By Zachary A. Goldfarb
Washington Post Staff Writer
Thursday, July 2, 2009
An investigator at the Securities and Exchange Commission warned superiors as far back as 2004 about irregularities at Bernard L. Madoff's financial management firm, but she was told to focus on an unrelated matter, according to agency documents and sources familiar with the investigation.
Genevievette Walker-Lightfoot, a lawyer in the SEC's Office of Compliance Inspections and Examinations, sent e-mails to a supervisor, saying information provided by Madoff during her review didn't add up and suggesting a set of questions to ask his firm, documents show. Several of these questions directly challenged Madoff activities that much later turned out to be elements of his massive fraud.
But with the agency under pressure to look for wrongdoing in the mutual fund industry, she wasn't able to continue pursuing Madoff, according to documents and two people familiar with the investigation, and her team soon concluded its work on the probe.
Walker-Lightfoot's supervisors on the case were Mark Donohue, then a branch chief in her department, and his boss, Eric Swanson, an assistant director of the department, said two people familiar with the investigation. Swanson later married Madoff's niece, and their relationship is now under review by the agency's inspector general, who is examining the SEC's handling of the Madoff case.
Madoff confessed in December to running "a giant Ponzi scheme" worth potentially $50 billion, and he was sentenced Monday to 150 years in prison after victims told a judge about how Madoff had destroyed their lives. Authorities are continuing to investigate other people and firms that might have abetted the fraud.
The SEC's inability to detect Madoff's fraud was a high-profile embarrassment for the agency, which was already under scrutiny for the collapse of investment banks under its watch, helping fuel the financial crisis. SEC Chairman Mary L. Schapiro, who took over shortly after the Madoff case came to light, has acknowledged that the agency's performance was a failure, saying the SEC needed to improve enforcement and its surveillance of financial markets.
At least five times over nearly 20 years, the SEC has investigated Madoff's business, but it never discovered the tremendous fraud. In 2007, for instance, the agency reviewed his activities after warnings from a one-time rival, Harry Markopolos, that Madoff was probably running a Ponzi scheme.
Three years before, in early 2004, Walker-Lightfoot was assigned to examine Madoff's relationship with various hedge funds. The SEC suspected that Madoff may have been allowing the funds to trade ahead of his own trades, which would give them an unfair advantage.
The agency asked Madoff to turn over reams of information -- accounting statements, trade confirmations and other documents -- and told him to detail his strategy, called "split-strike conversion." Madoff told the SEC that he used sophisticated trading practices to buy and sell stocks, employing stock options as hedges to limit losses. He told investors he never lost money.
Walker-Lightfoot, a staff lawyer, had previously worked at the American Stock Exchange, where she developed an expertise in specialized trading strategies. When she reviewed the paper documents and electronic data supplied by Madoff, she found it full of inconsistencies, according to documents, a former SEC official and another person knowledgeable about the 2004 investigation.
For example, the standard industry practice was that a firm buying a security must pay for it -- or "settle" -- within three days. But Madoff's settlements were erratic. Sometimes he settled only a day later after the purchase, sometimes seven days later.
She was also focused on his claim that he was using the same strategy for all his investors, which would involve trading stocks and hedges at the same time. On review, he seemed to be following different approaches on different accounts.
Her concerns would later prove to be on the mark. Earlier this year, the Justice Department accused Madoff of fabricating his strategy, generating false account statements and trade confirmations, and lying to investigators.
In early March 2004, Walker-Lightfoot shared her concerns with her supervisors, said a former SEC official and another person aware of the conversation.
Donohue, who still works for the SEC, was not available to comment for this article, an agency spokesman said. Swanson, no longer with the agency, declined to comment.
In response to Walker-Lightfoot's concerns, Donohue asked her to describe what additional information she wanted from Madoff, a person familiar with the discussion said.
So she sent Donohue an e-mail with nine follow-up questions she wanted to ask Madoff's firm, documents show. Several focused on the unusual trading patterns she had noticed. Others touched more broadly on questions about how Madoff ran his business.
"Do you hold any other form of brokerage account statements or accounting documents for these accounts?" Walker-Lightfoot asked. "Do you have the prime brokerage or custodial banking agreements for these accounts?"
If pursued, these questions may have led to discovery of the fraud. That's because Madoff was in fact maintaining personal custody of investors' assets, unlike the practice followed by many investment companies. These firms use a third-party custodian to hold investors' funds, and that helps assure investors that their funds are where the companies say they are.
In a separate e-mail to Donohue later in March, Walker-Lightfoot put some of her suspicions in writing.
For instance, documents show, she detailed her findings on two accounts at Madoff's firm. One belonged to a hedge fund called Tremont and the other to a smaller hedge fund called Sway.
Madoff had told the SEC that all his accounts traded based on the same specific conditions. But in her e-mail, which she copied to colleague Jacqueline Wood, Walker-Lightfoot noted "significant differences between the Tremont and Sway account transactions." The variation in the dates of trades seemed to contradict a key part of his strategy and "does not make sense," she wrote.
She also flagged other doubts about Madoff's strategy. He was supposed to buy and sell stocks and then trade options as a hedge against any loss. But his financial records suggested that he often completed trades without the corresponding hedges or hedged without completing the corresponding trades. As she wrote, "the corresponding equity activity/or hedge restructuring" didn't occur. In reality, the later criminal complaint said, many of the trades never happened at all.
One month after Walker-Lightfoot raised her concerns, Donohue told her to focus on a separate probe into mutual funds, documents show. At the time, there was intense pressure to investigate this industry. The press and other regulators, such as then-New York Attorney General Eliot L. Spitzer, were challenging industry practices. About a dozen of her colleagues were already assigned to pursue the issue.
Walker-Lightfoot e-mailed Donohue, saying she was "not sure what you want [J]acqui [Wood] and I to do concerning Madoff, but I'm focusing on the mutual fund project, as requested." She asked, "Should we just focus on mutual funds and return to Madoff when we're done?"
The next morning, Donohue responded: "Concentrate on mutual funds for the time being."
A few weeks later, Donohue told Walker-Lightfoot to turn over her work on Madoff to Wood, according to a person familiar with the matter. Not long after that, the material was boxed by Wood for transfer, this person said.
Many of the people interviewed for this story, including current and former SEC officials, spoke on the condition of anonymity because of the agency's ongoing investigation into its handling of the Madoff case.
A spokesman at the law firm where Wood now works said she would be unavailable to comment.
Walker-Lightfoot's lawyer, Julie Grohovsky of Wheat Wu, declined to comment, except to say her client had been "a dedicated and exemplary SEC employee who had been uniquely qualified to work on the investigations conducted by the Office of Compliance Inspections and Examinations." Walker-Lightfoot left the SEC in 2006 after filing a complaint with the agency alleging that she'd been subjected to a hostile workplace. A person familiar with the complaint said it was settled in Walker-Lightfoot's favor.
SEC spokesman John Nester declined to comment, citing an ongoing investigation by the agency's inspector general, H. David Kotz.
Kotz said he is reviewing "all the circumstances surrounding the SEC's various examinations of Mr. Madoff, including the 2004 examination" and said he is interviewing more than 100 former and current SEC officials. He said he has reviewed Walker-Lightfoot's story. "While we are considering all information provided, it would be incorrect to assume that the OIG's final report or analysis of any particular examination or personnel decision will be based on the input of any single source," he said.
The investigation includes a review of Swanson's relationship with Madoff's niece, Shana. Kotz said earlier this year that he was looking into "allegations of conflicts of interest regarding relationships between any SEC officials and members of the Madoff family and whether such relationships in any way affected the manner in which the SEC conducted its regulatory oversight of Bernard Madoff."
Swanson married Shana Madoff in 2007. The SEC has said he worked on reviews related to Madoff in 1999 and 2004 but he never did while he was involved with his future wife. SEC officials are not permitted to work on matters that involve people with whom they're romantically linked.
Madoff boasted at a business roundtable discussion about his close relationship with SEC regulators, saying "my niece just married one."
In a letter this week to a congressional committee, Kotz recommended several steps to avoid a repeat of the Madoff debacle, including better oversight of auditors, independent custodians and bounty programs to encourage whistleblowers to come forward.
After Walker-Lightfoot's inquiry concluded, the Madoff investigation was transferred to the SEC's New York office, and the documents collected by the Washington office were shipped there. The Office of Compliance Inspections and Examinations in Washington was too busy working on mutual funds and other cases deemed to be of higher priority, according to agency officials.
A New York team, building on the work done in Washington, then began looking into Madoff's firm, reporting in 2005 that it had found three violations of minor rules, officials said. The probe found no evidence of fraud. Madoff received a private deficiency letter from the agency, warning him to improve certain practices.
According to a person familiar with the matter, Walker-Lightfoot never was consulted on the case again.