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Madoff Case 'Failures' Put SEC in Spotlight
Agency Looked for, Didn't Find Fraud

By Binyamin Appelbaum
Washington Post Staff Writer
Friday, December 19, 2008

An investigation of Bernard L. Madoff's company by the Securities and Exchange Commission that ended without finding evidence of fraud is emerging as a defining failure for an agency struggling to defend its reputation.

Investigators from the SEC's New York office set out in January 2006 with a list of questions including, specifically, whether Madoff was running a Ponzi scheme. They concluded in November 2007 that there was no evidence of fraud.

Last week, Madoff confessed that his company was "one big lie," according to a complaint filed by SEC officials. Madoff told investigators that he had taken $50 billion from clients -- perhaps the largest Ponzi scheme in history.

The SEC's inability to catch Madoff is the subject of an internal investigation announced this week by Chairman Christopher Cox, who criticized his staff for "apparent multiple failures." Experts on securities fraud, including a number of former SEC employees, said the most troubling of those failures is that investigators went looking for fraud yet did not find it.

"Finding a Ponzi scheme is easy if you know that that's what you're looking for," said one former SEC enforcement official, who spoke on condition of anonymity because he still has dealings with the agency.

The experts cautioned that much remains unclear about the history of the SEC's interactions with Madoff, including the 2006-07 investigation. Without a full picture, they said, it is impossible to determine what mistakes may have been made by SEC staff.

Some also criticized Cox for passing judgment before the investigation was complete and for failing to accept a measure of responsibility.

"I am outraged that Chairman Cox immediately points the finger at front-line employees, even before he begins the internal investigation," said Colleen M. Kelley, president of the National Treasury Employees Union, which represents SEC employees. "The hardworking, dedicated front-line employees at the SEC have been outgunned, underfunded and have suffered from inadequate leadership that is ambivalent about the agency's mission."

Yesterday an agency spokesman declined to comment, citing the ongoing investigation.

Madoff attracted investors by promising steady returns with almost no risk of losses. He quoted a long-term average return of 1 percent a month and 12 percent a year, according to materials distributed to his clients.

It was a spectacular and improbable track record. Measured by a Wall Street ratio that compares risk and reward to evaluate hedge funds, investing with Madoff was more than a sixfold improvement over simply investing in the broad-based Standard & Poor's 500-stock index.

Michael S. Meade, chief executive of Lampost Financial Group, a brokerage and hedge-fund manager, said one client who had invested with Madoff asked him for an evaluation. He investigated, then cautioned the client, saying the results were implausible. The investor remained with Madoff.

"This guy had pheromones for middle-age, well-to-do people," Meade said. "They were attracted to the guy and just threw all caution to the wind if given the opportunity to invest with him."

Analysts and journalists had raised questions about Madoff's performance since at least 1999.

The SEC's decision to investigate Madoff was prompted by the repeated complaints of Harry Markopolos, a Boston investment professional who concluded in 1999, while working for a competitor, that Madoff's apparent success could not be legitimate.

Markopolos said he tried for six years before persuading the SEC to investigate. In November 2005, he sent the agency's New York office a 17-page statement titled "The World's Largest Hedge Fund Is a Fraud." The document was obtained and published by the Wall Street Journal.

Markopolos detailed 29 overlapping reasons that led him to conclude that it was "highly likely" that "Madoff Securities is the world's largest Ponzi Scheme." He presented mathematical evidence that the trading strategy Madoff described could not produce the returns he claimed. He noted that Madoff's purported trading had left no footprints in the marketplace. Most of all, he argued that the details of Madoff's business model -- the structure, the strategy, the secrecy -- made sense only as an elaborate lie concealing a massive fraud.

The argument made a limited impression on SEC officials, who noted in an internal memo that they were opening an investigation but only "because of the substantial amounts at issue . . . in an abundance of caution."

The resulting investigation took almost two years but "found no evidence of fraud," a second memo said.

A person familiar with the matter confirmed the authenticity of the memos, which were published by the Wall Street Journal.

The SEC investigation ruled out the possibility that Madoff was making money for his investors through illegal insider trading. The next step, according to several experts on fraud investigations, was to rule out a Ponzi scheme by verifying the existence of the assets reported by the firm. The operator of a Ponzi scheme pays returns to investors with money received from other investors.

Investigators attempted this reality check by reviewing records provided by Madoff and from hedge funds that funneled money to Madoff.

But the investigation relied entirely on documents provided voluntarily by the companies, the SEC said. Staff members decided not to request the power to subpoena records, which requires the approval of the SEC's commissioners. And the SEC now says that Madoff provided investigators with falsified records and that he concealed from investigators the extent of the investment pool entrusted to his firm.

Another former SEC official who has investigated Ponzi schemes said that perpetrators generally present false records.

"You ought to be able to figure that out," he said, speaking on condition of anonymity to preserve relationships.

It is not clear why investigators accepted Madoff's answers to Markopolos's questions. Madoff was a Wall Street legend, an acquaintance of senior regulators and a major political contributor, mostly to Democrats. The SEC is investigating whether relationships between Madoff's family and regulators played a role.

One simple possibility is suggested by Madoff's long career: He was a very successful salesman.

Michael Ocrant, then a reporter for the trade publication MAR/Hedge, spent hours interviewing Madoff in 2001 for a story that laid out reasons to suspect his success. Extensive reporting had convinced Ocrant that fraud was the likely explanation. Madoff nearly changed his mind.

"What I remember more than anything is that by the time I left, feeling that maybe all these guys who are saying this is a Ponzi scheme or front-running are wrong. Maybe Bernie has really figured out a great trading system," Ocrant recalled. "Because that's how cool and calm and responsive he was."

Staff writer David S. Hilzenrath contributed to this report.

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