Victims stinging from history’s largest alleged Ponzi scheme may be wondering how a former Nasdaq stock-market chairman became an alleged swindler.
The answer is shockingly simple: It’s how he got paid.
According to a new study by Washington University professor Judi McLean Parks and Cornell University professor James W. Hesford, people are most likely to cheat when they have either rewards or penalties in their compensation plans versus a flat salary.
This explains the plight of Bernard Madoff, 70, who wooed investors to his multibillion-dollar investment pool without ever disclosing his billions in losses.
“It’s all just one big lie,” Madoff finally confessed to family members, according to prosecutors, “basically, a giant Ponzi scheme.”
Prosecutors allege that Madoff ripped off $50 billion, topping even WorldCom and Enron, with a basic scam that uses funds from new investors to pay off the old.
Victims of Bernard L. Madoff Investment Securities LLC, who are just now beginning to surface, include well-known charities, foundations, hedge funds and some of the world’s largest banks. Madoff allegedly also duped private investors, who may suddenly find themselves downsized from multimillionaires to those people who lift seat cushions looking for nickels.
Nothing like running a multibillion-dollar Ponzi scheme and not getting caught until you are a septuagenarian. Madoff (pronounced “MAY-doff,” as in “MAY-doff with all the loot”) may have just set a world record for fraud.
Investigators will likely find that most of the missing money went to cover his bad bets, perpetuating the profitable illusion that he was simply amazing.
Financial incentives and penalties encourage people to exaggerate, said McLean Parks, co-author of the unpublished study “Give & Take: Incentive Framing in Compensation Contracts.”
“Times get tough, and all of a sudden they can’t perform as well as they thought they could, and they still want that incentive, so many of them will cook the books,” McLean Parks said.
To explore this hypothesis, McLean Parks paid students to solve anagrams. The students put their completed word-scramble work in envelopes they believed were unmarked, then self-reported their scores separately.
The findings: Most of the students who were paid a flat $30 fee for the exercise honestly reported their results. Students paid $2 for every anagram they claimed to have solved frequently lied about their results to make more money. And students asked to return $2 for every unsolved anagram lied even more to keep what they had.
Observing that financial incentives and penalties can encourage cheating is like calling marriage a leading cause of divorce. But study participants who faced both incentives and penalties didn’t stop at just cheating on paper.
“They not only cooked the books,” McLean Parks said. “They stole our pens.”
These were nice pens that test subjects were expressly instructed to return, and they went right into their pockets and out the door, McLean Parks said.
The study raises red flags over commissioned sales forces, factory workers who are penalized for defect rates, CEOs who live or die by their stock performance and money managers trying to keep their bad trades a big secret.
Incentives and penalties are intended to align the interests of employees with those who employ them. But when times get tough, they can lead to rampant cheating.
“The cure itself,” said McLean Parks, “could be worse than the disease.”
Nevertheless, I’m not sure Madoff would agree that he simply acted in accordance with human nature. When approached by an FBI investigator, he allegedly said, “There is no innocent explanation.”
Al Lewis: 201-938-5266 or al.lewis@dowjones.com
