JANUARY 5, 2009 Madoff Chasers Dug for Years, to No Avail
Regulators Probed at Least 8 Times Over 16 Years; Congress Starts Review of SEC Today
By KARA SCANNELL
Bernard L. Madoff Investment Securities LLC was examined at least eight times in 16 years by the Securities and Exchange Commission and other regulators, who often came armed with suspicions.
SEC officials followed up on emails from a New York hedge fund that described Bernard Madoff's business practices as "highly unusual." The Financial Industry Regulatory Authority, the industry-run watchdog for brokerage firms, reported in 2007 that parts of the firm appeared to have no customers.
Mr. Madoff was interviewed at least twice by the SEC. But regulators never came close to uncovering the alleged $50 billion Ponzi scheme that investigators now believe began in the 1970s.
The serial regulatory failures will be on display Monday when Congress holds a hearing to probe why the alleged fraud went undetected. Among the key witnesses is SEC Inspector General David Kotz, who was asked last month by the agency's chairman, Christopher Cox, to investigate the mess.
The situation is even more awkward because SEC examiners seemed to be looking in the right places, yet still were unable to unmask the alleged scheme. For example, investigators were led astray by concerns that Mr. Madoff, now under house arrest, was placing orders for favored clients ahead of others to get a better price, a practice known as "front running." Front running isn't thought to have played a role in the firm's collapse.
Concern that the SEC lacks the expertise to keep up with fraudsters is the latest criticism of the agency, which saw the Wall Street investment banks it oversees get pummeled or vanish altogether in 2008. With Congress likely to take a hard look at how to structure oversight of financial markets, the SEC is struggling to maintain its clout.
The failure to stop Mr. Madoff also is an embarrassment for Mary Schapiro, the Finra chief who has been nominated by President-elect Barack Obama as the next SEC chairman. Finra was involved in several investigations of Mr. Madoff's firm, concluding in 2007 that it violated technical rules and failed to report certain transactions in a timely way.
Ms. Schapiro declined to comment. Mr. Cox has previously acknowledged mistakes by the SEC. The agency declined to comment.
Regulatory gaps abound in the paper trail generated by the SEC's scrutiny of Bernard L. Madoff Investment Securities, according to a review of the documents. Many of the details haven't been reported previously.
For years, Mr. Madoff told regulators he wasn't running an investment-advisory business. By saying he instead managed accounts for hedge funds, Mr. Madoff was able to avoid regular reviews of his advisory business.
In 1992, Mr. Madoff had a brush with the SEC's enforcement division, which had sued two Florida accountants for selling unregistered securities that paid returns of 13.5% to 20%. The SEC believed at the time it had uncovered a $440 million fraud.
"We went into this thinking it could be a major catastrophe," Richard Walker, then-chief of the SEC's New York office, told The Wall Street Journal at the time.
The SEC probe turned up money that had been managed by Mr. Madoff. He said he didn't know the money had been raised illegally.
With no investors found to be harmed, the SEC concluded there was no fraud. But the scheme indicated Mr. Madoff was managing money on behalf of other people.
In 1999 and 2000, the SEC sent examiners into Mr. Madoff's firm to review its trading practices. SEC officials worried the firm wasn't properly displaying orders to others in the market, violating a trading rule. In response, Mr. Madoff outlined new procedures to address the findings.
Some outsiders were becoming suspicious. Harry Markopolos, an executive then working at a rival company, met with an official at the SEC's Boston office in 2001 to lay out his concerns about Mr. Madoff's steady returns. The same month, Barron's, a Dow Jones & Co. publication, and hedge-fund trade publication MarHedge suggested Mr. Madoff was front running for favored clients.
In 2004, the SEC's examination staff in Washington opened a limited inspection into whether the firm was front running. After finding no evidence of that, officials transferred the exam to the SEC's New York office.
In 2005, the New York staff began a broader examination, interviewing Mr. Madoff, his brother, two sons and a niece, all of whom worked at the firm. The SEC found that his investment-advisory business had 16 clients and managed $8 billion. Any firm that offers advice to more than 14 clients is required to register with the agency and undergo reviews.
Mr. Madoff "would not acknowledge" that these accounts were an investment-advisory business, the 2005 report by the New York staff said, because he received commissions from trades, not a percentage of the profits, the typical arrangement for hedge funds.
Mr. Madoff said the firm's trades were executed in foreign markets outside of U.S. trading hours. For Jan. 20, 2005, "All orders and executions took place between 2:49 a.m. and 8:57 a.m. This report supports BMadoff's assertion," the SEC concluded.
Madoff Fraud Case
Q&A: The Madoff CaseList of Victims of Alleged Madoff FraudDiscuss: Is the SEC an effective regulator?Complete Coverage: News, victims list, moreAfter examining customer statements made over four days in January 2005, the SEC concluded that they matched the investment strategy Mr. Madoff described. The findings "somewhat alleviated" their concerns of front running, an agency report said.
The report doesn't say whether the SEC looked at bank statements or other records that would have determined whether or not the trades took place. The examination uncovered some technical trading violations that resulted in a letter from the SEC. A predecessor to Finra conducted its own review in 2005 and found no violations.
In November 2005, SEC investigators in New York met with Mr. Markopolos, who prepared a 21-page report outlining his concerns. His conclusion was that Mr. Madoff's firm "is the world's largest Ponzi scheme."
The 2005 review and Mr. Markopolos's report prompted the SEC to open an enforcement case, a notch more serious in the SEC's world than the previous examination. "The staff is trying to ascertain whether" the allegation that Mr. Madoff "is operating a Ponzi scheme has any factual basis," according to the SEC case memo.
After sifting through documents and interviewing Mr. Madoff, the SEC concluded that neither he nor Fairfield Greenwich Group, a New York firm that funneled investors' money into the firm, told investors Mr. Madoff was making investment decisions. Fairfield revised its disclosures to investors.
The SEC also found that Mr. Madoff misled the agency in 2005 about the strategy he used for customer accounts, withheld information about the accounts and violated SEC rules by operating as an unregistered investment adviser. "The staff found no evidence of fraud," according to the SEC case memo. Mr. Madoff agreed to register his business that September, and the SEC didn't make its findings public.
Finra's full-scale examination in 2007 indicated that parts of Mr. Madoff's firm had no customers. It didn't provide an explanation of this finding. "At this point in time we are uncertain of the basis for Finra's conclusion in this regard," SEC staff wrote last month, after Mr. Madoff was arrested.
"We don't have access to that document, nor have we received any feedback from the SEC on our examinations of the Madoff broker-dealer," said Nancy Condon, a spokeswoman for Finra.
Write to Kara Scannell at email@example.com