Corporate Frauds and Regulatory Shortcomings: SEC’s Madoff Report

A few days ago, the U.S. SEC’s Office of Inspector General (OIG) released a report (over 450 pages) identifying various lapses that led to SEC’s failure to uncover Madoff’s Ponzi scheme much earlier than December 2008 when the scandal broke out. To the interested reader, the executive summary might be more manageable given the length of the main report.

The principal findings of SEC’s investigation are contained in the first two paragraphs of the executive summary below:

The OIG investigation did not find evidence that any SEC personnel who worked on an SEC examination or investigation of Bernard L. Madoff Investment Securities, LLC (BMIS) had any financial or other inappropriate connection with Bernard Madoff or the Madoff family that influenced the conduct of their examination or investigatory work. … We also did not find that senior officials at the SEC directly attempted to influence examinations or investigations of Madoff or the Madoff firm, nor was there evidence any senior SEC official interfered with the staffs ability to perform its work.

The OIG investigation did find, however, that the SEC received more than ample information in the form of detailed and substantive complaints over the years to warrant a thorough and comprehensive examination and/or investigation of Bernard Madoff and BMIS for operating a Ponzi scheme, and that despite three examinations and two investigations being conducted, a thorough and competent investigation or examination was never performed. The OIG found that between June 1992 and December 2008 when Madoff confessed, the SEC received six substantive complaints that raised significant red flags concerning Madoff’s hedge fund operations and should have led to questions about whether Madoff was actually engaged in trading. Finally, the 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.

As the foregoing demonstrates, despite numerous credible and detailed complaints, the SEC never properly examined or investigated Madoff’s trading and never took the necessary, but basic, steps to determine if Madoff was operating a Ponzi scheme. Had these efforts been made with appropriate follow-up at any time beginning in June of 1992 until December 2008, the SEC could have uncovered the Ponzi scheme well before Madoff confessed.

In essence, the report zeroes in on shortcomings in the expertise of the relevant SEC staff and in the investigative procedures adopted by them. For instance, the report notes that on a number of occasions the SEC had indeed come within striking distance of unearthing Madoff’s Ponzi scheme, but the matter was not pursued beyond a point thereby allowing Madoff to continue his deceptive activities. Several letters were drafted by SEC at various points in time seeking further information from Madoff, but they were never sent, including on account of the fact that “it would have been too time-consuming to review the data they would have obtained”. The report notes that the concerned enforcement staff were either inexperienced to conduct such investigations, or they were willing to accept Madoff’s explanations on various matters as plausible. Madoff’s own standing and reputation in the securities industry seems to have played a role in the softness displayed by SEC’s enforcement staff: “… Madoff’s reputation as a broker-dealer may have influenced the inexperienced team not to inquire into Madoff’s operations”.

Professor Jayanth Varma offers some excellent observations:

By and large, the investigation report tells the same story. But I think the report pushes the incompetence story a bit too much to the point where it almost reads like a whitewash job. I counted the term “inexperienced” or “lack of experience” being used 25 times in the report and that count excludes several other similar phrases. When an investigator is a good attorney, the report complains that the person had no trading experience; when the person had trading experience, it complains about his lack of investigative experience.

I am a firm believer in Hanlon’s Razor: “Never attribute to malice what can be adequately explained by stupidity,” but the report’s furious attempt to document incompetence makes one wonder whether it is trying to cover up something worse than incompetence.

One significant downside in SEC’s enforcement efforts was that it was relying largely on information provided by Madoff himself rather than on complainants or through verification of third party sources. For example, SEC asked for trading records relating to the Depository Trust Company (DTC), but sought those copies from Madoff himself. The report notes:

Had they sought records from DTC, there is an excellent chance that they would have uncovered Madoffs Ponzi scheme in 1992.

During an interview with the OIG, Madoff stated that he had thought he was caught after his testimony about the DTC account, noting that when they asked for the DTC account number, “I thought it was the end game, over. Monday morning they’ll call DTC and this will be over … and it never happened.” Madoff further said that when Enforcement did not follow up with DTC, he “was astonished.”

This was perhaps the most egregious failure in the Enforcement investigation of Madoff; that they never verified Madoff’s purported trading with any independent third parties. As a senior-level SEC examiner noted, “clearly if someone … has a Ponzi and, they’re stealing money, they’re not going to hesitate to lie or create records” and, consequently, the “only way to verify” whether the alleged Ponzi operator is actually trading would be to obtain “some independent third-party verification” like “DTC.”

A simple inquiry to one of several third parties could have immediately revealed the fact that Madoff was not trading in the volume he was claiming. The OIG made inquiries with DTC as part of our investigation. …

What was even more astonishing was that Madoff was using past investigations by SEC (that were not pursued further) as proof of his own credibility and to scout for more investments:

We also found that investors who may have been uncertain about whether to invest with Madoff were reassured by the fact that the SEC had investigated and/or examined Madoff, or entities that did business with Madoff, and found no evidence of fraud. Moreover, we found that Madoff proactively informed potential investors that the SEC had examined his operations. When potential investors expressed hesitation about investing with Madoff, he cited the prior SEC examinations to establish credibility and allay suspicions or investor doubts that may have arisen while due diligence was being conducted. Thus, the fact the SEC had conducted examinations and investigations and did not detect the fraud, lent credibility to Madoff’s operations and had the effect of encouraging additional individuals and entities to invest with him.

In that sense, inadequate regulatory enforcement has had the effect of perpetuating a fraud that should have otherwise come to light.

There are varied opinions as to the utility of such an investigative (or, perhaps more accurately, introspective) effort as the SEC has conducted. While some are impressed by SEC’s self-critical approach, others view it as SEC’s move to exonerate itself. Yet others go much farther: Professor Larry Ribstein has a provocative post titled Is the SEC necessary? where he argues that “the market would do a better job if SEC just didn’t get in the way” and that “the Madoff fiasco provides new reason to wonder whether the benefits of [the threat of an SEC investigation] outweigh the costs of misleading the market that the SEC is minding the store”.

Perhaps one of the more productive outcomes of SEC’s report is the lessons it provides for regulators in future occasions: on what to do and what not to do. To that extent, even regulators in other jurisdictions (such as India) can take a leaf out of this exercise. India too has had its similar share of questions being raised due to the Satyam scandal. The principal difference in Satyam’s case was that there were no whistles blown earlier on or investigations commenced by regulatory authorities that ought to have opened up the can of worms. Nevertheless, significant questions still remain. For example, much like the Madoff case, the auditors in Satyam seemed to convinced by explanations by the management, headed by Ramalinga Raju, on questions such as the availability of bank balances with the company without placing much insistence upon independent verification with third parties such as the banks themselves.

A tangential outcome of SEC’s report could be in helping shape India’s own fraud alert system that the government is putting in place.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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