The Securities and Exchange Commission has now admitted what has been obvious to anyone paying attention over the past several months:  Inspectors utterly failed to detect Bernard Madoff’s massive Ponzi scheme despite numerous warnings over a sixteen year period that something was amiss.  The Wall Street Journal reported on the contents of the “executive summary” which was posted on the SEC site on September 2 (download the 9.5 MB pdf document by clicking on this link.)

Were the lapses in SEC oversight in this case a one time outlier or evidence of a systemic problem?

Sixteen Years of Warning Signs

The OIG found that between June 1992 and December 2008 when Madoff confessed, the SEC received six substantive complaints that raised significant red flags concerning Madoff’s hedge fund operations and should have led to questions about whether Madoff was actually engaged in trading. Finally, the SEC was also aware of two articles regarding Madoff’s investment  operations that appeared in reputable publications in 2001 and questioned Madoff’s unusually consistent returns.

The SEC report goes on to provide details of the various warnings starting with the 1992 allegations in which the SEC already suspected that Madoff was running a Ponzi scheme due to highly dubious claims of “100% safety” combined with “extremely consistent rates of return … to special customers.”  The report provides information regarding what can only be described as a road map to Madoff’s fraud which was provided by Harry Markopoulos (click here for a link to his submission to the SEC entitled “The World’s Largest Hedge Fund is a Fraud” dated November 7, 2005).

There were others who suspected what was going on as well and it appears that such reports were either ignored or entirely misunderstood by SEC examiners, although they apparently conducted “investigations” that shockingly did not even include verification of Madoff’s trades:

The OIG investigation found the SEC conducted two investigations and three examinations related to Madoff’s investment advisory business based upon the detailed and credible complaints that raised the possibility that Madoff was misrepresenting his trading and could have been operating a Ponzi scheme. Yet, at no time did the SEC ever verify Madoff’s trading through an independent third-party, and in fact, never actually conducted a Ponzi scheme examination or investigation of Madoff.

Referring to one of the examinations, the report states:

The Enforcement staff almost immediately caught Madoff in lies and misrepresentations, but failed to follow up on inconsistencies. They rebuffed offers of additional evidence from the complainant, and were confused about certain critical and fundamental aspects of Madoff’s operations. When Madoff provided evasive or contradictory answers to important questions in testimony, they simply accepted as plausible his explanations.

Were these examiners in awe of Madoff or too intimidated or inexperienced to question his lies and misrepresentations?  Did the SEC send junior level examiners without the experience to push further?  I somehow get the picture in my mind of a 22 year old examiner fresh out of school timidly asking the great Madoff questions only to meekly accept obvious lies.  Actually, this is the most charitable assumption.  It would be more damning if the examiners actually had years of experience.

Trusting Investors Caught in the Scam

While I generally do not have much sympathy for Ponzi scheme victims who should have known better, it is worth noting that many Madoff investors were “reassured” that their investments were safe by the numerous SEC examinations that seemed to exonerate Madoff’s strategy and operations:

We also found that investors who may have been uncertain about whether to invest with Madoff were reassured by the fact that the SEC had investigated and/or examined Madoff, or entities that did business with Madoff, and found no evidence of fraud. Moreover, we found that Madoff proactively informed potential investors that the SEC had examined his operations. When potential investors expressed hesitation about investing with Madoff, he cited the prior SEC examinations to establish credibility and allay suspicions or investor doubts that may have arisen while due diligence was being conducted.

If one assumes that SEC inspectors are experienced and competent, then surely the fact that Madoff was inspected several times over more than a decade would be enough to put to rest any “paranoid” thoughts of being a victim of a Ponzi scheme.

Not only did the SEC inspectors fail in their core mission to uncover fraud, it appears that they provided Madoff with free marketing material to use on his less incredulous clients who suspected something might be amiss.

Name Dropping, Intimidation, Bulging Veins

Madoff was quite a story teller and a “captivating speaker” according to the report.  He never neglected to emphasize his history in the industry and dropped names frequently:

… Throughout the examination, Bernard Madoff would drop the names of high-up people in the SEC.” Madoff told them that Christopher Cox was going to be the next Chairman of the SEC a few weeks prior to Cox being officially named. He also told them that Madoff himself “was on the short list” to be the next Chairman of the SEC. When the NERO examiners would seek documents Madoff did not wish to provide, Madoff became very angry, with an examiner recalling that Madoff’s “veins were popping out of his neck” …

I’ll bet his veins were popping out of his neck, but in reality, Madoff had little to worry about given the subsequent reaction of the examiner’s boss when told of Madoff’s antics:

… when the NERO examiners reported back to their Assistant Director about the pushback they received from Madoff, they received no support and were actively discouraged from forcing the issue.

“Too Time Consuming”

One of the more outrageous findings was related to the lack of due diligence in a 2004 examination of Madoff’s operations:

In the first of the two OCIE examinations, the examiners drafted a letter to the National Association of Securities Dealers (NASD) (another independent third-party) seeking independent trade data, but they never sent the letter, claiming that it would have been too time-consuming to review the data they would have obtained. The OIG’s expert opined that had the letter to the NASD been sent, the data would have provided the information necessary to reveal the Ponzi scheme.

What more can be said about this kind of total incompetence?

Systemic Oversight Problems Exist

Investors must operate under the assumption that the SEC’s massive lapses in judgment and competence extend beyond the Madoff affair.  While it is possible that the behavior of examiners outlined in the report was an aberration, there is ample reason to believe otherwise.  The most damning aspect of the report is that the SEC examiners appeared to be just as susceptible to the common psychological tendencies that Madoff used to exploit his victims.

Those who believe that a government agency can really protect investors from the next Madoff are hopelessly naive.  Instead, investors must rely on common sense and treat all claims of extraordinary returns with a high degree of skepticism.  Not all people have the skill set or temperament to be security analysts or to understand investment related topics.  Such individuals can and should delegate responsibility for the management of their investments to others but can never abdicate their responsibility to oversee the manager.  While it is possible that the SEC will reform its practices in the future, the nature of government regulation is such that it can never be blindly relied upon to protect against fraud or loss.