The Madoff Files: A Chronicle of SEC Failure
Over and Over, Agency Skipped 'Basic' Steps to Find Fraud, Report Says

By Zachary A. Goldfarb
Washington Post Staff Writer
Thursday, September 3, 2009

Washington's top cop for Wall Street, hamstrung by bureaucracy and inexperienced investigators, failed to thoroughly pursue multiple warnings about Bernard L. Madoff's multibillion-dollar Ponzi scheme, according to a scathing new critique of the Securities and Exchange Commission by its internal watchdog.

The report, issued Wednesday by the commission's inspector general, offers the first detailed examination of one of the agency's most public embarrassments.

It says the SEC received repeated allegations that Madoff was probably cheating investors, including detailed road maps provided by outside businessmen, only to fail to discover the fraud.

The SEC opened inquiries five times in a 16-year period. But in each instance, inexperienced officials, at times ignorant of other agency probes into Madoff, took his explanations at face value and did little to verify them.

Madoff himself told the inspector general that he was "astonished" that the SEC did not verify whether he was carrying out the billions of dollars of trades he claimed to be making after he supplied the agency with account details.

"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," the inspector general, H. David Kotz, concludes in the report.

The extensive number of contacts between the SEC and Madoff raises questions about whether the agency is capable of spotting and stopping other financial frauds. The SEC has said it doesn't have the resources necessary to oversee the exploding number of financial firms and can review many of them only once every few years. It became aware of Madoff's fraud only when he confessed to it in December.

The financial crisis has exposed many breakdowns in regulation, but none has involved such a large fraud by a single person. The inspector general's report "makes clear that the agency missed numerous opportunities to discover the fraud," SEC Chairman Mary L. Schapiro said. "It is a failure that we continue to regret, and one that has led us to reform in many ways how we regulate markets and protect investors."

Federal prosecutors say Madoff may have stolen up to $65 billion from his clients. He claimed that he engaged in a highly specialized trading strategy that persistently beat the market, but in fact, he did little trading and instead used proceeds from some investors to pay others.

His fraud left thousands of clients, including charities, retirees and celebrities, devastated. Madoff is serving a 150-year sentence in a federal prison in North Carolina.

The inspector general's report concludes that the agency's failings were the result of misjudgments but not improprieties. It says that no SEC officials who worked on the review of Madoff's firm had "any financial or other inappropriate connection with Bernard Madoff or the Madoff family that influenced the conduct of their examination or investigative work."

The report, in particular, exonerates Eric Swanson, a former SEC official who worked on a Madoff probe and later married Madoff's niece Shana, who was a compliance officer at his firm.

The report issued Wednesday is a 22-page executive summary of a 450-page investigation likely to be released later this week. It contains a number of startling anecdotes recounting how the SEC bungled its Madoff probes since the first review in 1992.

The inspector general found that SEC officials received detailed warnings but were generally not equipped to capitalize on them.

In May 2003, for instance, the Office of Compliance Inspections and Examinations in Washington received a letter from a well-known hedge-fund manager identifying red flags at Madoff's firm. An SEC supervisor involved in the review called these "indicia of a Ponzi scheme."

But it took seven months to launch the probe. One OCIE staffer said that "there was no training" and that "this was a trial by fire kind of job."

Agency officials ignored several of the questions in the hedge-fund manager's letter that went to the heart of the fraud and focused on others, because, according to the associate director in charge of the review, "that was the area of expertise for my crew."

The team prepared to ask Madoff for detailed information about trades but decided against it. Officials said such information "can be tremendously voluminous and difficult to deal with" and can take "a ton of time" to review.

The Washington office stopped its probe as it shifted resources while public pressure mounted to review the mutual fund industry.

At the same time, however, the SEC's New York office, unaware of the Washington probe, began its own review. It uncovered detailed concerns about Madoff's firm in the internal documents of another financial services company that had come under review.

SEC officials arrived at Madoff's firm in Midtown Manhattan and learned that he would be their primary contact. He provided them with contradictory information. But when they sought to confront him about it, he said he had already given the information they wanted to investigators in Washington -- which was news to the SEC officials in New York.

Shortly thereafter, they concluded their investigation without answering the questions that had spurred the review.

In 2005, fraud analyst and onetime Madoff rival Harry Markopolos wrote a detailed letter to the SEC's Boston office warning, "The world's largest hedge fund is a fraud." The Boston office had worked with Markopolos before and found him credible.

Boston sent the letter to the SEC's New York office, where officials viewed Markopolos skeptically and did not understand his reasoning, which was based largely on statistics. The team assigned to look into Madoff had little experience reviewing potential Ponzi schemes.

In May 2006, SEC investigators interviewed Madoff, who didn't bring along a lawyer. When asked how he consistently beat the market, he told the investigators, "Some people feel the market," the report recounts.

Madoff told the inspector general that he expected to be exposed when he told the investigators that his trading was processed through the Depository Trust Co., an important financial intermediary. He gave the SEC his DTC account number, which they could have used to verify the trades he claimed to have made.

"I thought it was the end, game over. Monday morning they'll call DTC, and this will be over," Madoff told the watchdog earlier this year. "And it never happened."

The report calls the agency's decision to never verify Madoff's trading "the most egregious failure in the Enforcement investigation." That investigation was closed in August 2006. It took a single phone call to DTC after the Ponzi scheme was exposed in December 2008 to find out that he had not placed any trades with his investors' funds.

Concerns about Madoff's firm continued to arrive. In March 2008, the office of then-SEC Chairman Christopher Cox received an e-mail from a source who had contacted the agency several times, urging investigators to look into secret files Madoff maintained on a computer he carried. Cox's aides sent the e-mail to the enforcement division.

An enforcement staffer who had worked on the Madoff case replied: "[W]e will not be pursuing the allegations."

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