Red Flags, Regulatory Failings On The Road To Madoff’s Fall

Dec 15 2008 | 12:57am ET

Almost a decade ago, one of Bernard Madoff’s competitors wrote the following prescient words in a letter to the Securities and Exchange Commission: “Madoff Securities is the world’s largest Ponzi Scheme.”

It seems that Harry Markopolos could not have been more right. Since warning the SEC about Madoff in 1999, Markopolos doggedly pursued the matter with the regulator, finally triggering an investigation last year.

But that probe yielded nothing. “Staff from the Division of Enforcement in New York completed an investigation in 2007, and did not refer the matter to the Commission for enforcement action,” the SEC said in a Friday statement.

That was not the only apparently missed opportunity to detect the alleged $50 billion fraud perpetrated by one of the most respected men on Wall Street. With perfect hindsight, many are pointing to a whole raft of red flags raised by certain aspects of Madoff’s business, which included running a hedge fund, as well as managing money for hedge funds.

Indeed, according to some, simply the fact that he wasn’t running a hedge fund should have raised eyebrows.

“Why would a good businessman work his magic for pennies on the dollar?” former hedge funder Joe Aaron asked The Wall Street Journal. Instead of setting up shop as a hedge fund manager, Madoff worked as a broker-dealer with an asset management business on the side. In doing so, he apparently forfeited the huge fees that hedge fund managers enjoy.

Others questioned Bernard L. Madoff Investment Securities’ lack of an independent custodian and its use of an accounting firm run out of a small storefront in a New York City suburb. Some said that his consistent returns beggared the imagination, especially given the strategy he claimed to employ.

“It seemed implausible that the S&P 100 options market that Madoff purported to trade could handle the size of the combined feeder funds’ assets which we estimated to be $13 billion,” Jim Vos, the head of investment advisory Askia, told the Journal.

And if those red flags were apparent to some would-be investors, critics say they should have been apparent to regulators.

“It is astonishing that this apparent fraud seems to have been continuing for so long, possibly for decades, while investors have continued to invest more money into the Madoff funds in good faith,” Nicola Horlick of London’s Bramdean Alternatives, which may have lost more than US$30 million, told The Telegraph. “The allegations appear to point to a systemic failure of the regulatory and securities markets regimes in the U.S.”

A 1992 SEC investigation resulted in a lawsuit against a pair of accountants who were raising money for Madoff. Madoff denied knowing that the accountants were doing anything illegal, and a court-appointed trustee concluded that all of the investors’ money was, in fact, invested with Madoff.

Madoff’s firm had another run-in with the SEC came in 2005, when it inspected the firm’s market-making business, which last month was the 23rd largest on the Nasdaq Stock Market, of which Madoff used to serve as chairman. That inspection did, in fact, uncover something untoward: three violations of best-execution rules.

And then, last year, was the investigation reportedly prompted by Markopolos, which looked into whether Madoff’s returns were due to front-running. The probe found no evidence of front-running. It is unclear whether it found any evidence of the apparently non-existent returns.

Another regulatory failing came in the wake of Madoff Securities’ registration as an investment adviser in 2006. The SEC is supposed to inspect newly-registered firms within a year, but Madoff fell through the cracks.

The reports of the SEC’s failure to detect Madoff’s alleged misdeeds adds fuel to the fire of the agency’s critics. The incoming Barack Obama administration is reportedly planning a top-to-bottom review of securities and market regulation in the U.S.


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