How the SEC missed Madoff

In honor of Harry Markopolos' testimony to the SEC about his heroic efforts to alert the SEC to Bernard Madoff's Ponzi scheme, it is worth revisiting his now-famous 2005 report to the SEC and what we can learn from it about the SEC and its failures.

I recently had the good fortune to be introduced to a senior attorney in the SEC's enforcement division.  Unfortunately, I wasn't quick or brave enough to ask the only question everyone has wanted the SEC to answer from the moment the Madoff scandal: "How in the world did you miss this?"  Especially in light of Markopolos' efforts, there is only one answer:

Damned if I know.

The more facts emerge, the more inexplicable the SEC's failure is.

True, some of the criticisms levied at the SEC have been off-mark. For example, Christopher Cox blaming the SEC staff for having Madoff voluntarily produce documents rather than seeking an immediate subpoena should be taken as seriously as all of Cox's other statements and actions as SEC chair; that argument only works if you assume that a subpoena would have been enough to force Madoff to voluntarily produce his real records (which the SEC had no idea existed) and blow his criminal scheme, as opposed to producing the fake ones that had worked so well up to that point. For all the pathetic bleatings of Meagan Cheung (to whom Megan recently introduced us ), she was right that a subpoena would not have worked absent a search warrant and FBI agents forcibly confiscating everything.

But while the SEC doesn't have search-warrant power under normal circumstances, it knows people who do.  And it certainly had enough to go on to justify bringing those people in.  Even aside from Markopolos' reporting and hindsight bias, the opening and closing recommendations of Cheung's enforcement branch are incongruous.  The opening report states that the staff immediately found that Madoff was acting as an undisclosed (and unregistered) investment adviser to the Fairfield Sentry funds-of-hedge-funds, and also stated:

[T]he staff found, that during an SEC examination of BLM that was conducted earlier this year, BLM - and more specifically, its principal Bernard L. Madoff - mislead the examination staff about the nature of the strategy implemented in the Sentry Funds' and certain other hedge funds' customers' accounts, and also withheld from the examination staff information about certain of these customers' accounts at BLM.

(Emphases added.)

In its closing recommendation, Cheung's staff stated:

The staff did find, however, that BLM acted as an investment adviser...in violation of the registration requirements of the Advisers Act....As a result of discussions with the staff, BLM registered with the Commission as an investment adviser...

We recommend closing this investigation because [B]LM voluntarily remedied the uncovered violations, and because those violations were not so serious as to warrant an enforcement action.

(Emphasis added.)

I cannot read the bolded sections of the opening and closing statements together: they simply do not compute.  Generally, every time the SEC believes that a target has misled the agency in an investigation, several high-powered defense lawyers can each put another kid through college with the fees from the ensuing action.  In fact, Madoff's acting as an unregistered investment adviser should have been enough to justify an immediate action: in theory (that is, assuming he was not running the world's largest Ponzi scheme), Madoff may have had a good-faith argument (the details of which I will not get into for the sake of anyone still reading this) as to why he should not have been required to so register (and many people in the field wouldn't even cut the SEC that much slack), but that violation combined with his earlier history of documented decit should have been enough to immediately force an enforcement action, even if he subsequently registered.   

It is true that an enforcement action on those grounds may not in and of itself have uncovered the Ponzi scheme, but the pressure put on the organization - along with a decline in incoming investments that would likely have ensued - may well have forced its collapse even if the SEC didn't yet know what it had.

And we haven't even gotten yet to the Markopolos reports.  Markopolos is right that the SEC has very little internal capital markets or derivatives experience, and a shocking lack of knowledge about those fields.  He is also right that this situation must be remedied, but that is a subject for another post.  For now, it is enough to recognize that those flaws still do not excuse the hapless Ms. Cheung and her branch.  

It is true that few if any lawyers (surely including myself) - whether at the SEC or in private practice - could equal Markopolos' detailed knowledge of derivatives trading. But even if the SEC lawyers couldn't independently verify Markopolos' evidence, they should have known who to call to help them out.  New York is not lacking in derivatives expertise, after all, and the New York branch chief (despite technically being a "mid-level staffer," per Cheung's whining) will - trust me on this one - get her calls returned by anyone in the financial community.  (They could also have consulted the economics and business school faculties at Columbia or NYU, with the same results.) It should not have required more than a few phone calls or emails to find people who could judge Markopolos' claims.  In fact, while the SEC lawyers would likely have needed specialized help to judge Markopolos' math, even they should have recognized who to contact to verify some of Markopolos' other arguments -  such as the size of the option market and the price of protection over time. 

Generally, Markopolos' evidence required the SEC to go outside the internal consistency of Madoff's records, and it does not appear that the SEC did so -  or even recognized that it needed to do so. That was their greatest failure.