By Binyamin Appelbaum and David S. Hilzenrath
Washington Post Staff Writers
Tuesday, December 16, 2008
The Securities and Exchange Commission learned about what it describes as one of the largest securities frauds in history when Bernard L. Madoff volunteered his confession, raising questions about the agency's ability to police the financial marketplace.
The SEC had the authority to investigate Madoff's investment business, which managed billions of dollars for wealthy investors and philanthropies. Financial analysts raised concerns about Madoff's practices repeatedly over the past decade, including a 1999 letter to the SEC that accused Madoff of running a Ponzi scheme. But the agency did not conduct even a routine examination of the investment business until last week.
On Thursday, Madoff was charged with securities fraud after telling his sons that he had taken $50 billion from investors. The list of victims ranges from some of the world's largest banks to small charities. The Securities Investor Protection Corp., which offers limited protection to brokerage customers in cases of fraud, said yesterday that it would liquidate the company, Bernard L. Madoff Investment Securities.
Multiple investigations are just beginning. Investigators have not said when they believe Madoff began the fraudulent practice of using new investments to pay existing investors. It is not clear how much money was lost or how many people were involved.
But there is the beginning of an explanation as to how so many people failed to spot the alleged fraud.
Madoff may have avoided scrutiny, regulatory experts said, in part because he simultaneously operated a legitimate, regulated and high-profile business as one of the largest middlemen between the buyers and sellers of stock. In that role, he helped to create Nasdaq, the first electronic stock exchange, and advised the SEC on electronic trading issues. He was a large campaign contributor and a familiar of senior regulators.
"Bernie had a good reputation at the SEC with a lot of highly placed people as an innovator as somebody who speaks his mind and knows what's going on in the industry. I think he was seen as a valuable resource to the commission in its deliberations on things like market data," said Donald C. Langevoort, a Georgetown University law professor who specializes in securities regulation and served with Madoff on an SEC advisory committee.
At the same time, Madoff's separate investment business operated on the outskirts of regulation, during a period when the government has intentionally allowed private, unregulated transactions. Private investment pools, such as hedge funds, are subject to limited oversight, and Madoff constructed his investment business to avoid most of it. The SEC said Madoff did not register with it as an investment adviser until September 2006.
Finally, experts say the Madoff case may simply point to the inherent limits of regulation.
"The SEC going back to its formation, and the Justice Department going back to its formation, are never adequate to crime at its time. It's simplistic to look back and say that this was the SEC's fault," said former SEC chairman Arthur Levitt, who knew Madoff when both worked on Wall Street and consulted with him while at the SEC. "A very skillful criminal can almost always outfox the regulator or the overseer."
Ira Lee Sorkin, an attorney for Madoff, has said Madoff's firm is cooperating fully with the government in its investigation. Madoff has been released on bail.
Madoff's business as a middleman, or broker-dealer, was subject to regular scrutiny by the SEC, including a routine examination in 2005 that identified some problems and a 2007 investigation that was closed without any further action.
But Madoff's investment advisory business was never the primary subject of an SEC examination, according to people familiar with the case.
Regulators now suspect that he may have run a second investment advisory business that was never registered with regulators, according to people familiar with the investigation.
The SEC does not have the resources to examine investment advisers on a regular schedule. Instead, the agency prioritizes examinations of companies based on their risk profile, which is basically a process of judging books by their covers. People familiar with the process said the SEC tends to focus on high-risk investment strategies, such as trading in derivatives.
Lori A. Richards, director of the SEC's Office of Compliance Inspections and Examinations, said that only 10 percent of the 11,300 investment advisers registered with the SEC are examined on a regular basis -- those with high-risk characteristics. They are examined every three years. Others might be examined randomly or where there is cause, Richards said.
From 1998 to 2002, the SEC aimed to examine every adviser at least once every five years and to examine newly registered advisers during their first year, but a 50 percent increase in the number of advisers since 2002 ended that practice, Richards said.
Richards declined to comment on Madoff's firm.
Some experts said that the SEC's criteria made sense and that the fraud Madoff allegedly constructed was successful in part because it avoided the appearance of risk. It avoided the scrutiny of investors and regulators by claiming to engage in vanilla trading and reporting steady but unspectacular returns.
"I think the SEC is going to have a PR issue to deal with, but I'm not sure you'd find that the SEC staff did anything wrong," said Barry Barbash, a partner at Willkie Farr & Gallagher and a director of the SEC's Division of Investment Management during the Clinton administration. "They've had to make judgments, and they decided to look at derivatives, short sales, insider trading, all the things that Madoff never had."
Others said that the SEC should have flagged Madoff for examination no later than the moment he registered as an investment adviser, in 2006, because of the history of complaints against his firm and because of its unusual characteristics. These included Madoff's history of smooth earnings -- above 10 percent a year, every year -- and his company's reliance on a small auditing firm that had no other large Wall Street clients.
Aksia, a New York-based consulting firm that advises institutional investors about hedge funds, found that Madoff's auditor worked out of a 13-foot-by-18-foot office in Rockland County, N.Y., with only three employees. The employees of the firm, which had only Madoff as a client, included a 78-year-old living in Florida and a secretary, Aksia said it discovered. The auditor, Friehling and Horowitz, did not respond to a request for comment.
"If it's true that the SEC had begun receiving warnings in 1999, then even if they did nothing before then, surely when he registered with them in 2006, he should have gone to the top of their list," said Barbara Roper of the Consumer Federation of America.
Madoff avoided scrutiny despite the dogged bell-ringing of a Boston accountant, employed by another investment firm, who repeatedly accused Madoff of breaking the law in a series of letters to the SEC that began in 1999. The accountant, Harry Markopolos, said he sent his most recent letter in April.
A former SEC enforcement official said the letters should have raised red flags for regulators.
"It is not common to get complaints about somebody who's running a large amount of money that it's a Ponzi scheme," said the former official, speaking on condition of anonymity.
He said that investigating a Ponzi scheme is not difficult: The agency can simply demand proof that the investment adviser holds the amount of money he claims to hold. And he added that regulators also should have noticed that Madoff was audited by a tiny company with no reputation. He said there are only a few accounting firms with the sophistication to audit an investment adviser that, at the time of registration with the SEC, reported $17 billion on assets.
Regulators should have noticed instantly, he said, that Madoff's auditor was not on the list.
Staff researcher Meg Smith contributed to this story.