Saturday, March 28, 2009

How Madoff Did It

These are tough times for trust. Successful marketplaces -- indeed, all social systems -- require a level of ethical behavior among their participants. The recent arrest of Bernard L. Madoff, accused of bilking thousands of investors in a $50 billion Ponzi scheme, is only the latest incident to diminish trust on Wall Street. Wharton operations and information management professor Maurice E. Schweitzer and G. Richard Shell, professor of legal studies and business ethics, have conducted extensive research on the role of trust in markets. In an interview with Knowledge@Wharton, they explain why even the most sophisticated investors put their faith in Madoff and how his actions have damaged markets in general.

Knowledge@Wharton: Why is it that even sophisticated investors are being snookered in Ponzi schemes, still?

Maurice Schweitzer: The Madoff scandal is a story about several powerful influence principles working in concert. These are textbook principles. And in this case, you have four that are key. One is scarcity, where investors were told, "The fund is closed. But maybe I can get you in." It was exclusive, and there were some clients that got fired [because they asked too many questions]. The second key principle is authority. Madoff was somebody who in 1990 was the chair of NASDAQ. He pioneered electronic trading. He was a board member. He had this air of authority. And we know from the Milgram experiments and other studies that authority figures exert a huge amount of influence over us. Third, social proof. Everyone's doing it. From the Abu Dhabi Investment Authority to Line Capital of Singapore, to Stephen Spielberg and the owner of the New York Mets. You look around and everybody else is investing here. It seems like a reasonable thing to do. And fourth, the liking principle. We're influenced by people that we like. And here, social networks, meetings in country clubs, the charity events -- this is what brought people in. So you have in concert these four classic influence principles working together. And on the other hand, you have motivated reasoning. You have these investors who want to believe. They want to believe that they can earn the 10%, 11% interest, like clockwork. So they're willing to suspend their disbelief. And I think we failed to realize how powerful all of these factors are, when they work together.

Knowledge@Wharton: If the allegations against Madoff are true, this scheme lived longer than most Ponzi schemes. How was he able to sustain this?

G. Richard Shell: There was a failure of regulation. That seems to be getting explored in Congress now. And this particular scheme was remarkable in that the con artist conned the regulators as well as their investors. Maurice's point about the authority that this fellow had is partly responsible for that -- because [Madoff is] one of them. When you've been the head of the NASDAQ, you're inside the tent as far as the regulatory group is concerned. It's very difficult when there are no outward visible signs of fraud, to pick this up. And then it built on itself, so that as years passed, it became more and more credible. I think that in hindsight, it looks easy to spot, because it was a secret formula. He didn't reveal it to anybody. There were quite a number of people who decided not to play, because they couldn't see behind the veil of where the money was coming from. They look pretty smart now. But when you're doing this prospectively, and you have this opportunity, they look like the suckers. They look like the people who are being overly prudent. And the smart money is getting involved. So I think the length of this one has something to do with the fact that he was able to con the regulatory system at the same time he was conning the investors. That's a double whammy that's really hard to pull off over a period of time and over many different markets.

Read it all here.

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