02/07/2009 05:12 am ET Updated May 25, 2011

Madoff, Merkin and the Epidemiology of Fraud

In 1854, John Snow, a British physician, turned his attention to an outbreak of cholera along Broad Street in London. Investigating the area where the outbreak was taking place, he noticed that the afflicted homes were clustered around a particular well. Although it was commonly believed that cholera was the result of poisonous gases in the air, Snow came to the conclusion that the well was both contaminated and the source of the outbreak. Such was the birth of modern epidemiology.

Epidemiology--the piecing together of evidence to understand how disease and wellness move through a population--is a critical element of public health. It also sheds important light on how we act as tribal beings, how we travel and congregate, and how behaviors spread. Social capital--the mixture of alliances, trust, and reputation that fuel our interactions--also moves though a population in a distinct way, whether for good or ill. The Bernard Madoff scandal represents an extraordinary moment in what might be called the epidemiology of social capital--shedding light on the extent to which friendships, philanthropic involvement, and other social ties influence presumably "rational" decisions, like where and how money is invested.

Like most Ponzi schemes, Madoff used the trust of closed groups such as private clubs and philanthropies to extend his reach. The real question, however, is how he moved from group to group and person to person over time. Certain people are emerging as highly effective carriers of the Madoff virus. For example, Ezra Merkin, the money manager and chairman of GMAC, played a key role in introducing Madoff to elite circles and to steering philanthropies on whose boards he sat to invest with Madoff. This was sometimes done under the cloak of Merkin's investment firm, so that groups that thought they were investing in Merkin were actually investing in Madoff.

Merkin was a key carrier but he was hardly alone. Other philanthropies report that they were introduced to Madoff through their donors. Indeed, on an individual level, becoming a Madoff client often required a personal referral. This underscores another theme in the process. At a certain point in his trajectory, Madoff's reputation became such that people began to flock to him. Having Madoff invest your money was considered a great favor--so much so that it eroded the skepticism of otherwise sophisticated people. Tracking this flow of referrals and favors and how they moved across a rarified stratum of society will tell us a great deal about how social networks determine access and influence decision making.

For more than forty years, academics have made valiant attempts at recreating social networks in the lab, beginning with Stanley Milgram's famous "six degrees of separation" study, in which participants in the Midwest were asked to forward a packet to a friend who would forward it to a friend and so on until it reached a stranger in Boston. More valuable, however, is real-world data that captures actual social networks in all their complexity.

Small steps to lay the foundation for this type of data gathering have begun. Last month, the SEC finalized the requirements for public companies and mutual funds to file their financial information in XBRL, an interactive data format that puts financial information into a uniform structure. This will help counter the practice of companies "burying reality in mounds of narrative" (in the words of Philip Moyer, who heads EDGAR Online, the major publisher of SEC data), obfuscating their finances in the same way that cell phone plans are intentionally made complicated so that consumers cannot easily comparison shop. Mark Cuban (the Dallas Mavericks owner who is in the middle of his own skirmish with the SEC) has pointed out that the SEC needs to go further, expanding XBRL reporting requirements to cover everything from the bank bailout to investment advisers like Madoff. But more importantly for understanding the epidemiology of fraud, Cuban suggests that the government as well as watchdog organizations begin to analyze the data in real time, in order to spot the red flags that signal possible malfeasance early on.

The Madoff case presents an invaluable opportunity to go even further. Financial transactions are just one element of the story; many of these financial transactions came about only because of the social interactions that preceded them. In their case against Madoff, federal prosecutors and the Securities and Exchange Commission will be collecting reams of information to tally up the damage of who was cheated of how much, and when. They should also piece together the details of how Madoff became Madoff--who introduced him to whom, which donations opened which doors, and so on.

Analyzing the social networks of Madoff and his clients will give us a better understanding of how trust, exclusivity, and connections accelerated the spread of the Madoff virus. This information will not only show how social networks fuel decisions with far-reaching consequences, but could also shed further light on the differences between the networks of enterprises that are legitimate and those that are not.