It's the popular game in which players build a tower made of wooden blocks and then, one by one, remove a block from any story except the last one completed and place it on top of the structure. As the tower grows higher, it grows weaker and less stable. The game ends with a crash when the last piece pulled is one too many, and the construction falls.

By December 11, 2008, too many players had pulled too much principal and interest from constructionist Bernard Madoff 's tower of fraud, and it finally collapsed. It was a crash that resounded around the world-from New York's East Side to London and Switzerland and beyond-with no end in sight to its reverberations. And there are no winners.

For years to come, financial markets will feel the repercussions, as will insurers and all manner of advisors. Stricter regulatory supervision is just one of the implications. Madoff 's actions violated in grand, conspicuous style, the first "commandment" of principles-guided regulation set 14 months ago by the New York State Insurance Department: Do No Harm.

The Facts Thus Far

The tremors from Madoff's fallen tower are far stronger even than those from Carlo Ponzi's pyramid. And while lower, perhaps, on the Richter scale of econoquakes than the sub-prime mortgage meltdown, they will play a significant role in shaping the future for all who must earn and hold the trust of clients for financial services guidance and products.

It helps to put everything in a context: for those who have had difficulties keeping up with the avalanche of events within just the past month, herewith the basic blueprints of the tower's rise and fall.

In 1960, Bernard Madoff established Bernard L. Madoff Investment Securities LLC, based in New York City, of which he is the sole owner. He also operated an investment-advisory business that took in billions of dollars from institutional investors, wealthy individuals, and middle- class people. Some of these, especially the latter, invested through third-party "feeder funds," such as those offered by Tremont Capital Management and Fairfield Greenwich Advisors, the latter of which has more than $10 billion in client money invested with Madoff.Madoff also owned Madoff Securities International, the UK-based securities trading firm, which bought and sold European stocks with Madoff 's money.

Since, as we shall see, Madoff the financier and Madoff 's several businesses were one and the same, for the sake of simplicity "Madoff "will suffice to refer to either.

Madoff was indeed successful. He boasted a track record of only 13 losing months over 15 years. Investors saw statements showing annual gains of about 10 percent-not earth-shaking, perhaps, in the land of high rollers, but remarkably consistent.Madoff himself enjoyed a lavish lifestyle, with a luxury apartment in Manhattan and homes, at one time or another, in Palm Beach and Montauk and a yacht moored in Bermuda. He made conspicuously large charitable contributions. A prominent player in the financial community, Madoff helped develop Nasdaq and served for a time as its chairman. He served on various committees advising the SEC on securities-trading rules. In short, he was well-known, wellliked, and just about universally trusted. "Things Fall Apart; the Centre Cannot Hold"

Life was good, at least on the surface. Underneath it all was a very simple, if very well hidden, classic Ponzi scheme:Madoff was using money placed with him by newer investors to meet obligations to previous ones. The profits and trades reported to investors on their statements were as fictitious as the emperor's clothes, but as long as money kept flowing in,Madoff 's fiction looked nicely dressed. Inevitably-and perhaps as a consequence of the global financial crisies-the requests for payouts exceeded Madoff 's capacities. According to a variety of sources, and reported in various of the media, early in December 2008, Madoff told his sons, who worked for-though apparently not entirely together with-him, that clients were asking for some $7 billion in redemptions and that he was having difficulties meeting those obligations.

He also said he wanted to pay bonuses to employees in December, earlier than usual.When the sons asked to discuss the bonuses further, Madoff finally came clean: he is reported to have told his sons that the business was "all just one big lie," "basically a giant Ponzi scheme," and that there was only somewhere between $200 million and $300 million left. He assured them that he planned to surrender to authorities, but first wanted to distribute to certain employees portions of the remaining money. The sons evidently consulted their own attorney who then notified federal officials the evening of December 10. Perhaps Madoff thought to echo King Lear: "How sharper than a serpent's tooth it is to have a thankless child!" The following day,Madoff was arrested and charged by federal prosecutors in Manhattan with criminal securities fraud. The SEC has also filed separate civil charges. The claimant-victims began lining up.

Although Madoff declined to enter a plea, the criminal complaint alleges that he told the FBI agents who entered his apartment on December 11 that "[t]here is no innocent explanation." Indeed, Scott Friestad, SEC deputy enforcer, said the civil complaint "alleges a stunning fraud- both in terms of scope and duration." Andrew M. Calamari, Associate Director of Enforcement in the SEC's New York Regional Office, called it fraud "that appears to be of epic proportions."

Madoff posted a $10 million bond, secured by his Manhattan apartment, and was released under house arrest.

If Madoff 's apparent confessions suggest contrition, there is reason to doubt that he has either seen the error of or changed his ways. Less than a week into the new year, prosecutors sought to revoke his bail and have him jailed when it was discovered that Madoff had mailed some $1-million-worth of jewelry and other assets to friends and family. His attorney, Ira Sorkin, described the "gifts" as heirlooms that did not amount to significant assets; prosecutors disagree. As of this story's filing, the judge has taken the matter under advisement and intends to issue a decision on January 12, the date for which a preliminary hearing has been set.

It has been reported that investigators found on Madoff's desk 100 signed checks, with a total value of $173 million, that he was preparing to send out to friends and family at the time of his arrest. Investigators had previously said that Madoff planned to distribute more than $200 million when he realized his scheme had come apart.

The Facts and the Players

The investigations continue apace, conducted by the FBI, the SEC, federal prosecutors from the US Attorney's office for the Southern District of New York, the Financial Industry Regulatory Authority (the securities industry's self-regulator), and Irving Picard, the court-appointed trustee for Madoff 's business, who is overseeing the firm's liquidation and the recovery of assets for investors. Thus far:

•Madoff has said that the total losses amount to approximately $50 billion, which would make his the mother of all Ponzi schemes. As the Wall Street Journal noted, the figure is nearly five times larger than the accounting fraud that brought down WorldCom in 2002. But many believe that sum includes sham profits and that the actual amount of investor deposits is lower. As of the end of December, investors world-wide had collectively disclosed exposures to the firm of about $30 billion. Bloomberg News undertook its own tally, based on disclosures and press reports, and reported that, as of January 5, they calculated the total invested with Madoff at approximately $37 billion.

•Where did the money go? That, in large measure, is the object of the investigators' forensic analysis. As ordered by the court,Madoff has given federal authorities a detailed list of all assets and identification of any banks or brokerage accounts that hold whatever is left of his and the firm's money. But virtually no one believes the list is complete.Madoff likely has an account or accounts in offshore tax havens or in places with "robust" privacy laws. Some, even much, of the money invested may have gone to those who took redemptions over the years. As of January 5, the trustee was said to have recovered $830 million in liquid assets, but that is surely just the beginning.

Sources familiar with large-scale fraud in general and with the Madoff case in particular point out that locating all the assets will be a complicated and lengthy process. The infamous BCCI scandal- in its time one of the largest in world financial history- blew up in 1991; there are still missing assets and not all claims have been settled. The same sources, however, note that, to date, between 75 percent and 80 percent of the assets have been recovered, an outcome that should offer some comfort to Madoff's victims. On the other hand, Richard Beales, formerly US markets editor for the Financial Times and himself a lapsed investment banker, wrote in breakingviews on January 7, that "[e]ven longterm, [investors] shouldn't expect to recoup much-a few pennies on the dollar at most."He adds, "The problem is, most of the money probably never existed."

•Who are the victims? The trustee has sent claim forms to 8,000 former Madoff customers-individuals and institutions- with open accounts, though not to the feeder funds. However, that number is presumed to be a small fraction of the total number of investors who may have been defrauded, and it does not include clients from earlier years. The latter may still file a claim even if they did not receive a form.

The media have had a field day reporting the names of victims, domestic and international, famous and not, individuals, banks, non-profits, and, yes, insurance companies. Insurers for the most part report exposures that are either indirect or not significant, in their estimation. One prominent exception is Tremont Group Holdings, part of Mass.Mutual, which disclosed in December that its clients lost $3.3 billion, more than half of the assets overseen by Tremont, to Madoff's scam. Like so much about the scandal, it remains unclear what, if any, exposure Mass Mutual may have to Madoff-related losses, but legal experts have suggested that, as Tremont is managed independently from the insurer's other businesses,Mass Mutual is likely protected from liability. Red Flags... and the Occasional Herring Any number of warning signs, of varying degrees of obviousness, should have set off alarms for investors and third-parties: "The cheese stands alone"-As Richard Beale points out, because Madoff's investment group was buried within his market-making firm,"he acted as his own administrator, prime broker, and custodian. That appears to have allowed him to fabricate consistent-looking documentation that fooled even those of his investors who did some digging."

"Silence is golden"-Madoff routinely declined to reveal information about his investors and investment strategies when queried even by those clients who considered themselves friends. He claimed that his trading system was "proprietary" and that he therefore would disclose nothing about it. One donor to a charitable organization wanted his $20 million pledge to be managed by Madoff, reported Crain's New York Business. Though the charity does not ordinarily allow donors to choose their own advisors, the sum was so considerable that it agreed to conduct due diligence. Madoff refused to fill out the requisite forms, and the charity chose to tell the donor it would not work with Madoff, even at the risk (unrealized, as it turned out) of losing the gift.

"If it looks too good to be true..."- Madoff understood that unusually high returns would have looked suspicious, and he was clever enough to report profits running about 10 percent annually. But the sheer consistency, through market upswings and down-turns, should have sown the seeds of doubt rather than lulling investors into a false sense of security, as it evidently did.Madoff boasted that he had only 13 losing months over the course of 15 years. Paul Sullivan, writing in the "Wealth Matters" column in the January 6 New York Times, opined that "[consistency] at the highest level isn't bad; it's impossible. There are too many variables that inhibit being great on a regular basis." After all, even Babe Ruth had bad innings. Moreover, according to the Wall Street Journal, to which client statements and other information were made available, a consultant hired to review a corporation's late-1980s investments with Madoff became suspicious about the returns. He found that, between 1980 and 1990, Madoff showed earnings for the client of 22.6 percent annually, double the average return on the Dow Jones for that period. In addition, the number of options Madoff claimed to have purchased often outnumbered the amount of options that actually changed hands in the public exchanges. That pattern is evident on client statements issued as recently as 2006, implying that Madoff had been making the same unlikely claims for at least 17 years. "Size matters"-Madoff 's books were audited by Friehling & Horowitz, a threeperson accounting firm. Jack Siegel, a lawyer who advises non-profits, commented, "If you'd seen a PriceWaterhouse [Coopers] or Deloitte as the auditor, you would've trusted them. A $50 billion fund is not going to be audited by a three-person firm."

"Overseeing vs. overlooking"-In 2002, following the Enron and WorldCom scandals and under Sarbanes-Oxley, the Public Company Accounting Oversight Board was created to help avoid fraud. It required, among other provisions, that firms such as Madoff 's be audited by accounting firms registered with the Board. The SEC promptly pulled that provision's teeth, issuing a rule-subsequently extended several times-waiving the requirement for privately held brokerages. Thus Friehling & Horowitz continued, unregistered, to audit Madoff. And while state laws typically require that accounting firms undergo peer review, New York law has a loophole enabling Madoff 's accountants to escape that review as well. "See no evil"-Writing in MarketWatch shortly after Madoff 's arrest, Mark Hulbert suggested that the reason so many failed to see problems is what he calls "the Big Lie theory": the bigger the lie, the more likely it is to be believed. He and other have also pointed to the role of emotion in financial decision-making: "We like to think of ourselves as objectively analyzing the data under the cool light of reason, but far more often than not our emotions are running the show."

"Fame! Fortune!"-As noted earlier, Madoff was prominent and respected in the financial community, and the Wall Street Journal reported that family members also had leadership roles in the very groups that police the financial industry and lobby for favorable regulations. Personal, social relationships played a role, too, in calming any investors' suspicions. Many considered him a friend, enjoying his hospitality and self-deprecating humor.

Reparations and Payback

Recovered assets are only one source of compensation for the victims. A key player in the post-debacle clean-up is the Securities Investor Protection Corporation (SIPC), the non-profit entity funded by an annual fee from brokerages. Effectively a guarantee fund, SIPC does not protect investors from market losses; but, according to SIPC president Stephen Harbeck, because it is treating the Madoff matter as a "missing asset" case, it may have more flexibility in reimbursing clients. The accounts in Madoff's investment advisory business qualify as SIPC-covered brokerage accounts, but Irving Picard, the trustee, will first have to collect information from each customer to determine whether and to what extent they qualify for relief through a combination of firm assets and SIPC funds. Experts say clients who invested through third parties most likely will not qualify for SIPC funds. The actual Madoff assets are probably paltry, but the SIPC's pockets are no deeper. Harbeck has told Congress that SIPC has $1.6 billion in assets from fees paid by member broker-dealers, another $1 billion in credit available from the US Treasury (credit that has not increased since 1970), and a line of credit from a group of international banks. While the first payouts to investors could be made as early as a month from now, Harbeck said that the Madoff case "is of a completely different order of magnitude" from anything SIPC has seen before. He added that he didn't know if SIPC will need to ask the Treasury or Congress for additional money or whether resolving Madoff losses would wipe out group's funds.

If the prospect of destitution is frightening to Madoff investors-many of whom have, in fact, been wiped out financially- some among them who received "profits" are at least as unnerved. A so-called "clawback" provision could allow the trustee to attempt to collect from those investors any fictitious profits they received; for cases in New York State, those monies would have to have been collected by investors within a six-year period prior to the Madoff liquidation. The premise for the provision is that redemptions were paid using other investors' money, making the payments not assets but fraudulent transfers.

According to Richard Beales, should the trustee sue for the return of redeemed principal, those investors would have a better chance of retaining their money if they can demonstrate that there were no red flags alerting them to possible fraud or, in the absence of red flags, if they can show that they conducted a diligent investigation whose result revealed no problems.

March of the Litigators

Among his many unforgettable aphorisms, Benjamin Franklin observed that "in this world nothing can be said to be certain, except death and taxes," to which Ellen Melchionni, president of the New York State Insurance Association, adds wryly, "And trial lawyers."

Less than a week after Madoff's empire crumbled, the scandal had already "triggered [a] litigation torrent," as D&O Diary put it. Initially, Bernard Madoff and his firm were the objects of lawsuits. But recognizing the improbability of recovering any significant funds there, investors and attorneys quickly turned to the feeder funds. The sums involved range from $2 million, invested by a Long Island family, to New York University's claim of $24 million in losses. A law firm on Long Island was especially quick off the mark: it issued a press release on December 12, announcing that it had filed a class action suit against Madoff and his firm, seeking to "recover damages estimated to exceed $50 billion" on behalf of "our clients and all the victims of this giant scheme."

As though things weren't already tough enough: MarketWatch reported on December 30 that "[t]he financial crisis has triggered a jump in securities class-action lawsuits, a trend that may weigh on insurers... ." The article cites Jay Gelb, an insurance industry analyst with Barclay's Capital, who wrote to his company's investors that "[h]igher-than-anticipated D&O and E&O losses in the wake of continued financial market turmoil could become apparent in 2009."

More recently, a number of publications have reported on the findings of the Stanford Law School Securities Class Action Clearinghouse, whose annual report shows that what the group's director, Joseph Grundfest, calls an "amount of litigation aimed at a single industry" higher than any "since the passage of the 1995 Reform Act." It is likely even higher than that: attorney Kevin LaCroix, author of the D&O Diary, notes that the report only tallies class actions through December 15. He calculates at least 13 additional filings in the last two weeks of the year, "largely but not exclusively due to [a] flood of Madoff-related litigation." LaCroix also points out that the primary targets of that litigation are the "feeder funds" that invested with Madoff on behalf of their clients. Sharon Emek, of the CBS Insurance Group and past chair of IIABNY, notes that, since Madoff 's business is in bankruptcy, it cannot be sued. But there are real questions about whether or not suits against third-parties will, or even can, be successful from the plaintiffs' point of view. E&O and D&O policies explicitly exclude some allegations; and Stuart Fries, of Garber Atlas Fries & Associates, a long-time CIBGNY leader and PIA member said, "I don't see where the manager of a fund is going to be held liable, because the SEC gave Madoff a clean bill of health just last year. How can some fund manager figure out what the SEC didn't?"

More to the point, perhaps, Emek points out that the cost of litigation will, in many if not most cases, eat up the total coverage, leaving nothing for the claimant. Fries agrees, saying that even if negligence cannot be proven, "[y]ou can still be sued, and that has to be defended."He also explains that most E&O policies do not have an unlimited coverage for legal defense, and defense costs are included within the policy limit. On that score, at least, experts throughout the industry believe that "D&O and professional liability will take a hit," as Peter N. Resnick, a member of PIANY's board of directors, put it. "You'll see higher prices in the industry, maybe a tightening up of the whole market." Jeff Greenfield, PIANY past president, agrees: "Those who write E&O are highly exposed." Putting homeowners'

policies into play

Curiously, at least to some, investors with high-value homeowners' policies from Chubb, AIG Private Client Group, and Fireman's Insurance, may have recourse to that coverage for their financial losses as "lost or stolen" securities. Responding to queries from its members, PIA issued a statement explaining that coverage, if any, would be minimal and that Chubb, in a release to its producers, stated that its coverage would be limited to direct investments with Madoff. In general, PIA believes, "coverage for Madoff losses will be declined" because that "does not fit the requirement of 'direct physical loss to property.' There has been no physical loss to the money or securities."

The issue, of course, is that the "lost profits" not only lack physical reality, they lack reality of any kind. Emek, whose service on the board of a non-profit hit by the scam gives her more personal and immediate knowledge than most in the industry, says, "It's a fact: the loss can only be principal, not profit. There was never 'real' profit." She adds that the trustee, in the end, will find that, since Madoff was robbing Peter to pay Paul, "you only have your principal."

As far as insurers' exposure is concerned, while the legal costs will likely mount up quickly and substantially, Fries "can't see any company in the next few months paying anything."He points out that victims must establish proof, appeal to SIPC, hope for recourse from assets uncovered by the trustee, and-just to make anyone throw up his hands in despair-argue with the IRS over capital gains taxes paid for non-existent profit.

Battering the SEC and Other Capitol Hill Sport On January 5, the House Capital Markets, Insurance, and Government Sponsored Enterprises Subcommittee of the House Financial Services Committee held its first post-Madoff meeting. Surely enough has been said and written in recent weeks that the discussion and issues merit only a summary: Every politician with access to a microphone or reporter agrees that the Madoff fraud reveals "deep, systemic problems at the SEC." (Indeed, so many have taken up the same words and phrases that it is nearly impossible to give first-utterance attribution.) And there is bi-partisan agreement about the need to restructure the regulatory system. Even the SEC itself admits to failings and launched investigations on December 17. SEC chairman Christopher Cox, who called for the inquiry, appears to blame SEC career staff. The commission's inspector general, H. David Kotz, told the hearing, "We will conduct our work in a comprehensive and thorough manner, and if we find that criticism of the SEC is warranted and supported by the facts, we will not hesitate to report the facts and conclusions as we find them." No one else seems to believe there is any "if ": the SEC received warnings and information about Madoff 's affairs over the years that appear to have been entirely ignored or, if pursued, were not examined closely. Representative Brad Sherman (D-Calif.) was scathing, saying that the alleged fraud would have been clear if the agency had read Madoff 's annual SEC financial statements: "The fraud," he allowed, "is there on its face."

The questions directed at the SEC are old and familiar: who knew? what did they know? and when did they know it? But there are more long-term and far-ranging questions-ones that will ultimately have ramifications for the entire financial industry, including insurance: who should regulate? what should they regulate? how should they regulate? Even more to the point, perhaps: does regulation work?

It is here that the partisan divide becomes as plain as it is familiar. Rep. Spencer Bachus (R-Ala.), the panel's ranking Republican called for Congress to create a statutory and regulatory structure "for the 21st century." But he was careful to place limits on that new structure. Warning against a rush to judgment, Bachus said that failures of regulation and due diligence do not lead to the conclusion "at this stage of the inquiry that what is needed are broad new legislative or regulatory mandates on the rest of the securities industry."He added that the Madoff case implies "not necessarily a lack of enforcement and oversight tools, but a failure to use them.

Lack of enforcement-or, at least, of adequate resources-and of tools is precisely what concerns the other side of the aisle. Rep. Paul Kanjorski (D-Penn), who chairs the subcommittee, told his colleagues, "Clearly, our regulatory scheme has failed miserably and we must rebuild it now."Among other building blocks, the revitalization of the SEC's Office of Risk Assessment-introduced in 2004 but essentially dismantled since-was proposed by Rep. Paul Hodes (D-NH). The office's role was to identify problem areas, negative trends, and forms of fraud. For their part, Kanjorski and Carolyn Maloney (D-NY) would like to see greater regulatory authority given the accounting regulators: the SEC, the Financial Account Standards Board, and the post- Enron Public Company Accounting Oversight Board.

For Rep. Ron Paul (R-TX), the solution is comparatively simple: eliminate the SEC, because it gives investors a false sense of security. "Investors," he said, "should be self-sufficient."

What Does "Modernization" Really Mean?

So, once again, "regulatory modernization" is the hot topic in Washington and will doubtless be among the top priorities for the new Congress. The need for reform, of one sort of another, seems pressing. Justin Fox, commenting for TIME/CNN on January 5, is among those making the case that much of the contemporary regulatory structure was established in the wake of the 1929 crash, an environment vastly simpler and less globally interdependent. The "new financial landscape," he wrote, "is an amalgam of some heavily regulated areas and some unregulated ones. The general dividing line [has been] that sophisticated, wealthy investors and financial institutions were deemed capable of taking care of themselves, while retail investors and borrowers were presumed to need help from regulators. But," he points out, "that line didn't hold everywhere-it certainly didn't in mortgage lending. And the Madoff case demonstrated pretty clearly that wealthy investors aren't necessarily sophisticated."

The question, of course, is whether this means more and tighter regulation of every financial transaction. Fox thinks not: "The regulatory system would either have to be global, or the US would have to largely cut itself off financial from the rest of the world."

One path to reform-depending on one's definition of the term-is outlined in a blueprint put together in 2008 by former Treasury Secretary Henry Paulson. His streamlined system, touted as emphasizing principles over rules, would merge the SEC with the Commodities Futures Trading Commission, transfer some authority for securities activities to the Federal Reserve, and create oversight for market risk and business conduct, among other issues. It would also emphasize the industry's role in self-policing.

Others are advocating the reallocation of responsibility among various regulators and reviving the SEC's enforcement authority: the Financial Industry Regulatory Authority would be in charge of the biggest broker-dealers, the states would be responsible for the smaller ones, and the SEC would oversee everything.

First, Do No Harm

In the end, perhaps a genuine return to principles should be the beginning. A draft of such regulation was released by NYS Insurance Department Superintendent Eric Dinallo in November 2007. In it, ten principles each for the insurance industry and for regulators are outlined, each expressed as a "shall" or "should." Notwithstanding the on-going debate over just how such a regulatory scheme would look and be implemented, the approach appears to have the considerable virtues of being both free-marketfriendly and protective of consumers' interests.

Above all, principles-based regulation gets straight to the heart of the matter: professional ethics. One can only hope that the Madoff mess will not fade too soon from the headlines, if only because it serves as a brutal reminder of the consequences of abandoning ethical practices.

It is a reminder, too, of the truism that actions speak louder than words: Madoff 's company website included a statement that he himself "has a personal interest in maintaining the unblemished record of value, fair-dealing, and high ethical standards that has always been the firm's hallmark."

Considering Madoff 's ethics-as fictitious as his profits-one is reminded of the finally exasperated Joseph Nye Welch, head attorney for the US Army during the infamous Army-McCarthy hearings, who on June 9, 1954 asked rhetorically of Senator Joseph McCarthy, "Have you no sense of decency, sir? At long last, have you left no sense of decency?"

As we go to press, it has been revealed that Madoff stole $ 3 million from yet another senior citizen: his sister.

"Decency" seems the least of it.