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SEC Inspector General Report Shows Incompetence at Best and Fraudulent Cooperation at Worst

Expert Witness: Fulcrum Inquiry
The Madoff scandal is the largest financial fraud to have ever occurred. The Office of Inspector General recently issued a scandalous report entitled “Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme”.

The Madoff scandal is the largest financial fraud to have ever occurred. The U.S. Securities and Exchange Commission (SEC) Office of Inspector General (OIG) recently issued a report (OIG-519) entitled “Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme”. To anyone experienced in auditing matters, the OIG report is nothing short of scandalous.

According to the OIG report, the SEC resisted whistle-blowers’ efforts to help. In its 457 pages, the OIG report painfully details one grotesque mistake after another. For someone who knows how a financial investigation is suppose to be performed,
the report is simply painful to read. The SEC had at least eight opportunities to uncover the wrongdoing, not counting numerous publicly-available articles questioning the legitimacy of Madoff’s operations. The OIG report’s executive summary states:

“Despite numerous credible and detailed complaints, 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 SEC received more than ample information in the form of detailed and substantive complaints over the years to warrant a thorough and comprehensive examination and/or investigation of Bernard Madoff and BMIS for operating a Ponzi scheme, and that despite three examinations and two investigations being conducted, a thorough and competent investigation or examination was never performed.”

The OIG report properly recognizes that the entire scandal should have been identified had those involved employed the most basic of proper audit steps. In the OIG’s words:

“The most critical step in examining or investigating a potential Ponzi scheme is to verify the subject’s trading through an independent third party. 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.”

A Complete Failure to Follow-up on what was Already in Their Hands

The SEC consistently had the information necessary to check that a Ponzi scheme was occurring. Although multiple examples exist throughout the lengthy report, the following example is representative of the failure to obtain independent verification:

“On May 16, 2006, three days before Madoff’s testimony, the Enforcement staff reached out to the Director of the Market Regulation Department at the NASD and asked her to check a certain date on which Madoff had purportedly held S&P 100 index option positions. She reported back that they had found no reports of such option positions for that day. Yet, the Enforcement staff failed to make any further inquiry regarding this remarkable finding. The Enforcement staff also failed to scrutinize information obtained in the NERO cause examination when the examination staff had attempted to verify Madoff’s claims of trading OTC options with a financial institution and found that “no relevant transaction activity occurred during the period” requested.”

The testimony mentioned in the preceding quote then occurred. Despite the discovered information about missing holdings, here is what happened regarding Madoff’s supposed account at Depository Trust Company (DTC):

“During his testimony, Madoff also told the Enforcement investigators that the trades for all of his advisory accounts were cleared through his account at DTC. He testified further that his advisory account positions were segregated at DTC and gave the Enforcement staff his DTC account number. During an interview with the OIG, Madoff stated that he had thought he was caught after his testimony about the DTC account, noting that when they asked for the DTC account number, ‘I thought it was the end game, over. Monday morning they’ll call DTC and this will be over . . . and it never happened.’ Madoff further said that when Enforcement did not follow up with DTC, he ‘was astonished’”.

This was perhaps the most egregious failure in the Enforcement investigation of Madoff; that they never verified Madoff’s purported trading with any independent third parties.”

The following example comes from the second group of SEC examinations:

“In 2004 and 2005, the SEC’s examination unit, OCIE, conducted two parallel cause examinations of Madoff based upon the Hedge Fund Manager’s complaint and the series of internal e-mails that the SEC discovered. The examinations were remarkably similar. There were initial significant delays in the commencement of the examinations, notwithstanding the urgency of the complaints. The teams assembled were relatively inexperienced, and there was insufficient planning for the examinations. The scopes of the examination were in both cases too narrowly focused on the possibility of front-running, with no significant attempts made to analyze the numerous red flags about Madoff’s trading and returns.

During the course of both these examinations, the examination teams discovered suspicious information and evidence and caught Madoff in contradictions and inconsistencies. However, they either disregarded these concerns or simply asked Madoff about them. Even when Madoff’s answers were seemingly implausible, the SEC examiners accepted them at face value. … Both examinations concluded with numerous unresolved questions and without any significant attempt to examine the possibility that Madoff was misrepresenting his trading and operating a Ponzi scheme.”

The OIG reports hundreds of pages of incompetence. Here is still another example;

“The investigation that arose from the most detailed complaint provided to the SEC, which explicitly stated it was “highly likely” that “Madoff was operating a Ponzi scheme,” never really investigated the possibility of a Ponzi scheme. The relatively inexperienced Enforcement staff failed to appreciate the significance of the analysis in the complaint, and almost immediately expressed skepticism and disbelief. Most of their investigation was directed at determining whether Madoff should register as an investment adviser or whether Madoff’s hedge fund investors’ disclosures were adequate.

As with the examinations, 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.

Of the many to choose from, here is another example:

“In May 2003, OCIE’s investment management group in Washington, D.C. received a detailed complaint from a reputable Hedge Fund Manager, in which he laid out the red flags that his hedge fund had identified about Madoff while performing due diligence on two Madoff feeder funds. The Hedge Fund Manager attached four documents to his complaint, including performance statistics for three Madoff feeder funds. …The Hedge Fund Manager’s complaint identified numerous concerns about Madoff’s strategy and purported returns. According to the Hedge Fund Manager’s complaint, while Madoff purported to trade $8-$10 billion in options, he and his partner had checked with some of the largest brokers and did not see the volume in the market. … The complaint also described specific concerns about Madoff’s strategy and purported returns such as the fact that the strategy was not duplicable by anyone else; there was no correlation to the overall equity markets (in over 10 years); accounts were typically in cash at month end; the auditor of the firm was a related party to the principal; and Madoff’s firm never had to face redemption.”

SEC supervisors and senior examiners acknowledged at the time that this complaint indicated that Madoff was lying about his trading at indicated issues that were “indicia of a Ponzi scheme.” In spite of the seriousness of these issues and the enormous amounts involved, the examination was delayed (without any explanation) for seven months, until 2003. Once an examination did occur, the examination team that was assigned the task of auditing these allegations:

“…was composed entirely of attorneys, who according to one member, did “not have much experience in equity and options trading” but “rather, their experience was in general litigation.” As noted above, the complaint included issues typically examined by investment adviser personnel, such as verification of purported investment returns and account balances, but the group assigned to the examination had no significant experience conducting examinations of these issues.”

The Failings Start Earlier than the Bush Administration

Former SEC Chairman Christopher Cox and the Bush Administration have been widely (and properly) attacked for abdicating their regulatory role. Much of the SEC’s misdeeds regarding Madoff were under George Bush’s and his appointees’ watch. But, Madoff began operating his scheme in 1992 and George W. Bush became president in the spring of 2001, more than eight years afterwards.

The SEC under the Clinton Administration was also asleep. The OIG report states:

“The first complaint, brought to the SEC’s attention in 1992, related to allegations that an unregistered investment company was offering “100%” safe investments with high and extremely consistent rates of return over significant periods of time to “special” customers. The SEC actually suspected the investment company was operating a Ponzi scheme and learned in their investigation that all of the investments were placed entirely through Madoff and consistent returns were claimed to have been achieved for numerous years without a single loss. …

There were several red flags that should have triggered a wide-ranging investigation of the existence of a Ponzi scheme on the part of Avellino & Bienes and potentially Bernard Madoff. … While the SEC’s relatively inexperienced examination team conducted a brief and very limited examination of Madoff, they made no effort to trace where the money that was used to repay Avellino & Bienes’ investors came from, and relied upon DTC records from Madoff rather than going to DTC itself to verify if trading occurred. … The SEC missed an excellent opportunity to uncover this [Madoff] scheme by not undertaking a more thorough and comprehensive investigation.”

SEC Leadership Must have been Involved

The OIG report details numerous missed opportunities by many people over a long period of time. The auditing negligence involves (i) multiple offices (Washington, New York, and Boston), (ii) multiple SEC Divisions, and (iii) numerous junior and senior staff throughout these SEC groups and locations. To believe that this occurred without more senior people at either the SEC or NASD squashing these numerous investigations is just too much to accept.

The OIG report claims that "there had been no improper influence by Mr. Madoff on agency investigators or officials". This conclusion is not justified based on the details of the work described in the OIG report. Other than reading some emails and interviewing select SEC leadership, the OIG did not do any investigation in this area. The real conclusion should have been a statement that the investigators asked a number of SEC leaders whether they exerted any influence on Madoff’s behalf, and all of them denied doing anything wrong.

In spite of the report’s conclusions to the contrary, the OIG report itself impeaches the conclusion that no SEC leadership was to blame for the investigatory failures. The report provides the following example from the examination performed by the SEC’s Northeast Regional Office (NERO) during 2005:

“One effort was made to verify Madoff’s trading with an independent third-party, but even after they received a very suspicious response, there was no follow-up. The Assistant Director sent a document request to a financial institution that Madoff claimed he used to clear his trades, requesting records for trading done by or on behalf of particular Madoff feeder funds during a specific time period. Shortly thereafter, the financial institution responded, stating there was no transaction activity in Madoff’s account for that period. Yet, the response did not raise a red flag for the Assistant Director, who merely assumed that Madoff must have “executed trades through the foreign broker-dealer.” The [in-field] examiners did not recall ever being shown the response from the financial institution, and no further follow-up actions were taken.

At one point in the NERO examination, the examiners were planning to confront Madoff about the many contradictory positions he was taking, particularly as they related to Madoff’s changing stories about how many advisory clients he had. However, when the NERO examiners pushed Madoff for documents and information about his advisory clients, he rebuffed them. ... As the NERO examination continued, Madoff was failing to provide the NERO examiners with requested documents and the examiners continued to find discrepancies in the information Madoff did provide. As the examiners continued to review the documents Madoff produced, their confusion and skepticism grew. …

[The in-field examiners] sought permission to continue the examination and expand its scope. Their Assistant Regional Director denied their request. … When the examiners reported that they had caught Madoff in lies, the Assistant Director minimized their concerns, stating “it could [just] be a matter of semantics.” The examiners’ request to visit Madoff feeder funds was denied, and they were informed that the time for the Madoff examination had expired. The explanation given was that “field work cannot go on indefinitely because people have a hunch or they’re following things.”

Thus, the NERO examination of Madoff was concluded without the examination team ever understanding how Madoff was achieving his returns and with numerous open questions about Madoff’s operations. Many, if not most, of the issues raised … that triggered the NERO examination had not been analyzed or resolved. … [After preparing] a closing report for the examination that relied almost entirely on information verbally provided by Madoff to the examiners for resolution of numerous “red flags”, [o]ne of the two primary examiners on the NERO examination team was promoted based on his work on the Madoff examination.”

Although the OIG’s investigators indicate that they found no evidence that SEC leadership discouraged or hindered the investigation, this result is hardly believable. Throughout literally hundreds of pages containing details, the report catalogues that the multiple Madoff complaints received by the SEC were investigated only after long delays, if at all. The investigations that were performed were not staffed by experienced auditors, and involved unconscionable examples of both incompetence and unfinished work. It is unbelievable that this could have occurred without a conscious disregard of the truth by the SEC leadership.

Instead, the OIG’s detailed work focuses on low-level personnel. The OIG report makes no attempt to understand why these low-level personnel in multiple investigations were:

1. Blocked and starved of requested resources;
2. Despite the alarming evidence that they had gathered, stopped efforts before finishing their work;
3. Ordered to focus on front-running allegations when all evidence instead pointed to a Ponzi scheme; and
4. Promoted and praised for their performance after closing a Madoff investigation, even though the then-closed investigation failed to discover anything.

Although Chairman Cox denied being personally involved, leadership involvement included the Chairman’s office. SEC Chairman Christopher Cox received multiple complaints regarding Madoff. One such letter, dated December 6, 2006 stated:

“Your attention is directed to a scandal of major proportion which was executed by the investment firm Bernard L. Madoff … Assets well in excess of $10 Billion owned by the late Norman F. Levy, an ultra-wealthy long time client of the Madoff firm have been “co-mingled” with funds controlled by the Madoff company with gains thereon retained by Madoff.”

In response, a call was made to Madoff’s lawyer, who reported that “Bernie says he has not managed money for Norman F. Levy”. Based on this alone, the investigation was closed.

Although quite lengthy, this OIG report is worth reading if one is interested in government ineptitude. However, as an experienced auditor who knows how simple this would have been to address properly, this author found the whole mess much more appalling than interesting.

Additional information regarding the various failings of both the regulators and the various feeder funds is available from the Guilty Plea of Madoff’s CFO. Regardless of the incompetence (or worse) of the SEC, the investors also bear responsibility for their losses. For specifics, see Largest-Ever Ponzi Scheme Should Have Been Obvious to Anyone Who Looked Seriously.

Fulcrum Inquiry is a licensed CPA firm that performs financial investigations and forensic accounting.

Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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