors of 13.5% to 20%. However, the SEC did not look any more deeply into the
matter, and never publicly referred to Madoff. Through Sorkin, who once oversaw the SECs New
York office, Avellino & Bienes agreed to return the money to investors, shut down their firm,
undergo an audit, and pay a fine of $350,000. Avellino complained to the presiding Federal
Judge, John E. Sprizzo, that Price Waterhouse fees were excessive, but the judge ordered him to pay
the bill of $428,679 in full. Madoff said that he did not realize the feeder fund was operating
illegally, and that his own investment returns tracked the previous 10 years of the S&P 500. The
SEC investigation came right in the middle of Madoff's three terms as the chairman of the NASDAQ
stock market board.
The size of the pools mushroomed by word-of-mouth, and investors grew to 3,200 in nine accounts
with Madoff. Regulators feared it all might be just a huge scam. "We went into this thinking it could
be a major catastrophe. They took in nearly a half a billion dollars in investor money, totally outside
the system that we can monitor and regulate. That's pretty frightening," said Richard Walker, who
at the time was the SEC's New York regional administrator.
Avellino and Bienes deposited $454 million of investors' money with Madoff, and until 2007, Bienes
continued to invest several million dollars of his own money with Madoff. In a 2009 interview after
the scam had been exposed, he said, "Doubt Bernie Madoff? Doubt Bernie? No. You doubt God. You
can doubt God, but you don't doubt Bernie. He had that aura about him."
Bernard L. Madoff Securities LLC: 1999, 2000, 2004, 2005, and 2006
The SEC investigated Madoff in 1999 and 2000 about concerns that the firm was hiding its
customers' orders from other traders, for which Madoff then took corrective measures. In 2001, an
SEC official met with Harry Markopolos at their Boston regional office and reviewed his allegations
of Madoff's fraudulent practices.[64] The SEC claimed it conducted two other inquiries into Madoff
in the last several years, but did not find any violations or major issues of concern.
In 2004, after published articles appeared accusing the firm of front running, the SEC's Washington
office cleared Madoff. The SEC detailed that inspectors had examined Madoff's brokerage operation
in 2005, checking for three kinds of violations: the strategy he used for customer accounts; the
requirement of brokers to obtain the best possible price for customer orders; and operating as an
unregistered investment adviser. Madoff was registered as a broker-dealer, but doing business as
an asset manager. "The staff found no evidence of fraud". In September 2005 Madoff agreed to
register his business, but the SEC kept its findings confidential. During the 2005 investigation,
Meaghan Cheung, a branch head of the SEC's New York's Enforcement Division, was the person
responsible for the oversight and blunder, according to Harry Markopolos, who testified on
February 4, 2009, at a hearing held by a House Financial Services Subcommittee on Capital Markets.
In 2007, SEC enforcement completed an investigation they had begun on January 6, 2006 into a
Ponzi scheme allegation. This investigation resulted in neither a finding of fraud, nor a referral to
the SEC Commissioners for legal action.
FINRA
In 2007, the Financial Industry Regulatory Authority (FINRA), the industry-run watchdog for
brokerage firms, reported without explanation that parts of Madoff's firm had no customers. "At
this point in time we are uncertain of the basis for FINRA's conclusion in this regard," SEC staff
wrote shortly after Madoff was arrested.
As a result, the chairman of the SEC, Christopher Cox, stated that an investigation will delve into "all
staff contact and relationships with the Madoff family and firm, and their impact, if any, on
decisions by staff regarding the firm". A former SEC compliance officer, Eric Swanson, married
Madoff's niece Shana, a Madoff firm compliance attorney.
Red flags
Outside analysts raised concerns about Madoff's firm for years. The first real concerns about
Madoff's operation were raised in May 2000, when Harry Markopolos, a financial analyst and
portfolio manager at Boston options trader Rampart Investment Management, alerted the SEC
about his suspicions. A year earlier, Rampart had found out that Access International Advisors, one
of its trading partners, had significant investments with Madoff. Markopolos' bosses at Rampart
asked him to design a product that could replicate Madoff's returns. However, Markopolos
concluded almost immediately that Madoff's numbers didn't add up. After four hours of trying and
failing to replicate Madoff's returns, Markopolos concluded Madoff was a fraud. He told the SEC that
based on his analysis of Madoff's returns, it was mathematically impossible for Madoff to deliver
them using the strategies he claimed to use. In his view, there were only two ways to explain the
figureseither Madoff was front running his order flow, or his wealth management business was a
massive Ponzi scheme. This submission, along with three others, passed with no substantive action
from the SEC. At the time of Markopolos' initial submission, Madoff managed assets from between
$3 billion and $6 billion, which would have made his wealth management business the largest
hedge fund in the world even then.
The culmination of Markopolos' analysis was his third submission, a detailed 17-page memo
entitled The World's Largest Hedge Fund is a Fraud. He had also approached The Wall Street
Journal about the existence of the Ponzi scheme in 2005, but its editors decided not to pursue the
story. The memo specified 30 numbered red flags based on 174 months (a little over 14 years) of
Madoff trades. The biggest red flag was that Madoff reported only seven losing months during this
time, and those losses were statistically insignificant. This produced a return stream that rose in a
nearly perfectly straight line. Markopolos pointed out the markets are far too volatile even under
the best of conditions for this to be possible. Later, Markopolos testified before Congress that this
was like a baseball player batting .966 for the season "and no one suspecting a cheat."
In part, the memo concluded: "Bernie Madoff is running the world's largest unregistered hedge
fund. He's organized this business as a 'hedge fund of funds' privately labeling their own hedge
funds which Bernie Madoff secretly runs for them using a split-strike conversion strategy getting
paid only trading commissions which are not disclosed. If this is not a regulatory dodge, I do not
know what is." Markopolos declared that Madoff's "unsophisticated portfolio management" was
either a Ponzi scheme or front running (buying stock for his own account based on knowledge of
his clients' orders), and concluded it was most likely a Ponzi scheme.
In 2001, financial journalist Erin Arvedlund wrote an article for Barron's entitled "Don't Ask, Don't
Tell," questioning Madoff's secrecy and wondering how he obtained such consistent returns. She
reported that "Madoff's investors rave about his performance even though they don't understand
how he does it. 'Even knowledgeable people can't really tell you what he's doing,' one very satisfied
investor told Barron's." The Barron's article and one in MarHedge by Michael Ocrant suggested
Madoff was front-running to achieve his gains. Hedge funds investing with him were not permitted
to name him as money manager in their marketing prospectus. When high-volume investors who
were considering participation wanted to review Madoff's records for purposes of due diligence, he
refused, convincing them of his desire that proprietary strategies remain confidential.
By selling its holdings for cash at the end of each period, Madoff avoided filing disclosures of its
holdings with the SEC, an unusual tactic. Madoff rejected any call for an outside audit "for reasons of
secrecy", claiming that was the exclusive responsibility of his brother, Peter, the company's chief
compliance officer".
Markopolos later testified to Congress that to deliver 12% annual returns to the investor, Madoff
needed to earn 16% gross, so as to distribute a 4% fee to the feeder fund managers, who would
secure new victims, be "willfully blind, and not get too intrusive".
Concerns were also raised that Madoff's auditor of record was Friehling & Horowitz, a two-person
accounting firm based in suburban Rockland County that had only one active accountant, David G.
Friehling, a close Madoff family friend. Friehling was also an investor in Madoff's fund, which was
seen as a blatant conflict of interest. In 2007, hedge fund consultant Aksia LLC advised its clients
not to invest with Madoff, saying it was inconceivable that a tiny firm could adequately service such
a massive operation.
Typically, hedge funds hold their portfolio at a securities firm (a major bank or brokerage), which
acts as the fund's prime broker. This arrangement allows outside investigators to verify the
holdings. Madoff's firm was its own broker-dealer and allegedly processed all of its trades.
Ironically, Madoff, a pioneer in electronic trading, refused to provide his clients online access to
their accounts.[13] He sent out account statements by mail,[85] unlike most hedge funds,
which email statements.[86]
Madoff operated as a broker-dealer who also ran an asset management division. In 2003, Joe Aaron,
a hedge-fund professional, also found the structure suspicious and warned a colleague to avoid
investing in the fund, "Why would a good businessman work his magic for pennies on the dollar?"
he concluded.[87] Also in 2003, Renaissance Technologies, "arguably the most successful hedge
fund in the world", reduced its exposure to Madoff's fund first by 50 percent and eventually
completely because of suspicions about the consistency of returns, the fact that Madoff charged
very little compared to other hedge funds and the impossibility of the strategy Madoff claimed to
use because options volume had no relation to the amount of money Madoff was said to administer.
The options volume implied that Madoff's fund had $750 million, while he was believed to be
managing $15 billion. And only if Madoff was assumed to be responsible for all the options traded
in the most liquid strike price.[88]
Charles J. Gradante, co-founder of hedge-fund research firm Hennessee Group, observed that
Madoff "only had five down months since 1996",[89] and commented on Madoff's investment
performance: "You can't go 10 or 15 years with only three or four down months. It's just
impossible."[90]
In 2001, Michael Ocrant, editor-in-chief of MARHedge wrote a story in which he interviewed
traders who were incredulous that Madoff had 72 consecutive gaining months, an unlikely
possibility.[12]
Clients such as Fairfield Greenwich Group and Union Bancaire Prive claimed that they had been
given an "unusual degree of access" to evaluate and analyze Madoff's funds and found nothing
unusual with his investment portfolio.[48]
The Central Bank of Ireland failed to spot Madoff's gigantic fraud when he started using Irish funds
and had to supply large amounts of information that should have been enough to enable the Irish
regulator to uncover the fraud much earlier than late 2008 when he was finally arrested in New
York.

Case 3: The Olympus Fraud

The Olympus scandal was precipitated on 14 October 2011 when British-born Michael
Woodford was suddenly ousted as chief executive of international optical equipment
manufacturer, Olympus Corporation. He had been company president for six months, and two
weeks prior had been promoted to chief executive officer, when he exposed "one of the biggest and
longest-running loss-hiding arrangements in Japanese corporate history", according to the Wall
Street Journal. Tsuyoshi Kikukawa, the board chairman, who had appointed Woodford to these
positions, again assumed the title of CEO and president. The incident raised concern about the
endurance of tobashi schemes, and the strength of corporate governance in Japan.
Apparently irregular payments for acquisitions had resulted in very significant asset impairment
charges in the company's accounts, and this was exposed in an article in the Japanese financial
magazine FACTA and had come to Woodford's attention. Japanese press speculated on a connection
to Yakuza (Japanese organised crime syndicates). Olympus defended itself against allegations of
impropriety.
Despite Olympus' denials, the matter quickly snowballed into a corporate corruption scandal over
concealment (called tobashi) of more than 117.7 billion yen ($1.5 billion) of investment losses and
other dubious fees and other payments dating back to the late 1980s and suspicion of covert
payments to criminal organisations. On 26 October, Kikukawa was replaced by Shuichi
Takayama as chairman, president, and CEO. On 8 November 2011, the company admitted that the
company's accounting practice was "inappropriate" and that money had been used to cover losses
on investments dating to the 1990s. The company blamed the inappropriate accounting on former
president Tsuyoshi Kikukawa, auditor Hideo Yamada and executive vice-president Hisashi Mori.
By 2012 the scandal had developed into one of the biggest and longest-lived loss-
concealing financial scandals in the history of corporate Japan; it had wiped 7580% off the
company's stock market valuation, led to the resignation of much of the board, investigations across
Japan, the UK and US, the arrest of 11 past or present Japanese directors, senior
managers, auditors and bankers of Olympus for alleged criminal activities or cover-up, and raised
considerable turmoil and concern over Japan's prevailing corporate
governance and transparency and the Japanese financial markets. Woodford received a reported
10 million ($16 m) in damages from Olympus for defamation and wrongful dismissal in
2012; around the same time, Olympus also announced it would shed 2,700 jobs (7% of its
workforce) and around 40 percent of its 30 manufacturing plants by 2015 to reduce its cost base.
Auditors
The accounts of Olympus were audited in the 1990s by the Japanese affiliate of then 'big five'
accounting firm Arthur Andersen until the latter collapsed in 2002, when KPMG Azsa became its
auditor. KPMG remained the auditor up until 2009, after which the Ernst & Young ShinNihon (E&Y)
took over. At no point were any major issues signalled by the company's auditors; The Financial
Times (FT) reported that KPMG had raised some questions when the firm audited Olympus, but
audit reports were always unqualified, and E&Y signed off on "clean" audit reports in 2010 and
2011. According to an email sent by former chairman Tsuyoshi Kikukawa that Michael Woodford
made public, Olympus had replaced KPMG with E&Y after the former expressed disagreement with
the accounting treatment of the Gyrus acquisition. The FT queried why, this being the case, KPMG
had signed off on the 2009 accounts. Tsutomu Okubo raised a question in the upper house of the
Diet as to why the auditors apparently failed to stop the cover-up; the Japanese Institute of Certified
Accountants said that it would look into the auditors' role.
According to a letter filed with the UK Registrar of Companies, the auditors to Gyrus resigned
"partly because of its client's accounting for the securities". KPMG qualified Gyrus' accounts
because they could not ascertain that Axam was not a related party. The auditors also took issue
with the accounting treatment of the preference shares. In its audit letter to Gyrus Group dated 26
April 2010, KPMG considered that there were "circumstances connected with our ceasing to hold
office that should be brought to the attention of the company's members or creditors." Ernst &
Young, the firm that succeeded KPMG, also expressed reservations about the 2010 Gyrus accounts
for uncertainty, due to the lack of information about Axam. Bloomberg noted that both Gyrus
annual reports were filed late: instead of filing within the nine-month statutory limit, the accounts
were filed more than a year from the company's year end. In late November 2011 Michael Andrew,
KPMG International global chairman, said his firm had complied with its legal obligations to pass on
information related to Olympus's 2008 acquisition of Gyrus, and were removed as auditors for so
doing. Andrew said: "It's pretty evident to me there was very, very significant fraud and that a
number of parties had been complicit." However, the while the Japanese firm forced a 71 billion
restatement of dubious valuation of certain acquired assets, the firm signed off on the financial
statements in the same year that contained questionable figures other members of its global
network in UK and elsewhere had apparently expressed grave reservations over.
Although the Olympus inquiry had questioned the auditors' signing off on the accounting treatment
of preferred shares, and whether the handover from KPMG to Ernst & Young in 2009 was thorough,
E&Y's own review in turn questioned "the thoroughness and accuracy" of the Olympus inquiry's
findings. The E&Y concluded there were "no problems with the handover in terms of the
guidelines," but were looking into what more could have been done. It further said that its powers
of investigation were limited by their inability to question the outgoing audit firm.
Stock market and stakeholder reactions
Olympus had a market capitalisation of 673 billion on 13 October 2011, immediately before
Woodford was sacked. By the end of the next day, the valuation had fallen to 422 billion
($5.5 billion). Analysts at Goldman Sachs, Deutsche Bank and Nomura Securities, concerned about
corporate governance issues at the company as well as its balance sheet, all immediately
downgraded their stock ratings. Goldman Sachs, who had only upgraded its rating in a report dated
12 October, suspended its coverage after Woodford was removed from office. Nomura
and JPMorgan announced on 20 October that their coverage of the company was halted. It was
reported that Government of Singapore Investment Corp., the Singapore sovereign wealth fund
which was one of the principal shareholders, immediately disposed of its 2 percent stake on the
first hint of scandal. The share price plunged several days running upon market fears that the
shares would be delisted as the company could not meet its reporting mandatory deadline for its
quarterly results; in the week to 18 November Nippon Life announced that its stake had been
reduced by one-third, from 8.18 percent to 5.11 percent, because of the uncertainty; Mitsubishi
reduced its stake from 10 percent to 7.6 percent.
Some major foreign institutional investors have pushed to bring back ousted chief executive
Michael Woodford: UK fund manager Baillie Gifford, Harris Associates, and Southeastern Asset
Management, owning respectively 4 percent, 5 percent and 5 percent stake, all believed he was the
best candidate to lead the clean-up. Other investors have demanded more disclosures from the
company about the state of its affairs. Domestic investors, including Nippon Life
Insurance (8.4 percent stake), demanded "prompt action".

Chart showing Olympus share price between 20 July and 9 December 2011
On 2 November, a shareholder from Nara Prefecture was reported to have asked the company's
auditor to bring a case against former executives of Olympus to court to reimburse 140 billion
($1.79 billion) to the company, failing which he will sue them through another rights group,
Lawyers for Shareholders' Rights. Two American law firms announced that they were initiating
'investigations' of Olympus Corporation and some of its directors and were seeking investors who
purchased Olympus ADRs between 7 November 2006 and 7 November 2011 on the grounds that
the company's share price had been inflated through false accounting and that directors had hidden
substantial losses by "false statements and material omissions".
The quotation price of Olympus shares on the Tokyo Stock Exchange (TSE) on 15 November had
fallen by some 75 percent since the scandal erupted. The price continued to be volatile: trading was
halted as its price hit the upper limit for price falls. On 14 and 15 November, after the threat of
delisting ebbed, trading in its shares was once again halted when buy orders heavily outnumbered
sell orders; the price rose by the upper limit of 100. Trading only took place after hours as there
was a glut of unsatisfied buy orders. The share price rose in four straight trading sessions, reaching
834 yen at one point on 16 November.
Many long-time employees of Olympus Corp were shocked and angry, and felt betrayed by the
executives who were responsible for bringing public humiliation onto the company. Former
director Koji Miyata started a web site, called Olympus Grassroots, demanding clean-up at the
company they say they love. Miyata also circulated a petition targeted at employees calling on the
reinstatement of Woodford. As Olympus has a 70-percent market share in endoscopy, the scandal
caused anxiety and concern among the medical profession, which sees Olympus endoscopes as
irreplaceable.
While foreign shareholders supported Woodford's proxy fight to replace the Olympus board, he
failed to gain support from Japanese institutions; Sumitomo Mitsui bank, identified as the
company's main creditor, warned Woodford that he would fail. Woodford was disappointed by
their silence, but acknowledged that even had he won a shareholder vote to become chief executive,
the antipathy towards him of major shareholders and creditors, and the discomfort within the
company about his decision to publicly disclose the accounting irregularities, would have made
running the company difficult. On 6 January 2012, on failing to secure support from Japanese
institutional shareholders, Woodford said that the 12-week public scandal had taken an enormous
emotional toll on him and his family, and announced that he would abandon his proxy fight to take
control of the Olympus board. Instead, his lawyers had initiated legal proceedings in London
seeking unspecified damages for dismissal from his four-year contract.
Olympus convened an extraordinary shareholders' meeting for 20 April 2012 to vote on its
proposal for the new board and to approve the restated accounts. The board slate consisted of 11
candidates, the majority of whom were "completely independent" of Olympus. The company
controversially sought to promote its executive officer, Hiroyuki Sasa, to president; its candidate for
chairman was Yasuyuki Kimoto, a former senior executive of Sumitomo Mitsui Banking Corp. the
largest creditor of Olympus. Another proposed director is Hideaki Fujizuka, formerly with the Bank
of Tokyo-Mitsubishi. While the company argued the candidates were well-qualified, a shareholder
advisory firm urged investors to vote down the proposed president citing his lack of experience as a
corporate manager of a turnaround situation; it also expressed concern that the ex-bankers may
put banks' interests ahead of shareholders'. ISS also recommended shareholders not to approve the
accounts on grounds that it could undermine any legal recourse they may want to pursue in
future. Foreign shareholders oppose the nominations, citing "undue influence" of the creditor
banks.
Corporate governance concerns
Masaki Shizuka of the TSE expressed the concern that "investor confidence in information provided
by the company may decline." Tsutomu Okubo, who is to chair a new working team to discuss
reforms to the company act to strengthen corporate governance, questioned whether the corporate
auditor system was functioning properly, and whether the company's accountants were acting as a
proper check on management. Toshio Oguchi, representative director of Governance for Owners in
Tokyo, argued that the affair pointed to a dysfunctional board: "Even if they didn't know about the
tobashi, the fact that the board approved the payment cannot have been a correct decision.
The acquisition price tag was justified using sales forecast for the three companies Altis,
Humalabo and News Chef of 88.5 billion (US$1.2 billion) for the fiscal year ending March 2013
which CFO Asia said was "practically impossible to achieve". It further noted that the combined
sales targets for the three companies for the fiscal year to March 2012 were subsequently reduced
by 93 percent to a combined 6.5 billion (US$85.7 million). Despite the suspicions of wrongdoing,
Olympus strongly denied suggestions that the transactions were "something illegal or
unauthorized". CFO Asia said that if there was truly no corporate malfeasance, there are
"uncomfortable questions about the competence of the internal and external teams that evaluated
the three acquisitions, as well as the capabilities of the senior managers and board members that
accepted the sky-high valuations and approved the deals." Nikkei Business said similarly that the
size of the losses "could very well call management responsibility into question".
In a commentary in the Financial Times entitled "Olympus's deceit was dishonourable", John
Gapper noted that "It is still possible to believe that the accused trio of directors ... thought they
were behaving honourably ... [in hiding] failure discreetly and not to make their predecessors lose
face." He noted that accounting scandals were not uniquely Japanese, but that it was "a nice piece of
corporate satire to conceal losses by exploiting the widespread habit of paying too much for
acquisitions and writing them down the 'advisory fee' was especially creative". Gapper criticised
the weakness in governance, particularly how 12 out of 15 directors were either executives or
former executives of the company, and that Hideo Yamada, head of the Audit Board, was complicit
in the scam. He also noted that auditors KPMG and Ernst & Young would have to answer tough
questions about why the manipulation was never discovered or properly questioned.
Investors have expressed opinions that the management of such listed companies have unfairly
damaged their corporate value counter to shareholder interests and have cited underlying
problems in the quality of Japanese corporate governance ... They have even expressed fears that
such issues are occurring in other listed companies.
Tokyo Stock Exchange statement
Bloomberg View columnist William Pesek said: "Japan's corporate culture of denial, of ignoring
problems and letting them fester, keeps running up against a globalized world that values agility,
innovation and transparency. Olympus demonstrates all too painfully how much Old Japan
tolerates a lack of accountability among senior executives; inadequate disclosure; a disinclination to
challenge authority and absolute deference to corporate boards regardless of share performance."
While he also observed that the independence of the directors was inadequate, he said Japanese
executives were much more moderately paid compared to American ones. "Shareholders assume
directors are smart, devoted people working for the good of Japan Inc. Tough questions are rarely
asked." Errol Oh of The Star said a company apology for a fall in the share price "trivialises the
possible wrongdoings and misplaces emphasis on an effect rather than the cause ... Takayama's
remark on the 'inconvenience' of a fall in share price reflects a common flaw in the mindset of the
people who run listed companies. Somehow, they lose sight of the fact that they manage businesses,
not share prices."
During a press conference in early November, Financial Services minister Shozaburo Jimi said the
market should not call into question the standards of corporate governance of other listed
companies just because of Olympus. However, some journals linked the case of Daio Paper Corp,
also subject of a scandal involving diversion of funds by its chairman.