Madoff Rotary Presentation Apr23


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Madoff Rotary Presentation Apr23

  1. 1. Principles of Deception and Counterdeception The Bernard Madoff Case Michael Bennett April 2009 All statements of fact, opinion, or analysis expressed are those of the author and do not reflect the official positions or views of the CIA or any other U.S. Government agency. Nothing in the contents should be construed as asserting or implying U.S. Government authentication of information or Agency endorsement of the authors’ views. This material has been reviewed by the CIA to prevent the disclosure of classified information.
  2. 2. Case Summary <ul><li>World’s first global Ponzi scheme </li></ul><ul><li>Operated from the 1980s to December 11, 2008 </li></ul><ul><li>In December 2008, Bernard L. Madoff Investment Securities Inc. (BLMIS) issued statements to 4,800 account holders showing they had total balances of $64.8 billion </li></ul><ul><ul><li>Account holders included individuals, charities, trusts, pension funds and hedge funds </li></ul></ul><ul><li>Scheme unraveled as investors began to withdraw funds due as financial markets began to collapse </li></ul><ul><li>Madoff himself estimates $50 billion of his victims’ investments is gone </li></ul>
  3. 3. Ponzi Schemes <ul><li>Ponzi schemes are a type of illegal pyramid scheme named for Charles Ponzi. </li></ul><ul><ul><li>The scheme pays returns to investors from their own money or money paid by subsequent investors rather than from profit. </li></ul></ul><ul><ul><li>Potential investors are offered abnormally high short-term returns in order to entice new investors. </li></ul></ul><ul><ul><li>Paying high returns requires an ever-increasing flow of money from investors in order to keep the scheme going </li></ul></ul><ul><ul><li>At some point: </li></ul></ul><ul><ul><ul><li>The fraudsters disappear taking all the remaining investment money (minus the payouts to investors) with them </li></ul></ul></ul><ul><ul><ul><li>The scheme collapses under its own weight </li></ul></ul></ul><ul><ul><ul><li>The scam is exposed and the authorities step in </li></ul></ul></ul>Sources: and
  4. 4. Deception <ul><li>The deliberate effort to cause the target to believe something which is not true with the goal of leading him to act in a way that serves the deceiver’s interests </li></ul><ul><li>Deception goals: </li></ul><ul><ul><li>Surprise on the battlefield (strategic or tactical) </li></ul></ul><ul><ul><li>Mislead, misinform, or confuse an opponent with regard to one’s own intentions and capabilities </li></ul></ul><ul><ul><li>Competitive advantage </li></ul></ul>
  5. 5. Means, Opportunity, and Motive <ul><li>Fraudsters rely primarily on deception to achieve competitive advantage </li></ul><ul><ul><li>Technology has given them the means </li></ul></ul><ul><ul><li>Globalization has given them the opportunity </li></ul></ul><ul><ul><li>Money is usually their motive </li></ul></ul>
  6. 6. Deception Cycle Targets the Vulnerable Mind The Vulnerable Mind Analyst or decisionmaker Ambiguous, uncertain, inconsistent, contradictory, or missing information Flawed perceptions and judgments Decisions and actions that benefit the deceiver Deception story Channels, delays, and noise Reconstructed Story Deception Objective Deception planners exploit target’s, expectations, preconceptions, beliefs, fears, and biases. The deception story is presented to the target through multiple channels known to be monitored by the target. Target reconstructs the basic elements of the deceiver’s story, and since it is consistent with the target’s beliefs, it is accepted and acted upon in the manner the deceiver intended.
  7. 7. Why Does Deception Work? <ul><li>Cultural biases </li></ul><ul><ul><li>Phenomena are interpreted in terms particular to one’s own culture </li></ul></ul><ul><li>Personal biases </li></ul><ul><ul><li>Preconceptions and beliefs formed through personal experience </li></ul></ul><ul><li>Organizational biases </li></ul><ul><ul><li>Generally associated with the limitations and weaknesses of large bureaucratic organizations </li></ul></ul><ul><li>Cognitive heuristics and biases </li></ul><ul><ul><li>The innate ways that human beings perceive, recall, and process information </li></ul></ul>
  8. 8. Gilovich – Determinants of Questionable Beliefs Something from nothing Too much from too little Seeing what we want to see Believing what we are told The imagined agreement of others <ul><li>To see order or meaningful patterns where non exist </li></ul><ul><ul><li>Driven by the representativeness heuristic, misconceptions of regression, and biases related to causality and hindsight </li></ul></ul><ul><li>Addresses the illusion of validity – confidence in a judgment that is unwarranted by the predictive accuracy of the input </li></ul><ul><ul><li>Driven by errors in detecting covariation, confirmation bias, the effects of absent or hidden evidence, and overconfidence </li></ul></ul><ul><li>Not the same as wishful thinking – The tendency to adopt self-serving beliefs about ourselves and comforting beliefs about the world around us </li></ul><ul><ul><li>Based on egocentric biases affecting how people view themselves and what information they consider and how much </li></ul></ul><ul><li>The distortions in accuracy resulting form the need or desired to tell a good story </li></ul><ul><ul><li>Driven by sharpening and leveling, biases of causality, availability, and imaginability, the affect heuristic, and support theory </li></ul></ul><ul><li>The tendency to project onto others our beliefs, attitudes, and predispositions (mirror imaging) </li></ul><ul><ul><li>Driven by false consensus effect and the reluctance to voice agreement </li></ul></ul><ul><li>When examining evidence relevant to a given belief, people are inclined to see what they expect to see </li></ul><ul><ul><li>Driven by confirmation bias, overconfidence, multiple endpoints, belief persistence & polarization, and biases in prediction, explanation, & revisions </li></ul></ul>Seeing what we expect to see Cognitive Motivational/Social Source: Gilovich, T., How We Know What Isn’t So: The Fallibility of Human Reason in Everyday Life , 1991.
  9. 9. Impact of Cognitive Bias “ It was like a religion,” Wolfer says of the promise of steady returns, which would be echoed by other acolytes. “These people firmly believed in the story.” – Seattle Times Only about half of the money was taken out, the people say, indicating that many clients preferred Madoff's returns to Gruebel's advice. – Seattle Times “ Many of our clients do not have the time, the ability, or the interest to meet the actual person who’s going to execute the trade or structure the investment.” – Condé Nast Portfolio “ Madoff apparently figured out what industry insiders have known for years: More than agents, more than lawyers, business managers are the financial gatekeepers to Hollywood’s elite”. – Condé Nast Portfolio “ In a social setting — that’s where it always happened,” said Jerry Reisman, a lawyer from Garden City, N.Y., who knew Mr. Madoff socially. “Country clubs, golf courses, locker rooms. Recommendations, word of mouth. That’s how it was done.” – New York Times <ul><li>Good stories and second-hand sources of information can distort beliefs </li></ul><ul><li>The deception is more plausible when it is confirmed by multiple sources </li></ul><ul><ul><li>Ambiguous info is fit to the deception story </li></ul></ul><ul><ul><li>Consistent info is readily accepted and taken as confirmation </li></ul></ul><ul><ul><li>Inconsistent info ignored or subjected to critical scrutiny and rejected </li></ul></ul><ul><li>Target can reconstruct the deception story from even small amounts of information </li></ul><ul><li>Alternative story lines are out of sight and out of mind </li></ul>Believing What We Are Told Seeing What We Expect To See Too Much From Too Little
  10. 10. Fundamental Principles of Deception All deception works within the context of what is true. All deception requires deceit. Deception depends on manipulating what the target registers. Deception Truth Deceit Misdirection Provides the target with real data and accurate information Provides the target with false data and wrong or misleading information Determines where and when the target’s attention is focused – what the target registers Influences how the target registers, processes, and perceives data and information and, ultimately, what the target believes and does Denial Blocks the target’s access to real data and accurate information Denying the target access to the truth is the prerequisite to all deception.
  11. 11. Principles of Deception and Heuristics and Biases All deception works within the context of what is true. All deception requires deceit. Deception depends on manipulating what the target registers. Deception Principles Truth Deceit Misdirection Influences how the target registers, processes, and perceives data and information and, ultimately, what the target believes and does Denial Denying the target access to the truth is the prerequisite to all deception. The source of expectations, preconceptions, and beliefs Out of sight, out of mind Reinforcing the biases Diverting attention and reducing suspicion
  12. 12. Counterdeception <ul><li>Counterdeception is characterized by five dimensions of action: </li></ul><ul><ul><li>Awareness </li></ul></ul><ul><ul><ul><li>Primes the observer to register cues in the environment that signify either a threat or opportunity </li></ul></ul></ul><ul><ul><li>Detection and exposure </li></ul></ul><ul><ul><ul><li>Intelligence and analysis activities aimed at determining what the adversary is trying to make you believe and therefore what he wants you to do </li></ul></ul></ul><ul><ul><li>Discovery and penetration </li></ul></ul><ul><ul><ul><li>Focuses on determining the adversary’s real capabilities and intent </li></ul></ul></ul><ul><ul><li>Negating or mitigating the effects of deception </li></ul></ul><ul><ul><li>Exploiting the adversary’s own deception plan </li></ul></ul>
  13. 13. Principles of Counterdeception Target’s observations The Prepared Mind The Prepared Organization Target’s decisions & actions Awareness Detection & exposure Discovery & penetration Negate or mitigate effects Exploit Target’s Perception & Understanding Know Yourself Know Your Adversary Know Your Channels Know Your Situation <ul><li>Self assessment </li></ul><ul><li>Collection methods </li></ul><ul><li>Threat assessment </li></ul><ul><li>Situation assessment </li></ul><ul><li>Collection methods </li></ul><ul><li>Self assessment </li></ul><ul><li>CE/CI operations </li></ul><ul><li>Counterdeception operations </li></ul><ul><li>Analytic methods </li></ul><ul><li>Situation assessment </li></ul>Principles of Counterdeception Source: Bennett, M. and E. Waltz, Counterdeception Principles and Applications for National Security , Artech House, Inc., 2007. Human reasoning capabilities Organizational measures
  14. 14. Characteristics of the Vulnerable Mind Cognitive Heuristics and Biases The Vulnerable Mind Something from nothing Too much from too little Seeing what we want to see Believing what we are told The imagined belief of others <ul><li>Errors in detecting covariation </li></ul><ul><li>Confirmation bias </li></ul><ul><li>Effects of absent or hidden evidence </li></ul><ul><li>Overconfidence </li></ul><ul><li>Biases of causality, availability, & imaginability </li></ul><ul><li>Affect heuristic </li></ul><ul><li>Support theory </li></ul><ul><li>Confirmation bias </li></ul><ul><li>Overconfidence </li></ul><ul><li>Multiple endpoints </li></ul><ul><li>Belief persistence & polarization </li></ul><ul><li>Prediction, explanation, & revisions </li></ul>Seeing what we expect to see <ul><li>Sees reality according to its own preconceptions and expectations </li></ul><ul><ul><li>Has difficulty generating a wide enough range of hypotheses; tends to selects the first hypothesis that seems to fit the evidence at hand </li></ul></ul><ul><ul><li>Readily accepts new information that is consistent with preconceptions and expectations at face value </li></ul></ul><ul><ul><li>Fits ambiguous information to expectations and preconceptions </li></ul></ul><ul><ul><li>Searches for information consistent with expectations </li></ul></ul><ul><ul><li>Criticizes, ignores, or rejects evidence that contradicts preconceptions and expectations </li></ul></ul><ul><ul><li>Maintains beliefs in the face of contradictory evidence </li></ul></ul><ul><ul><li>Fails to recognize the implications of missing evidence </li></ul></ul><ul><li>Is unduly influenced by a good story </li></ul><ul><ul><li>Weighs plausibility too heavily </li></ul></ul><ul><ul><li>Fails to properly gauge the reliability of information provided by second hand sources </li></ul></ul><ul><li>Is overconfident </li></ul><ul><ul><li>Certainty about judgments that are out of proportion to their actual accuracy </li></ul></ul><ul><li>Lacks in-depth knowledge of adversary </li></ul>Cultural Biases and Personal Experience Organizational Biases Gilovich’s Determinants of Belief Ambiguous, inconsistent, contradictory, or missing information
  15. 15. Characteristics of the Vulnerable Organization “ Our staff lives to bring cases, particularly big and difficult cases…If we had more resources we could clearly do more.” - Linda Chatman Thomsen, chief of the SEC’s enforcement division, “ The SEC also never shared information with Finra about the whistle-blower complaints against Madoff.” – “ Our current fragmented regulatory system can allow bad actors to engage in misconduct outside the view and reach of some regulators.” – Stephen Luparello, interim CFO of the Financial Industry Regulatory Authority, Limitations, weaknesses, and biases The Vulnerable Organization Rules, policies, and standard operating procedures to be effective and efficient Division of labor and specialization Hierarchical structure <ul><li>Alternatives are limited in number and character </li></ul><ul><li>Conflicting objectives </li></ul><ul><li>Security constraints </li></ul><ul><li>Ambiguous boundaries and responsibilities </li></ul><ul><li>Irrelevant, misleading, or ambiguous information </li></ul><ul><li>Resource constraints – Personnel and funding </li></ul><ul><li>Overemphasis on consensus, consistency, and being decisive </li></ul><ul><ul><li>“ Climate of opinion” </li></ul></ul><ul><ul><li>Suppress, ignore, or undermine contradictory views or dissent </li></ul></ul><ul><ul><li>Coordination process </li></ul></ul><ul><ul><li>Wait and see attitude </li></ul></ul><ul><li>Inadequate collaboration processes </li></ul><ul><ul><li>Excessive rivalry </li></ul></ul><ul><ul><li>Coordination process </li></ul></ul><ul><li>Inadequate learning processes </li></ul><ul><ul><li>Lack of feedback from judgments and predictions </li></ul></ul><ul><li>Emphasis on secrecy over effectiveness </li></ul><ul><li>Overemphasis on current intelligence </li></ul><ul><ul><li>Time pressure/constraints </li></ul></ul><ul><ul><li>Current events approach </li></ul></ul>Large Organizations <ul><li>Filters, delays, and chokepoints </li></ul><ul><li>Bureaucratic politics </li></ul>
  16. 16. The Best Defense <ul><li>The Prepared Mind </li></ul><ul><ul><li>Continually tests and retests judgments </li></ul></ul><ul><ul><li>Continually updates and evaluates evidence </li></ul></ul><ul><ul><li>Is continually alert to cues and anomalies </li></ul></ul><ul><ul><li>Diligently updates and evaluates the credibility of information sources </li></ul></ul><ul><ul><li>Makes a conscientious effort to see the problem or situation form the adversary’s point of view </li></ul></ul>“ I am deeply concerned that Madoff is running a very sophisticated fraudulent pyramid scheme,” stated an October 2005 e-mail to the SEC from an anonymous “concerned investor” who claimed the suspicions led him or her to withdraw more than $5 million from Madoff's investment fund. “ Although I cannot point to anything concrete, their returns of 12% to 18% annually for the last 20 years or so tells me something is wrong there,” the whistle-blower wrote. “If you can look into their operation, perhaps it will reveal a greater truth.” –
  17. 17. Know Yourself <ul><li>Examine your own: </li></ul><ul><ul><li>Assumptions, preconceptions, expectations, beliefs and biases for exploitable weaknesses </li></ul></ul><ul><ul><li>Methods of collecting and analyzing information </li></ul></ul><ul><ul><li>Decision making processes </li></ul></ul>
  18. 18. Know Your Adversary <ul><li>The potential for deception exists in any situation </li></ul><ul><li>Are there means and motive for deception? </li></ul>And yet, just about anybody who actually took the time to kick the tires of Mr. Madoff’s operation tended to run in the other direction. James R. Hedges IV, who runs an advisory firm called LJH Global Investments, says that in 1997 he spent two hours asking Mr. Madoff basic questions about his operation. “The explanation of his strategy, the consistency of his returns, the way he withheld information — it was a very clear set of warning signs,” said Mr. Hedges. When you look at the list of Madoff victims, it contains a lot of high-profile names — but almost no serious institutional investors or endowments. They insist on knowing the kind of information Mr. Madoff refused to supply. – New York Times “ The more one has a reputation for honesty—the easier it is to lie convincingly.” – Michael Handel, War, Strategy, and Intelligence
  19. 19. Know Your Situation <ul><li>Continually evaluate the environment for cues indicating deception </li></ul><ul><li>Situations with high stakes and asymmetric power difference are often associated with deception </li></ul>Asked how long it took him to figure out something was wrong, Markopolos said, “It took me five minutes to know that it was a fraud. It took me another almost four hours of mathematical modeling to prove that it was a fraud.” It was the performance line that Markopolos said caught his attention. “As we know, markets go up and down, and his only went up. He had very few down months. Only four percent of the months were down months. And that would be equivalent to a baseball player in the major leagues batting .960 for a year. Clearly impossible. You would suspect cheating immediately.” “ Maybe he was just good,” Kroft remarked. “ No one's that good,” Markopolos said. –
  20. 20. Know Your Channels <ul><li>Data and information are the raw material from which knowledge is formed and decisions are made. </li></ul><ul><li>Your channels of information can be compromised! </li></ul><ul><li>Consider the source! </li></ul>Credibility is context dependent! Credibility must NEVER be taken for granted!
  21. 21. It’s Not Just Investment Fraud <ul><li>They’re out there </li></ul><ul><li>Prepare your mind </li></ul>“ It just sounded too good to be true.” – Condé Nast Portfolio
  22. 22. Thank You! <ul><li>Are there any questions? </li></ul>