Madoff: Hiding in Plain Sight, Thanks to SEC

by John Berlau on December 28, 2008 · 18 comments

in Bailout Watch, Features, Nanny State, Personal Liberty, Politics as Usual, Precaution & Risk, Regulation, Zeitgeist

When news broke of Bernard Madoff’s alleged $50 billion worldwide Ponzi scheme, news accounts first protrayed him as a shadowy hedge fund manager outside the scope of regulation by the Securities and Exchange Commission. But as the sheer magnitude of the fraud became clearer, so did the picture of Madoff’s place in the Wall Street-Washington world.

Madoff’s businesses were actually subject to a variety of financial regulations, something Madoff would actually use as a selling point to investors. Last year in a speech, Madoff said, “In today’s regulatory environment, it’s virtually impossible to violate rules.” He registered as an investment adviser in 2006, and had been under the SEC’s extensive regulatory framework for securities broker-dealers since he founded his firm almost 50 years ago.

And far from being a shadowy figure, Madoff was a pillar of the financial establishment. He showered campaign contributions on politicians, mostly Democrats. He was also quite chummy with many of the financial regulators charged with overseeing him.

For instance, Clinton administration SEC Chairman Arthur Levitt, who has championed onerous mandates like the burdensome Sarbanes-Oxley accounting mandates to preserve “market intergrity,” appointed Madoff during his SEC tenure to what the New York Times describes as “a large advisory commission … that explored the rapidly changing structure of the financial markets.”

An even closer connection was SEC assistant inspections director Eric Swanson who, according to CNBC reporter Charles Gasparino, “was part of the team that examined Madoff’s brokerage firm” in 1999 and again in 2004. “During those exams, the SEC team said it found almost nothing wrong,” Gasparino writes in The Daily Beast. In 2007, after leaving the SEC, Swanson married Madoff’s niece Shana, who is the regulatory compliance attorney at her uncle’s firm

While there is no evidence of wrongdoing with regard to Madoff by either Levitt or Swanson, SEC officials, for whatever reason, looked the other way, despite numerous allegations and “red flags,” some received as early as 1992. And since 1999, rival investment manager Harry Markopolos had sent the agency detailed analysis of why he though Madoff consistent postive returns were mathematically impossible without running a Ponzi scheme or insider trading. In a 2005 submission he made to the SEC that was recently made public by the Wall Street Journal, Markopolos charged that it was “highly likely” that “Madoff Securities is the world’s largest Ponzi scheme.”

But despite the SEC’s incompetence in heeding these warnings, many are still arguing that to prevent future Madoff-type frauds, we need more regulations that give more power to the SEC. But it’s hard to see how any additional powers could have made a difference in this case, given that the SEC almost seemed determined to look the other way for violations of the most basic rules against securities fraud that had long been in place.

Since hedge funds were among Madoff’s clients (and biggest victims, as this WSJ editorial points out), calls are again being intensified for further hedge fund regulation to bring them under the cumbersome registration process for investment advisers. (The SEC already has full authority to investigate hedge funds and other unregistered investment entitities if there are suspicions of fraud.) This is what the agency tried to do a few years ago, only to have a three-judge federal appeals court panel throw out the rule in 2006 in a unanimous finding that the agency had stretched the law.

But the SEC can’t argue that this would have helped them prevent Madoff’s fraud, because, as noted above, Madoff had registered as an investment adviser in 2006, and was registered as a broker-dealer for decades.

This broker-dealer registration gave the SEC full power to investigate all affiliated businesses. As MarketWatch commentator David Weidner pointed out (in a column with a curious headline about “lack of regulation” that is the exact opposite of the author’s point — often columnists, unlike bloggers, don’t wite their own headlines), “Broker-dealers are supposed to be the most scrutinized of the investment community. If Madoff was running separate businesses, the SEC and FINRA should have been looking at all of them as a whole.”

In fact, the fact that Madoff was under such heavy regulation probably helped him in constructing the alleged facade. As business reporters Binyamin Appelbaum and David S. Hilzenrath wrote in their perceptive Washington Post article, “the fraud Madoff allegedly constructed was successful in part because it avoided the appearance of risk.” The article quoted an expert as saying that SEC regulators “had to make judgments, and they decided to look at derivatives, short sales, insider trading, all the things that Madoff never had.”

So The SEC was too busy hounding unregistered hedge funds, short-sellers, and entrepreneurial companies for trivial minutiae from Sarbanes-Oxley and other mandates to notice the fraud right in front of them. The regulators didn’t just “drop the ball,” as President-Elect Barack Obama recently asserted. They lost focus on where the most important “ball” was.

Getting that “ball” back by paying attention to warning signs about where the real fraud is, and rolling back the mounds of red tape on honest investors and entrepreneurs that also wastes the time the agency has to go after the real problems, must be the number one priority of newly designated SEC chairman Mary Schapiro.

Alan December 28, 2008 at 5:40 pm

After every massive regulatory failure, the only "lesson learned" is to do less. The ideological mind at work.

cordblomquist December 29, 2008 at 10:12 am

What regulation would have stopped Mr. Madoff?Most of the time, regulatory failures result in a "Do Something!" attitude taking over in Washington. That's why we have something like the Sarbanes-Oxley accounting rules at the PCAOB. SarbOx wouldn't have prevented Enron-type disasters, but that doesn't matter.This dead-weight, do-nothing regulatioin is, in fact, something. And that is what law makers were pressured to do. It doesn't matter if it's effective, or even if it has bad effects, something had to be done and the something we usually get is something worse than the status-quo.

Alan December 29, 2008 at 5:59 pm

Take your pick:…..….. you might want to talk with Hans about the possibility of putting some muscle into the OTS:…..

SJ December 29, 2008 at 6:21 pm

If the U.S. Gov't immediately paid each account a maximum of $5 million in settlement — based upon Nov 30, 2008 Bernard L. Madoff Investment Securities LLC end of month statements dollar value amount — in exchange for look back taxes paid & walk forward theft deductions, this would save $billions, along with the cost and effort of the legal process, and, in particular and most favorably, the excessive legal fees and the decade plus time of the adversarial legal process. In addition, claw back rights would be extinguished.This would be a matter of the benefit to public policy, as a whole, and the immediate amelioration in the life circumstances of thousands of the elderly who, and reasonably so, thought that after so many years the SEC was watching out for their honest interests in terms of both brokerage and investment advisory/power of attorney fiduciary responsibilities of Bernard L. Madoff and of Bernard L. Madoff Investment Securities LLC.For example, if the average individual account had a $2 million balance, and there were 5,000 such accounts, the total amount paid by the U.S. Government to all account holders would cumulatively amount to $10 billion, which is an estimated $7 billion to $10 billion LESS than the total estimated $17 to $20 billion the U.S. Treasury will lose to tax refunds & theft deductions.

Alan December 30, 2008 at 3:47 am

I'm all for ameliorating the condition of those who reasonably thought that after so many years the SEC was watching out for their honest interests. As well as making sure that the SEC actualy does watch out for our interests in the future. But I also want to see Madoff do hard time, so I am all for puting him through the adviserial legal process. This would be an "investiment" in terms of future deterance, and a satisfaction in terms of justice done.

cordblomquist December 30, 2008 at 6:10 am

None of these articles are calling for additional regulations, but why would they? Madoff wasn't defying a convoluted regulation, he was committing good-old-fashioned fraud. He was a liar, and that's already illegal when it comes to private contracts.The SEC has some legitimate law-enforcement powers. Certainly they need to have adequate funding to ensure that people aren't being defrauded. However, the SEC's mission has creeped well beyond tracking down hucksters such as Bernie Madoff and has been expanded to such ridiculous tasks as throwing Martha Stewart in prison for something that shouldn't even be illegal and enforcing myriad regulations that don't protect anyone from the likes of Madoff.

Alan December 30, 2008 at 6:51 am

"But despite the SEC’s incompetence in heeding these warnings, many are still arguing that to prevent future Madoff-type frauds, we need more regulations that give more power to the SEC."Yes, more power to the SEC. Subpoena power. And the ability to approve, oversee, and even assign a firm's auditors

cordblomquist December 30, 2008 at 7:38 am

Subpoena power is not a new regulation, it's expanding their policing and investigatory powers.Certainly it makes sense for the SEC to also investigate the quality of auditors, but to actually assign a specific auditor would open the door to incredible abuse. Many articles written about the Madoff case note that SEC employees are usually from the same industry and go back to the investment industry after leaving the SEC. Chances are giving these folks the ability to assign a specific auditor would concentrate auditing power in the hands of a few firms who had former or future employees at the SEC. The SEC should be able to determine if an auditor is doing their job if there is a reasonable suspicion that they aren't, but it shouldn't be given the power to hand out auditing jobs to specific firms.

Alan December 30, 2008 at 11:42 am

"New Regulation" vs. "Expanding Policing Powers" is a technical, and, to my mind, not a very important distinction. Policy wonks might get all excited about such trivia, but those of us who expect regulators to do their job have a simple way of putting it: Massive Regulatory Failure – Find the cuase and fix it.Not exactly the can-do, defeatist, ideologically blind attitude on display here.The first line of defense for investors against fraud and management malfeasance is the public auditor. Auditors are supposed to be objective and to serve the public interest. I think the cozy relationship that auditors have with the companies they are auditing is a bigger problem than any potential revolving door issue with the SEC and is well worth looking into. In any case, I would not trust your judgment on this issue, since you have decided apriori to the SEC investigation that "no new regulation is going to help." I think we are going to see a change in attitude from the Bush/Libertarian "look the other way" approach to "regulatory reform."

cordblomquist December 30, 2008 at 3:34 pm

Alan, I appreciate your point of view and notice how I don't label you in any way, let alone call you a blind ideologue.My point is that we don't need a new regulation, as in a new rule that companies ought not violate, because Madoff broke a lot of rules.The existing rules need to be enforced. It's absolutely necessary for the SEC to protect investors against fraud and investigate the activities of companies that are suspecting of fraudulent activity. However, the SEC has a hard time doing that as it is often prosecuting people for crimes that are little more than paperwork screw-ups, rather than genuine cases of malfeasance or fraud.My reservations about the SEC appointing auditors don't stem from the ideological blinders that I just can't seem to shake, but instead from the problems we've seen with the government lending its blessing to other institutions, like the blessing it bestowed upon Moody's and Standard & Poor's as rating agencies. Moody and S&P gave securities their highest ratings, which were in fact complete junk. But because they were the official raters in the eyes of the SEC, their bunk ratings weren't challenged. In effect, the SEC created a rating duopoly that failed at its job and wasn't able to be checked by competition.If we do the same thing with auditing–give the power to the SEC to appoint "trusted" auditors–we run the risk of certain auditing firms becoming too powerful as a result. We could the SEC favoring just a handful of auditing firms until we're in a worse situation than we're in now.Madoff no doubt had a horrid auditor that was in on his game to some degree, but that doesn't mean that all auditing of securities brokers is flawed. We risk concentrating auditing power in the hands of the firms that are best able to court the SEC's favor and risking a Moody's / S&P securities debacle all over again.

Alan December 30, 2008 at 4:57 pm

RE: My point is that we don't need a new regulation, as in a new rule that companies ought not violate, because Madoff broke a lot of rules.That remains to be seen. I think you need to keep an open mind on this point, since we don't have all the facts yet and there are still investigations being conducted.I'm not a technical expert in this area, or a "policy wonk", but over the years I have heard stories about the cozey relationships between autditors and the firms they are supposed to be watching as a matter of public trust. Such as "management consulting" deals, and the like. I think some sort of creative solution to the problem of "shopping" for an auditor should be considered.CEI has claimed itself to be a "full service think tank" meaning, I believe, that it goes beyond impartial policy analysis and into advocacy programs, such as this web site. Unfortunitly, I don't believe these two callings are entirely compatable, and the net result seems to be what I characterized as an "idelogically blind attitude." In my mind it lowers the credibility that I attach to any recomendation coming from the organization.

David Dzidzikashvili December 31, 2008 at 9:58 am

SEC needs to do better job in monitoring and keeping a good eye on what goes on, but I hope we’ll be able to find a good balance between too much regulation and no regulation. Hands off approach doe not seem to work and too much regulation overburdens the business world. Very strange how the SEC did not react to “red flags” of Madoff’s operations.

David Dzidzikashvili January 9, 2009 at 2:39 pm

Obviously Madoff won’t be able to withstand the public and mounting political pressure, the society needs to see justice done and the Fed (finally) is taking seriously this scandal. But I wonder, how many more Madoffs are we going to see in 2009? I am sure Madoff is not the only sinner in his world of greed & no rules…

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