The SEC Fiddled While Rome Burned (Part 2 of 3)
Part 2 of 3.
In 1992, the Securities & Exchange Commission was presented with a trail straight into Bernie Madoff’s $50 billion Ponzi scheme. But the SEC ignored it. Then, in 2000, in a memo urging the SEC promptly to investigate Madoff, an independent forensic accountant outlined his conclusions to the Commission that Madoff’s investment fund, which Madoff kept cordoned off from his market making and proprietary trading businesses, was an outright fraud. The SEC again did nothing.
In November 2005, the same accountant submitted a 19-page document to the SEC about Madoff’s fund entitled “The World’s Largest Hedge Fund is a Fraud.” Still, the SEC continued to sit on the sidelines. In fact, it was not until the swindler himself spoon fed authorities his $50 billion Ponzi scheme in December of 2008–decades after the smoke signals first became evident–that SEC investigators were finally able to put two and two together. By that time, needless to say, it was too late.
So is the SEC to blame for failing to nip Madoff’s fraudulent Frankenstein in the bud? Fortune Magazine’s Allen Sloan wrote in a column last month that we shouldn’t have expected the SEC to catch Bernie Madoff:
You’re likely to get caught if you run a few inches outside the baseline, because regulators are set up to catch that. But run so far out that you’re playing on a whole different ball field? You can get away with that if you’re enough of a financiopath, and your luck holds. . . . If a big fund is engaged in a big fraud, the SEC’s unlikely to find it without an outside tip. Or maybe even with one. That’s how things worked with Madoff. And how they work in the real world.
What is this “real world” that Sloan is living in? Apparently, it is a world in which the more evil and “financiopathic” you are, the less responsible the SEC is for the damage you do. But if the SEC cannot be expected to discover and remedy massive frauds in our financial markets, then what can it be expected to do? Isn’t that its core mission and purpose?
Sloan’s point may carry more weight in a situation in which there is no reasonable way for the SEC to obtain the information it needs to detect a given swindle. But where the information is put right under its nose, and the agency does nothing, that’s something different. The SEC cannot be expected to uncover all fraud all the time, but when a gigantic Ponzi scheme is presented to it on a silver platter, wrapped up with a bow, the agency is duty-bound, at the very least, to have a gander at what’s inside. Even former SEC Chairman Christopher Cox admits that the SEC’s failure to investigate the Madoff Ponzi, despite a line of red flags stretching back decades, was a major regulatory failure.
With all due respect to Mr. Sloan, the question is not whether the SEC botched the Madoff case. The question is why the SEC botched it, and how can a regulatory disaster of this magnitude be prevented in the future.
The Birth of a Con Man
Bernie Madoff started his securities firm in 1961 with $5,000 in his pocket made from life-guarding in Jersey. At first, the firm merely matched buy and sell orders on cheap stocks, making money on the spread between the offering and selling price. During the 1970s, however, new rules permitted firms like Madoff’s to trade more expensive stocks. Exploiting the new rules, Madoff, to the surprise of many, began taking significant market share from the NYSEX.
Madoff’s was also one of a handful of firms that helped create the first computerized system of distributing and updating stock quotes. That technology later became the NASDAQ. Madoff ultimately served as NASDAQ Chairman in 1990, 1991 and 1993, and on its board of governors. At that time, his firm became the largest “market maker” at the NASDAQ, for both buying and selling.
Madoff began using questionable techniques to generate business early in his career. In the OTC market, it used to be a common practice for a firm to pay clients a small amount for each share they traded, in order to encourage them to make large trades. Madoff’s firm, however, was the first prominent practitioner of paying brokers to execute customers’ orders in what was a kind of “legal kickback.” While this payment for order flow strategy has generated critique by ethicists, Madoff viewed the payments as a normal. “If your girlfriend goes to buy stockings at a supermarket, the racks that display those stockings are usually paid for by the company that manufactured the stockings,” he told CNN in 2000. “Order flow is an issue that attracted a lot of attention but is grossly overrated.” Using this method, Madoff’s firm became the largest dealer in NYSE-listed stocks in the U.S., trading about 15% of transaction volume in these stocks.
“He was a man with a good idea who was also a terrific salesman,” stated Charles Doherty, former president of the Midwest Stock Exchange. “He was ahead of everyone.”
Still, matching buy and sell orders wasn’t the sexy work of Wall Street that Madoff secretly coveted. Managing other peoples’ money was. This ultimately led Madoff to create the now-infamous investment advisory arm of his firm, despite having little, if any, experience managing an investment fund. He ran the fund in a separate small office and hired only a couple of employees. To certify his books, Madoff retained a tiny three-person accounting firm operating out of a 13-by-18-foot office in a small plaza New City, N.Y. The firm, Friehling & Horowitz, was not subject to the oversight of the Public Company Accounting Oversight Board and for upwards of 15 years told the American Institute of Certified Public Accountants, the prestigious body that sets U.S. auditing standards for private companies, that it was not in the auditing business.
By 2008, there were a few hedge funds, like Ascott Partners and Ariel Fund, that had invested directly in Madoff’s fund. A few well-known foreign banks, Spain’s Banco Santander and Austria’s Bank Medici, were also in the mix. But most of the money in Madoff’s fund came from lesser known “feeder funds,” which in turn were funded by hedge funds, funds of hedge funds, or partnerships, which in some cases were funded by still other funds. Needless to say, with so many links in the chain, so many layers of funds and investors, it was very difficult to find a direct line into Madoff’s fund. And, as we now know, it would be even harder to find a line out.
Madoff’s Little Helpers
But in 1992, almost 17 years before Madoff’s shocking confession, there was more than enough evidence to warrant an investigation into Madoff’s investment business. At that time, SEC investigators happened upon Avellino & Bienes, a small accounting outfit in Manhattan. The outfit’s head honcho, Frank Avellino had been working with Madoff since the 1960s. Basically Avellino would find investors for Madoff’s fund and issue notes to them, taking a commission for himself. Thus Avellino & Bienes did not operate as a feeder fund, but rather was selling promissory notes directly to investors.
What struck the SEC was that the Avellino had raised $441 million from 3200 clients based on unbelievable guarantees that the investments would fetch between 13.5 and 20 percent per year. Frank Avellino was also promising that if those returns were not forthcoming, he would make up the difference to investors. (Said Avellino later in a deposition, “If I ever was short and there was a shortfall, I would be in trouble.”)
When investigators approached Avellino in 1992, he told them without hesitation that Bernie Madoff, whose brokerage house was by that time one of the biggest on the street, was managing the money. None of the records in the case, however, reflect that the SEC contacted or otherwise involved Madoff at all in connection with their investigation of Avellino & Bienes.
To be sure, the SEC could have screened Madoff, the fund manager of record, to determine whether he had endorsed the promises being made, whether he was making similar promises to other investors, and/or whether Madoff was otherwise part of the Ponzi. Given that Madoff and Avellino were so closely linked it would have made sense to do so. But making sense was not high on the SEC’s priority list. Nor was ruffling the feathers of Bernard Madoff, who was fresh off a two year stint as Nasdaq Chairman and whose business and reputation were humming.
Instead, once the SEC determined that the money raised by Avellino & Bienes was still in Madoff’s fund and could be returned, they cut a quick and dirty deal with the firm, without any further investigation of Madoff, wherein Avellino & Bienes were to shut their doors, return the money they raised, and agree to an audit. Open and shut.
But when the audit, overseen by Price Waterhouse Coopers, was derailed by improper book-keeping as well as Avellino’s outright refusal to produce any proper records (“My experience has told me not to commit any figures to scrutiny,” he said), the SEC did not reopen its investigation. Price Waterhouse did not push the issue, choosing instead to pocket its fees, $428,679, paid by none other than Avellino himself. Though the firm ostensibly closed up shop, Avellino continued to raise money for Madoff in a shadow network of foundations and partnerships, including “The Kenn Jordan Foundation,” named after an elderly man who used to live in a small Fort Lauderdale apartment before he died a decade ago.
The Private Investigator
It’s one thing to fail to sniff out leads in a case. Maybe investigators were busy. Maybe there were other matters to be attended to and too few resources. But it’s a whole other thing to ignore credible evidence of a gigantic Ponzi scheme that someone drops right into your lap. Enter one Harry Markopolos, a geeky derivatives wiz with an impeccable comb-over who while working for Boston’s Rampart Investment Management in the late 1990s was called on by his bosses to figure out how Bernard Madoff kept booking double-digit returns, through thick and thin.
It took Markopolos about five minutes, by his own account, to figure out Bernie Madoff’s purported returns were a fraud, and a few hours to provide the details of why. “To believe in [Bernard Madoff] was to believe in the impossible,” he later told Congress. Using an SEC contact in Boston, Markopolos began dripping notes and memos into the Commission’s New York office in 1999. He got little response from the SEC, and had to badger investigators constantly to get his calls and emails returned. In November 2005, Markopolos submitted a 19-page document to the SEC entitled “The World’s Largest Hedge Fund is a Fraud” in which he specified in painstaking detail why Madoff Securities was “the world’s largest Ponzi Scheme.” Still nothing from the SEC zombies.
Markopolos’s last emails to the SEC on the matter were sent only a few months before Madoff’s confession. “I gift-wrapped and delivered the largest Ponzi scheme in history to [the SEC], and somehow they couldn’t be bothered to conduct a thorough and proper investigation because they were too busy on matters of higher priority,” Markopolos recently told Congress. The SEC, Markopolos said, is “captive to the industry it regulates and is afraid” to bring big cases against prominent individuals. The SEC “roars like a lion and bites like a flea” and “is busy protecting the big financial predators from investors.” Markopolos emphasized in his congressional testimony that the SEC employees with whom he worked, did not have the vocabulary and education to understand Markopolos’s reasoning: “Financial illiteracy among the SEC’s securities lawyers was pretty much universal.”
Lip Service?
But it turns out that, at least for show, the SEC may have sniffed around a bit more on the case than Markopolos thought. In January 2006 the SEC’s New York Regional Office opened an investigation involving Bernard L. Madoff Securities LLC (“BLM”) and two of its largest hedge fund clients. According to documents in the file, the informal inquiry began with a report, possibly by Markopolos, that Madoff’s firm “operates an undisclosed multi-billion dollar investment advisory business … as a Ponzi scheme.” SEC staff subsequently obtained documents from Madoff’s firm and the two hedge funds, and talked to an officer at Madoff’s firm.
Based on the intitial investigation, the Case Opening Report concludes that: (1) Madoff’s firm was an investment advisor to the hedge funds, but was not disclosed as such; (2) the Madoff official “mislead the examination staff about the nature of the strategy implemented in the Sentry Funds’ and certain other hedge fund customers’ accounts, and [3] also withheld from the examination staff information about certain of these customers accounts … .” The report also observes that Madoff’s fund acted as an unregistered investment advisor to other hedge funds.
Based on this evidence, the staff took further testimony from Madoff himself and a representative from one of the hedge funds. The SEC closed the case rather quickly, however. Madoff and the hedge funds voluntarily remedied the violations and, according to the Commission, “those violations were not so serious as to warrant an enforcement action.” In other words, it appears that there was no investigation of the original allegation that Madoff was running a Ponzi scheme.
The Case Closing Recommendation concluded that: 1) Madoff’s firm acted as an investment advisor to certain hedge funds, institutions and high net worth individuals without complying with the registration requirements of the Investment Advisor’s Act; 2) the hedge funds’ disclosures to its investors did not adequately describe Madoff’s advisory role; and 3) Mr. Madoff “did not fully disclose to the examination staff either the nature of the trading conducted in the hedge fund accounts or the number of such accounts at BLM.”
Consequently, Madoff belatedly registered as an investment adviser, after having evaded the requirement for decades. The SEC’s traditional practice was to examine the books and records of a newly registered advisor within the first year. But the SEC declined to do so with Madoff’s investment fund, despite conducting mutiple examinations of brokerage business during the same period.
The Mea Culpa
After Madoff’s unprecedented swindle came to light, then-SEC Chairmen Christopher Cox, in an unprecedented mea culpa, called the SEC’s handling of the Madoff firm “deeply troubling,” vowing to investigate its “multiple failures.” Cox stated that he was “gravely concerned” that “specific and credible evidence” provided to the agency over a period of at least 10 years had not previously been referred to the Commission for commencement of a formal investigation. He ordered an internal investigation by the agency’s Inspector General. But many fear that the investigation has been compromised in the transition to the Obama Administration.
Stay tuned for Part 3.
