102: Eugene Soltes – Unraveling a $65-Billion Ponzi Scheme and Notorious Cases of Insider Trading

Chat with Traders is brought to you by Trade the Pool. Did you know that every decade the market reinvents itself? Online brokers opened the doors. Mobile apps made trading seamless. and commission free trading erased barriers. Now a new era has begun. Meet, trade the pool, limited risk trading. And now you also have unlimited time to reach the profit target. From now on, your trading risk is capped. and your trading opportunities are limitless.

Trade the pool funds home-based stock traders with up to$200,000 in buying power. That means you can trade larger positions and scale your strategies without risking your own savings. It's time to trade with more capital, making it truly worth your time and effort. Ready to trade the pool? Click the link in the description and join the stock trading revolution today.

Are you ready to get serious about trading? Then join Tasty Trade, Investopedia's best platform for options trading in twenty twenty six. Options, futures, and more. Tasty Trade has everything you trade all in one platform. Get low commissions, including zero commissions on stocks. So you can keep more of what you earn. Trade smarter with advanced charting tools, a pre-built strategy selector, risk analysis tools, and more features. Visit Tastytrade.com slash.

Tasty Trade Inc. is a registered broker dealer and member of FINRA, NFA, and SIPC. Podcast. Episode 102, and I have something a bit different for you this week. Here's the rundown. My guest is Eugene Saltis. Eugene is a finance professor at Harvard Business School, and over the past eight years, give or take. He's gotten to know and spent a lot of time with many big-time executives and professionals who have been convicted of major financial crimes, such as cooking the books.

fraud, Ponzi schemes, and even insider trading. What began as nothing other than self-interest has escalated into a 464-page book, which was released in October this year, 2016. The book is titled Why They Do It. Inside the mind of the white collar criminal.

Intrigued by the subject matter, I invited Eugene onto the podcast and we got talking about how Bernie Madoff became the mastermind behind the biggest fraudulent scheme in US history sucking billions upon billions of dollars from unsuspecting investors, some of the notorious insider trading cases, and ultimately why they do it. As I mentioned, Eugene's book is available now, so if you'd like to take a closer look or even grab a hardcover copy, just go to chatwithraders.com.

forward slash why they do it and that'll take you directly to why they do it on Amazon. But also worth mentioning, you can get this as a free audiobook too when you sign up for a free audible trial, all at the same link, chatwithraders.com forward slash why they do it.

Okay, folks, here it is, my interview with Eugene Saltis from Harvard Business School in Boston. How's things? What's been going on? Uh things have been well. Uh I actually just uh just been doing a pile of presentations on the book. So uh actually just I've back uh I was doing one at another university. Uh a couple of schools are actually giving it as as I guess reading in some of the finance classes and uh I guess uh

It's both easier and I think probably a little bit more lively if I give a presentation uh than than the than the professor. But given how many schools there are in Boston I've now done this five times, so So you're getting to know it pretty well. Yeah, at this at this point I I uh I don't know backwards and forwards quite yet, but I I think probably a couple more iterations I'll get there.

You're getting there. Nice. Nice. Oh, that's cool, man. It's good that there's a lot of interest around it. Very cool. My copy arrived in the mail uh just the other day. Obviously I haven't really had a chance to read too much of it, but it's definitely something I will be reading for sure.

Oh good. Um well there seems to be uh uh it's it's certainly a different take on some of the uh I guess white collar crime in compared to some other books written on the topic. So at least it spurs some different conversation, which seems to be uh Well received so far. So I wanted to bring you onto the podcast because I'm really intrigued by this book you've written, uh which is titled Why They Do It.

Uh but before we talk about that, let's hear a little bit about yourself. So, you know, besides now wearing the badge as an author, what else do you do? Well my my my main job is uh I'm a professor at Harvard Business School and in this role I teach a a number of our executive education programs, primarily in finance, accounting, and some of these uh say gray, gray area decisions.

like those described in the book. And most of my empirical work uh this is a qualitative work we're talking about the book, but most of my empirical work w looks at uh issues around financial economics and corporate disclosure. Okay. And is it true that you had aspirations of becoming a trader yourself before you went down this path? I di I did. Actually in many ways this is what I I expected to maybe hopefully do an interview with you

But in a different context. So I actually spent uh m my background in college, uh I was uh i uh in economics and I did a master's in statistics. So very much thought I was gonna be a kind of a quantitative finance uh finance guy. spent uh spent uh some time at UBS uh trading uh trading uh options, exotic options and uh But then they f I I ended up going to get a PhD and then the financial crisis hit and I found myself uh look looking at a different prospects. Uh And uh

was offered a position at Harvard Business School and a had a couple of other offers and and thought that would be something interesting to try it very much. I didn't know if uh I uh I would ever be be truly meant to be an academic, but it turned out it it suits me very well because ultimately I get to explore the same kinds of questions that I'm interested in in the financial world, but I get a l a lot more time to delve into them much more deeply. Um so it's been a lot of fun.

Right, right, okay. And how long have you been doing this for now? Uh so th this is my I've been on the faculty of uh Harvard Business School for eight eight years. Uh in this bo uh book uh s kind of uh strangely enough actually has been continuing that in entire time. It actually originally even began as I was a graduate student. So th this project is very much one that's uh my my entire life as as a scholar

Let's talk about the book. Like what motivated you to write this book? What sparked the idea for it? Well it started out not not as a a scholarly project or or an intellectual endeavor. It started out very much as I'll say a a question of personal interest. The same that I think many, many people have.

So actually as a graduate student when I was actually finishing up my dissertation, a big empirical data set looking at the how uh dissemination by the media affects the volatility and cost of capital. for firm shares. So a very kind of traditional asset pricing type project. I'm up at three in the morning watching TV, desperately trying to stay awake while I wait for some regressions to come out. And I came across a show on MSNBC called Lock Up.

And it's uh it's a great kind of show to watch at three in the morning that's a cross between a reality T V show and a documentary. And they go into prisons and basically interview people to understand w what what happened. And most of the people on the show are are violent offenders, uh murder, assault, rape, uh things of that nature.

I'm watching the show and thinking about the people uh that are kind of closer to my heart, which is as a financial economist, I'm thinking about all these business leaders. people that I, like others, looked up to, people that were on the cover of Fortune, you know, are on C N B C talking, and you know, the Titans of industry. And I was watching the show and just wondering if they were in this position, what

What would they say to some of these these questions? Uh these are the people that we hear so much about, we read, we hear from them, when they're successful, but all of a sudden when when they've made some errors and and uh you know are sent away to prison, they they disappear and we never hear from them again.

And so that evening, uh, out of just personal interest I I sent some letters to a couple of the people, people from Enron and and Tycho, that came that came to my mind that were very much still in the news at the time, eight eight years ago. And uh went then went back to my dissertation work and then uh a couple months later I uh start getting letters uh back from people.

Some started responding to my questions, others, like the CEO of uh Tycho, Des Kozwalski, said, uh sure, I have I have time now. Come visit me and we can chat. And it's it's actually just from that that really just Personal curiosity of trying to understand what's happening here that this project uh was created. So what sort of things were you saying to them in the letters?

Re really I think o open mind and curiosity. So I I would start uh start saying, you know, I'm uh as I joined the faculty and I was writing uh writing people, you know, I I'm a I'm a faculty member at HBS. You know, I I I'm a financial economist at heart. And I've looked at your career and you know you did a lot of amazing things.

uh impressive things. But simultaneously I'm also trying to understand what happened. How did you end up in the position you're currently in? And could you spend some time and could we kind of just walk through things and I'd like to better understand your perspective. I think one of the things that probably made m uh that that helped me uh create these conversations

and kind of s spurred interest on the part of people I was writing. People who were in some cases uncomfortable talking originally or or haven't sp you know spoke spoken to people in the media, is that I did commit and the nice part being an academic, I didn't need to just have one conversation like a journalist and then have to write an article at the end of the week. I could commit that I would spend as much time as it as I needed to really try to understand their perspective, whether that was

days, weeks, months, in some cases a couple of years with some people before I really felt I was understanding their their their perspective. Because that's ultimately what the goal of this project was, is to put myself in their shoes and try to See the world as they saw it. And and convey that convey that to you know my students and and ultimately people that read the book.

So when you initially sent letters to these people who you've documented in your book now, did you actually have intentions of writing a book at that time or was it still just general curiosity. N yeah, no. This de this definitely didn't start stars a book. If anything quite quite I I think h had I realized how much time and and effort that I would ultimately spend this project, I I might have run the other direction. Um

Th this starred it started as i I mean, genuinely just as curiosity. I thought I was just gonna have some conversations because it would just make me a more informed person. Uh frankly I I still do this now in a variety of other contexts when I'm trying to learn about a new industry. I write leading people in industry and and want to sit down and and learn from them.

And the same thing if we want to understand successful people that that have ended up making some mistakes, oftentimes quite significant mistakes. I think we need to spend time and and sp speak to those individuals in the same manner. Um and then uh what kind of got the ball rolling is that one of the initial letters I received back was uh from Steven Richards, who is the global head of sales of Computer Associates. Um an Australian, uh actually originally before he moved to the United States.

And in this really articulate and I think thoughtful and reflective letter, he describes some of the pressures and challenges that that he faced and

I took this this letter, uh, wi with uh with Stephen's permission and actually wrote a Harvard Business School case around it. Basically just literally reprinted his letter and then wrote the context behind what was going on at Computer Associates. I really kind of um I could say subtle fraud in that they didn't make up anything, but rather they had contracts that came in on Monday and Tuesday and they backdayed them to the following Friday to make them go in the prior quarter.

So a a pretty uh you could say different from some of the more, you know, larger and egregious frauds, but ultimately, because of this backdating for a few days, eight senior executives went to prison uh for quite lengthy sentences. And so I took this letter that Stephen wrote, I wrote this case and we we taught it as the last class in the the MBA curriculum at at HBS.

And uh students and my colleagues had a lot of interesting things to say after after the hour and a half discussion with ultimately nine hundred students uh were read this uh read this case on the first pass through. And uh it's still today, I mean what's interesting from this one case, this is now still taught to everyone that comes through HBS. It's taught at the end of the first semester uh it for all the MBA students.

And then it's taught in many of our executive programs and it's taught it now around sixty other business schools uh around the world.

Um so this really thoughtful letter is kind of it after actually hearing the discussion and questions that students and and colleagues would ask me after doing this case discussion, did I realize there might be something really hear more substantive than just a kind of personal curiosity, that learning from these executives perspective, we might gain a deeper appreciation for some of the challenges and and mistakes that that they they faced and made.

Um so this is where I started delving more deeply into both the background about what might be going on, the psychology, the sociology, the different, you know, literatures that could explain this. And then simultaneously I really started speaking to many more people. to get their perspective.

Right. So it's evident that some people were responding to your letters, but you know, generally speaking, how willing were they to speak with you? Or was there some hesitation because I imagine that most of them probably weren't overly proud of where they've ended up. Yeah, I think I I think this is one of the I'd say uh ninety ninety plus percent of the individuals I wrote ultimately ended up uh speaking uh speaking to me. Um

Uh there was uh uh two or three cases where people still had ongoing litigation, uh and for that reason they didn't feel comfortable talking. Uh say in some cases even people with ongoing litigation were still willing to chat. Um And there were two or three other people that were were just simply uh I think this was just such an overwhelming experience for them that they just literally couldn't bring themselves to speak about it. But by and large

People were willing. What what I learned is that no one write no one was i except for a couple unusual exceptions, no one wrote back that they were excited to talk about this. What they what they would write back is saying, you know what?

This was challenging, but you know what, I I think I I see that there's an educational benefit for helping, you know, students. Uh some of these people are graduates of Harvard Business School and Wharton and some of the top business schools. And so they they do feel that there's things that they can share. Both with the mistakes they made, but they also think and and I agree with them that there are things that they could share about some of the better things they did in their career.

So in most cases when I would start talking with people, we wouldn't jump in and talk about the challenging parts in their in their life. What we do is spend many conversations oftentimes, talking about how they got from, you know, college or or even, you know, out of high school. How did they go from those those modest beginnings to becoming a a you know, a a corporate superstar?

Um so talk about the things in life that were actually really successful, that that not only served to help me understand their background, where they came from, and some of their actually quite innovative things they may have done that were entirely appropriate, but it also helped build a relationship that we were able to then understand one another and actually kind of delve more deeply into into various things.

And one of the people who I believe you spent the most time with um in creating this book was Bernie Madoff, probably also the most publicized character. For those who may be unfamiliar, bring us up to speed with who is Bernie Madoff and what is he infamous for?

Yeah. So Bernie Madoff is is uh uh we'll we'll go down at least I think the history and and certainly for quite a bit is is the the m you know the mastermind of of the largest Ponzi scheme in history uh in in on the order of twenty twenty billion dollars uh in terms of you know you could say misappropriated uh assets.

Now what's fascinating about Madoff Madoff's career though is that he actually began in in the nineteen nineteen sixties his is is kind of a coming from a fairly uh m middle class, nothing nothing from an extraordinary background, but kind of started with these off off exchange, over the counter securities He came up kind of from n from nothing, so to speak. And from this built a a brokerage firm that that actually was extraordinarily innovative.

Um in bringing in uh electron uh electronic uh trading, things that we we take for granted today. Many of those innovations were led by his firm and and then later the NASDAQ, which he became chairman of. He he also uh was one of the pioneers of paying for order flow to help divert order flow from the main exchanges to other exchanges, something that we also now take for granted that there's a lot of different exchanges where people can competitively trade securities.

Um he also helped his firm also helped lead the practice of uh decimalization, of actually bringing down spread, something that a every trader can appreciate, um of of not not uh uh not having these extraordinarily wide spread So his firm paved the way in in a number of these regards. At one point, I believe in it was in the nineteen eighties, his firm traded actually ten percent of all nicely listed s stocks off the exchange. Just an extraordinary volume.

Uh against this background of building a ex really quite remarkable brokerage firm. Madoff also created a investment management business and a a kind of you could say it started out as a as a side venture uh alongside this brokerage business, but but ultimately grew to become this. rather extraordinarily large uh fund in the tens and tens of billions of dollars that would ultimately become the heart of the Ponzi the Ponzi scheme.

Um and and it's for that that we now uh I think remember and and think about uh mate Madoff. And you know, one of the things that made him it makes him different from Any of the executives I spoke with, but then you could say executives, any executives that have been convicted. is is not only the size uh of his fraud,

Uh we're we're talking, you know, if we go the second and third largest looking at like Allen Stanford, uh we're we're talking they're uh five billion, you know, five billion type dollars. Uh made offs is quadruple that. Uh so we're talking a huge magnitude But simultaneously, Madoff's victims were also people that in many cases he knew. These were family, these were friends, the these were individuals that were close within the Jewish community.

And that's what makes his fraud pretty exceptional, is that these these are not distant, abstract victims like when we think of insider trading, people that you can't even really identify. These were these were close, intimate contacts. And I think it's it's unraveling how he could do that to to people that were trusted him, that were so close to him that that really has has created so much uh I think fascination and just kind of horror about what what he did.

So what exactly did he do wrong? Like how does a Ponzi scheme work? Yeah, so the the basis of a Ponzi scheme is is is it's misappropri misappropriating assets. So in I mean in his case, uh how how it would be billed and how he described it is uh would be quite uh m m kind of mundus mundane description at first is a quote books and records violation.

But essentially it starts with the fact that he was trading trading for securities. Specifically you could say he would he likes to think of it as he was naked shorting a strategy to clients, but ultimately not repurchasing those shares and ultimately had a capital violation.

In in that regard, it's not something you could say that exceptional. That's that's that's uh a a regulatory violation to the extent that you're you have more securities, basically you're over levered, but you don't have a sufficient number amount of capital. That's a violation, but that's something that many institutions run into. Now what firms normally do in that case is you you then get your capital under control.

you you you do something to to fix that problem. Um you raise more capital, you uh you let's say you you get out of that. Now in Bernie Madoff's case what he did is in some sense he he continue continued kind of doubling down. And the problem is is you do that and you you keep having more more losses. He w he basically was trying to tout and and

s sell a strategy to people that ultimately w wasn't successful, this notion of a it's a strict s uh something he called the split strike conversion. Uh it's kind of an an option kind of an option arbitrage based strategy. And it he ultimately wasn't able to trade that profitably. Now, ultimately it seems like he was doing some trading for clients throughout the eighties and in even the early nineties.

Not completely, but doing some. But ultimately by the late nineteen nineties, he wasn't trading at all. And this is when it became a true Ponzi scheme, is that ultimately money was coming in the door. So a hundred dollars would come in the door and then ultimately he was paying out fifty of that to to investors the following day to to uh to satisfy redemptions or or other other money going out the door.

Where it's literally you're you're taking in money and immediately paying it out to someone else. There's actually no underlying business. uh go going on. And that's ultimately by the nineties what his business became, which is r rather remarkable in that For all pregnant for at least a decade, uh and potentially quite a bit longer. There was no actually substantive uh actual business at this investment management firm he was running, despite the fact that it was probably

One of the largest. We're talking, you know, uh uh there's been various estimates. We're talking fifty billion dollars plus. uh in terms of of of money uh um um money under management, which would place it in the leagues of of even some of the largest hedge funds today. Uh but ultimately h he wasn't doing anything with it. So that last part we said he'd taken a hundred dollars and then pay out fifty dollars to investors are those

Investors who are invested with him, or are they is that someone else like how does that part work? I'm not on I don't quite understand that bit. So so this is actually investing for him. So he has he has this group group of investors uh that you know he had you know hunt hundreds of people direct directly through him.

far more even through some of the feeder funds that were were giving him money. And they were they were they w every um as additional investors were were paying money into his funds. And y you know, one of the things about about Madoff is

people were kind of jumping kind of head over heels again over one another to try to give him more money. So in and he would always be saying, actually I I'm not gonna take more now. I can't take more money, money now. But then ultimately some people he did let invest. And so ultimately this money that came into this this fund would be sitting in this pot, so to speak.

And then there would be redemptions. He he was creating statements that were going out to people on a monthly and quarterly basis, describing uh rates of return. We're talking, you know, eight to twelve percent in a lot of instances. And then there would be redemptions. And the question is, well, where'd the money from redemptions come?

Well the money sh ought to have come that if you were invested in this fund, it should have been kind of that that pot that was designated in some sense to you, that was actually being invested in the securities that were described on the statement that you were receiving.

Turns on his case, actually that that pot, so to speak, wasn't not really a pot. It w literally when someone wanted a redemption of of fifteen million dollars, he was looking around for fifteen million dollars of proceeds that were coming in to p to pay that money. to pay that money off that was coming in redemption.

You know, ultimately what ends a Ponzi scheme is the fact that when the amount of redemptions ex exceeds the amount of of money flowing into the fund. And that that's what he ran into, you know, by by you know, t when we talked to two thousand eight uh He he starts confronting. So when you say redemptions, you're talking about when uh investors want to take their money out of his fund.

I exa exactly. Uh and this could be for their own liquidity reasons. Um you know, to the extent that uh very few people were removing money because the returns were not uh adequate because they were fantastic. If you actually look at a graph, uh any of us w would jump it w would jump into that. It's kind of like it would be like the equivalent today if we could invest in in Treasury bills at at it at a at nine percent. Uh that would be fantastic.

Um but in some sense also you could say too good to be true. And one of the major uh accusations and and also a a delicate area which there's been much discussion about whether some of the more sophisticated investors in some sense look the other way or were even reckless in not in not uh

Recognizing that they were getting for decades these these kind of consistent eight to ten percent returns, which a as has been shown, was totally infeasible with the strategy that he was uh touting that he was actually trading in and selling to people.

Right, okay. So the returns looked really good on paper, but in reality those the money actually wasn't even there, is that correct? Yeah, the money money wasn't uh the money wasn't there. I mean he would actually produce a statement. Uh and I actually got one of these statements from from eBay recently. But the statement would would show a list of the various uh uh essentially calls and put uh put options that that he purchased.

And then this underlying basket of of uh you know S S and P shares. But what if you actually look at uh look at so it on the statement it describes exactly the the the you know the calls and puts that lead to a you know the particular rate of return that that you know investors expected to receive. The eight point six percent they thought that they received that much.

Turns out though this this statement simply reflected a after-the-fact creation of of uh some securities that led to that output. He actually never invested in any of those call options, any of those put options. In fact if you actually look at the amount of money, the tens of billions of dollars he had invested, it was not actually even feasible for him to be running the strategy because he simply had too much money to actually he he would have overwhelmed those of those various markets.

So h how did he benefit from running this Ponzi scheme? Well, uh I mean that's that's a that's an interesting question to ask now given he's he's serving a hundred and ten year pres uh prison sentence for it, but but I'll say you could say at the time He was one of the most respected individuals in the securities markets. This was a guy that had

it kind of the creme de la creme of investors wanting to give him more money. He was the leader uh he had leadership positions in many of the most prestigious organizations, for example the chairman of the NASDAQ.

He was someone that regulators called when the SEC wanted to talk about the changes that they were gonna be making to the securities market, you would pick up the phone, you'd call the major uh banks, you'd call be calling Goldman Sachs, you'd call Merrill, you'd also call Bernie Madoff. So he was a well, well respected, admired leader in the securities industry.

He so that's one. Two, he he also was was very, very well paid. Even by the the eighties, he was acknowledged as one of the uh the higher paid people on on Wall Street. Um in large part it seems like at that point actually from his brokerage business. But obviously to the extent that he was taking in you know billions of dollars to his investment management business, uh you know, even taking a a small spread, which is a question that people often ask, is hedge funds today charge

you know, the common is still, you know, two and twenty percent. So two percent fees off of assets under management and then twenty percent of profit. Bernie Madoff didn't do that. He basically was kind of like running a hedge fund, but in some sense of charging two and twenty, he said all I want to be paid for is for the trades that I do. In some sense he trading commission.

And that always struck people is on one hand, people thought that he's just this generous guy that he was doing so well that he didn't need to t make more. He didn't need to take two and twenty and make, you know, hundreds of millions of dollars a year. He'd be happy with, you know, m the modest quote millions of dollars a year that he would make from the trading commission.

I think we now look in hindsight and the reason why he was taking you quote such a modest amount is simply because he wasn't actually doing anything. If he would have taken two and twenty percent this would have um capsized much, much earlier. uh because he would have been just taking so much out of the fund. But ultimately he became wealthy because of this. Um so prestige and and wealth are the things that you could say the benefits while this was actually ongoing.

But I don't think that actually is what uh you know, you could say motivated him to start a Ponzi scheme. Um i I don't think even though he I think is generally regarded as as kind of the number one villain when it comes to harm done in financial markets uh as a white-collar offender. I think giving uh saying Bernie Madoff designed a Ponzi scheme and tried to create this.

Is giving him frankly just far too much credit. There's no one that could have actually designed a Ponzi scheme that would that you could knowingly say would last decades and take in tens of billions of dollars. Um that that's That's almost too brilliant of a thing to do, uh, in a sinister way. Um what what happened here is a series of of mistakes.

one leading to another that got larger and larger and because of a a combination of his unique personality, which actually allowed him to I think allow allowed people to trust him very easily. I mean he's a cordial friendly, very, very smart individual, which allowed people to trust him. And then uh a a series of in some sense luck when regulators looked at his business a number of times, uh they they overlooked uh a number of things that could have been red flags.

Um and then ultimately uh he he just was able as he describes it, it's a comedy of errors. Uh but what really is is it's a kind of just really tragic way of seeing a a person who's incredibly smart and clever uh ultimately use that information and knowledge to to perpetrate a just a

really damaging Ponzi scheme that, you know, ultimately for both friends, family, and and the larger investor community has had so much harm. Okay. So at the end of the day, how were his investors uh hurt or damaged by this? Yeah, so the investors that were directly through uh invested directly uh through him, and then there was another group that was invested uh through feeder funds.

Uh basically small smaller investors that were being aggregated together through these feeder funds and then investing in him. Ultimately when his his uh uh Ponzi scheme unraveled, the question is well what was last? Uh there actually wasn't that much left. There was actually, you know, there was I believe a couple billion dollars, which yes, that's a lot of money, but that's not a lot of money considering the tens of billions of dollars that ought to have been sitting there.

Uh the uh ultimately his his fund was basically put in a you could say almost like a receivership and a a lawyer has basically been going after people that profited uh fr from from uh that basically took out proceeds over time, profited from the fraud, and has been s suing them to get their money back, in some sense re put in the hole and to help repay investors that

In some sense you could say lost everything. Um'cause immediately after the fraud was revealed, the question is was there literally anything left? People that had their life savings in some instances, uh, some of the smaller investors, to even some of the wealthier investors that that lost, you know, we're talking millions and millions of dollars uh in in individual accounts.

Uh so in that regard it it was it was pretty devastating uh to individuals um that that really trusted him as a a leader in the financial market. So how did things come unstuck? Like how did Bernie Madoff get caught out on all of this? Like you said it he was able to pull this off for o over a decade or something like that. How was he able to do that for so long and how did he come unstuck? I I think uh a s a series of of uh a i there was a t a number of times in which he nearly got caught.

So in two thousand six actually the Securities and Exchange Commission actually brought him in and and and for a deposition because there was actually some uh accusations that he actually might be uh uh tr trading in front of some of his brokerage clients. Some people thought that one way to explain the fantastic returns of his investment management clients is that he was essentially using the data in orders from his brokerage business to allow people to front run.

And that's what was producing it. So the SEC went in and basically brought him in and questioned him and and looked into whether it was front running. Um At the end of that i he they actually asked him where where all the assets were being kept at this depository bank. And he actually gave them their account number.

And he he described how when he was coming home and and he was thinking about he actually thought uh the kind of the game was up at that point in time because he gave them the depository number which had the regulators actually called and actually tried to verify that information. it would have been a a a i there was a problem of missing zeros.

Uh he had in the order of uh you know a couple million dollars of securities there, where one hedge fund that was invested in him should have had several billion dollars in that account. It was so wildly off. But ultimately in that case and and regulators didn't look into that.

And the interesting part is well the question is why? And there's been a lot of questions. I I don't uh a lot of people have been very, very critical that the the SEC and others may have uh for overlooking this. At the same time Bernie Madoff was such a well respected individual in the financial industry that

To to think that this guy could have been doing a Ponzi scheme at the time, that the guy that's the chairman of one of the largest exchanges in the world was was basically nothing more than a fraud. It's almost so uh Inconceivable, so unbelievable that it's not really a plausible hypothesis. And so they were looking into front running, something that would be you could say uh e might have been doing sometimes. It could have been plausible. So they looked into a much more plausible charge.

But ultimately they didn't find any evidence of that and as as Madoff reflects, the reason they didn't find any evidence of front running is because he wasn't doing any trading at all, ironically. And uh But ultimately, so this is two thousand six.

Ultimately a couple of years goes by and frankly the scheme could have gone on uh potentially longer had it not been for the fact that as a financial crisis emerged, what what happened? A lot of institutional investors, a lot a lot of individual clients Started to need to withdraw money. And so he ran into the problem of basically a cash flow issues that he needed additional inflows.

significant inflows to maintain the amount of outflows and and reached a point where the redemptions were going to uh get to the level where it was just unsustainable to continue to run the Ponzi scheme. So it's that point in which he, you know, a as it's described, told his sons and ultimately called regulators and and and quote, turned himself in for for running this. Is that really what happened? He actually turned himself in, did he?

Well, it's it's along with I could say technically I believe his sons are the ones that that turn turned uh technically turned him in. Um but but ultimately it was a family matter in that It's he wasn't caught he wasn't caught red handed by an auditor or a regulator. The reason why that that week or that day in particular uh i everything unwound is because

He along with his sons uh alerted regulators to what was going on. Right, right, okay. Are you ready to get serious about trading? Then join Tasty Trade, Investopedia's best platform for options trading in twenty twenty six. Stocks, options, futures, and more. Tasty Trade has everything you trade all in one platform. Get low commissions, including zero commission on stocks.

so you can keep more of what you earn. Tasty Trade is packed with advanced charting tools, backtesting, a pre-built strategy selector, risk analysis tools, and more features to help you trade smarter. See equities and derivatives with high trading volumes, dividends, upcoming earnings reports, and more with their pre built watches.

Or create a custom watch list to keep an eye on the companies and sectors that matter to you. Manage your positions with speed and precision using Active Trader Mode or one click trading and smart order tracking. Plus Tastytrad's Stellar Trade Desk team offers live support during trading hours if you need it. Visit Tastytrade.com slash chat for more info. KC Trade Inc. is a registered broker dealer and member of Finra, NFA and SIPC.

Have you ever watched a stock explode and thought, if only I had the capital? or sat on the sidelines because your account balance felt too small to matter. Good news With Trade the Pool's limited risk platform, you don't need millions or even thousands to start trading the U.S. stock market. Bypass the PDT and tap into over 12,000 U.S. listed equities. From penny stocks to big caps, ETFs, even the newest IPOs, and short anything you like, with zero locate or hard to borrow fees.

Start your evaluation, get funded with up to$200,000 in buying power so you can go big without risking your own savings. And now you can also have unlimited time to reach the profit target. It's a game changer. Not ready to trade yet? Trade the pool offers a free demo and educational resources. practice on live data, master the platform, and build confidence risk-free before you even pay a cent. Click the link in the show notes to start trading with Trade the Pools Capital.

You've spent a lot of time with Bernie Madoff in coming up with content for this book. What was he like as a person? Like was there anything off about his personality? I mean, most of us couldn't fathom blatantly ripping off our family members and close friends and that sort of thing. For him it seems like it wasn't really an issue.

Yeah, that's I mean the first time I remember, you know, my first conversation, you've read so much about someone like Bernie Madoff. I mean, you know, it could you know, international news, you know, for for My first conversation, I mean, it was uh it was a couple of years uh after he was convicted that I first spoke with him on on the phone. And this is someone that you you you've just read so much about that you wonder what the what is this guy gonna be like?

I is he going to be, you know, uh, you know, angry? Is he going to be, you know, reflective? Uh you know, what's his personality? What what's what's kind of fascinating about Madoff is, you know, I would say my interactions with him have been uh you know, he he's cordial. He's he's smart as a whip. I mean his memory, his ability to to talk about detail, uh to go into uh the understanding of nuances in the financial market.

To really delve down, I mean many ways uh I can say I've I think we've come to relate to each other in some ways in this academic sense that we can talk about really detailed things in the securities market. I mean he's he's read it papers and books that I assigned to my students in class uh are things that we've we've spent time talking about in part because I want to see

how he thinks about uh s matters that are not around his case, but the security market more broadly. He's a smart, smart guy. Um and cordial. But that's simultaneously I know in the back of my mind I I'm entirely aware of of what what he's done. And frankly he he has an awareness of it, but it's in a a very kind of distant sense. Um I mean once he reflected that in in a quite genuine way, he said, you know,

I I've often wondered, I can't believe how large these losses became. Like it's just so unbelievable. I I don't know how to explain how how I did this and you know is there is there a flaw in me? How can I have done this?

And I think w my time with him has in some sense been that self-questioning, uh of trying to understand why a career which could have in many ways led to a you know, a prosperous and, you know, career of where he would have retired as a you know, successful, well well respected executive, uh, ended up now he's known as the, you know, greatest corporate villain and and he's gonna die in prison.

Uh, which is something which, you know, he doesn't express anger. Uh I think you know, I I I think he'd be the first to say that, you know, he deceived people and so in some sense

uh the fact that he broke the law, his p his punishment is is justified for that reason. And he doesn't hold in some sense a grunge, which is what also distinguishes him that someone that's about to, you know, be imprisoned for life a and never have any of those comforts that that he spent his entire life around, he he's able to take that uh in a way that um

Kind of take take those punches in in a way that is I think different than how most people would would be doing it, which would be a a form of a crisis. Uh which is actually I think deeper revealing about his personality, is uh how he's able to kind of confront these just radical situations with with a degree of almost uh unusual calmness. Yeah, it's it's certainly an interesting tale.

Um another character who's profiled in your book is Michael Rand. I'm keen to hear a little bit about his story. I think what's interesting about him is he was someone uh who you got to know and he was one of the few executives uh persecuted from the two thousand and eight uh global financial crisis. What was his story?

Yeah, Michael Rand's case is is is is fascinating and it's not one that that made made the news as much, in particular because it was uh post financial crisis and there was already so much news of trying to understand what was going on. But so Michael Michael was a the chief accounting officer at Bezer Holmes, a a uh w a fantastic home builder that was doing spectacularly well uh in a you know post two thousand period as as there was the m mortgage boom.

And what Beezer did was actually build uh homes and and housing districts. They were the type that would build, you know, the n nice homes and then build the roads in the community around around these homes. business was doing fan fantastically well. Actually, their problem if if anything you could say was they were doing so well that every single quarter they were just blasting past estimates of both analysts and their own internal estimates.

of how well they were doing. And that actually became a source of of challenge, uh, which is ultimately uh where where kind of Rand's case uh d becomes both interesting and and a turn for the worse. And so in in his case, when the the uh firm was doing very, very well, one of the things they had to do was was take reserves. for uh the amount of expected expenditures

to complete houses. So Beezer finishes a home and after they sell it to the customer, there might be some additional paint work that has to be done. There might be uh some pipes that are leaky that need to be replaced. And so like most firms, they would actually put a reserve associated with this additional work. And ultimately uh m Michael uh was brought uh

uh uh brought in front of a a judge. So you know ultimately mortgage crisis happens. Uh Bees are Bees are you know is struggling like most other home builders. And ultimately he's indicted uh for for what would be called cookie jar accounting. And he was being held responsible for not over-reporting earnings, as almost as an invariable case, but actually under-reporting earnings.

And the charge against him is saying that when Beezer was actually doing so well that he basically instructed his executives, his subordinates, to basically over reserve. And in in over reserving, try to actually lower earnings for the firm so they wouldn't blast past uh estimates uh as as significantly as they were.

And and it's a it's a pretty interesting case because I can't think of very many instances in which an executive is actually held is ultimately, you know, being in part criminally held responsible for for under reporting earnings. But what makes this case even I think more interesting is if you actually look at how he was prosecuted, the the attorney starts out the case against him saying that a accounting officer is like an umpire at a baseball game.

And the umpire is supposed to call the balls and the strikes as as he sees them. He's not supposed to look at the scoreboard and then decide whether it's a ball or a strike. And what the prosecutor said is that what I'm going to show you in this case is that Michael Rand was like an umpire who looked at the scoreboard and then decide whether something was a ball or strike.

Now what's interesting is to the extent people know a little bit about how accounting works, managers actually have discretion. And actually have a fair amount of discretion both under US GAAP and under IFRS. And so the case really hinged around whether he actually used discretion uh with within uh a a kind of appropriate guidance or with not uh or outside. And if the a lot of the emails that were brought up, for example, he sent one email that was sent to the executives that said

You know, to to the executment said, please put all the reserves you reasonably can. This quarter is too high. Now, as prosecutors looked at it, they said Michael Rand expressed it in a normative judgment. He said this quarter is too high, therefore anything that his executives did with the accounting estimates were fraudulent. As Mike looks at it, he looks at the emails and said, I said, take all the reserves you reasonably can.

To the extent executives stayed later and found more opportunities for reserve, that's totally appropriate. And it is, that that's something acceptable with it within the accounting system. And to the extent that he said this quarter's too high, it's simply expressing a judgment. But it's not wrong simply because you have a judgment of whether this quarter is good or bad that that makes an a estimate right or wrong.

So it's a really fascinating case because it really tries to uh it really challenges our notion of actually what discretion managers have when they make these estimates for for quarterly or annual earnings. And you know, that you can actually be held accountable for for not just fraudulently overstating earnings, but ex a this is a case where someone's actually being held accountable for under reporting earnings.

So it's a really interesting case and one that uh for Rand has been significant. He he actually just started serving his his sentence which will be uh upwards of five years earlier this year. So what was his motive? Like why did he want to underreport earnings? Yeah, I mean it's is he is he would look at it was never under reporting. He was saying he was using his discretion to in some sense uh

to make to use his appropriate discretion to try to slow the growth. And the reason why you'd want to, you know, slow the growth is because if you start blasting through your earnings estimates every quarter by thirty or forty percent. What's gonna happen is that analysts are then gonna predict next quarter you need to grow by forty percent. And in some ways, at some point you're gonna create unrealistic expectations.

This is interesting what if you look at Microsoft during the nineties, when Microsoft was doing extraordinarily well If you go to the ear earnings conference calls, management was actually trying to walk down analysts in the investment community, telling them that they're not going to do as well next quarter as they have done in the past.

It's actually what Facebook is doing right now with their mobile advertising. They're trying to tell the market they're they're not going to grow as quickly as they have been in the past because the problem is you can actually build in expectations that become so ambitious or so high that you actually can't meet them. And I think that's what they were worried about at Beezer Homes is that they were just doing so well that they were essentially making their own kind of uh

a problem. And so what they wanted to do is essentially say, let's be as conservative as we can with our accounting. Therefore, uh, you know, w we d we don't wanna be pushing it uh in any way to be aggressive. Well if anything, we wanna be the other extreme. We wanna be overly conservative. uh to to try to slow down uh this this just extraordinary growth we're showing to the market.

So I mean it would be fair to say from what you've learned from speaking with him that he had no intent of doing wrong. Well I think I think that that comes to to the question. I mean, there there are different ways to interpret. I I I have a qu I I bring uh the emails and I show uh show students, uh and the email that says, Take all the reserves you reasonably can, this quarter's too high.

And if you ask a class of people, uh executive, say, how many of you think that this email i is intentionally manipulative? How many of you uh think that this is perfectly acceptable, you'll see it'll be fifty fifty. Half the class will say this is uh this is this was uh the intent to do wrong, but trying to be clever about it in being saying he he's saying it's that it's reasonable. Um

Uh the other half of the class was saying he said it's reasonable, this is the kind of stuff that firms do all the time. You need to be in aggressive as a corporate manager. And so to the extent that you say, you know, it's reasonable, there's actually nothing wrong with that at all. It's he's not even trying to be clever. in this in this instance. And so

I think ultimately, and I think this is the challenge, talking to talking to the executives, we can never really uh know exactly what what their mindsets were at the time. And I don't even think they going back can actually know exactly what they were were thinking at any point in time. What we can do is look at the evidence and what it actually presents. And the but I think the question that Rand's case raises is if a if a manager is how much discretion a ma can a manager actually have?

So a a great example that that he actually uh gave to me, but I think's an important one, uh, is so suppose your your firm uh i is about to prepare its annual report and you have some outstanding litigation. Uh let's say it's whether the government regulators or maybe uh a private civil suit. And you need to reserve, uh put put uh put an account, reserve uh some expected uh uh liability associated with these future payouts.

from this litigation. And you go to your first lawyer and your first lawyer looks at looks at the the charges or looks at the case and says, I think this is gonna cost about a hundred million dollars to settle. And you go, wow, that that's a lot. That if we actually settle for 100 million, we're we're not going to meet our current quarterly expectations. I want to make sure that that.

what not what uh that that that's actually the correct estimate. So you go to a second lawyer who's been just as good in the past. it predicting your your future obligations. Great another great lawyer. This lawyer says it's fifty million. And you go, wow, that that's better. If we actually do fifty million, that will hit our quarterly earnings. And you go, Well, let me just get a third opinion. You go to the third opinion and the third opinion says it's twenty five million.

Another lawyer, well respected, has done good for you in the past. The question is what are you obligated to actually reserve? Are you actually obligated to reserve a hundred million? Fifty million, twenty five million, some average of those three things. In in many instances you could actually say it's up to ma there's a lot of managerial discretion involved. If you actually ask a class of lawyers, they will actually say you need to reserve the amount that's reasonable.

Well, the question is, you have three all reasonable lawyers, and so you can kind of pick one. If you ask a class of managers, they're gonna go, we're gonna pick 25 million. Well the trick is if you pick the twenty five million because you've shopped around for a different estimate, you're able to meet your earnings estimates, you're gonna blow through them if anything, stock price is gonna go up.

But the only reason why you've managed to hit those expectations is because you shopped around for the kind of estimate that kind of works well for you in that instance. That's pure manual discor discretion, and that's allowed under accounting. That's not actually something we would say is manipulative, but in a way it you could say it's certainly earnings management because you're you're trying to manage earnings by looking for estimates that that kind of work well for you.

So it's an example like that that uh that certainly m shows how complex this is, is that what makes something fraudulent and what makes something uh the kind of discretion that managers get a as leaders within a firm, um it's not always clear cut. Yeah, no, it definitely sounds like a very complex issue and and quite a fascinating one. I mean, I had no idea that uh companies could

use uh quite a bit of discretion in how they report their earnings. That's that's new to me. So another interesting example is uh like pension assumption. This was a a wildly uh kind of uh uh practice that p firms were employing is that if you actually go back a decade, if you look at the rate of return that a lot of firms expected on their pensions, they were putting, you know, eight and nine and ten percent.

Which I I think any of us, unless you were invested in Madoff's Ponzi scheme, you weren't gonna get a ten per a nine or ten percent uh consistent rate of return uh going going forward. Uh those were really optimistic. Why? Is because they found someone to justify it, but if they would say the rate of return on their pension assets were six percent, they would have to fund them a lot more.

And so it was advantageous to find someone to say that actually an eight eighty percent rate of return for your pension assets are appropriate so you don't have to fund them as much that helps actually maintain earnings. And we actually have some really nice academic work actually showing that firms when they were actually having a tough quarter

they would actually meet their earnings guidance not by uh cutting costs or not even by uh uh finding additional sources of revenue, but by changing their pension assumption and by changing their pension assumption that influenced their quarterly earnings. So really subtle ways in which firms can in some c sometimes legally manage their earnings, in other cases uh illegally min uh manipulate it.

Right, right. Well, Eugene, I'd like to narrow in on insider trading if we could. Um so I I guess maybe the first question I should ask around this and and I'm pretty interested to get your take on it. What is insider trading? Like how do the courts determine whether or not something is deemed as insider trading? So let me focus on I I'll I'll go according to the United US US definition. Uh because if we go uh globally there's different definitions of illicit insider trading.

But the US is is by and large where the vast majority, and we're talking probably ninety percent plus of the insider trading cases are prosecuted and criminal. I believe actually the UK, which is would be second in insider trading charge. didn't have its first insider a criminal insider training charge, I believe, till two thousand and eight.

So it is really a still a a very much uh US US phenomenon in terms of prosecution and and the US so we can think of Insider trading is any time an insider, a board member, an executive, an employee, someone with confidential insider knowledge trades in a firm share. Now, a lot of insider trading is not illegal. Executives are allowed to trade in shares. Board members are allowed to trade in shares. And as long as they report those trades to regulators, that's acceptable.

However, then there's another form, which is illegal insider trading. And illegal insider trading occurs when people misappropriate information from the firm. and trade in it for their own personal benefit. or give someone else a trade with it for their own personal benefit. So the the idea is when you you're essentially stealing information from from a firm and then you're using that information in some way to benefit oneself outside that context.

So let me give uh an example that shows how I'll say tricky this notion of insider trading uh trading is. And so one of my you could say favorite cases around insider trading, uh and this is a civil case uh about a year ago, is to uh a couple analysts at actually Capital One, the credit card company.

And these guys were basically acting like a sophisticated hedge fund trader would, that they had this hypothesis that the amount of purchases at retailers like Chipotle, uh McDonald's, uh retailers would be correlate correlated with with the uh sales, monthly sales, quarterly sales for the firm. So what they did was basically take the credit card database, there are two analysts inside the firm,

basically come up with a very, very elaborate algorithm that would textually search the milli billions of credit card transactions occurring at Capital One. And they basically found that there was a significant correlation that when more people bought burritos at Chipotle, Chipotle would report better than expected same store sales, and the stock would go up.

This is the kind of sophisticated thing that goes on at hedge funds, you know, sophisticated textual searching to come up with a hypothesis to try to create tr uh tradable strategies. And so these couple guys came up with this and and very quickly made made just a tremendous amount of money and you know, hundreds of thousands of dollars.

And ultimately n the SEC discovered this and then went after them for for a legal illegal insider trading. And the reason this was illegal is because these were two traders who misappropriate information. They took information that belonged to Capital One. and then use this for their own trading purposes to to personally benefit. Now what's weird is that there would have been two ways to basically do the same exact thing that would have been legal. So capital one

could have actually hired these two guys and said, you know what? It's okay. We could use this credit card data for our own trading purposes. Can you tr make these trades on behalf of Capital One? If they were trading on behalf of Capital One and not themselves? it would have been acceptable. But even more extraordinarily would have been Capital One

Minus whether they had an agreement with uh customers that might have not allowed this. But Capital One could have actually sold this data to hedge fund.

And in fact there's actually two credit card companies that actually do sell this kind of data to hedge funds. So a hedgef a well known hedge fund trader could pay Capital One a million dollars to get these kind of aggregated uh the these these records of just Not showing the person's name, but just showing uh the the billions of transactions that were done and just sell it, let's say a million dollars a month to a hedge fund.

And then the trader at a hedge fund could have run the exact same search these two guys did and traded on it and probably made millions of dollars. And and there are ways of actually legally doing this. And that would not be illegal insider trading. That's actually fully legal. So the weird part is is that Prosecutors and regulators, not only in the United States but globally, often say that It ultimately makes the markets unfair.

And frankly, that's totally misleading and that's actually wrong. That's not what illegal insider trading is. A legal insider trading is misappropriating information. There's a whole lot of ways within financial markets to become appropriately more informed than other investors. Using information that they can't access because it's either too expensive or they don't have and legally trade on it.

So this is what makes insider trading so uh interesting is that the rhetoric about what makes it right and wrong is actually totally different than actually what the law says is right and wrong.

That's a pretty interesting case study that you bring up there about the credit card data. I mean that sounds somewhat unethical to me that that Credit One would actually sell uh was it Capital One, sorry, would actually sell credit card data to hedge funds.

Yeah, I probably should clarify. I don't I I'm uh I'm very certain Capital One actually doesn't sell that data, but I will note but I I I believe it's actually footnoted in my book. Uh if if some of your listeners wanna look, the several companies that actually do sell similar data. But we can think of a lot of other contexts. So for example, um there's a number of uh uh of satellite uh data providers that actually sell satellite data of parking lots at well known retailers, uh the the Walmart

the cost goes of the world. And using satellite data you can see how many cars are in the parking lot. to hopefully try to make better training insights. There's companies that actually have uh these helicopters that go over basically oil uh oil reservoirs. that actually can detect how much oil is actually in the reservoir to give a sense of how much oil is being basically sold and refined in any given month so people can infer what oil prices will be.

I mean I can kind of give a laundry list of of of data sources that that hedge funds top hedge fund traders routinely use. Every top hedge fund has access to because it's expensive data, but it's expensive data if you can afford it and get access to. that that actually is extremely valuable. Now the reason why we say that's not illegal is because hypothetically, me and you and anyone listening could go buy this data.

But in fact, many of these data sources are expensive. We're talking thousands, tens of thousands, hundreds of thousands, millions of dollars in some instances. So practically speaking, they're they're limited to a small number of investors who can actually afford to acquire that kind of insight. But ultimately it's not illegal because technically you're not misappropriate. You're not stealing it from anyone. You're you're you're acquiring it uh legitimately.

But it does get on the borderline between w what does it mean to to act uh you know could say uh fairly in a financial markets, but uh the only reason why someone trades a share is because you believe you have an insight that someone else uh doesn't have. The only reason you're buying a share is because you think it's gonna go up, and the only reason that person is selling it to you is because presumably they think it's gonna go down.

So in some ways insider trading isn't isn't actually deceptive because the people who are, let's say, buying shares because they have i privilege inside information, they're not being deceptive. They're actually telling the people, I believe these shares are going to go up in value. Um the trick is is that well how do you actually acquire that insight? Did you acquire it legitimately or illegitimately? And that's a very, very

fine and and delicate question and something that still I think uh security regulators are actually struggling. This is why we've seen a number of cases go in the United States the Supreme Court. Because it is a very uh it's a very gray area, especially when you're operating in these very uh aggressive kind of bounds of of really unique data sources. Mm. Now who are the victims of insider trading? Are there victims of insider trading at all?

Yeah, this is this is the I think the the challenging part. Uh often most time people think that the the victim of insider trading are are is the the market itself. Uh I I tend to find that n not especially convincing because as I just described, there's a lot of instances in which uh sophisticated investors are actually trading on information that I don't have all the time. So there's lots of instances where we have information imbalance.

But what I will say the harm of insider trading comes from the misappropriate of information. If we actually think of insider trading not as someone having information that I don't have, but rather someone stealing information and then using that for their own advantage, it actually makes a lot more sense of why this is something that we could prosecute uh criminally and why it's actually serious.

So the best instance we can actually think of this from some cases that that occurred earlier in the eighties is that when people misappropriate information about a a takeover or some M and A event, is that if you have some confidential information around a a potential acquisition You know, if the firm's acquired, the stock price is gonna go up. So what do you start doing? You start buying shares in the firm.

And if you start buying heavily enough and you tell some buddies about it, you tell some other investors about it, what's going to happen? Those shares are going to rise, rise, rise in price. And what could you effectively do? You either make that acquisition more more expensive, or ultimately you could make the firm price go up so much that it makes it uh un infeasible for for that actual acquisition to actually take place.

So by stealing information from the firm that is thinking of doing that acquisition, you've actually harmed that firm. But that's a really subtle way of trying to interpret who's the victim. And because in some sense in this instance we're saying it's the firm with information that's actually having that information stolen.

One of the most interesting cases uh in the nineteen eighties, uh, about insider trading is actually a reporter from the Wall Street Journal who actually wrote a well known column called The Hurt on the Street uh Hurt on the Street Column. And he actually uh gave his columns and and some of the information to to his partner at the time.

who actually would trade on it. So there's no evidence that he actually biased his column. But basically this guy would write uh one of the most influential columns uh uh you know it was in the Wall Street Journal. It was the kind of column that would move market. If he talked about, you know, firm X and spoke positively of it, the firm X was going to rise the following day. And what was interesting about his this case is that ultimately he was convicted criminally.

uh for insider trading and the question was well what did he do wrong? He he you know, he wasn't trading on this. It was actually just his column that he actually gave to someone. It was a column that he wrote himself about the firm insight that he himself believed. But what the judge uh ultimately explained is that he misappropriated information from the Wall Street Journal and gave it to someone. And as though that's information that he wrote, this is his column.

His column belonged to the Wall Street Journal. And the only one that could do anything with that column was the Wall Street Journal. And by giving that to someone else, he could have jeopardized the reputation of the Wall Street Journal. And the only one that had the ability in the uh to jeopardize the reputation of the Wall Street Journal was the Wall Street Journal itself. And so this is just kind of shows you how people over time insider trading has kind of evolved and changed what it means.

But uh this case you could say the victim was the Wall Street Journal and the prior example I gave the the firm was the uh the the firm thinking of doing an acquisition. But it it's subtle. It's it's not um as oftentimes uh described simply as the quote market that's harmed like in these in uh uh in these instances.

Now, when we think about, I guess You know, w when people hear about insider trading, probably one of the first things that come to mind is, you know, someone from who has information who maybe can't trade it themselves ringing someone else uh and letting them in on something uh right away before it's known to the general public, um sort of giving them a head start. In those types of situations there's two parties involved, okay? What is the incentive

from the party giving out the information to do so, generally speaking. Yeah, this is and this is one of the the questions that that's uh that's been evolving about does the person need a a personal benefit? And and right now a according to, you know, securities law in the United States, it's the person that's tipping tipping uh someone off uh of a hint actually needs to receive something in return.

Historically that's been viewed as money. They actually get some kind of monetary compensation in return. What's interesting is the recent case which is uh Raja Gupta, the former managing director of Goldman uh of of McKinsey and Company. I mean, one of the most you know uh kind of celebrated executives uh in the world.

He was actually sitting on the board, a board of Goldman Sachs, and after one Goldman Sachs meeting, he actually called a a billionaire uh hedge fund, Raj Rod Natum, and actually divulged some of the confidential information that he just learned at uh at the Goldman Sachs board meeting. Uh soon after that call.

And so the question was a asked a as though regulators went after him, uh both civilly and criminally, for insider trading because he tipped exactly as your example is, he tipped off some information uh to to this hedge fund trader. And then the question became, well what what did he receive in return? Because in this case he didn't receive any any money or or a sports car or a a a Rolex watch or anything. But the the court prosecutor successfully argued that he basically received friendship.

Uh and so this just shows you how kind of nebulous this becomes that in and he was convicted, uh he he actually recently got out of prison. But in this case and he he is appealing his case because his view that there was no personal gain from this and if there was no personal gain he didn't engage in insider trading.

But ultimately the court the jury decide that he did receive something and that something could be fuzzy like friendship. Um just showing you how kind of diverse these benefits can be.

Just speaking in broader terms now, Eugene, your book that you've written is titled Why They Do It. So, you know, it'd be foolish of me not to ask you Why do they do it? Like why do people who are already wealthier than probably ninety-nine point nine percent of people commit financial crimes?

Yeah, so most of the time we we think of uh the popular explanation of why successful people engage in white collar conduct is because it's a a failure of of reasoning. That coming from the school of economics, this is that People like executives weigh the expected benefits against the expected costs. And to the extent, the benefits could be money, could be power, exceed the cost.

they go ahead. So this is a failure of reasoning. And what I argue in the book is this actually doesn't look like in most of these instances so much of a failure of reasoning, but rather how I describe it, a failure of intuition. The executives themselves don't see the harm associated with these actions at the time they are actually making them. And the reason why. they don't see this harm is because the harm itself is so distant.

The victims themselves are are psychologically and physically distant from them and the harm itself is temporarily offset. Well at the time they're actually doing the harmful acts, think of something like a Ponzi scheme. People are going uh going head over heels trying to give you more money.

putting you in prominent positions. It's not until later that the harm itself is actually revealed. And as a result, because there isn't not that negative feedback mechanism, uh like when you if you were to physically hurt someone because this harm is actually so distant that intelligent Even quite smart people can actually do quite harmful things to the market and actually not viscerally see that harm at the time they are actually making it.

And so that's what I explore in the the the course of the book and and some of the challenges that are associated with that and at least how I kind of step back and think about that is that we all do things that we we know are wrong. For example, anyone that drives, we we all speed a little bit and we find ways of rationalizing the speed limit's too low

Uh we we're not gonna get a ticket if we're only going five miles per hour to the speed limit. Uh we find all kinds of ways. Everyone else is going that same speed. We find all kinds of ways to rationalize why even though we know what we're doing is wrong, it doesn't really matter. But if you wanna know why people don't proceed to do things that are actually significant, is because they feel it's actually harmful.

And if you actually feel something is harmful, and a particular act is harmful, you don't even consider doing it. It never even enters your decision set. And this is why even if right now around the world we were to uh in my town we were to drop in Cambridge the prohibition against murder tonight. Police say there's no there's no prohibition, there's no sanctions. I'm not gonna be worried if I walk outside that someone's gonna come up and stab me.

Why? Because w most well socialized people have know that hit stabbing someone is harmful, so it's not even going to enter their set even if there are no sanctions associated with it. The problem with most white collar crimes is that there isn't that visceral feeling of actually doing something harmful. And so you can actually do these really damaging things that ultimately harm investors, employees, uh and ultimately oneself.

But not get that sense a a feeling of of actually doing anything harmful at the time. Right. So take it you haven't seen the Purge movies. Oh yeah. I I it's funny, I watched that just uh just uh just a month ago. Uh you know. Yeah, it's it it's an interesting interesting hypothesis and but

One the one that I not not to say I I particularly wan wanna test it, but but I'm willing to say I we could say that there are some countries this is how at least I've thought I thought about it in theory. There are countries where you could say the the rule of law is actually so weak.

in some of the securities markets, but effectively you don't see people running amok and doing everything, you know, that would be considered unethical. Um, you know, countries in western I'll say Western Europe for instance. Up until the nineteen late nineteen nineties, there really wasn't any prohibition in most Western European countries against uh illegal tr uh insider trading, as we generally think some of the most egregious insider trading would be.

And uh sure, there was probably some, but that wasn't what everyone was going to seek seeking to do in securities markets. Why? Because people had I I think were reasonably socialized that there's there's more honorable ways to actually engage in trading.

Much like uh to the purge, I think there's more honorable ways of probably dealing with our problems than going to stab your neighbor. Fortunately. I think that was a great analogy I was just uh playing around. But um

One of the things I either heard you talking about this in a another interview you've done or I'd read it somewhere but It was kind of getting at the point that, you know, it's very easy for us to judge because we're not in the situation as these people who have been convicted of financial crimes. Do you think that most people in their same situation would have perhaps done the same thing? Yes.

So that's my that's my hypothesis that in a lot of these maybe not all but in a lot of these instances we would we would behave similarly. And I think that's the I think the humbling challenge which I pose to to my students and and to readers readers of this book. I mean I think the the the trouble is we we oftentimes think we we view the world and and questions and ethical decision making with our current

you know, norms and beliefs and values and incentives and pressures. But it's not the right way of thinking about how to actually resolve these issues in the context in which these executives are are actually facing them. We would need to place ourselves in the position surrounded by their norms. intuitions, uh belief, beliefs, pressures, culture, which which is wholly different.

Um and I think much more challenging that if I took one thing away from this this project myself, it's that to have a little bit more, I think, humility. about where where I think our limitations, as I described, this is these are failures of intuitions. These aren't not necessarily failures of reasoning. And our intuitions as humans are not well designed to see these distant kinds of harm. So we're all susceptible to doing things that have these these distant kinds of harm.

Just we're generally not placed into the decision making context in which if we we mess up in one of these instances, it has such dramatic repercussions on on other other individuals as a CEO or CFO of a firm a firm would. I mean one of the challenges with I'll say corporate training or or you could say business school education when it comes to thinking about ethics

and thinking about these dilemmas is that we may like really easy in these kinds of training exercises that if we're gonna talk about an insider training dilemma, what do we do? We we give you a case Which which we then discuss in class or in that training exercise. And in doing so we've actually made life really, really easy because we've first we've identified what the ethical dilemma is. Two, we've now are p talking about it in a group of of different minded individuals.

And then three, we're going to spend a while actually engaging in reasoning, maybe half an hour, maybe an hour-long discussion talking about it. In the real world, all three of these things don't exist in most instances. I would actually argue the hardest part for a lot of instances is actually identifying the really the ethical dilemma, the moral challenge in the first place. Because in a lot of instances, so I I mentioned Raja Gupta earlier.

Rajagupta, twenty three seconds after Goldman Sachs board meeting calls a hedge fund trader and divulges this information. I mean this isn't something that you really need a case study to decide whether that's a good or bad decision. I mean this is a just a horrendous myopic and and really pretty stupid decision. And if I am confident that if he would have seen this on a sheet of paper talking about it, he would have identified this and and probably changed his course of action.

The problem is that even someone as smart as Gupta, I mean really a brilliant strategic mind, could overlook the most basic challenge associated with this, which was identifying the ethical dilemma in the first place.

And that's something that I I I think ex executives especially as people go up within an organization, have a more and I think more difficult time actually trying to identify which are the kinds of decisions that really could have that could could undermine me and my success in my organization.

Because it's very easy to to believe that I know how to solve these myself and my my my reasoning and intuition are are going to be spot on each time. Which in fact I think the evidence suggests that that's not necessarily the case.

So humility is what uh what I've taken that out and and hopefully people that read my book will will gain a I think a bit of that uh that challenge and uh maybe think a little bit uh become a little bit more self aware by seeing these oftentimes just really extraordinary individuals do things that had just such extraordinary a and really quite tragic consequences.

Yeah, I think that's that's a really fair point. N now those who are living out uh prison sentences What sort of life do they lead in prison? Like does having money afford them any luxuries or are they mixed in with, you know, the gangbangers and the murderers? What's what's life like for them in prison?

Uh prison, I mean, as much as it's easy to say, I think casually because of the harm some of these individuals d have done that a couple of years in prison doesn't seem uh significant. Uh I I would I would push back on anyone who who can kind of casually dismiss a couple of years in prison like that.

uh is I think being a little too cavalier. Uh prison's prison's nasty. It's exactly uh for my visits, it's exactly like one would expect. It's it's dirty, it's cold, and it's loud. It's just really, really unpleasant.

Um being privileged doesn't doesn't afford them uh it affords them great lawyers to hopefully try to reduce their sentence, to hopefully try to get them out of prison in the first place. But ultimately once they're convicted and if they're sentenced to prison, uh they they don't get any, you could say, uh

ex privileges so to speak uh that makes them uh uh really exceptional, uh other than they have the resources to, you know, call home, uh, to write letters, uh, to get a modest amount in their commissary account. Um they're fortunate they generally have better family relationships, people will come visit them, but the but i it's pr it's difficult. Um I'll say the part that I found interesting about this project is that

By and large, the executives were not remorseful. Uh, they weren't remorseful about their crimes. They recognized that they did it, they recognized that they were punished. But they didn't the harm itself never really resonated with them, in part, as I explained, because the harm itself seemed so different uh diffuse and distant.

But the thing that did weigh uh on on these executives was was their w the the impact on their family. It's it's missing their their son's graduation, uh their daughter's birthday. Uh i i it that's what weighed so heavily on these individuals.

But the trouble is that no one no one thinks I'll say, even when you're engaging in in things that were are clearly criminal, the kinds of things that are clearly gonna potentially land you in prison, no one thinks that they're actually doing something uh uh that's gonna land them in prison. People invariably see that's what those guys those are other people that go to prison. Those are the bad guys. It's not me. That's not a a position I could see myself in.

And that's the problem is that there are executives that are actually doing things that are gonna land them in prison, but they can't recognize it even at the time that they're actually doing it. Which makes deterrence uh uh challenging in that regard is because you want people to think about, oh my god, if I do this.

I'm gonna miss my my I could miss my daughter's wedding. I could miss my son's graduation because that would deeply impact I think decision making. The trouble is while these decisions are going on, people are not thinking that. Do you feel as though those who you've you've c documented in your book Do you feel as though most of them were fairly prosecuted, or do you think some of the punishments were too harsh?

I th that's a that's an interesting question. I I've thought I've thought about that in in in some instances where it depends how you want to uh I think look at it. I I think By and large they're fair. Um because the the the the impact of their decisions are are really quite extraordinary.

Um at the same time I'll say from the standpoint if if we're thinking from deterrence or even the impact on their lives, whether someone's in prison for five years or in one year, I I it almost is serving the same same in some sense effect. Of what it's doing. Their ability to actually uh go back into business in the future is eliminated. Their reputation is gone.

The only thing that really in some sense impacts by in some instances being in prison for three years as opposed to one is what they're what they're missing out. Which from my standpoint, missing out on on more events in life, uh, you know, the i their time from their kids and their spouse. It would be if that was serving a a strong deterrent effect, I I would actually be, I think, in favor of that. The trouble is I don't think that's actually serving a strong deterrent effect.

Um as a result, I I actually don't know if a lot of the effort but which has been created to lengthen sentences is actually serving uh the the objective in which regulators oftentimes have have kind of spelled out of why we we ought to send a pre prison uh people as long as they do.

I mean many instances where I do think the senses are pretty extraordinary, which I don't know if it's speaking about the white collar crimes are too long or are our murder or manslaughter is too short. But a lot of these instances, I mean we look at senses like Madoff or even some of the uh the CEO of Venron. They're in prison for longer than people who actually convi uh that commit

uh certain types of of of murder. Uh you know, certainly longer than manslaughter, but even people with, you know, second degree charges. It's pretty extraordinary to think that you could actually be a CEO and engage in in a white collar crime and actually be in prison for longer than someone who who killed someone. Um uh that I think that's pretty pretty humbling to think that I think that actually on one hand recognizes that regulators think that that is it it is that serious, which

It perhaps is. On the other hand it actually suggests that that in my view that maybe people who convict uh some of these violent offenses maybe they need to be in prison longer also. Um It's a challenging question, but these these things are I think always kind of changing over time and judges the one thing I I have been happy is that judges have been using a lot more of their, I think, own individual discretion to find out what's the appropriate sentence for individuals

rather than r s uh just relying on sentencing guidelines which oftentimes produce just really uh odd and really just extraordinary sentences because it's based upon dollar dollar losses rather than the underlying crime itself.

Where really people should be punished for the underlying crime, not the the dollar, so to speak, because that's in some ways unrelated. If you're a bigger firm and you commit fraud, that's simply going to have a bigger dollar amount associated with it. But that doesn't make that offense actually any worse or better than someone from a just a relatively smaller firm that did the exact same offence. That's a that's a really fair comment. I I think you answered that really well.

Uh now there's one other thing I'd like to ask you about, um and then we'll probably uh call this a wrap. But I I guess this probably comes under the category of of financial crimes. Uh and I'm not sure how f closely you've been following this case, but uh Nav, the trader who's uh allegedly uh responsible for the flash crash. I don't think he's been sentenced just yet, but the latest thing I read is he's um expected to serve about six years in prison. What are your thoughts on that?

Yeah, I I'll say I don't know all the all the details uh of of his case, so I I probably uh I I don't want to uh unfairly uh uh uh judge without knowing all the details.

But I'll say the f but the the flash trading is actually uh pretty interesting in that going back to our discussion around insider trading earlier, is that There's just a lot of I think opportunities in which people are trading on information or trading in ways that we would if we step back are saying that would be potentially unfair. A lot of these things are are, you could say, uh allowed, or in some cases it just simply haven't been deeply investigated or people are willing to overlook.

So a lot of these kind of cases that that pop up in the news, uh for example of this one

It it makes me question if we were to step back and rather than having uh you know a specific individual, uh we could say the same thing with the the LIBOR case, uh Tom Hayes in the UK. Um we have these individuals that become almost figureheads for for these offences which really represent a much broader um I'll say cultural and and uh institutional problems that frankly a lot of other people are doing things that are similar

uh but but are for whatever reason not being punished in the same way. Uh and I think this goes back to what we well ideally we'd rather do is rather than trying to find an individual uh is actually think about Well, what institutionally is causing some of these things to arise, and then figure out how to, I think, fairly met up sanctions against. all the people that are actually involved in this rather than than a a single finger fi figurehead. Um

But that's challenging. That requires many more resources and I think the one area where I'm I'm pretty sympathetic to regulators is that there are no limited uh limited uh limited resources. So what they have the incentive and and frankly they're forced to do is not go after all the instances they see, but go after the ones where they have a great case and can create the really convincing evidence to to make the conviction.

And it's though that particular or two or three individuals that end up being sanctioned. Uh, rather than kind of all the individuals that are much more genuinely involved in that type of misconduct.

Eugene, let's leave it at that, man. Um guys listening to this podcast, if you want to grab a copy of Eugene's book or just find out more about it, uh you can go to chatwithtraders dot com slash why they do it, all one word, no dashes. Um and that'll take you directly to uh Eugene's book, Why They Do It on Amazon. So that's chatwithraders dot com forward slash why they do it. Eugene, where else can listeners go to find out more about you?

Uh well on my my webpage I I uh describe a little bit more of some of my my academic work uh related to this and uh slowly but surely I'm a I'm a social media uh I'll say uh amateur. Uh but I've been slowly tweeting s slowly but surely about some of the interesting uh in in unusual cases that I do see pop up every once in a while. Um so trying to highlight I think some of these interesting issues that we've been discussing uh today in some of uh some of the work.

A good one. So do you want to give out the link for your website and also your Twitter handle? Uh yes. So it's it's uh at Eugene Soltis and then uh my website it's at uh Harvard Harvard Business School. So it's uh either accessible via eight eighthbs.edu and and you'll see me pop up uh Eugene Sultis. Uh and I also have uh EugeneSultis.com describes a little bit more and also gives an excerpt uh the the actually the first chapter of the book if people want to read that.

Oh, very cool. Well I'll make sure to include all those links in the show notes as per usual. Uh Eugene, thanks very much for doing the podcast, man. It's a lot of fun. Thanks so much, Aaron. I really enjoyed it. You've reached the end of this episode of Chat with Traders, but rest assured there are more episodes loaded with soon. if you'd leave a rating. with traders.