Academic

Madoff and Affinity Fraud

By Gordon Smith, Christine, Hurt, Vic Fleischer, Fred Tung, Lisa Fairfax, David Zaring

In the past few weeks, some have referred to the Madoff scandal as an affinity fraud.  I have written several articles on affinity fraud?that is, securities investment schemes targeting members of a particular group that are perpetrated either by a member of the targeted group or by those claiming to advance the group?s interests.   Because the victim and perpetrator are generally from the same affinity group, the perpetrator is able to rely upon the shared sense of group identity and trust among group members to gain the confidence of potential victims, making such victims especially susceptible to the perpetrator?s fraudulent scheme.  People who conduct the schemes generally focus on members of religious, racial, or ethnic groups since the trust among such group members can be particularly high.  Although affinity fraud refers to a wide variety of sometimes conventional investment schemes, it differs from other securities fraud because perpetrators establish their credibility by appealing to a group identity and the trust shared among group members.  For many years, securities regulators have identified affinity fraud as one of the top 10 securities and investment schemes facing their department.   And some affinity frauds have involved large amounts of money, with one scam defrauding investors of more than $500 million.  While we have yet to learn all of the details associated with the Madoff scheme, it appears to have many of the hallmarks of an affinity fraud.

Indeed, the nature of the fraud makes it easier to commit and more difficult to detect and prevent.  As an initial matter, relying on affinity groups to perpetrate a fraudulent scheme not only allows the scheme to spread more quickly to a broader audience, but also means that the fraud spreads through less formal channels since perpetrators can take advantage of informal group networks.   Then too, the high level of confidence people place in their group members means that these scams can go undetected for long periods of time.  This is because group members are often reluctant to believe that other group members have defrauded them, and even when they accept that they have been defrauded, they can be reluctant to notify authorities.  Instead, they turn to intra-group remedies.  Thus, it is not unusual for frauds to remain undetected for more than a decade.  Moreover, while investor education and diligence are always important, they are less helpful in the context of affinity fraud because the high trust within groups means that even more sophisticated and diligent investors fall prey to such fraud.  Hence, the affinity relationship upon which perpetrators rely makes these crimes easier to commit, while ensuring that perpetrators can commit them with little fear of being caught.  From this perspective, it is no wonder that such scams are a popular form of fraud.  If the Madoff scheme reflects an example of affinity fraud, it constitutes the largest and most dramatic example.  It also explains, at least in part, why so many were defrauded as well as why the fraud remained undiscovered for such a long time.  To be sure, while characterizing the Madoff scheme as an affinity fraud may help us to understand the scheme, it does not negate the potential role of better, or more rigorous, oversight.

Full post as published by Conglomerate on January 22, 2009 (boomark / email).