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The elements of the Fraud Triangle

In the video on Step 2.5, we introduced the concept of the Fraud Triangle. The idea was originally developed by Dr. Donald Cressey, a criminologist who claims that three elements – pressure, opportunity and rationalization – must exist for an ordinary person to commit fraud.

Professor Evans mentioned some examples of these elements in the video, but let’s explore the Fraud Triangle further by examining how it relates to a real-life corporate fraud: Bernard Madoff’s Ponzi scheme.

The phrase ‘Ponzi scheme’ describes a fraudulent operation where the perpetrator persuades clients to invest in his or her business, by promising very high short-term returns. The income for these returns does not come from actual business activities, but from the investments of earlier clients, who were also persuaded to invest in the scheme. Fraud schemes like these are named after Charles Ponzi, who set up several similar operations in the 1920s.

Bernard ‘Bernie’ Madoff is an American fraudster who was arrested in 2008 after turning his Wall Street wealth management business into a huge Ponzi scheme and defrauding thousands of clients. Madoff’s Ponzi scheme is thought to be the largest financial fraud in the history of the US: some estimate that it cost as much as $65 billion.

In this article Bernard Madoff is the Fraud Triangle, the writer Walter Pavlo applies the Fraud Triangle to Madoff’s Ponzi scheme. He identifies what pressured Madoff into committing the fraud, the opportunities that enabled him to perpetrate the fraud for so long, and how he must have rationalized his behavior.

  • Pressure: In the 1980s, Madoff was seeing consistent returns of 15-20% until the crash of 1987. Trying to continue to provide the high return that his customers expected in a market that was recovering slowly and yielding far below 15% put a pressure on Madoff to find alternative ways to create a profit.

  • Opportunity: As the market declined, and Madoff continued to yield higher than average returns, his clients tried not to question it. Several large investment banks wanted to invest even though Madoff refused to disclose the means by which he made these returns. In reality, he was providing them with false statements of profit while he took their money and invested it in treasuries yielding only 2%. The flow of new clients and the lack of accountability allowed him to continue his fraudulent operations.

  • Rationalization: To Madoff there was little distinction between the risk associated with fraud and the normal risk associated with investing. He continued to rationalize the scheme by claiming that he told his clients about the risky nature of investing and warned them that losses could be expected. This ‘warning’ acted as permission to continue taking more money into the scheme.

While each factor of the Fraud Triangle is important to understand how and why a fraud occurred, the Opportunity element is what allows researchers and investigators to pinpoint what can be done to prevent these types of crime in the future. Regulatory bodies and professional investment institutions can learn from these gaps and explore ways to reduce the level of opportunity available to commit fraud.

Did you know about Bernard Madoff’s Ponzi scheme before this course? Do you agree that it is a good demonstration of Donald Cressey’s Fraud Triangle? Share your reactions to this article with other learners in the comments.

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This article is from the free online course:

The Data Explosion and its Impact on Fraud Detection

Kogod School of Business at American University

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