Inspector General concludes Madoff investigation bungled and bungled and bungled and bungled by SEC and then they bungled it some more

News Brief

By Cydney Posner

Today, the Inspector General issued its report on the SEC's failed investigation of Bernard Madoff. You might want to take a peek at the executive summary, which is really quite shocking. Here, Chair Schapiro says she's sorry and is trying to address the situation.

The investigation did not find evidence that any SEC personnel who worked on an SEC examination or investigation of Madoff had any financial or other inappropriate connection with him or his family that influenced the conduct of their examinations or other improper influences. The report does cite six detailed and substantive complaints received by the SEC from a number of reputable individuals, but concludes that "a thorough and competent investigation or examination was never performed." These complaints "raised significant red flags concerning Madoff's hedge fund operations and should have led to questions about whether Madoff was actually engaged in trading….[T]he SEC was also aware of two articles regarding Madoff's investment operations that appeared in reputable publications in 2001 and questioned Madoff's unusually consistent returns." While the SEC conducted two investigations and three examinations of Madoff's business as a result of the complaints, the SEC never verified Madoff's trading through an independent third party nor did it actually conduct a Ponzi scheme examination or investigation of Madoff. Instead they looked at whether Madoff should register as an investment adviser or whether Madoff's hedge fund investors' disclosures were adequate. In one case, instead of looking at whether Madoff was engaged in a Ponzi scheme, they focused on front-running because, as the supervisor said, "that was the area of expertise for my crew." In some cases, the teams assembled were inexperienced (often composed entirely of attorneys who did not have much experience in equity and options trading) and did not plan adequately for the examinations. In some instances, more senior staff dismissed concerns expressed by junior members. The teams also seemed to disregard suspicious evidence, accepted at face value implausible or contradictory explanations and did not follow up or seek independent verification, often because it would be too time-consuming. For example, several complaints raised that issue that Madoff could not have been engaged in the level of options trading he claimed on an options exchange because of insufficient volume and could not have been trading options over-the-counter because it was inconceivable he could find a counterparty for the trading. But when the examiners asked Madoff about this issue and he said he was no longer using options as part of his strategy, they stopped looking at the issue, although his representation was inconsistent with the internal e-mails, the two magazine articles and the investment strategy he claimed to employ. The report identifies as the "most egregious failure" (and there seems to be a lot to choose from) the fact that Enforcement never verified Madoff's purported trading with DTC or any independent third parties. Madoff himself admitted that he "was astonished" when, after Enforcement asked for his DTC account number, no one ever followed up. A simple inquiry would have revealed the absence of trading in the volume Madoff claimed.

The investigation also found that numerous private entities (which did not have regulatory authority to compel information), conducting due diligence regarding Madoff and looking at the same red flags, concluded that an investment with Madoff was unwise. However, some Madoff investors drew comfort from the fact that the SEC had conducted an investigation (and, to establish credibility, Madoff made sure to advise them of that fact).

In one instance, Madoff's reputation as a broker-dealer was cited as a possible reason that the inexperienced team did not inquire into Madoff's operations. In some cases, the staff apparently did not understand the complex information provided in the complaints. Madoff was reported to have made efforts during the examinations to impress and even intimidate the junior examiners from the SEC, telling them stories, name-dropping and becoming extremely agitated if they asked for documents he did not want to provide. Madoff even told them that he himself "was on the short list" to be the next Chairman of the SEC. On a conference call, a senior-level Washington D.C. examiner reminded a junior examiner that Madoff "was a very well-connected, powerful, person." The investigation also found the Enforcement staff was skeptical regarding the complaints about Madoff because he did not fit the "profile" of a Ponzi scheme operator and was seen as a reputable member of society.

One of the two primary examiners on one of the examination teams was later promoted based on his work on the Madoff examination, and the staff attorney on the Enforcement investigation received the highest performance rating available at the SEC, in part, for her "ability to understand and analyze the complex issues of the Madoff investigation."

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Cydney Posner Special Counsel, San Francisco
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