research@hec - Issue #33 - (Page 2)

finance research hec Trust and financial markets: Lessons from the Madoff fraud Bernard Madoff used funds provided by new investors to pay some of his clients over many years.* This mechanism, known as a Ponzi scheme, made thousands of victims. But how could such a fraudulent system thrive on so large a scale for such a long time? Hervé Stolowy and his co-authors analyzed the mechanisms at work and looked at the role trust played in the fraud’s origins and subsequent development. Hervé Stolowy B iography Hervé Stolowy, who holds a degree from ESCP, has been professor of accounting at HEC since 1994. He is a certified Decision-making on the financial markets is driven by information and trust, with the Madoff fraud illustrating the extent to which that trust can be abused. This extreme case can also serve to illustrate the fundamental mechanisms (usually less visible) underpinning any market relationship. How did Madoff’s fraudulent scheme last so long? As Hervé Stolowy explains, the three trust-producing mechanisms identified by Zucker** (process, institution, and characteristic-based trust) operated in parallel and enabled the scheme to keep going. public accountant (France), has a PhD in accounting and is a qualified dissertation supervisor. Stolowy’s interests include financial accounting, international accounting, intangible assets, and accounts manipulation. He is a member of the GREGHEC (HEC Management Research Group) under the joint supervision of HEC and the CNRS. 2 • May-June 2013 PROCESS-BASED TRUST Investments are often decided on past returns, and it was the stability of returns over a long period that attracted many investors to the Madoff fund. According to Hervé Stolowy, this mechanism for producing trust is process-based. A large amount of information is required to establish trust at the beginning of a relationship, with information accumulating over time until trust becomes established. Trust then continues to grow while the need for information decreases. Bernard Madoff benefited enormously from this process. His name was associated with important players in the world of finance, such as Merill Lynch and Goldman Sachs. He helped to build the NASDAQ stock exchange and to automate transactions. In short, Madoff was so highly regarded in his field that most actors trusted him instantly. INSTITUTION-BASED TRUST At the same time, trust in the institutions that control broker activities served Madoff’s interests. The US financial markets are renowned across the world for being trustworthy, while the SEC, the supervisory authority, enjoys the prestige that comes from seventy years of experience and a reputation as a model agency. However, the SEC gave its backing to the Madoff fund for many years, thereby reinforcing the fraudster’s credibility. New investors, comforted by the work of the regulatory bodies, placed their trust in Madoff far more quickly than if they had had to rely on their own firsthand knowledge alone. CHARACTERISTIC-BASED TRUST Madoff used his links with the Jewish and South American communities to recruit his clients, as well as with the world of Hollywood and some of France’s leading families, in what is termed “affinity fraud.” The fraudster managed to convince these individuals that his funds were open only to the privileged few. This air of exclusivity served to enhance investor trust. FALSE INFORMATION BASED ON REAL DATA Account statements played a key role: the documents were similar in all respects to the statements

Table of Contents for the Digital Edition of research@hec - Issue #33

Cover & Contents
Trust and financial markets: Lessons from the Madoff fraud
How employees use performance-based incentives for personal gain
How to improve performance: when managing offshore contracts

research@hec - Issue #33