The Triad Business Journal published a column by Andrew J. Haile, an assistant professor of law, in its Dec. 26-31 edition. “Ponzi scheme a painful reminder, but so was Enron” offers a cautionary lesson in the wake of the Bernie Madoff investment scandal.
Haile is an attorney in the Greensboro office of Brooks, Pierce, McLendon, Humphrey & Leonard. He focuses on business and corporate matters, particularly in the area of tax, mergers and acquisitions, and financing transactions.
Below is the column written by Haile:
Ponzi scheme a painful reminder, but so was Enron
The last couple of months have brought back to our attention twolessons that should have been learned long ago: “Don’t invest in whatyou don’t understand” and “If it seems too good to be true, it probablyis.”
Most recently, the Ponzi scheme engineered by Bernie Madoff showsthat even sophisticated businesspeople can lose sight of theseprinciples when they are enjoying healthy investment returns. Madoffwas arrested Dec. 12 for running what might be the largest fraud inWall Street history — investor losses as high as $50 billion.
One of the many notable aspects of this case is that Madoff did notprey on the weak. His primary investors were high-wealth individuals,hedge funds and institutional investors, all of whom the securitieslaws presume to be able to take care of themselves. Presumptions aside,these investors were enticed to invest in Madoff’s funds.
This was because of the funds’ high returns, reported to be 12percent to 15 percent annually for decades running. Unfortunately, few,if any, of the investors questioned the legitimacy of Madoff’spurported strategy for making these returns. Madoff called it the“Split-strike Conversion” strategy. Maybe a corollary to the “Don’tinvest in what you don’t understand” principle should be: “If the nameof the investment strategy means absolutely nothing, that’s probablywhat you’ll end up with if you invest.”
Similarly, the meltdown of Fannie Mae, Freddie Mac and majorcommercial and investment banks reinforces the lesson from the Madoffscandal. Even the so-called “masters of the universe” can lose sight ofinvesting fundamentals if they are seeing favorable returns. In thepost-mortems taking place over the now-cold bodies of Bear Sterns,Lehman Brothers, Fannie and Freddie, we have learned that many of thedecision makers at these organizations had no real understanding of thequality (or lack of quality) of the mortgage-based securities they held.
Instead, they put blind faith in the ratings given to the securitiesby various rating agencies. The comfort that “expert” rating agencieshad vetted the securities combined with the high returns from what arenow being called “toxic assets,” lulled executives at these formerlyvenerable institutions into complacency. Fortunes, reputations and jobshave been lost as a result.
The response to these events includes calls for additionalregulation. At least with respect to the Madoff scandal, however, themea culpas from Securities and Exchange Commission chief ChristopherCox indicate that the SEC had the necessary authority to detect thescandal years ago. Commentators and politicians will doubtlessly debatethe need for more regulatory authority.
But, there’s an even more effective preventative to thesesituations. It’s the very thing that finally broke the Enron scandal:asking fundamental questions.
In March 2001, Bethany McLean, a reporter for Fortune Magazine wrotean article asking simply: “How exactly does Enron make its money?” Oncethe question was asked, it became clear that not only was there no easyanswer, there was no answer at all. If Madoff investors had askedquestions, they might still have their money. If Wall Street bankershad asked questions, they might have realized the shoddiness of themortgage-backed securities they were holding.
The Enron-era scandals were only seven years ago. But memories areshort. Every few years, it seems, we forget these hard-learned lessons.Lately, there’s been no shortage of reminders.