Macbeth’s betrayal: Three financial fraudsters and their red flags

Although investors don’t often greet each other with “Worthy gentleman!” King Duncan and family offices can have a lot in common.

In Shakespeare’s Macbeth, King Duncan was betrayed by his kinsman, a general in his army. Macbeth’s bravery and victories had earned him the king’s respect, trust and a royal visit. Duncan was then murdered in his sleep by the power-hungry and ambitious Macbeth. The king’s guards, while negligent, were falsely blamed for the murder, and were slain by Macbeth to cover up his treason.

Many parallels can be drawn from the risks King Duncan ignored (trusting Macbeth, having weak guards, etc.) and the risks that family offices encounter when investing in funds. Although rather less dramatic, the king’s guards and family offices’ advisors are analogous; a lack of diligence may lead to an unconsented violation by someone who was supposed to protect the office’s interests.

So, then, what are the signs of a Shakespearean tragedy in the making?

In the first of this three-part series, we focus on recent fraudulent investment schemes perpetrated by Bernie Madoff, Arif Naqvi and Sam Bankman-Fried to identify the red flags that might help advisors prevent the family office from meeting the same fate as King Duncan.

Bernie Madoff: The dangers of reputation

Bernie Madoff infamously ran a multi-year Ponzi scheme. He did so because he appeared to be a well-respected investment professional as well as the co-founder of the Nasdaq. For years, Madoff sent out fictional statements to his investors showing consistently strong annual returns. However, the almost US$50 billion in “gains” never existed.

The CIOs of his many investors (including the banks Grupo Santander, Fortis, HSBC, RBS, RBC, UBS, MNP Paribas, brokers like Nomura, multiple funds and funds of funds, many large charitable foundations and family offices) that invested with Madoff didn’t discover it, either because they performed no due diligence, or because their due diligence was perfunctory, before investing, and because they ignored warning signs thereafter. The SEC didn’t stop it despite being warned several times. The financial press also didn’t discover it.

Despite a troubling lack of transparency and several warning signs, investors gave Madoff lots of money. They trusted his reputation over their checklists and systems, a common pitfall of many Ponzi schemes. Reputation can be used as a weapon, and family offices can be particularly vulnerable, especially as relatively “small fish.”

Only two people in the story shine. Harry Markopolos began researching Madoff in 1999, uncovering data – an unusual consistency of returns over many years – that suggested Madoff’s results were fraudulent. He brought this to the attention of the SEC several times, over several years, with evidence. The SEC chose not to pursue it. Jim Vos of Aksia LLC, a hedge fund consultant, warned clients to avoid investing in Madoff funds because they used a tiny accounting firm. It later transpired that the two-person firm didn’t even conduct audits.

Ultimately, it was the 2008 banking crisis, which prompted some investors with liquidity issues to request some or all of their capital back, that brought down Madoff. He was forced to admit the cupboard was bare.

Arif Naqvi: The importance of reporting

Arif Naqvi founded the Dubai-based private equity firm Abraaj in 2003. It was backed by the likes of the Gates Foundation, Washington state’s pension fund and the World Bank. With that kind of (supposedly) astute investor leading the way, Abraaj’s PE funds grew in value rapidly to about US$14 billion.

As every fund manager knows, you start raising your “new fund” before the mediocre results of your last fund come in while you can still “sell the sizzle.” To succeed in raising a US$6 billion fund to start in 2018 or so, Abraaj needed to show prior success. Naqvi subsequently fabricated consistent past returns of 17 per cent per annum for prior funds by playing valuation games with their illiquid and hard-to-check private investments.

Eventually, the house of cards collapsed, albeit in slow motion. Perhaps karma exists: Naqvi’s rise was facilitated by the Gates Foundation, and his fall began there. A Gates employee noticed in 2017 that Abraaj Fund IV had called about 50 per cent of the committed capital and was now calling for more capital, but there were no reports to show where the original 50 per cent had been invested. He became suspicious and began asking for reports. He was put off and misled, but he persisted, and managed to connect with at least one other investor. Rumours spread. Eventually there was a run as investors demanded answers – and their money back.

With their relatively limited resources to perform due diligence, family offices may be complacent regarding due diligence or may not have the time to read hundreds of pages of reports. They often just assume that big investors – pension funds, sovereign wealth funds etc. “surely” must have done deep diligence. And they often feel lucky to get into funds despite being so (relatively) small, and don’t want to get a reputation that could see other funds lock them out.

Even so, the need for due diligence – and prudence in the face of FOMO – is essential. Never underestimate the need to ask questions and perform independent analysis, no matter how rudimentary or time-consuming.

Sam Bankman-Fried: Lending money to a sister firm

The rise and fall of Sam Bankman-Fried and FTX echoes the rise and fall of Madoff and Naqvi.

Bankman-Fried, who on Thursday was sentenced to 25 years in prison, fashioned a persona as an astute investor and entrepreneur, philanthropist (“effective altruism”) and political funder (at US$40 million, the 30-year-old was the second largest donor to Democrats in the 2022 U.S. midterms).

Established in 2018, FTX was the third-largest cryptocurrency exchange until it filed for Chapter 11 bankruptcy in November of 2022. It collapsed when news leaked that it had lent US$10 billion to Alameda Research, a hedge fund effectively owned by Bankman-Fried.

Alarm bells went off with investors for three reasons: a) the depositors into FTX apparently did not authorize or know about the loans; b) the loans were to a related party (conflict of interest), and c) the loans do not appear to have been appropriately secured. He breached his agreement with FTX depositors by lending their money to his hedge fund without consent, to fund risky bets, and to fill holes when those bets went bad. He was found guilty of fraud in 2023.

The common threads

The saga of Bankman-Fried best demonstrates and summarizes the common threads of a fraudulent investment scheme:

1. Bankman-Fried, like Madoff and Naqvi, used his reputation and connections to win over investors and regulators who should have spotted troubling red flags.
2. All three heavily donated to charitable causes, politicians and political lobbyists, potentially incentivizing them to avoid investigating their activity, but in any event to build and cement their reputations as highly successful – and high minded – people.
3. There was a lack of internal and external controls. When referring to FTX, John J. Ray III, FTX’s new CEO post-debacle, said: “Never in my career have I seen such a complete failure of corporate controls and a complete absence of trustworthy financial information.” It is worth noting that he had previously served as CEO of Enron, appointed after its massive fraud was discovered.
4. There was lack of transparency. For example, no independent board or independent committee was governing conflicts and there was no system for the conflicts to be brought to the attention of independents.
5. The guardians, the trusted gatekeepers, failed the investors. Like King Duncan’s guards, the money managers failed to protect their investors. Madoff preyed on charities, managing many endowments. Naqvi raised money from pension funds, charitable foundations and government sovereign funds. Bankman-Fried raised money from pension funds, VCs and individuals, wealthy or not. Where were the due diligence skills and prudence of the highly paid managers?

For the astute advisors to family offices, these famous examples can provide guidance to help them protect their “Duncan.” The key takeaway is the importance of due diligence, no matter how apparently successful and reputable the fund manager. It is the shield by which any ill-begotten plot can be foiled.

Avoiding a Ponzi scheme is one thing, but a family office can face many other pitfalls, even with a legitimate investment. Fund managers can deploy several strategies that are not fraudulent in a legal sense but are designed to advance the fund manager’s interests at the unwitting investor’s expense. Join us soon for Part II: IRR and other Shell Games.

Martyn Siek and David Latner are Toronto lawyers focused on investors and tech startups.

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