What the Paterno Scandal Tells Us About Trust

Joe Paterno was the de facto leader of a powerful movement. He thought he could outrun an ethical blemish in his movement, while still preaching the gospel of high values.

Where have we heard this before? Try Watergate. The Catholic Church. The SEC.

We keep replaying Captain Renault – shocked, shocked to find that something has been going on.

The Myth of Trust Shattered

One of the more common myths about trust is that “it takes a long time to create, and only a moment to destroy.”

If that were true, Bernie Madoff would have been destroyed when Harry Markopolis first blew the whistle way back in 2000.  But the SEC wasn’t in a listening mood. It takes a lot more than a moment to destroy trust when you’re dealing with a former NASDAQ Chairman.

If it were true that trust takes only a moment to destroy, then the Catholic Church would have taken decisive action back in 1984 when charges were made against priests and hushed by the bureaucracy at the cardinal level. But it takes more than a priest defending NAMBLA to destroy trust in a hubristic institution.

If it were true that trust could be destroyed in an instant, then Paterno’s non-response way back in 2002 to a first-hand witness account and the complaint of a mother would have been fatal to his following. But trust isn’t destroyed in an instant, not to an institutional network highly dependent on the leader.

In truth, trust dies a very slow death; ask any counselor to battered women.

Trusting the Hubristic

I use the Trust Equation as a deconstructive tool for analyzing trustworthiness.  It points to credibility, reliability, intimacy, and low self-orientation as drivers of trustworthiness.

Most businesspeople think credibility and reliability are the main drivers of trustworthiness.  They focus on credentials, track records, and reputation. “Madoff was the chairman of NASDAQ; Elie Wiesel invested with him. He must be trustworthy.”

Sadly, that’s what fosters hubris. Paterno breathed his own exhaust long enough to be shocked that others could consider child abuse and hypocrisy important enough to keep him from one more Saturday. Nixon could never come to grips with the essential lesson of Watergate – the coverup is always ethically worse than the crime.

It’s easier to trust people who truly believe in their own trustworthiness – even if that trustworthiness has been, by any objective standard, destroyed.

The Checks and Balances of Trust

Resumes can be forged; track records can be altered. Reputations based solely on hearsay can be abused.

Reputation is based on the assumption that the past is what it appears to be, that the future will look like the past, and that if X million other people say it’s so, it must be so.

Usually that works. Occasionally it doesn’t.  That’s why reliance on any one aspect of the trust equation is inadequate.

It’s not like the other factors of the trust equation (intimacy, low self-orientation) can’t be faked either. Intimacy is the most powerful factor, and the preferred vehicle of the con man. Again, don’t trust any one variable.

But today’s lesson is about over-trusting institutional hubris.

Consider some words: Paterno, Papa, JoePa, il Papa, Godfather, paternal. As children, we all want the benevolent and powerful protection of the father figure. And so when our institutions’ leaders garb themselves in that kind of imagery, we all too often react as kids.

As adults, we need to be adult about our institutions. The blind adulation of a million is not ten times better than the adulation of a hundred thousand. If the adulation is unfounded, then it’s just ten times stupider and more tragic.

Paterno was a great coach whose greatness was decidedly on the decline. His legacy wasn’t unhinged by a moment, but by a steady erosion in his trustworthiness. The fact that he was among the last to know is a testament to how profoundly we can fool even ourselves.

The value of a second opinion looks mighty high today.


Whom Can You Trust? How Can You Know?

This blog mostly writes about how businesses and people can become more trustworthy, and more (intelligently) trusting. What we don’t write as often about is who not to trust.

How do you spot a con? Should you trust your instincts? What’s the role of credentials? Who do you trust? (This blogpost will deal mainly with personal trust).

I must lead with two caveats: there is no trust without risk, and there is no riskless world available to any of us. There is only so much you can do to avoid risk. That said, let’s talk about it.

The following 17 rules are mostly exclusionary: violation of one rule may be enough to blacklist, but the absence of violations isn’t enough to guarantee no risk. Just as there are codes, there are codebreakers. There are always Bernie Madoffs, con men who know how to use all the rules of trust against us.

The Trust Equation comes in very handy here. Since it is a formula for trustworthiness, let’s reverse-engineer it to define what the anti-trust equation looks like.

Let’s imagine you are looking for a pediatrician, a financial planner, a gardener, a lawyer, an events planner. How do you know you can trust them?

Trust Equation Component 1: Credibility

1. Credentials. If someone has no credentials, while others in their business do, they have a lot of explaining to do. You probably have better things to do. Move on.

2. Clarity. If the person can’t explain it to you clearly, and we’re not talking about nuclear physics, move on. That includes lawyers and financial planners.

3. Fine print. If there’s a lot of it, that’s not good. And if they say ‘you don’t need to worry about this, you can just sign it,’ that’s definitely not good.

4. Does it feel ‘almost too good to be true?’ Listen to that feeling; it’s probably right, it is too good to be true.

Trust Equation Component 2: Reliability

1. Track record. Do they have a track record at all? If not, not good.

2. Integrity. Do they say what they’ll do and then do it? Do you know? Does anyone know? Do they have a reputation at all? If no, keep walking.

3. Are they unprepared for meetings, and wing it, and you know it?

4. Do they show up on time? Call to let you know they’re running late?

Trust Equation Component 3: Intimacy

1. Do you feel personally at ease with them as a human being, not just an expert? Not star-struck, or blown away—just comfortably at ease. If not, you can do better.

2. Did they do most of the talking? That’s not good, you know. Move along.

3. Does your child or pet like them? Not like them? (Not limited to pediatricians and veterinarians).

4. Do they share others’ secrets with you to ingratiate you? That means you can’t trust their discretion.

Trust Equation Component 4: Self-Orientation

1. Did they engage you in conversation about your problem? Letting you talk about it? If not, that’s not a good sign.

2. Do they blame others for their shortcomings? A sign of not taking responsibility.

3. Do you feel pressured by them to act quickly? Be wary of “we can only keep this open for one more week,” or “we’re only taking a few more investors.”

4. Check your own motives. Are you looking for a quick fix, a special deal? Then you’re the ideal con target. You might as well wear a target.

5. Maybe most important of all: Did you feel guilty about asking questions? About not moving along at the seller’s speed? Did you feel pressured to give certain answers, or to offer certain information? Check your gut: your own feelings of guilt or pressure are serious warning signs. Ignore them at your peril.

Postscript: I was tempted to write this post as a 100-point quiz.  You know, deduct so many points for each “bad” answer, and end with “if your potential trustee scored between X and Y, you probably should…”  You know the type.  And it would probably be more popular.

But I don’t think that’s right in this case. The idea that you can precisely put a meter on trust is a dangerous idea. There’s  more than enough false precision out there already. Let’s just leave this at the personal, your-mileage-may-vary level: it’s meaningful if it’s meaningful to you.

The Banality of Bad Behavior in the Financial Planning Business

My eye was caught by a headline in “When Bad Firms Happen to Good Advisors.

Some well-regarded experienced financial planners, the story said, signed on with the most recent mini-Madoff–Sir Allen Stanford and his Stanford Financial Group. Then they got burned.

Interesting story, I thought; even really good, ethical planners got sucked in, it seemed. Here is Bob Hogue, a Houston planner looking to move from Bank of New York:

Stanford offered service providers he knew well: Lockwood Financial’s platform of money managers, with which he had already built his business on, top-notch client and data management technology provided by Odyssey Financial Technologies (a leading European vendor), and a custodial relationship with Pershing, the custodian he was already using. Adding to the appeal, Pershing guaranteed easy transition of client data, no change in account numbers, if Hogue and the three FAs in his Dallas office moved to Stanford. “There weren’t any other firms offering all that,” says Hogue. He and the three other Bank of New York financial advisors joined Stanford’s Dallas office in November, 2007.

There was all the hooplah, too—yacht cruises, fabulous food, beautiful facilities. But Hogue et al weren’t seduced by that.

Or were they?

What Passes for Good Behavior in the Financial Planning Business

Stanford advisors got incentives for selling the CDs, including a 1 percent commission and, depending on the size of the sale, eligibility for a 1 percent trailing fee for each year on the CD’s contract, as well as trips and bonuses and invitations to the annual sales meeting, awarded based on how much money an advisor funneled into Stanford International Bank. [italics mine]

Wait a minute. What do CDs yield– – 3-4%? At those rates, commissions would eat up half the owner’s yield. We cry “usury” at credit card charges in the 20% range–how about 40-50%? And on a CD?

And, if these CDs were in fact yielding higher—7%, 8%–then they were far outside the normal risk range of the usual buyers of CDs.

What kind of a financial planner rakes 50% off the top of a “conservative” product that his customer could buy for nothing at an FDIC-insured bank? Or sells a highly risky product to people looking for conservation of wealth?

According to, apparently the answer is “good advisors.”

50% fees on CDs? Good? In what dictionary? Let’s get real.

What Good Behavior in Financial Planning Should Look Like

A financial planner friend tells me that when she gets calls from wholesalers pitching products for her to sell, after they describe their new product, their next line is typically “let me tell you how much commission you can make on this.” When she says, ‘never mind that, what’s the yield for the customer?’ the response is usually, ‘uh, hang on a minute, let me look that up.’

That’s the normal pitch. Wholesalers are not stupid. This means: the average financial planner is not in it for you, they’re in it for themselves; that’s why the wholesalers lead with commissions, not benefits to clients.

The same planner tells me she often finds clients who have been put 100% into a variable annuity product, for example, when they have near-term needs for retirement or college expenses. “It makes no sense,” she says. Until you check out how the previous planner made 5%, 6%, 7% commissions up front by selling them this concoction. Then it makes a ton of sense. For the advisor.

Earth to–bad advisors do this, not “good” advisors! This is the banality of evil. The incessant trickle-down of selfish, anti-customer, opaque behavior eventually makes routine, daily ripoffs get termed “good.”

Madoff and Stanford are anomalies. But the daily, garden-variety, grinding low-ethics, customer-hustling, devious behavior is all too common. See, for example, Michael Zhuang’s comment on a blogpost of just last week.

Can Ethical Behavior Be Increased in Financial Planning?

There are many ethical, customer-focused, honest, trustworthy planners. I know some of them, they do exist. They are as good professionals as in any industry. And there are seedier, greedier industries out there.

But so what? Since when is “he’s worse” an excuse for unethical behavior? Just last month the SEC charged a former President of NAPFA, one of the industry’s two professional associations, with kickbacks.  (Well, at least he wasn’t a Madoff….)

What can you do as a consumer? Search hard for the good planners. Don’t let yourself get snow-jobbed. Ask a lot of questions. Do not be intimidated. This is still a caveat emptor business. So caveat.

But–if you run a financial planning firm, you can make a real difference. Dare to be above average. Look at client-focused behavior in other industries. Talk to highly successful firms who are known for straight dealing. You know who they are in your business–emulate them. Read up on trust. Conduct focus groups. Talk to your critics. Steep yourself in the literature on how short-term anti-customer behavior kills long term shareholder wealth. Dare to do good!

Call me naïve, but I still believe that a critical mass of people in the financial planning business know the difference between today’s norm of selfish, short-term anti-client mindset and the longer-term client-focused strategy that is possible, and that in fact creates loyalty and mutual profitability. 

If I’m right about that, then it just takes some concerted courage by a few to speak up and start making a difference. And if you’re still reading, maybe you resemble that remark.

Marketing Science is Great in Theory…

Lately I’ve been struck several times by the huge gap between what we might call management science, and the reality of what really happens in the world of management.

  • Corporate training people plan multi-stage programs for the maximal developmental impact; the programs more often than not get cut off in mid-program.
  • CEOs pronounce intentions; the tea leaves are read, rightly or wrongly, and the reactions are very often deep cynicism or blind faith—not much in the rational middle area.

This runs deeper than just events overtaking plans. This pattern of the irrelevance of theory in the real world of practice is rooted far more deeply—in the human psyche.

Consider the latest on Barnard Madoff and Susan Boyle.

Madoff Less Sociopath, More Common Crook?

Fortune Magazine  tells How Bernie Did It. Many things are astonishing about Madoff. One I figured out ahead of the crowd—the fact that his “investments” were pure vaporware.

But I mistook the scale of his crime for the scale of his mental bentness. I was hardly alone in thinking him a sociopath. Now, I think, he’s just more of a common crook.

In a recorded phone call Madoff made to Fairfield Greenwich’s representatives just before an SEC visit, Madoff began with these words: “Obviously, first of all, this conversation never took place…okay?”

These are Tony Soprano lines—not mentally ill or deluded, just garden variety sleazy crook talk. This fosters distrust based not on mental stability, but on the much more familiar grounds of low integrity.

Madoff went on to remind Fairfield of their cover story, that Madoff only executed strategies formulated by Fairfield. He then essentially told Fairfield he would send Fairfield’s revised strategy on to them, contradicting himself in an almost Kafkaesque way.

Madoff successfully threatened Fairfield with taking away their golden goose–and Fairfield groveled and apologized for daring to let their customers withdraw funds! Finally, it appears Fairfield left their own money in too.

And so–Fairfield claims they were bamboozled along with all the rest. And they appear to mean it.

How is it that can you be complicit with a crook, take massive ill-gotten gains, grovel to a blackmailer, then get ripped off–and then feel righteously indignant about it?

This is the same mindset that says ‘no convict is guilty,’ at least according to the inmates. Which begs the question: What’s the difference between Fairfield Greenwhich and the Craigslist Killer’s fiance’?  (answer–the fiance is less into denial).

The best logic of the best court system can’t lay a finger on the self-judgment of those being judged. Our ability to rationalize overwhelms our capacity to be rational.

Susan Boyle: Irrational Reactions

The NYTimes today has the last (please) word on the Susan Boyle phenomenon, and it is again about how “rational thought” is an oxymoron. Let’s look at what we all thought. We thought:

-she’s a frump; no, wait, she’s an angel
-Simon Cowell judged a book by its cover; me, I just changed my mind based on new data
-people use stereotypes all the time, except for me of course

Susan Boyle proves people are prejudiced. But people won’t change. “Proof” is pitifully weak when up against assumptions.

In business, I often think of Indiana Jones’ encounter with the intricately practiced Arabian master of the sword, threatening to bring years of skill and practice to bear on Indiana in the form of whirling cold steel.  Jones responds with a disgusted eye-roll—and a point blank shot from his .45.

Theory is the sword—so often outclassed by the blunt force of emotion, a far more powerful driver of human behavior.

Management theories that don’t take human reality into account are so much whistling in the wind.

The Ethical and Regulatory Morass of the Stanford Scandal

I didn’t start out looking for trouble.

But like the camera shots in a Sergio Leone western, every time the camera pulls back for perspective in the Stanford Investment Bank story, the plot changes.

But let’s begin at the beginning. You of course know Madoff–the man with the minus touch.

Now we have "Sir" Allen Stanford–let’s call him mini-Madoff. He’s head of the Stanford International Bank (SIB), now accused by the SEC of bilking about $1.8 billion through, what else, a Ponzi scheme. Based in Antigua, operated out of Mississippi and Texas, a very private management team.

SIB had an outside lawyer from the prestigious firm Proskauer, Rose. His name is Thomas Sjoblum. On February 10, in the SEC offices in Fort Worth, Texas, Mr. Sjoblum accompanied his client, SIB’s Chief Investment Officer Laura Pendergest-Holt, to a 4-hour deposition by her.

The next day, Mr. Sjoblum told the SIB folks he was resigning from the case.

Musta been one helluva testimony Ms. Pendergest-Holt gave, eh? So it would sound.

In a blackberry email to an SEC lawyer two days later, Sjoblum clarified:

"I disaffirm all prior oral and written representations made by me and my associates … to the SEC staff regarding Stanford Financial Group and its affiliates.”

For me, it all started with that funny word–“disaffirm.” In a blogpost on February 20 I said “disaffirm” was a tortured linguistic construct aimed at putting distance between telling the truth and technically not lying.

But then the real fun started. Pull the camera back a few feet.

I then separately heard from two lawyers for whom I have very high regard, suggesting I had been too hard on Sjoblom. They suggested Sjoblom was a whistle blower whose actions were principled, difficult and courageous.

They were not alone. The blog AmLaw Daily had written the day before:

…Sjoblom…sniffed out the fraud, withdrew his representation, and told federal investigators he essentially took back everything he had told to them in recent weeks…

Am Law Daily contacted a number of legal ethics experts to discuss Sjoblom’s decision to come clean about a client’s alleged frauds–especially given the possibility that in doing so, he disclosed confidential client information to the government…

Experts said Sjoblom did precisely the right thing–and, more importantly, that the federal Sarbanes-Oxley Act likely made his decision much easier than it otherwise might have been.

"He [Sjoblom] did the right thing here," says Stephen Gillers, a legal ethics expert at New York University School of Law.

I started looking for crow to eat. Until, that is, I read the Memphis Daily News account of what actually happened at that February 10 SEC deposition.

By the SEC’s own notes, Sjoblom came out swinging—asking if the SEC had yet referred the case to Justice, arguing that the SEC didn’t have geographic jurisdiction, arguing that the (allegedly) bogus CDs Stanford sold were not “securities” under the relevant legal definition.


Suddenly the aspiring Hollywood screenwriter in my head switched stereotypes: this was not the plot for the courageous whistle blower movie. This was the script for the B "mob lawyer" movie. Could he really have had a Saul on the road to Damascus conversion in one afternoon?

So–what happened in that room? Did Ms. Pendergest-Holt really drop a bombshell that blindsided Sjoblom? Or did Sjoblom do a Claude Raines (“I am shocked, shocked! to discover my client has lied to me for years about billions of dollars!”)? Incidentally, Ms. Pendergest-Holt was arrested by the FBI a few days later.

Let’s pull the camera way back.

Attorney Sjoblom is an ex-assistant chief litigation counsel in the SEC’s Division of Enforcement. On February 10 he aggressively explores defenses for SIB just before Pendergest-Holt comes on and says things that get her arrested. The next day he resigns.

The obvious question becomes, ‘What did Sjoblom know, and when did he know it?’ Of course I don’t know, but let’s consider what Sjoblom might have known:

  1. In 2003, a whistle blower case against Stanford was brought in front of the NASD (FINRA’s predecessor).
  2. In fact, according to Henry Blodget, "at least five former Stanford employees told the SEC they thought Stanford was running a Ponzi scheme, from 2003 on."
  3. A January 2008 lawsuit was filed against Stanford alleging endemic lack of compliance.
  4. A Venezuelan analyst wrote a report called Duck Tales in January 2009 which did for Stanford what Markopolis did for Madoff–blew the conceptual lid off.
  5. But the nail in the "shocked, shocked!" coffin is in the FBI arrest claim for Stanford’s Pendergest-Holt:

..the complaint alleges there were stormy preparation sessions for Pendergest-Holt in January and February “during which the bank’s shaky asset base became apparent to a wider circle of officials and to the lawyer — ‘Attorney A’ — who later quit.”

Um, who might ‘Attorney A’ be? Whoever it was, he knew something was up back in January.

So–just when did Sjoblom "sniff out the fraud?" The day after he heard testimony in Dallas? Or way before?

If he knew anything in advance–then why the aggressive denial-of-jurisdiction rant at the outset of the hearing? How much charade does a lawyer have to go through before he can speak some truth? I know legal ethics is much concerned with maintaining client confidences. But how much pretzel-twisting is required to serve that particular god?

The legal experts said Sjoblom did “exactly the right thing.” They also say that Sarbanes-Oxley made it far easier for lawyers to reveal confidences in certain situations. Let’s assume both statements are true. How horrible it must have been pre-Sarbanes–how many would-be whistle-blowing lawyers went to the grave mute?

How much in-your-face evidence of massive fraud does it take before a lawyer can say "my client is a crook and a liar" in a legally acceptable manner?

May I suggest the right answer should be–"less than this."

If this was a praiseworthy, ethical act consistent with the highest standards of the law, then something is very wrong–either with a lawyer, with legal ethics, or with the law itself. The law owes society more than citing last-minute tortured "disaffirmations" in the face of egregious criminal wrongdoing as examples of ethical behavior.

Note: It’s possible that Professor Gillers was not aware of all this background when he called Sjoblom’s actions "exactly the right thing." For all I know, given the background, he might even agree with me. I’d welcome his perspective here, and I’d welcome any correction from anyone about matters of law or fact.

Regulatory Policy 2.0 – The Alternative

[Second of a two-part Blog Post]

Yesterday I suggested that our existing 3-legged approach to regulation (separation, compliance, transparency) not only failed to prevent Madoff, but positively enabled him.

Today I’ll talk about an alternative.

Until last weekend, when the world discovered Madoff hadn’t bought stocks for 13 years (TrustMatters readers heard about it 5 weeks earlier here), the consensus was Madoff was so sophisticated no one could follow him.

Turns out sophistication itself was the ultimate scam. Madoff built a Potemkin village. He knew what a trading system and a hedge fund should look like, and gave us the appearance of one.

In fact, it was just another Nigerian Ministry scam.  Give me your bank account numbers. and I’ll make you rich. Trust me.

The SEC, like all regulators, relied largly on three mechanical approaches:

• structural separations
• compliance processes
• disclosure.

All were built around the modern sophisticated financial world. What they entirely missed was the human element of any great scam. Hide stuff in the most obvious of places. Utterly believe your own lies. Get the con to focus on your spiel while you swap the pea out of the walnut.

They missed the “man” in con man.

If past is prologue, as unfortunately it usually is, there will be a firestorm of protest and we will end up, through the best efforts of Congress, Fox News and the tabloids, with More of The Same. The same trio of regulations that Madoff manipulated. And it will cost billions and billions more in regulation and in stifled economic sub-optimization.

So what’s the answer?

Human-based regulation–beyond structure, processes, disclosure. Regulation 2.0.

Human-based regulation recognizes and embraces three human traits:

1. We live up (or down) to expectations
2. People are infinitely creative–regulators must be as well
3. Selective audits plus severe consequences both inform and deter people.

Set clear expectations. We cannot allow confusion between “ethics” and “compliance.” The phrase “but it was legal” cannot be permitted to be the end of conversation. Regulators have to continue dialogue with non-lawyer citizenry, stay in touch with norms and mores. Most important—they must have a visceral sense of the “rightness” that their agencies were built on in the first place, and unflinchingly convey that sense of mission and expectations to their industries.

Harness Creativity. Regulators can find role models in the audit profession, the IRS, and the GAO. They can look farther afield at successful police departments, e.g. New York City’s counter-terrorism operation. The ultimate objective can never be to just ensure compliance—it must be to fulfill mission.

Visiting RIA offices to review papers too easily becomes a bureaucrat’s exercise. We need regulators who think like cops, who are inherently suspicious, who demand proof, who creatively out-think the Madoff du jour. (Harry Markopolis’ testimony in Congress—the second part—gives excellent examples of this, epitomized by the simple, “is something funny going on around here? Here’s my card—call me if you see anything suspicious.”)

Selectively audit, severely penalize. Auditors and the IRS have excellent track records doing selective audits. You don’t need to examine every book—just let every bookkeeper know that their books might be the ones examined next.

Combined with the public announcement of severe consequences, this approach both tells the industry what behavior is expected, and says they are accountable to the public they serve. It’s like a police perp walk—it publicly shames and humiliates.

(From this point of view, the continued absence of a perp walk for Mr. Madoff, together with the absence of any consequences thus far, sends the wrong message. It says “old” regulation still holds sway: he can stay in his comfortable digs until the legal process grinds its way to some determination of whether or not he has committed a violation of a particular law).

Madoff’s scam was old-school, Nigerian-Ministry, thuggish. That doesn’t mean the SEC employs incompetent people. It does mean, however, that they are toiling under an inadequate philosophy of regulation.

We will not regain trust in our institutions until we remember that trust is, at its heart, a human thing—and begin to act that way.

Regulation 2.0 is a good start.

Regulatory Policy 2.0 : The Real Meaning of Madoff

[First of a two-part Blog Post]

Madoff has been a late-night TV comedy staple for some time now. While his victims surely don’t appreciate the humor, most of use have relegated him to cafeteria conversation, alongside Lindsay Lohan and the Oscars.

That would be a big mistake.

L’affaire Madoff will dramatically affect our approach to regulation. And in this case, our first instincts—can you say, ‘Sarbanes-Oxley 2.0’—would be the worst. We need Regulatory Philosophy 2.0. Here’s why, and how.

The Latest on Madoff. The headlines this past weekend screamed one thing: Madoff Bought No Stocks for 13 Years. ‘Look how brazen he was, how could the SEC miss that, no way his sons weren’t in on it all along, etc.’

It was no surprise to readers of this blog.

On January 17, I wrote, in a blogpost titled Madoff—Investment Fund or Virtual Reality Game

It’s beginning to look like Bernie Madoff’s business model had less in common with a hedge fund or investment management firm than it did with an online virtual reality game. Sort of a Sim City for investors. The money sent in was real: everything thereafter was from Oz…
…[It] was bupkus. Virtual reality money. Sim City money. Monopoly Money. In the real world, it didn’t exist except in Bernie’s bank account and a computer program.

This was not a case of sophisticated hedge fund managers in Greenwich or rogue currency traders in Hong Kong. The SEC was not out-gunned, outsmarted, or out-manned. This was not a Danny Ocean operation.

This was as simple as a Nigerian inheritance email spam scam. Gimme your bank account number and I’ll send you money. A garden variety mugging. Like a good magician, Madoff got us to look one way, while he swapped card decks.

Overnight, this recasts the regulatory task facing the SEC. We can no longer rely on traditional regulatory philosophy: we must get personal, human, and trust-based.

Regulatory Philosophy 1.0. Regulation (and not just in the financial industry) has become driven by three models—separation, compliance, and transparency. None of them stopped Madoff—in fact, they enabled him.

Separation. Think building walls—to legally and physically separate potential co-conspirators. Think traditional anti-trust laws. Think separating accountancies and consultancies. It is a heavy-handed, expensive, and sub-optimal way to regulate.

Madoff used this to his benefit—claiming his brokerage and investment management businesses were separate because, ‘after all, they had to be.’ Therefore FINRA could claim “it wasn’t my job.” Madoff knew FINRA would make that claim; in fact, he depended on it.

Compliance. This approach turns legislation into a blizzard of administrative processes, which must be complied with. Think check-boxes, filed copies, no-later-than dates, renewal requirements. All monitored and tracked in the latest systems. This approach is less heavy-handed, but equally oppressive—and mind-numbing to boot.

Madoff used this also to his benefit. You want forms? I’ve got forms. But the data was itself bogus.

Transparency. Lawyers, financiers, mortgage brokers and credit card operators love transparency-as-panacea. Coupled with a convenient belief in efficient market theory, this enables people to blame those who didn’t read the small print (Rick Santelli, are you listening?).

Madoff used this to his benefit too—blitzing investors with day-trader-like “records” of trades (bogus). We have come to measure “transparency” by the pounds of documents “disclosed,” rather than by their truth or import.

If we focus only on outrage at Madoff and at government bureaucrats, our politicians will do what they’ve always done: legislate more structural boundaries, design more and more checkbox procedures, and require publication of more minutiae. And thus we’ll enable Madoff 2.0–even faster this time.

Regulation 2.0.  There is a better way.

It is based on a simple fact–people are human. People are good and bad, trusting and non-trusting, sometimes all at the same time. Systems don’t commit fraud, people do. In this case, one Bernard Madoff.

Yet our existing regulatory processes are entirely non-human. Walls, processes and transparency are mechanical things. Devised by people, they can be broken by people. And being inhuman–we don’t trust them.

Our existing Philosophy of Regulation does not engender trust. To trust our institutions, we have to return to a simple principle: trust is inherently human. We have taken the human part of trust out of regulation, and we’re paying the price.

Tomorrow’s BlogPost: Why we need to build regulatory policy more around personal trust.

I Have Done Nothing Illegal

You know the old joke: “Legal ethics is an oxymoron.”

Now, it may or may not be that lawyers are disproportionately ethically challenged. But the real oxymoron is not about lawyers—it’s about the legal-ization of ethics.

An act can be immoral or unethical without being illegal. And the absence of illegality does not make an act moral. This should not be a hard concept to grasp.

Yet, there is no shortage of businessmen and politicians who aggressively assert legal non-guilt as if it could mask the stench of grossly unethical behavior.

Googling “I have done nothing illegal,” and variations on the theme, provides such gems as these:

Illinois Governor Rod Blagojevich—“I’m here to tell you right off the bat that I am not guilty of any criminal wrongdoing.”

New York’s former State Senate Majority Leader Joseph Bruno, responding to a damning indictment, sounds like the ex-boxer he is, saying
After being hounded for three years, I am being indicted on a prosecutor’s sleight of hand.” Bruno insults an entire profession by calling millions of dollars in sales-commissions-or-is-it-kickbacks “consulting fees.”

Remember Senator Alan Cranston of the Keating Five? Talking to congress, he said, “You know that I broke no law.

Enron’s Jeff Skilling testifies that he and Lay never broke the law.

Confirming their virtue, his buddy Ken Lay said: “We don’t break the law.

Former New Jersey Senator Robert Torricelli, explaining the scandal that led to his resignation: “…had not denied taking gifts from Mr. Chang, but said that he took no ‘illegal gifts’…

Back in 2006, San Jose’s mayor Ron Gonzales kept it simple. Indicted for fraud, bribery and conspiracy, he said “I broke no law.

Lousiana’s former Governor Edwin Edwards, being charged with $1M in racketeering and extortion said, ”I know I didn’t break any Federal laws.”

Really blurring the ethics/law boundaries, Pennsylvania State Senator Fumo’s 2007 response to a 139-count Federal indictment was, “I know in my heart that I have not done anything illegal.

Over on Long Island, the late Republican Joseph Margiotta was convicted of federal mail fraud and conspiracy charges in a municipal insurance kickback scheme, and served 14 months. Even then, he explained, “I didn’t break any law.

When Don Imus was brought back to the air from the racist dead, part of the rationale for it, as provided by the CEO of Citadel Broadcasting was, you guessed it, “he didn’t break the law.” So I guess all that other stuff—no biggie.

I can’t wait to hear from Madoff. His scam deftly sought out legal vacuums. So if and when he says, “I’ve broken no laws,” it’s important we remember he’s still a sociopathic ripoff artist.

When someone says, “I didn’t do anything illegal,” you can bet your bottom dollar they did two things wrong. One was the scam itself.

The other is worse. They have demeaned both the law and ethics.

The law cannot and should not substitute for ethics. For one thing, it puts an unsupportable load on the law—and lets unethical and immoral people off the hook.

Worst of all, it equates moral arguments to whining complaints made to third parties. That’s a recipe for abdicating personal responsibility. You can’t trust people who have no inner moral compass. A thief with a legal loophole is still a thief. A con artist with a good lawyer is no less a con artist.

That is the true meaning of “legal ethics is an oxymoron.”

When someone to whom we entrust our life savings or our political leadership acts badly, and then defends himself by saying,“I broke no law,” they should be shunned and shamed—outed and shouted—exposed to derision and disgust in all forms of public dialogue. Not to mention voted out or fired.

Bruno, Blago and Bernie ought to be ashamed of themselves. If they can’t even manage that, their status in court has no claim on our judgment.

From Mistrust to Cynicism to Corruption

Q. What do Mark Twain, Clint Eastwood and Bernie Madoff have in common?

A. They all tell tales of the path from mistrust to corruption.

In 1879, Harper’s Monthly published Mark Twain’s wry tale The Man that Corrupted Hadleyburg—a dark, cynical sketch of a town whose pride rested on its reputation for incorruptibility. A stranger manipulates that pride into corruption, and makes the town the cause of its own ruin.

The Wikipedia summary makes for eerie reading in these past-Madoff days.

94 years later, Clint Eastwood channeled the same stranger/corruption theme in High Plains Drifter, his second directorial effort. Elizabeth Abele’s review nails it:

…not only is there little difference between the law and the bad guys, but the "good, decent people" [of Lago, Arizona] do not appear deserving to be saved. In their silence and passivity, they are as guilty as anyone. The approaching outlaws are in many ways a McGuffin. The Stranger’s true adversaries are the townspeople–who simplistically reward the Stranger for his opening slaughter of their hired guns by hiring him as their savior.

Cue the Good Townspeople burned by Bernard Madoff, financial crackhead (I mean "crackhead" in the sense of someone consumed by an ever-growing need for more and more money to feed his insatiable, and growing, need. If the shoe fits…).

Stipulated: Madoff’s a bad man, and many innocent people were harmed.

But a great many other people bear the same kind of responsibility as the citizens of Hadleyburg and Lago. Such as “feeder” funds like Fairfield Greenwich Group , which claimed in writing (and charged greatly) to perform high levels of due diligence on its Madoff investments.

And how about its sophisticated partners and customers at institutions like Banco Santander and Union Bancaire Privee? Like the Good Townspeople of Lago, it beggars belief that none among them had suspicion skeletons in their closets.

Here’s the roadmap downhill from broken trust.

In Twain’s and Eastwood’s stories, an organization starts out proud of its reputation for rectitude. Then someone descends into venality. It starts with “borrowing” to tide things over the weekend. But–as with any crackhead–it doesn’t stop there.

There comes a critical point when the bad guy is found out. The organization or society of which he is a part can go one way or the other. It can be horrified and reject the miscreant. (Let’s refer to this as the “right thing to do.”)

Or, it can choose “tolerance.” He’s really a good guy, he hasn’t done it before, haven’t we all cheated on our taxes one time or another? Just let it be.

And the crackhead steals the family silver.

Tolerance then leads to cynicism. Hey everyone does it, it’s nothing new, what are you, naïve, don’t you know how things work? Knock it off. It’ll work out.

And the crackhead knocks over a store.

Finally, you end up with corruption. Hey, Bernie’s making a ton for everyone. Not everyone can get in on it, but I know someone who can get you a piece of the deal. Shhh, everyone knows it’s a little “off,” but look at those returns. Waddya, nuts? Just sell a little to your cousin. Hey if you don’t, someone else will. Might as well be you. I’ll be gone, you’ll be gone, what’s the harm. Wink wink, nod nod, know what I mean, know what I mean?

And the crackhead corrupts everyone.

In the Eastwood version, the Stranger renames the town “Hell” as he rides off into the sunset. Twain’s Hadleyburg too gets a name change.

John Wayne didn’t care for this movie (or for Eastwood in general, I suspect). But while John Wayne was hell on bad guys, I’m not sure he knew how to recognize a helltown of crackheads. And just changing the town name won’t do the trick.



Trusting and Trustworthiness: The Chicken or the Egg?

Most talk you hear about trust uses that one word—“trust.”  But on closer reading, the talk turns out to be about one of two very different things: either about trusting, or about trustworthiness.

They are not the same.

Trusting is about the one doing the trusting.  Being trusted is about the one who would be trusted, or trustworthiness.

•    When you read about the poor charities who got ripped off by Bernie Madoff, that’s about trust-as-trusting.
•    When you read about how Bernie Madoff pulled off the con, that’s about trust-as-trustworthiness.
•    Surveys that talk about declining trust are usually about a decline in trust-as-trusting.
•    When we read stories about how there are more securities violations, we’re reading about a decline in trustworthiness.

Which is the chicken, and which is the egg—trusting, or trustworthiness? Which causes the other?  Which should drive policy?

Years ago I consulted to a convenience store chain with a serious store manager turnover problem (150% per year).  They wanted us to profile a successful store manager so they could hire to that spec. 

Sounded like a good plan.

Until we found out that each store manager was routinely given a lie detector test every month to see if they were stealing. 

Let’s say you’re a store manager.   After 6 months of being hooked up to a polygraph and asked if you were a thief, you might figure “hmm, someone must be getting away with something—I wonder how he’s doing it?”  So you start experimenting.

And in a few months, you’ve a turnover statistic.

So which was the chicken, and which the egg?  Trusting, or trustworthiness?

The company management thought the trustworthiness came first, that they were being victimized by untrustworthy employees.  They wanted to find trustworthy people, so they could trust.

In this case, it turned out to be the opposite problem.  Management’s mistrust lowered the trustworthiness of the store manager.  People live up (or down) to our expectations of them.

Sometimes it’s the other way. There are real Madoffs out there, and you’d be a chump not too protect yourself against them.

But here’s the thing.  Think of trust as a risk mitigation strategy. Unlike fight or flight—the usual risk mitigation strategies—trust actually alters the risk in question.

If you take a risk and trust someone—or take a risk to show that you are trustworthy—you can influence the other’s behavior.  People tend to respond in like manner to well intended gestures. 

Madoff is not the norm.  To subject every store manager (or any other job) to the kind of scrutiny that would prevent a Madoff can be a very expensive proposition.  (See Sarbanes-Oxley; airport security).  We need to think very carefully about the right responses to unusual events.