The Madoff Case: Another Black Eye for the SEC
Last week’s revelations about Bernard Madoff’s $50 billion Ponzi scheme raise serious questions about the efficacy of the SEC’s examination and enforcement programs. Although Mr. Madoff apparently managed large amounts of other people’s money for many years, he did not register his firm as an investment adviser until 2006. Newly registered advisers are supposed to be examined within the first year. However, “[t]here is no indication the SEC ever conducted that examination.”[1] There is no indication that the SEC sought to inquire whether, as it appears, Mr. Madoff’s failure to register previously was illegal. Further, the alleged scheme was consummated on the 17th floor of the offices of a regulated entity, Bernard Madoff Securities Investments (“BMSI”). As a registered broker-dealer, BMSI was subject to examination by the SEC at least every three years. According to a statement by the SEC, its examiners reviewed the firm’s market-making business in 2005 and found that he violated technical rules about executing trades. However, they somehow failed to detect Madoff’s enormous fraud.
The SEC’s inability to detect such a large long-running fraud by entities that it regulates is inexcusable in light of numerous “red flags.” Most importantly, he acted as his own prime broker and custodian. In contrast, nearly all hedge funds use independent prime brokers which could prove the existence of assets. Second, the steady returns generated by Madoff in every kind of market was a red flag. Mr. Madoff claimed that he was buying a group of stocks while simultaneously selling options that pay off for the buyer if these stocks soar, and buying options that pay off if they decline. The supposed goal was to have smooth, steady returns. However, in 1999, whistleblower Harry Markopolos, who previously worked for a rival firm, researched Mr. Madoff's stock-options strategy and was convinced the results likely weren't real. Mr. Markopolos wrote a letter to the SEC characterizing Madoff Securities as “the world's largest Ponzi Scheme." The Division of Enforcement investigated Mr. Markopolos’ allegations as recently as 2007, but took no action. [2] Third, until at least November, 2006, the firm, which claimed to manage billions of dollars and be among the largest market makers in the stock market, used as its auditor Friehling & Horowitz, a small firm with only three employees. Finally, Madoff was notorious for discouraging due diligence. According to prosecutors, and Madoff kept the financial statements for his hedge fund business under "lock and key," and was "cryptic" about the firm.
The SEC's inaction in the face of obvious warning signals demonstrates the “check-the-box” mentality of its examination program. Examiners follow predictable steps in inspecting the records of broker-dealers, and are rewarded for meeting a quota of exams. They are not rewarded for finding significant problems, and historically have had little interaction with the Division of Enforcement staff. Given the Division of Enforcement’s occasional track record of extending preferential treatment to wealthy, well-connected individuals,[2] one can only wonder whether Madoff’s impeccable credentials discouraged the staff from investigating his activities. The Madoff debacle will likely encourage regulatory reformers who are seeking to end the SEC’s status as an independent agency.
[1] “Fees, Even Returns and Auditor All Raised Flags,” Wall Street Journal Business (Dec. 13, 2008), available at http://online.wsj.com/article/SB122910977401502369.html.
[3] See Office of Inspector General’s Semiannual Report to Congress (April 1, 2008-Sept. 30, 2008), at 38-43.
[2] “SEC Had Chances for Years to Expose Madoff’s Alleged Ponzi Scheme,” Wall Street Journal (Dec. 15, 2008) p. A16.
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