Tara Browne

Page |1 THE DARK SIDE OF ENTREPRENEURIAL ACTIVITY: BERNIE MADOFF’S PONZI SCHEME INTRODUCTION In George Lucas and Steven Spielberg’s “Star Wars” Saga, there exists the concept of “The Force”; an ever-existing power that lives in everything. The Force can be a dominant weapon for good, but it can also be used for evil. Much in the way a knife or a gun may be used for the protection of innocent lives, the same weapon could be used to harm innocent lives. The deciding factor comes down to the intent of the individual wielding it. In this same way, there exists a “good” and “bad” or “productive” and “destructive” side of entrepreneurship. The same qualities which serve to make an entrepreneur a successful, productive member of society, can also turn out to be the same qualities which make him into a destructive, dark entrepreneur. The following paper will critically discuss the dark side of commercial entrepreneurial activity. De Vries (1985, 1996), Vecchio (2003), and Baumol’s (1990, 1993) entrepreneurial personality and cognitive characteristics as well as situational and economic factors will be discussed as they pertain to development of dark entrepreneurs. The Ponzi Scheme’s history as well as Bernie Madoff’s entrepreneurial adaptation of it will also be analyzed. The paper will be concluded with conjecture on measures to prevent dark entrepreneurial activity or move dark entrepreneurs toward positive entrepreneurial activity. SCHUMPETER’S ENTREPRENEUR For the most part, the majority of academic research and literature focuses on economically and socially positive entrepreneurship (Lockwood et al., 2006). Schumpeter describes the carrying out of a new combination of means of production as “enterprise” and the individual carrying out this enterprise as an “entrepreneur” (Schumpeter: 1934: 74). Brouwer describes Schumpeter’s entrepreneur as one who “takes delight” in opposition, is a “creative non-conformist” who is not “shunned by society, but warmly welcomed by the banking community that grants him credits to finance his attack on established positions” (Brouwer, 2002:89). Truly entrepreneurial activity is that which not only introduces a new means of production, it may introduce a new good or new quality of good a new market, the conquest of a new source of supply, and even the creation of a monopoly position or the creation of an organization which breaks up a monopoly position (Schumpeter, 1934: 66). THE DARK ENTREPRENEUR: DE VRIES, VECCHIO & BAUMOL’S THEORIES In comparison to the study of the positive side of entrepreneurship, established most famously by Schumpeter (1934), the study of the dark side of entrepreneurship is relatively new. Its definitions and related theories are still in the process of finding theoretical coherence and clarity. Many writers like Goltz (2009), Morin (2015), and Posin (2015) view “dark entrepreneurship” as simply the downside and difficulty associated with trying to start one’s own business. On the other hand, De Vries (1985, 1996), Vecchio (2003), and Baumol (1990, 1993) are three theorists who speculate about the characteristics of entrepreneurs which influence them to act in a socially and/or economically destructive entrepreneurial manner. For the intents and purposes of this paper, de Vries (1985, 1996), Vecchio (2003), and Baumol’s (1990, 1993) theories on entrepreneurial personality and cognitive traits will be the basis from which this discussion of dark entrepreneurial activity will launch. De Vries (1985:1) asserts that entrepreneurs have a “bias toward action, which makes them act rather thoughtlessly.” He quotes entrepreneur Derek du Toit as evidence toward his assertion: “The entrepreneur…does not take kindly to suggestions or order from other Page |2 people” (de Vries, 1996:2). De Vries (1985:2-5) identifies entrepreneurs “need for control,” “sense of distrust,” and “desire for applause,” as three main negative personality characteristics which can lead to the entrepreneur acting irrationally or in a manner that has a negative impact on the company or the society in general. Describing Schumpeter’s entrepreneur in less than flattering terms, DeVries (1996) adds that entrepreneurs also tend to be acutely narcissistic with a general allergy toward authority. He asserts that these negative personality characteristics then drive the entrepreneur to resort “to primitive defensive mechanisms” (de Vries, 1996: 2) such as surrounding himself with “yes-men” (de Vries, 1996: 10). It is worth noting, however, that some of the more extreme cases de Vries (1985) offers as examples of entrepreneurs displaying negative and potentially damaging personality characteristics, are also entrepreneurs de Vries (1985:3) describes as “very gifted” with remarkable creativity. Though de Vries (1985) doesn’t directly emphasize it, there appears to be a correlation between how gifted and creative an entrepreneur is and how emotionally and mentally fragile he may be. Could there be a direct association between the level of creativity displayed by an entrepreneur and their propensity for either incredibly positive or negative entrepreneurial acts? This paper may not be the forum for which to explore this possibility, but it would be a notable topic for further examination. De Vries (1985:5) does make it a point that entrepreneurs’ “do not necessarily have more personal problems than other people, not do they inevitably have personality disorders.” What is different about entrepreneurs versus the general population is the means by which they deal with stress and disappointment. It is the mix of irrational and creative that make an entrepreneur the successful societal contributor (de Vries, 1985:5); but, it may also be this mix which makes them successful and damaging dark entrepreneurs. Vecchio (2003) agrees with the “Big Five” personality traits of entrepreneurs being “risk-taking, need for achievement, need for autonomy, self-efficacy, and locus of control” (Vecchio, 2003: 306). However, he adds on four cognitive attributes related to entrepreneurs: “overconfidence, hubris, escalation of commitment, and counterfactual thinking” (Vecchio, 2003:307). Vecchio (2003:313) argues that the findings for the cognitive entrepreneurial traits have more scientific evidence than the personality traits and deserve a place in the consideration of what makes entrepreneurs tick. He lumps “overconfidence” and “hubris” together asserting that when overconfidence results in failure it’s often considered hubris (Vecchio, 2003:314). He notes the entrepreneurial “desire for applause” may point toward a “narcissistic tendency that is reflective of difficulties regulating self-esteem” which may be the root of the overconfident, hubristic nature of the entrepreneur (Vecchio, 2003: 314). Baumol (1990:893) introduces the idea of societal “payoffs” as motivating factors for dark entrepreneurial activity. He also asserts that a common assumption is made “at first blush” when analyzing Schumpeter’s entrepreneur: the entrepreneur is a productive member of society (Baumol, 1990: 897). Baumol (1990:897-898) suggests that if Schumpeter’s definition of “entrepreneur” is simply someone who is “ingenious and creative in finding ways to add to their own wealth, power, and prestige” then it should be no surprise to anyone that some entrepreneurs wouldn’t be overly concerned with whether or not their endeavour helps or hurts society overall as long as it is of benefit to the entrepreneur. This, Baumol (1990: 898) affirms, is directly related to whether or not the “rules of the game” (i.e. the general laws which govern society) make it easier and more rewarding for an entrepreneur to profit via productive or destructive entrepreneurial means. According to Baumol (1993:1), negative or “dark” entrepreneurs engage in “systematic sabotage” (i.e.: dark entrepreneurship). This systematic sabotage doesn’t happen by coincident but as a direct Page |3 result of “the structure of payoffs in an economy [which makes] unproductive activities such as rent seeking (and worse) more profitable than activities that are productive” (Baumol, 1993:1). In other words, sometimes it quite literally pays to be a dark entrepreneur. Though de Vries (1985, 1996),Vecchio (2003), and Baumol (1990,1993) spend a painstaking amount of time describing nuances, situations, cognitive and personality traits which influence dark entrepreneurship, none attempt to formulate a concrete definition. One hypothesizes this could be due to the possibility that destructive (“dark”) and productive (“good”) entrepreneurs are actually the same; it’s the circumstances (“rules of the game” and “payoff” (Baumol, 1993)) surrounding them which induces the movement toward or away from productive entrepreneurship. Could dark entrepreneurship simply be the natural reaction of productive entrepreneurs that comes with changing rules of the game and a new system of rewards? The following offers up an example. [THIS SECTION HAS BEEN CUT FOR LENGTH] THE DARK ENTREPRENEUR: BERNIE MADOFF On 11 December 2008 Bernie Madoff was arrested on charges of fraud, money laundering, false filings, and theft (Zarrabi & Lundberg, 2015). In June 2009 he pled guilty on all charges and admitted to swindling investors out of $65 billion. He was subsequently sentenced to 150 years in prison (Yang, 2014). Bernie Madoff had successfully committed the world’s largest Ponzi Scheme (Zarrabi & Lundberg, 2015). But how, in the day and age of the U.S. Securities and Exchange Commission (S.E.C.), of close financial monitoring and watch-dogging was Madoff able to commit such financial atrocities? Through ingenious dark entrepreneurship. It’s well established that Madoff utilized the Ponzi Scheme as the means to enact his fraudulent plan (Yang, 2014; Zarrabi & Lundberg, 2015; Barazesh, 2009). In this way, he did not exhibit a genuine “dark entrepreneurship” but more so a “historical” dark entrepreneurship by utilizing a previously known system to generate capital and maintain his business. However, what was genuinely entrepreneurial about Madoff’s execution of the Ponzi Scheme was his “carrying out of new combination” of means of production (Schumpeter: 1934: 74). Ponzi schemes are both dubious and creative in that they use a mix of convolution and the investors desire to generate more money as a trap (Yang, 2014). Ponzi Schemes are only successful so long as new investors are found and the old investors don’t pull out (Yang, 2014). The moment an investor decides to cash-in, the scheme collapses; which is exactly what happened to Madoff when, in 2007, his investors requested their $7 billion in returns and Madoff only had $200 million (Yang, 2014). Madoff turned truly “dark entrepreneur” by utilizing a variety of new techniques which had, to date, not been utilized in that capacity before. Zarrabi and Lundberg (2015: 3) write “At the end of each month Madoff sold all stocks and financial instruments so that the hedge fund only reported the amount of cash to the authorities…investors did not have any online access to their investments, instead they received [sic] a mail with their account information and balance each month.” By doing so, he used smoke and mirrors to confuse his clients into thinking they understood the process of how their money was being generated. "People, even smart people, can be fooled by such schemes because they are drawn in by those who seem smart and experienced” (Barazesh, 2009). Madoff also took advantage of the federal “5% payout” law. The law states that private foundations are required to pay out 5% of their funds every year. As Zarrabi and Lundberg (2015:5) explain, “Madoff mainly managed money for charities…therefore [he] could avoid sudden or unexpected withdrawals” which would mean a fast end to his scam. Page |4 Bernie Madoff exhibits entrepreneurially qualities according to four separate theorists: Brouwer (2002), de Vries (1985, 1996), Vecchio (2003), and Baumol (1990, 1993). These translate to “dark” entrepreneurial qualities due to the manner in which he exercised these qualities: to the deficit of society and the economy as a whole. To reiterate, Brouwer (2002:89) describes the entrepreneur as one is not “shunned by society, but warmly welcomed by the banking community that grants him credits to finance his attack on established positions.” It was Madoff’s banking and government ties that allowed him to run his scam for such an extensive period of time. Before his arrest in 2008, Madoff was a respected and prominent figure on Wall Street and even in Washington. His company, Madoff Investment Securities LLC was “the sixth largest market maker on Wall Street” (Zarrabi & Lundberg, 2015: 2). Harry Markopolos, a financial fraud investigator at Rampart Investment Co. in Boston, had raised the red flag on Madoff’s Wall Street dealings as early as 1999 (Douglas, 2008). No action was taken for nearly another decade presumably due to Madoff’s respected position on Wall Street (Zarrabi & Lundberg, 2014) (Fingleton, 2013). Madoff was the chairman of the Securities Industry Association where his brother was also a member (Zarrabi & Lundberg, 2014: 4). In the aftermath of the Madoff scandal, the S.E.C. was accused of being intentionally misleading during the investigation (Fingleton, 2013). It later came out that the S.E.C.’s inspector general at the time of Madoff’s investigation and trial was David M. Becker. Mr. Becker’s family had inherited a Madoff account via his mother’s estate (Henning, 2011). Madoff had, indeed, been “warmly welcomed” not only by Wall Street and the government, but was also trusted by his investors. A 70 year-old “veteran of Wall Street,” Madoff had started his firm in 1960, helped launch NASDAQ, and sat on the board of the National Association of Securities Dealers and advised the United States S.E.C. (Yang, 2014:3). As Yang (2014) states, “It was easy [for investors] to believe... he knew exactly what he was doing.” De Vries (1985:1) asserts that entrepreneurs have a “bias toward action, which makes them act rather thoughtlessly” as well as an ongoing need for applause and approval. Baumol (1990:897-898) states dark entrepreneurs will engage in “systematic sabotage,” when destructive entrepreneurial activity becomes more profitable than productive entrepreneurial activity. The entrepreneur will take any means necessary in order to “add to their own wealth, power, and prestige” (Baumol, 1990:898). Combine these with Vecchio’s (2003:306) cognitive characteristics of “overconfidence” and “hubris” and one begins to piece together when and why Madoff turned dark entrepreneur. As previously stated, Madoff’s business started tanking in the 1990s when the economy took a down-turn. This is the turning point. Madoff knew that he couldn’t “keep his promises to his clients about high returns” and therefore faced a business collapse (Barazesh, 2009) (Yang, 2014). He could have chosen to downsize, relocate, and close the business or any other above-board action by which to react to the sinking economic conditions. Instead, his hubris and “bias toward action” won out. Instead of coming clean, Madoff convinced his investors that he had come up with a solution via a proprietary investment strategy called a “split-strike conversion” (Barazesh, 2009). He sold his investors on the idea using financial jargon to confuse them into thinking he knew what he was doing, when really it was nothing more than smoke, mirrors, and hubris. CONCLUSION: SUGGESTIONS FOR FURTHER STUDY & COUNTER-MOTIVATING THE DARK ENTREPRENEUR Page |5 Given that the field of dark entrepreneurship is still relatively new, more research is needed in order to create a strong theoretical framework by which to judge is someone is truly a dark entrepreneur or not. A strong place to start recording data would be interviewing white collar criminals such as Bernie Madoff under the context of understanding him from an entrepreneurial point of view, rather than solely psychological. Also, according to Baumol (1990), an effective way to redirect if not offset all together Dark Side Entrepreneurs is by changing the rules of the game. As aforementioned, Baumol (1990:894) states that “How the entrepreneur acts at a given time and place depends heavily on the rules of the game—the reward structure in the economy...” He goes on to assert that the nature of an entrepreneurs objectives stays the same over time, but it’s the reward system which changes, forcing the entrepreneur to reallocate his or her entrepreneurial resources, possible toward unproductive or destructive (aka “dark side entrepreneurial activity”) means to the same end. One then asserts that educated policy makers, aware of the entrepreneur’s nonnegotiable nature, could make laws which align the reward system of the entrepreneur with the legal system in order to make the favourable outcome for the entrepreneur align with a productive outcome for the legal system and economy in which the entrepreneur operates. Arguably, it may be easier to change circumstances than to change the intangible nature and traits which urge the entrepreneur to act in his or her best interests, which may or may not align with society’s best interests as well. Evidence for this assertion lay in the example of 18th century Parliament imposing restrictions on royal grants in monopolies. This action forcibly redirected dark entrepreneurs’ destructive activities of rent seeking (which not only tied up the legal system but harmed competition) by removing the reward system: winning frivolous rent suits (Baumol, 1990: 917). Given that the rules of the game had changed as well as the system of rewards, many dark entrepreneurs crossed back over into productive entrepreneurship by refocusing the entrepreneurial resources and efforts on the improvement of the agricultural industry (Baumol, 1990: 917). There hadn’t been any major change to the entrepreneurs ultimate goals, but the rules of the game and reward system instead (Baumol, 1990: 918). De Vries notes that major cultural or societal disruptions have a direct influence on the making of new entrepreneurs as well as factors such as “favourable taxation” and a “wellfunctioning banking system” (de Vries, 1996: 8).