Harry Markopolos, "The Man Who Knew"

[00:00:00] Hello, this is Dean Curnutt and welcome to the Alpha Exchange where we explore topics

[00:00:07] in financial markets associated with managing risk, generating return, and the deployment

[00:00:12] of capital in the alternative investment industry.

[00:00:20] Corporate fraud is an unfortunate, costly, and seemingly never-ending aspect of the

[00:00:24] world of business.

[00:00:25] In the best case, fraud is prevented or at least caught before harm is done.

[00:00:30] All too often, however, these cases of deception lead to large financial losses, impacting

[00:00:35] the lives of many – shareholders, individuals, and certainly those that are courageous whistleblowers.

[00:00:41] A little more than 15 years after the unwind of the Madoff Ponzi scheme, I invited Harry

[00:00:46] Markopolos back to the Alpha Exchange.

[00:00:49] Harry is often simply referred to as the man who knew.

[00:00:53] He chased Madoff for years, serving up a comprehensive slew of evidence to the

[00:00:58] that was mind-boggling in its degree of logic, rigor, and scope.

[00:01:02] Our conversation looks back on the lessons of this Ponzi scheme and also zooms out

[00:01:06] to consider other examples of corporate fraud including Theranos and FTX.

[00:01:12] Throughout our discussion I seek to gather Harry's insights on the commonalities

[00:01:16] in these cases, how to detect them, and also importantly, how to prevent fraud.

[00:01:21] He points to a few areas of progress on the enforcement front but makes a strong

[00:01:25] case that the penalties associated with being caught need to be considerably larger.

[00:01:30] I hope you enjoy this episode of the Alpha Exchange, my conversation with Harry Markopolos.

[00:01:38] My guest today on the Alpha Exchange is Harry Markopolos.

[00:01:42] He is the man who knew.

[00:01:44] Well known for his work in uncovering the very long-term fraud that was Bernie Madoff.

[00:01:52] Harry, it's great to reconnect and welcome to the Alpha Exchange.

[00:01:55] It's good to be back, Dean.

[00:01:57] It's been a few years since we last did one of these podcasts.

[00:02:00] We've also done a lot of in-person meetings over the years, I should say over the decades.

[00:02:04] When you wrote your book, no one would listen.

[00:02:06] I bought 30 copies.

[00:02:08] You came by the office and I had you sign every one of them.

[00:02:11] I do remember that.

[00:02:12] So thank you for doing that.

[00:02:14] Speaking of fraud, my publisher, I never got paid on any of those copies.

[00:02:19] Exactly.

[00:02:20] The more copies I sold, the more I owed them.

[00:02:22] Hopefully I haven't defaulted on you.

[00:02:24] No, no, you haven't.

[00:02:25] I got defaulted by my publisher.

[00:02:27] They thought I was a one and done author, which so far I have been.

[00:02:30] But I write another book, I'm not going to do a deal like I did the last time.

[00:02:33] I've never taken advance.

[00:02:35] I just want a percentage.

[00:02:36] Well, your foray into writing was not something you planned.

[00:02:39] But it turns out here in Easy to Read Writer, you had more metaphors and kind of little

[00:02:45] one-liners in that book.

[00:02:47] A serious book, but you managed to bring in quite a bit of humorous writing style.

[00:02:52] And the reason I asked you to do that was because I certainly was fascinated by your work.

[00:03:00] You and I met in 2002 in Boston.

[00:03:02] We were chatting about variant swaps and some of the math behind that.

[00:03:06] And I was one foot out the door after the meeting.

[00:03:09] It was the first time we met.

[00:03:11] And you asked me about Madoff.

[00:03:12] You said, it's a fraud.

[00:03:14] It's a Ponzi scheme.

[00:03:15] It could be that they're front running the market making business.

[00:03:19] And then you thought about it for all of about 10 seconds.

[00:03:22] You said, no, it's a Ponzi scheme.

[00:03:24] I'm certain of it.

[00:03:24] And that stayed with me.

[00:03:26] The conviction with which you said that stayed with me that when I was on a train in

[00:03:31] December 08 and on my BlackBerry, we all used BlackBerry's back then, I saw the

[00:03:37] headline and your name was the first that came to my mind instantaneously.

[00:03:41] I just couldn't believe it.

[00:03:43] And then in the aftermath, we learn of all the work you did along the way.

[00:03:48] 2001, 2000, I want to say five, seven, at least five times with incredible detail

[00:03:55] that you reached out to the SEC to try to flag this thing down.

[00:04:00] You were the fourth guest on the Alpha Exchange and that was December 18.

[00:04:04] It was a 10 year anniversary of Madoff.

[00:04:07] And it's not a happy event, of course.

[00:04:08] And I know it's changed your life forever, but here we are on

[00:04:12] roughly the 15th year after it.

[00:04:14] And so I figured I'd reach back out to you and talk a little bit about Madoff

[00:04:19] and more broadly about corporate fraud.

[00:04:22] And then some of the work you're doing now on the fraud uncovering front.

[00:04:27] Again, thanks.

[00:04:27] It's awesome to talk.

[00:04:29] Let's get the conversation underway.

[00:04:30] I want to repeat back to you something you said on our first podcast in 2018.

[00:04:37] You said 45 degree angles don't exist in finance.

[00:04:41] They may exist in trigonometry or geometry, but we don't get 45 degree

[00:04:48] angles in finance and I just love that insight.

[00:04:53] And that was up into the right, as you said, Madoff's returns.

[00:04:57] So I'd love for you to just start there.

[00:04:59] You took a look at the returns, walk us through your reaction and just

[00:05:03] looking at the time series of the returns.

[00:05:05] You'd say that that couldn't exist again, but we still have cases.

[00:05:10] You'll see things like that.

[00:05:12] Did a case more recently than Madoff and that was in 2016,

[00:05:16] platinum partners in New York.

[00:05:19] It was an Orthodox Jewish led scheme out of Brooklyn and Manhattan near

[00:05:24] Carnegie Hall and they were better than Madoff.

[00:05:26] They were at 18% and 10 years, they only had one losing month.

[00:05:31] So they had a higher batting average than Madoff.

[00:05:34] And you say that thing can't happen again, but it does.

[00:05:36] People walk into that.

[00:05:38] Look at private credit.

[00:05:39] Some of the alphas that they're claiming in private credit, very

[00:05:43] dodgy product, I think too much money flowing in what makes private

[00:05:48] credit guys think that they can underwrite risk credit better than banks.

[00:05:53] I don't think they can.

[00:05:54] And these guys are claiming sharp ratios, sometimes as high as 10,

[00:05:59] which is great when you're not marking your portfolio daily, because

[00:06:03] it doesn't really trade in a listed market on a transparent price exchange.

[00:06:08] So we do see a lot of scams from time to time.

[00:06:11] If I had to point out one that I'd be leery of right now, it would

[00:06:14] be private credit, I would say.

[00:06:16] Would be high on the risk radar for me.

[00:06:19] And that one, if I could just jump in, it's dodgy in the sense

[00:06:22] of, and I'll just borrow from Cliff Asness here, it's a soapbox

[00:06:26] issue for him personally, which is, as you said, they're not

[00:06:29] marking to market so you can get a pretty high sharp ratio if you

[00:06:32] make the denominator of vol so low.

[00:06:35] He calls it vol laundering, which is just not paying attention

[00:06:38] to actual fluctuations.

[00:06:40] It's dodgy.

[00:06:41] It's probably not fraudulent in the sense that Madoff was.

[00:06:45] And back to Madoff, you were responsible for trying to replicate

[00:06:50] this split strike conversion strategy and maybe just touch on the

[00:06:55] impossibility of using an option strategy like that, essentially a

[00:06:59] risk reversal and earning a three as sharp ratio on a consistent basis.

[00:07:05] Most obvious thing was he was using the wrong options.

[00:07:08] Why would you use the standard before 100 OEX option, which had

[00:07:11] the American extra subs, those things he gained all the time.

[00:07:15] He was claiming to replicate the OEX stock basket, which you

[00:07:18] wouldn't because your hedge will be the OEX, there's no hedge on the

[00:07:21] futures, it's an imperfect hedge because the OEX standard before

[00:07:24] is 100 is constructed vastly differently than the S&P 500, the

[00:07:28] SBX, which is where your futures layoff was.

[00:07:31] So he's just changing the wrong product.

[00:07:33] And then he was trading individual options.

[00:07:35] And why would you do that?

[00:07:37] Why would you take on single stock company specific risk?

[00:07:40] All they needed was one company to miss earnings or have an accounting

[00:07:45] event or some other disaster, a natural disaster like Boeing, let's

[00:07:50] say you own Boeing shares and another one of their planes crashed.

[00:07:55] Well, how are you protected your portfolio?

[00:07:57] Boeing could drop in half and the returns were too smooth for Madoff.

[00:08:02] He should have been using an index type strategy and said he was using

[00:08:06] single stock baskets, which was poor risk management.

[00:08:11] And of course he never was really trading options and you could prove

[00:08:13] that just looking at the open interest in the OEX put options.

[00:08:17] So the math never worked for Madoff.

[00:08:18] It was an obvious fraud.

[00:08:21] The only problem was all the people that were feeder funds, the

[00:08:24] hundreds of feeder funds, all those cats were saying we've done great

[00:08:28] due diligence and in fact they did no due diligence.

[00:08:30] They just assume the other guys did.

[00:08:32] And that's typically the way it goes on Wall Street.

[00:08:34] Due diligence is nothing but marketing hype.

[00:08:37] It really doesn't exist in the real world except on rare occurrences.

[00:08:40] The due diligence aspect is interesting.

[00:08:43] I know someone who's done the work and I can free ride off of it.

[00:08:46] And I'm thinking of two other cases.

[00:08:49] Theranos, that was a really interesting one in which former

[00:08:53] U S secretary of state, George Schultz was on the board, Jim

[00:08:57] Mattis, Henry Kissinger.

[00:08:59] And so it became this free riding off the reputational equity that was on

[00:09:05] the board, even though these folks didn't have any experience in medicine.

[00:09:08] They were big names.

[00:09:10] So I think that's one.

[00:09:11] And then of course, FTX is another one where the benefit of association,

[00:09:16] whether it's with stars like Tom Brady.

[00:09:20] I don't know if you happen to see the Tom Brady roast on Netflix.

[00:09:23] I didn't catch it yet.

[00:09:24] It was quite funny.

[00:09:25] And they did a lot of the FTX part of things, but you get guys like

[00:09:30] Matt Damon and Tom Brady to show for you.

[00:09:33] And then you have these other VC investors who somehow think that

[00:09:39] someone else has done the work and we can free ride off of it.

[00:09:42] That seems to be some aspect of the commonality of these things.

[00:09:46] I'm wondering if you can talk about that.

[00:09:48] Walgreens, they put a hundred million dollar bet on Theranos and

[00:09:53] they never once did a proper due diligence test and CEO lost his job for that.

[00:09:58] Well, they should have, but it's easy.

[00:10:01] You go in there with your own blood test results for the old fashioned way.

[00:10:06] And you say, okay, I want to see your instant test results and sign me up.

[00:10:11] Take me to the Edison machine.

[00:10:13] Let's see how it works.

[00:10:14] If anybody at Walgreen or any of the investors that got built had done

[00:10:18] that this fraud wouldn't have gotten so big and of course, nobody did.

[00:10:23] Because everybody trusts, oh, it must be real.

[00:10:26] Look, it's a real company here.

[00:10:27] They have a building.

[00:10:28] They have PhDs and people with master's degrees in biosciences must be legit.

[00:10:34] And they didn't notice that.

[00:10:35] Wait a minute.

[00:10:36] Why are there so many security guards?

[00:10:38] Oh, proprietary technology.

[00:10:41] Oh, okay.

[00:10:42] What wasn't proprietary was give me a blood test and you could

[00:10:46] have bypassed all the bullshit and no one cut through it.

[00:10:49] And that's why so many people were fooled.

[00:10:51] And even George Schultz, God rest his soul, his own grandson told him

[00:10:56] it was a fraud and he worked there.

[00:10:58] And then they went after the grandson, Boyd Schiller, the law firm

[00:11:01] went after him tooth and nail.

[00:11:04] So why are you sending a premier law firm after a young 20 something

[00:11:09] who actually had ethics and obviously was very smart and figured it out

[00:11:16] quickly unlike the investment pros in Silicon Valley.

[00:11:21] And the rest is history.

[00:11:23] If we think about Theranos, FTX and Madoff, Madoff has the additional

[00:11:29] element of this affinity scheme.

[00:11:31] Very much targeting wealthy Jewish individuals oftentimes in the

[00:11:36] South Florida area, but perhaps all three of them have this idea

[00:11:41] that we want to believe in the quirky genius Elizabeth Holmes took on this

[00:11:45] persona where she lowered her voice.

[00:11:47] She dressed like Steve Jobs.

[00:11:49] Everyone loves the ADD of SBF.

[00:11:53] They just thought, wow, we can't even understand how smart this guy is.

[00:11:57] And with Madoff as of course you're more familiar than anybody.

[00:12:02] He had this unbelievable ability to create this love atmosphere that if

[00:12:07] you're getting into something that most people don't, you'd be lucky.

[00:12:10] If I did allow you to get in.

[00:12:12] It was the money club for sure.

[00:12:14] Madoff's alert so exclusive.

[00:12:16] I don't want you in.

[00:12:18] You have to beg.

[00:12:18] And even then I probably don't want you in because you're going to be a

[00:12:20] pain in the ass and he just insults you as a customer, which was phenomenal

[00:12:24] on his part, great con.

[00:12:26] As far as SBF, I'm not big into crypto, but I would say that was an

[00:12:32] affinity fraud too, because he attracted like-minded people and

[00:12:37] they're people that are young.

[00:12:39] They grew up during their financial crisis 2008, 2009, and they lost

[00:12:43] trust in their government as well.

[00:12:45] They should.

[00:12:46] None of the big banks were prosecuted.

[00:12:48] No one at AIG went to jail and the justice of Arbor just sat on their hands.

[00:12:53] And so you can see why they would lose trust in their government and

[00:12:57] rebel, and I think that was his affinity group as far as Madoff.

[00:13:01] He might've started in the Jewish community, but at the end he had

[00:13:04] far more non-Jewish victims.

[00:13:07] I would say more Catholics, more Protestants.

[00:13:10] He was pretty big in Europe.

[00:13:11] I mean, he had more feeder funds, way more feeder funds in Europe

[00:13:13] than he had in the U.S.

[00:13:15] And he was just getting started in Asia, of course.

[00:13:17] And they would have been the newest victims of the financial crisis

[00:13:20] hadn't collapsed the Madoff scheme.

[00:13:22] But everybody starts with an affinity group of some sort.

[00:13:26] And so SBF is no different.

[00:13:27] What did he get?

[00:13:28] 25 years with good behavior.

[00:13:30] He'll probably get 85% of that and he'll be out maybe when it

[00:13:34] turns 50 or thereabouts.

[00:13:37] That was actually a pretty good sentence for white collar.

[00:13:39] Madoff obviously got 150 years.

[00:13:42] Sir Alan Stanford at his Ponzi scheme.

[00:13:46] What did he get?

[00:13:47] 110 years.

[00:13:49] So sometimes you get big sentences and white collar, but usually

[00:13:51] it's two to seven years.

[00:13:53] So that's atypical what SBF got.

[00:13:56] Obviously not a sympathetic person.

[00:14:00] He fit the profile of a egotistical villain and I'm sure the judge

[00:14:05] held that against him at sentencing.

[00:14:07] And we'll see how long he lasts in prison.

[00:14:11] Looks sort of weak to me in prison.

[00:14:12] It looks like he's the type of person people would prey on.

[00:14:15] If you look at some of these episodes of fraud I was reviewing,

[00:14:19] WorldCom goes back a ways and Ron, these things kind of

[00:14:23] lasted three to seven years.

[00:14:26] Depends.

[00:14:27] The Madoff one, it's hard to date exactly when it started, but

[00:14:31] it certainly lasted a long time.

[00:14:34] Decades.

[00:14:35] Yeah.

[00:14:35] And it's not as if someone found it out.

[00:14:38] I mean, you did, but it's not as if someone acted on that.

[00:14:42] It was that the financial crisis hit.

[00:14:45] And so you might say, well, if the financial crisis didn't actually

[00:14:49] hit, it might've gone on for longer.

[00:14:52] What does that tell us about the length of this fraud?

[00:14:55] And, you know, in some parts, you sort of look back on this,

[00:14:58] Harry, and you see you documented all of this.

[00:15:01] He's got numbers in his reports printed on dot matrix paper that

[00:15:06] are just not closing prices type of thing.

[00:15:09] What does it tell us about something that could be so lengthy in duration?

[00:15:14] It tells you that no one's really looking that due diligence

[00:15:18] really is marketing hype.

[00:15:20] It's rare to see that in the wild, actual real due diligence where

[00:15:25] someone camps out at your operation for maybe several days, or maybe

[00:15:29] they come back a week later and spend a couple more days and

[00:15:33] they're just shadowing you watching what you do.

[00:15:35] And it would be very intrusive, but if someone's going to do that, then

[00:15:38] I would say at all levels of the organization, start at the back office,

[00:15:42] go to the middle office and then go to the top and the people making

[00:15:44] the investment decisions, you probably have a decent idea on whether it's real.

[00:15:49] And then you'd have to take all the documentation that you've compiled

[00:15:54] and you'd have to go to the third parties, to the custodians,

[00:15:57] to maybe the prime brokers, the trade counterparties and verify you do

[00:16:02] mean this kind of volume.

[00:16:03] And you'd have to take a look at the financial statements and you'd have

[00:16:06] to go to the custodian and say, what's the cash there on December 31st

[00:16:10] in this amount?

[00:16:12] It would take a lot of work to do real due diligence.

[00:16:14] And that's why so few people actually do it.

[00:16:17] And so few managers would even allow you to do due diligence.

[00:16:20] So it is a leap of faith when you're doing any kind of

[00:16:22] an investment, I would say.

[00:16:24] So what have we learned from Madoff?

[00:16:26] Probably not much.

[00:16:27] Maybe we learned that we're easy to be fooled.

[00:16:30] That would be a good listen because you had SVF and how many people

[00:16:35] lost money with three arrows and the like?

[00:16:37] I remember I was pitched, Harry, if you want a mortgage, come to me.

[00:16:43] Why would you pay your bank 4% for a mortgage?

[00:16:47] I'll pay you 6% to borrow from me.

[00:16:50] And I thought, what?

[00:16:52] So I knew I was being pitched a fraud.

[00:16:54] And of course it was a crypto scheme where these dudes, crypto bros,

[00:16:59] they have thought that they could earn 18% by depositing their crypto

[00:17:04] and pay me 6%.

[00:17:07] And they thought that was an arbitrage.

[00:17:10] And I thought that was the most ridiculous thing I've ever seen.

[00:17:13] Unfortunately, I didn't know how to short crypto or I would have.

[00:17:16] And you saw what happened in crypto.

[00:17:18] And of course now it's back again with a vengeance.

[00:17:21] So there's schemes all over the place.

[00:17:23] And I think you mentioned one here on that write up you sent me.

[00:17:27] I mean, Herbalife, these multilevel marketing schemes are considered

[00:17:32] cousins of the Ponzi scheme, but they're not Ponzi schemes.

[00:17:36] They're just making money luring you into the trap

[00:17:38] so that you'll lure your friends in and pay the company fees.

[00:17:42] In this case, it would be Herbalife.

[00:17:44] It could be anybody. It could be Amway or any others.

[00:17:47] Those are scams.

[00:17:47] They usually prey on different ass-naked groups.

[00:17:51] Those are affinity schemes.

[00:17:52] But law enforcement doesn't go after them because those companies

[00:17:55] have lobbied successfully and they have exemptions to the rules.

[00:17:59] Then they get away with pitching their horrible products

[00:18:02] that just suck money from poor people that can't afford to lose them.

[00:18:06] Wanted to get your thoughts on the spectrum of fraud.

[00:18:11] You know, fraud when you see it, there's obvious and absolute outright fraud.

[00:18:15] You've just described Herbalife, obviously, in the view of Bill Ackman.

[00:18:20] Herbalife was a Ponzi scheme and I think attached to the word Ponzi is fraud.

[00:18:25] My question is, is there some component of gray sometimes

[00:18:30] in the way in which businesses are set up that you might argue

[00:18:33] that one might say it's a fraud, another might say, well, this is

[00:18:37] business construction and a marketing setup, and it's not a fraud.

[00:18:41] Like I said, the pyramid schemes are the cousin of the Ponzi,

[00:18:45] not the Ponzi, though the Ponzi actually will get you jail time

[00:18:49] and the multi-level marketing scheme will make you rich

[00:18:53] and you'll just get rich on the backs of people that are too dumb

[00:18:56] and too poor to know any better that they think

[00:19:00] you're giving them the opportunity to succeed as an entrepreneur

[00:19:03] by building a business when in fact, they're just sucking you dry

[00:19:06] and all the victims that you lure in behind you.

[00:19:09] And when you run out of dumb people to take advantage of

[00:19:12] in the multi-level marketing schemes, it will crash.

[00:19:15] Just like when you run out of Ponzi scheme victims,

[00:19:18] when new money is overtaken by outflows, people want redemptions.

[00:19:22] That's when the Ponzi scheme is going to end.

[00:19:24] And so they're similar.

[00:19:26] Like I said, they're cousins, but they're not the same thing.

[00:19:29] One is criminal.

[00:19:29] That would be the Ponzi scheme.

[00:19:31] And one is just unethical.

[00:19:32] That will be the multi-level marketing scam.

[00:19:35] In some of these, not always a Madoff is unique

[00:19:38] in the sense that it's a private fund.

[00:19:40] It's not like you could short Madoff, but there are public securities.

[00:19:45] Enron's an example where the work of Jim Chanos,

[00:19:49] forensic accounting, to really dig in and realize what they were doing,

[00:19:53] establish a short position and frankly, hopefully profit from it.

[00:19:56] Ackman chased the MBA for years.

[00:19:59] He was right.

[00:20:00] Was ultimately correct.

[00:20:01] But in the meantime, MBA had much to say about

[00:20:05] call it short and distort.

[00:20:07] That's what the company is going to tell you.

[00:20:08] And so I'm wondering what you think the balance there is of

[00:20:12] an investor who's got conviction, thinks they've done the work.

[00:20:15] We've got a couple out there now.

[00:20:16] Muddy Waters is an example of a private vehicle

[00:20:20] that's generally focused on shorting and tries to use the media

[00:20:26] as some mechanism for getting people woken up to what they see.

[00:20:31] I'm wondering what you think the balance there is.

[00:20:33] When the company say short and distort,

[00:20:36] the only market manipulation that's taken place is by the companies themselves

[00:20:40] on the accounting frauds that they're running typically.

[00:20:43] And what do we know about Wall Street research?

[00:20:45] Dedicated short sellers like Muddy Waters, Jim Chanos,

[00:20:49] who I think retired last fall.

[00:20:51] But I believe he is managing his personal accounts still.

[00:20:54] And you have Hindenburg Research, very, very successful firm as well.

[00:20:58] And when those firms, Muddy Waters and Hindenburg do an analytical report,

[00:21:03] companies typically say short and distort.

[00:21:06] But the companies were doing the manipulations all along.

[00:21:09] And what they were telling investors was not true.

[00:21:11] And so usually the people that are looking out for your interests

[00:21:14] are probably the short sellers,

[00:21:17] because they seem to be the truth sayers on Wall Street.

[00:21:19] The Department of Justice is fast asleep and has been since 9 11.

[00:21:23] They don't pay any attention to white collar fraud.

[00:21:25] You haven't seen any meaningful

[00:21:27] criminal prosecutions of large companies

[00:21:30] since the days of Enron, WorldCom, Adelthea, Health South.

[00:21:36] And the government's been missing in action for over 20 years.

[00:21:39] And you saw that during the global financial crisis.

[00:21:42] When we talk about fraud, there's a couple of categories.

[00:21:45] You mentioned Health South and WorldCom, Enron.

[00:21:49] A lot of that tends to be internal accounting chicanery.

[00:21:53] These systems get super complex.

[00:21:55] I was just reviewing and reading up on WorldCom from 2002.

[00:22:01] And just the amount of time it took them to

[00:22:04] really uncover that there was something there.

[00:22:07] These systems are unwieldy,

[00:22:09] trying to track all the ledgers and so forth.

[00:22:13] So it was a month's process.

[00:22:14] And of course, there's people that don't ultimately want you to know.

[00:22:17] So it's pretty easy for them to put some sand in the gears.

[00:22:21] Financial fraud can be kind of more obvious.

[00:22:23] You looked at Madoff. You saw the 45 degree.

[00:22:26] Alan Stanford, I think, was offering CDs at 13 percent

[00:22:29] and calling them bank notes when rates were 3 percent, saying they were risk free.

[00:22:34] So those could be easier.

[00:22:36] I'm wondering on just the corporate side, you've got a great B.S.

[00:22:40] detector. You're willing to really dig in.

[00:22:43] What are some of the warning signs that you think immediately

[00:22:47] gets you interested and say, hey, I think this is worth a look?

[00:22:50] When you see year over year, revenues go down,

[00:22:54] your profits go up.

[00:22:56] My bullshit radar gets activated

[00:22:59] because I know they're doing some kind of something, at least financial engineering.

[00:23:03] Maybe it's stock buybacks or purchase shares.

[00:23:05] So the earnings per share continue growing.

[00:23:08] But you look at net income, you look at revenues down and down

[00:23:13] and you got issues.

[00:23:14] And there are certain companies when they hit a wall,

[00:23:16] are they going to be lured into let's just do some accounting chicanery?

[00:23:21] Let's just commit accounting fraud this one quarter,

[00:23:23] because, you know, once they get started on that path,

[00:23:26] counting fraud is sort of like heroin addiction.

[00:23:29] Once you stick that needle in, you're not pulling it out again

[00:23:32] till you get caught and hit rock bottom.

[00:23:35] There are companies, I would say that you look at the revenue.

[00:23:39] They could be tempted to cheat.

[00:23:40] The one that comes to mind now would be Apple.

[00:23:43] Revenues are down.

[00:23:45] Earnings per share tend to go up because why?

[00:23:48] They bought back shares. I'm not saying they're cheating.

[00:23:50] In fact, if you look at Apple's annual reports,

[00:23:53] you could do year over comparisons for multiple years there.

[00:23:56] I would say that their annual reports are

[00:24:00] how people should write their annual reports.

[00:24:01] They're in English and they give you the same format every year

[00:24:05] so you can do the cops.

[00:24:06] And so I'm not saying that they're cheating,

[00:24:08] but I'm saying they could be tempted to.

[00:24:10] And you take a look at their working capital.

[00:24:12] Is it negative or positive?

[00:24:14] Last year turned negative.

[00:24:16] But their business is not doing as well as it once did.

[00:24:19] It's still doing great.

[00:24:20] It's still one of America's greatest companies.

[00:24:22] I use their products. I swear by their products.

[00:24:25] Love their financial statements.

[00:24:26] But I'm saying even a company like that could be tempted.

[00:24:29] Someone that profitable.

[00:24:31] But the other companies,

[00:24:32] when you see companies that are not Apple

[00:24:34] and their revenues aren't growing

[00:24:37] and earnings for sure are going up,

[00:24:38] then I would certainly dig in.

[00:24:40] If you can't understand their financial statements

[00:24:42] because they don't make any sense,

[00:24:44] Apple's financial statements make sense.

[00:24:46] Other companies, if you look at those financial statements

[00:24:49] and you can't do year over year comparisons,

[00:24:51] you've got a problem. They're hiding something.

[00:24:53] And if you want to dig in,

[00:24:55] that's probably a good thing for the short sellers to do

[00:24:57] because they seem to be the only one

[00:24:58] with the talent for diagnosing accounting frauds.

[00:25:02] And they seem to be the only ones

[00:25:03] with a forensic accounting ability.

[00:25:06] And so you listen to those people

[00:25:07] because they're pretty smart.

[00:25:09] I was just again going through WorldCom.

[00:25:11] This woman was named Cynthia Cooper,

[00:25:13] Sharon Watkins on Enron.

[00:25:16] It's a tough slog.

[00:25:17] And I'm sure what you went through

[00:25:19] was extremely difficult for years.

[00:25:22] I'm just wondering if you could take us

[00:25:24] through the aftermath.

[00:25:26] You became quite a prominent figure in 2009 and beyond.

[00:25:31] And maybe just walk us through a little bit of that experience,

[00:25:36] but also what broadly has occurred

[00:25:39] in terms of what it means to be a whistleblower

[00:25:42] or someone who's trying to detect fraud.

[00:25:45] Is that viewed differently post-Madoff?

[00:25:48] What's changed?

[00:25:49] The Madoff case, my testimony before Congress,

[00:25:51] led us to the whistleblower program.

[00:25:53] I advocated that we needed a program.

[00:25:55] And I handed out statistics from the Association

[00:25:57] of Certified Fraud Examiners that showed

[00:25:59] that whistleblowers were 23 times more effective

[00:26:01] than law enforcement.

[00:26:03] Whistleblowers caught 46% of the fraud,

[00:26:05] law enforcement 2%.

[00:26:08] Congress agreed and we had a whistleblower program

[00:26:10] for the CFTC and the SEC.

[00:26:13] Now if you look at the government,

[00:26:14] other agencies are starting whistleblower programs,

[00:26:17] including FinCEN for money laundering.

[00:26:19] The IRS has a program,

[00:26:20] but it's been pretty much ineffective

[00:26:22] because the IRS hates whistleblowers

[00:26:25] and they lack the investigative resources

[00:26:26] to actually know tax fraud when they see it.

[00:26:30] The only fraudsters they go after,

[00:26:32] they go after the poor and the minorities

[00:26:34] who are low dollar amount frauds,

[00:26:36] typically earned income tax credit,

[00:26:38] payroll protection fraud.

[00:26:40] Their IT is pretty poor,

[00:26:42] that goes beyond poor,

[00:26:43] it's decades out of date.

[00:26:45] And so they can't do the large cases

[00:26:47] against the billionaires

[00:26:49] and the companies that are cheating.

[00:26:51] So they do a lot of small cases

[00:26:53] and pad their statistics on the backs of the weak

[00:26:55] and the poor and the minorities.

[00:26:56] So it just depends,

[00:26:57] it's a mixed bag out there on whistleblowers

[00:26:59] that say the SEC program and the CFTC program,

[00:27:02] people come in with complex large dollar frauds

[00:27:06] and the SEC punishes but it's pennies on a dollar.

[00:27:09] You haven't seen meaningful white collar prosecutions

[00:27:11] on Wall Street since the days of WorldCom,

[00:27:14] Enron, HealthSouth and Adelphia.

[00:27:16] And that was during President George Bush,

[00:27:18] his first term.

[00:27:20] And it hasn't been anything for two decades.

[00:27:22] Right now I'd say it's a very dangerous time for investors.

[00:27:25] Is the regime of regulation related to

[00:27:30] a bull market or a bear market?

[00:27:32] Yeah, I would say it is.

[00:27:33] In a bull market they don't do anything.

[00:27:36] Things are great,

[00:27:36] why should we worry about prosecutions?

[00:27:38] In a bear market,

[00:27:39] oh my God, things are terrible.

[00:27:41] We can't afford to go after these banks.

[00:27:43] People will lose confidence in them.

[00:27:44] They could be bank runs,

[00:27:45] it could cause a systemic collapse of these firms.

[00:27:48] Well, I would argue the opposite.

[00:27:50] You've just created moral hazard

[00:27:52] by not prosecuting.

[00:27:53] You've made the comment

[00:27:55] in some of your public testimony

[00:27:56] that you looked at Madoff

[00:27:58] and you very easily saw this is not possible.

[00:28:02] No one's running a three sharp ratio for 10 plus years.

[00:28:06] I think the fund barely lost money in August, 1998

[00:28:10] when LTCM went down.

[00:28:12] And then you asked some basic questions.

[00:28:14] Who are his listed option counterparties, et cetera?

[00:28:17] Where's the volume?

[00:28:19] But then you also had to do some math

[00:28:20] as part of your request to replicate this strategy.

[00:28:24] And you know a ton about options.

[00:28:26] And so I'm wondering just on the enforcement side,

[00:28:29] this came up in your testimony that these folks are

[00:28:33] not even that they're not empowered,

[00:28:34] that they're not equipped with the skillset

[00:28:37] to understand a lot of this complex stuff.

[00:28:40] How do you rectify that?

[00:28:42] The SEC took my advice and the testimony.

[00:28:45] They went out and got financial experts

[00:28:46] to join the SEC.

[00:28:48] As you know,

[00:28:49] when you get laid off on Wall Street in your 50s or 60s,

[00:28:54] it's hard to get another job.

[00:28:55] So the SEC offered employment to those folks.

[00:28:58] And so they have subject matter experts

[00:29:00] that they can make use of now.

[00:29:02] They may not have them at every office,

[00:29:04] but they exist somewhere typically within the SEC's ranks.

[00:29:07] And thanks to the audio visual capabilities of Zoom

[00:29:10] and WebEx and Microsoft Teams,

[00:29:12] those people can participate in analyzing cases.

[00:29:15] And I would say that if you have someone

[00:29:17] with industry experience,

[00:29:19] they can understand a fraud

[00:29:20] and hopefully simplify the explanation

[00:29:22] so that even the SEC's attorneys

[00:29:25] and federal prosecutors can understand them.

[00:29:26] And you have to be able to do that

[00:29:29] because your typical lawyers are not finance people.

[00:29:32] They're not accounting people.

[00:29:33] They majored in something else

[00:29:35] and then went into the law.

[00:29:36] And so if you're a financial expert,

[00:29:38] you have to simplify things

[00:29:40] so that laypeople like lawyers can understand your case

[00:29:43] because if the government's attorneys

[00:29:45] can't understand your case,

[00:29:46] then a jury's not going to.

[00:29:48] And the case will never get brought to trial.

[00:29:51] And so the SEC has done a lot to reform itself

[00:29:54] in the wake of Madoff,

[00:29:55] but they still have a long ways to go.

[00:29:57] I would say they still avoid the big cases

[00:29:59] and their punishments are no touch,

[00:30:01] light touch fines that encourage more fraud.

[00:30:04] They don't deter fraud.

[00:30:06] The Madoff case you're certainly most known for,

[00:30:08] but you've been involved

[00:30:10] and uncovered some other important cases,

[00:30:12] one of which is a currency manipulation case.

[00:30:16] Talk to us about that.

[00:30:17] Just kind of lay that out for us.

[00:30:19] I don't think a lot of people know

[00:30:20] nearly as much about that one,

[00:30:22] but it's certainly interesting.

[00:30:24] The custody banksters,

[00:30:25] they're promising to be honest fiduciaries.

[00:30:29] They're promising you the mutual fund,

[00:30:31] the hedge fund, pension funds.

[00:30:34] We're going to give you straight through

[00:30:36] real time processing, best price execution.

[00:30:40] We're a fiduciary.

[00:30:41] They had big contracts,

[00:30:43] dozens to hundreds of pages long.

[00:30:46] And they made all these representations

[00:30:47] and warranties that were worthless,

[00:30:49] not worth the paper they were printed on.

[00:30:51] So no one checked

[00:30:52] because the contracts had all the right stuff,

[00:30:54] best price execution, real time.

[00:30:57] And if they had looked at their price fills

[00:30:59] on currencies,

[00:31:00] what they would have noticed is

[00:31:01] they got the worst prices.

[00:31:02] If you were buying,

[00:31:03] you got the highest price of the day.

[00:31:05] And sometimes you got the higher than the highs.

[00:31:07] And if you were selling a currency,

[00:31:10] you got the lows.

[00:31:11] And sometimes you got lower than the lows.

[00:31:13] No one checked.

[00:31:14] This went on for decades.

[00:31:17] You got the same bad price fills

[00:31:19] to four decimal places

[00:31:20] that every other sucker got.

[00:31:22] And no one checked.

[00:31:23] So you had thousands of people

[00:31:25] working at the custody banks,

[00:31:27] at the mutual funds,

[00:31:28] the pension funds, hedge funds.

[00:31:30] No one noticed that their fills sucked.

[00:31:32] What can I say?

[00:31:33] You just have to look.

[00:31:35] If you look,

[00:31:36] if you turn over enough rocks,

[00:31:37] you're going to see snakes.

[00:31:38] That was an easy case.

[00:31:40] It took years to get the government

[00:31:41] to pay attention to it

[00:31:42] and to punish it.

[00:31:44] And the fines were minuscule.

[00:31:46] The slap on the wrist

[00:31:48] is a common refrain

[00:31:50] post someone paying a fine of some kind.

[00:31:53] I think you do make a good point

[00:31:55] that deterrence is about the severity

[00:31:57] of the outcome for being caught.

[00:32:01] I think that's at least part of the recipe,

[00:32:03] of course,

[00:32:03] very effective oversight

[00:32:05] is another part of deterrence,

[00:32:07] not enabling it to even occur

[00:32:09] in the first place,

[00:32:10] but consequences matter.

[00:32:12] That's important.

[00:32:13] So tell me what animates you these days?

[00:32:15] What are you up to?

[00:32:16] I'd love to just learn a little bit more

[00:32:19] about the kind of evolution

[00:32:21] of how you think about these over time.

[00:32:25] You talk sometimes about

[00:32:27] think it's the ACFE,

[00:32:29] which I've just learned

[00:32:30] that was started in 1988.

[00:32:31] I didn't know it was that old,

[00:32:33] but I'd just be curious.

[00:32:35] It's a very unique skill set.

[00:32:38] It's a very unique undertaking.

[00:32:40] You got to have a real strong nose for BS.

[00:32:44] It's an interesting type of person

[00:32:45] that's going to be drawn towards

[00:32:47] doing the work that you're doing.

[00:32:49] And I just love for you to reflect

[00:32:50] on your years of doing it at this point.

[00:32:53] I'd say that

[00:32:55] you got to go somewhere for training.

[00:32:56] The ACFE is a good source for that training,

[00:32:59] but then you have to go beyond it.

[00:33:01] You got to really self-train in this field

[00:33:03] and it really helps to have industry experience.

[00:33:06] I have a little buddy of mine,

[00:33:07] Crispius and Tilly.

[00:33:09] He was in sales

[00:33:11] and the durable medical device equipment market

[00:33:14] for hospitals and large physician practices

[00:33:17] for a long time.

[00:33:18] And now he does healthcare fraud cases

[00:33:21] and he's probably the world's best

[00:33:23] healthcare investigator.

[00:33:25] And here's a guy that he reads every case.

[00:33:27] He reads every pronouncement

[00:33:28] that the center for Medicare puts out.

[00:33:31] He looks at the budget for Medicare

[00:33:33] and what they're spending by category.

[00:33:35] And when he sees growth in certain categories,

[00:33:37] I mean, he just knows how to diagnose frauds.

[00:33:39] He's brilliant.

[00:33:40] But you don't become brilliant overnight.

[00:33:43] You become brilliant over a period of decades

[00:33:45] and it's a cumulative process as you train yourself up.

[00:33:47] You're always reading things.

[00:33:49] I would say that I'm doing that in finance.

[00:33:51] And if you wanted to be good in green energy fraud,

[00:33:55] you'd probably do the same in green energy

[00:33:57] and you'd read all the cases of fraud out there.

[00:33:59] There's a growing body of cases in green energy.

[00:34:02] I don't pretend to be an expert at it,

[00:34:04] but somebody should be.

[00:34:05] There's always new areas of fraud

[00:34:07] that you can train yourself in

[00:34:08] and you can make a living

[00:34:09] with the proper whistleblower programs

[00:34:12] and you can stop some fraud.

[00:34:15] Unfortunately, what's missing is the criminal enforcement

[00:34:19] and tough enforcement by the regulators.

[00:34:21] Back when you were chasing Madoff,

[00:34:23] there was nothing called artificial intelligence

[00:34:27] or machine learning.

[00:34:29] And now we can train these models

[00:34:32] on corporate transcripts.

[00:34:34] And what's got me asking this question

[00:34:36] is something you alluded to before,

[00:34:38] which is the way in which things are presented.

[00:34:40] Apple makes it easy

[00:34:42] if you see something changing over time.

[00:34:45] Searching for these things has gotten much easier.

[00:34:48] I was talking to an investment contact

[00:34:51] around looking for potential inconsistencies

[00:34:56] in corporate statements

[00:34:57] and they find that even grammatical errors,

[00:35:01] which might seem innocent,

[00:35:02] tend to be associated with some alpha

[00:35:06] in predicting volatility.

[00:35:08] You try to do something quickly, it's haphazard,

[00:35:11] and there is some coincidence

[00:35:14] with whether it's carelessness

[00:35:16] or just not being as exacting as you ought to be

[00:35:21] that's reflected in a corporate statement

[00:35:23] with grammatical errors.

[00:35:24] Now we couldn't do that 20 years ago.

[00:35:26] So my question is around these new data techniques.

[00:35:29] Do those make your way into your process at all?

[00:35:33] Yes.

[00:35:34] What I worry about AI is you're gonna have RI,

[00:35:36] real intelligence.

[00:35:38] And so I get asked by the fintechsters all the time,

[00:35:42] give us something for AI.

[00:35:43] And I'm not gonna make the bad guys harder to catch.

[00:35:46] So I'm not gonna help them.

[00:35:48] And the reason is there's no market

[00:35:51] for detecting fraud in the corporate world.

[00:35:54] The playing field favors committing fraud.

[00:35:57] By and by, I don't know that there's a paying market

[00:36:00] for AI fraud detection.

[00:36:02] I fear that it's the other way around,

[00:36:05] AI being used to commit fraud.

[00:36:07] I'm not seeing it as a boon to the fraud professionals

[00:36:10] that are trying to combat fraud.

[00:36:12] I have a feeling it's gonna be more of an opponent

[00:36:14] than an assist for us.

[00:36:15] I'm not saying we can't use it.

[00:36:17] I'm just saying that we'll see where it goes.

[00:36:20] But I have a feeling

[00:36:22] what Pensate is gonna be to commit more evil

[00:36:24] and not to stop evil.

[00:36:26] As we close out, as we talked about at the top of the call,

[00:36:30] you and I met in Boston talking about equity derivatives.

[00:36:33] We share that as part of our lineage.

[00:36:36] Are you actively looking at markets these days?

[00:36:39] Looking at financial product innovation

[00:36:42] or anything like that?

[00:36:44] I don't keep my hand in as much as I once did.

[00:36:48] For instance,

[00:36:49] I'm not reading the streets derivatives research.

[00:36:51] I see new math, I sort of like it,

[00:36:53] but in derivatives, well, Dean, you've been there.

[00:36:57] Most of the products are there to deceive you

[00:37:00] as an investor.

[00:37:01] And I'll show you the good stuff.

[00:37:03] But if you can't do the math for those products,

[00:37:05] you really shouldn't be buying them

[00:37:07] because there's always things hidden in there

[00:37:09] in those formulas

[00:37:10] that trip up people that don't know the math.

[00:37:12] And so you need to know for structured products,

[00:37:15] Dean, what percentage of those are good for investors?

[00:37:17] Come on, let me put you on the spot for a second here.

[00:37:20] Well, there's an old saying that structured products

[00:37:23] are sold not bought,

[00:37:25] which I always thought really captured.

[00:37:28] Hey, we can find something that optically looks better

[00:37:31] than it really economically is.

[00:37:33] That's the goal.

[00:37:34] It is, and they're hidden fees

[00:37:36] and deck stacked against you.

[00:37:38] If you own a structured product,

[00:37:40] you end up getting sold into one of those

[00:37:42] horrible products,

[00:37:44] your chances of winning are very slim.

[00:37:46] If you win, well, it wasn't designed for you to win.

[00:37:51] You just got lucky.

[00:37:52] You drew a real straight flush at the poker table

[00:37:54] if you went on a structured product.

[00:37:55] So you always have to be on guard

[00:37:58] when it comes to your investments.

[00:37:59] And I can see that's why a lot of people

[00:38:00] go to the index funds.

[00:38:02] There are occasions where some version

[00:38:04] of bells and whistles on a product can be helpful,

[00:38:09] but you really are evaluating that

[00:38:12] versus the trade off of liquidity.

[00:38:14] You just don't wanna be selling vol well below market

[00:38:18] or buying it well above market.

[00:38:20] And that's unfortunately,

[00:38:21] some of these products and their complexity

[00:38:23] is hiding that ultimate transaction,

[00:38:26] which is away from the fair value,

[00:38:28] even though it doesn't look like it.

[00:38:29] So you definitely have to be careful.

[00:38:31] And at least over time for me,

[00:38:33] I've really tried to emphasize liquidity.

[00:38:37] It's not just getting into the trade,

[00:38:39] but you never can decide

[00:38:41] the hold of product to maturity.

[00:38:43] That might happen,

[00:38:45] but you don't wanna pre-commit to it.

[00:38:46] The unwind price is critical,

[00:38:48] getting liquidity on the unwind is really important.

[00:38:51] So you gotta have the exit plan,

[00:38:53] not just the entrance plan.

[00:38:55] I like the liquidity like you do.

[00:38:57] If I can find some way to replicate something

[00:39:00] in a listed markets and avoid the private markets

[00:39:03] where I have to wait for tax forms,

[00:39:05] I prefer the liquid alternatives.

[00:39:08] Keep it simple.

[00:39:09] That seems to be the Harry MO.

[00:39:11] Why do something really crazy like private equity?

[00:39:15] You can replicate that stuff a lot cheaper

[00:39:17] with some combination of index funds.

[00:39:20] You just may have to go into the Russell 2000 or something,

[00:39:23] but you should be able to replicate it a lot cheaper,

[00:39:25] less fees, very similar returns.

[00:39:28] Look at where those products are right now

[00:39:30] when the windows are closed for IPOs.

[00:39:32] You're sort of stuck in buttermilk.

[00:39:33] They're not returning cash to the investors now.

[00:39:36] Well, Harry, it's been awesome

[00:39:38] to catch up after these years.

[00:39:39] Appreciate the insights.

[00:39:41] It was, I don't wanna use the word fun

[00:39:43] to look back on Madoff,

[00:39:44] because it's never fun,

[00:39:45] but I always do find it to be instructive

[00:39:48] and worth doing as an exercise

[00:39:51] because they're painful lessons,

[00:39:53] but they're important lessons as well.

[00:39:54] And you were a huge part of teaching those lessons

[00:39:58] and trying your very best to alert folks

[00:40:00] as to what was going on.

[00:40:02] Thank you for spending the time.

[00:40:03] It was great to catch up with you again.

[00:40:04] Thank you, Dean.

[00:40:05] Take care, be well.

[00:40:06] Look forward to seeing you hopefully

[00:40:07] in your Westchester one of these days.

[00:40:09] You've been listening to The Alpha Exchange.

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[00:40:18] As we aim to utilize these conversations

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[00:40:33] Thanks again and catch you next time.