How You Too Can Become a Financial Fraudster

Bernie Madoff plead guilty to financial fraud on Friday. The press has vilified him, portraying him as a calculating evil mastermind who bilked billions of dollars from innocent doe-eyed victims. And he may be truly evil, a sociopath with no regard for others. Or he might be a good person who made bad decisions, which drew him down a dark path into a downward spiral he could not control.

There are bad people, and then there are people who simply made bad choices. Which was Madoff? I’m not going to try to answer that question today, nor to defend Madoff’s actions or brush away the consequences of those actions. Rather I want to show how seemingly harmless decisions can lead someone down a path toward ever-widening financial fraud.

The Slippery Slope

Bernie Madoff controlled billions of dollars in other people’s assets. Most of us cannot even conceive of that much money. But many of us do control money belonging to others, which while not billions, would have just as much an impact if lost. And bad decisions with that money can lead to similar conclusions.

Imagine you control the bank account for an organization. For maximum emotional impact, let’s say it’s a non-profit providing food to starving kids in third-world countries. As the accountant for a non-profit, you don’t make much money. One day, your car breaks down. You don’t have the money to cover it, so you take a “loan” from your non-profit, figuring you can pay it back next month when you get your tax refund. But next month, you discover you’re not getting a refund, but actually owe back taxes due to money your ex-husband made when you were still married. If you get in trouble with the IRS, you won’t be able to pay back your first loan, so you take a second loan to cover your taxes while you figure out a way to pay back both loans. Suddenly, you’re slipping down the slope of embezzlement into financial frauddom.

Another scenario. You and your wife have a joint investment account, which you’ve agreed to invest in bonds and blue chip stocks. Then your pal Carl approaches you. He’s part owner in a promising new startup. He says they’ve run into cash flow problems and are looking for a $50,000 loan for six months and he’ll pay 2% interest a month. Your wife doesn’t like Carl. He has bad breath and his wife Margaret gossips too much. But 2% interest a month is a good deal. Knowing the risks, you decide to loan the money to Carl, figuring you’ll have it back in your account before your wife knows the difference.

Six months pass and Carl tells you he can’t pay back the loan. They’re still having cash flow issues. They need another loan of $100,000 to get to next year when Carl just knows things will turn around. Do you have any friends who can loan him $100,000? If not, Carl will go out of business and you’ll lose everything. Fearing the wrath of your wife, and not wanting to lose $50,000, you convince yourself Carl’s business really will improve next year and the additional loan is just temporary. So you talk to your friend Bill, who agrees to loan Carl $100,000. Carl now stays in business and uses some of Bill’s money to pay the interest on your loan. Now you’ve fraudulently invested your wife’s money in a risky investment, and aided Carl in what could be a Ponzi scheme.

The Lesson Learned

In both these scenarios we’ve slipped from innocent intentions to financial fraud. In the first scenario, we used money for a purpose that we weren’t authorized to use it for. In the second scenario, we used the money for the purpose we were authorized to use it for (eg: investment), but under conditions we were not authorized to use it for (eg: high risk startups). In both scenarios we justified our actions. And if things had turned out differently, no money would be lost and we may not have gotten caught. But does having no loss and not getting caught mean no wrong was committed?

The fact is that people get away with bad decisions like these all the time. And because they don’t get caught and there is no loss, we often feel no wrong was committed. “It all works out in the end” is a great philosophy up until the point it doesn’t. Which is exactly what Bernie Madoff has just discovered.

I propose, the lessons to learn from this are that it is wrong to:

  1. Use other people’s money in ways they haven’t given permission for.
  2. Put other people’s money at risk at a level which is vastly different than they’ve given permission for.

This applies no matter what your intention is, or how the money will be used. The key is permission.

But Intention Matters

Though using other people’s money in ways they don’t intend is wrong, the degree of wrongness depends on your intention. To go back to earlier, there are bad people and then there are those who simply make bad choices.

Bernie Madoff might have conceived of a massive scheme to defraud hundreds of investors of billions of dollars and then set about implementing that scheme like a Nigerian e-mail scam-artist. Or he could have started a legitimate business, ran into trouble, and decided to “borrow” his investor’s money to pay other investors until he made up the difference in his investments and could pay back the borrowed money. Except that he never “caught up” and went into a downward spiral, going from a few “loans” to outright embezzlement to a $65 billion Ponzi scheme. We may never know. But in our judgment of him, his intention matters.

In legal theory, this is called mens rea, that is, the state of your mind when committing the crime determines how the crime is punished. The clearest example of this is killing a person. A distinction is made between pre-meditated killing, such as with first-degree murder, and unintentional killing, such as with involuntary manslaughter.

Likewise, with financial crimes, I believe there are differences in intention. An individual who sets out to defraud others from the start should be treated differently than those who don’t intend to defraud, but do so anyway. Or possibly even those whose intentions change as driven by circumstances.

Avoiding the Slippery Slope

One reason to go through this exercise of how to slip into financial fraud is to understand how to avoid the slippery slope of small decisions snowballing into an uncontrolled downward spiral. By seeing the potential consequences of these actions, we can try to avoid the paths leading to those consequences.

Avoiding financial loss is not the goal, avoiding financial fraud is. This distinction is an important one. In my first example, we start embezzling by taking an unauthorized loan for car repairs. If instead, we went to the board of our organization and asked permission for the loan, we would be acting ethically. Even if later financial hardship prevented us from paying back the loan and the money was lost, by asking for permission first, we would have avoided the slippery slope (provided we acted in good faith in asking for the loan and truly intended to pay it back).

Likewise, if we had accurately presented Carl’s opportunity to our wife, along with the risks we knew were inherent in such a deal, then the loss is due to a bad investment decision, not fraud. And what I described as Ponzi scheme with Bill’s money used to pay the interest on Carl’s money is fine, since Bill gave the money to be used for operating expenses. He expected it would be used for this purpose. In fact, much of early-stage investing works on similar principles-with money from later investors reducing the risk of loss for earlier investors. The key is that all the investors are aware of the risks involved and their money is being used for the purposes they defined.

So, three rules for avoiding the slippery slope:

  1. Ask permission with good faith
  2. Avoid decisions which borrow against the future with other people’s money
  3. Make the right small decisions and the large decisions will follow


Bernie Madoff might seem an extreme case, and perhaps he is. But small decisions can often lead to large consequences. And circumstances can force you deeper. His sin may have been setting out to deceive all those he knew, or his sin may have been not stopping early before too much damage was done. Either way, there are lessons to be learned in how not to become a financial fraudster.

1 comment

  1. Bow of Eros says:

    You make some really good points. I’ll keep them in mind, should I ever have large sums of money to invest.:)

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