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Read It And Weep

We have just read the report from the Office of the Inspector General of the SEC, Case No. OIG-509, “Investigation of the Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme”.

After reading this sorry document – the 22 page Executive Summary of a 450-pager to be delivered in the coming weeks – we can say with all sincerity that we truly hope there was massive fraud and criminal deception at multiple levels within the Commission.  We have been dealing with regulators for the better part of three decades, and we have seen some humdingers.  But even we are not so cynical as to believe the SEC is as incompetent as the Inspector General’s report makes them out to be.

Even a saint would come away with a ruffled feather and a diminished opinion of human nature after reading this report.  An unmistakable whiff of fraud, meddling and deliberate cover-up emanates from nearly every paragraph of this horrifying document.

This Executive Summary is required reading for everyone who works in the finance industry – as well as for everyone who invests, anyone who cares about how our government works, anyone who either believes in, or doesn’t believe in the capitalist system, and anyone whose life stands to be affected by the foibles of human nature.  The voters of this nation should have it emblazoned on the insides of their eyelids in laser-hot day-glo letters.  The government has failed its citizenry.  The SEC is surely to blame, but they are not to be blamed alone.

The morning after this document came to light, former SEC Chair Harvey Pitt found himself under the bright lights of the Bloomberg TV studio, defending with sad and weary mien the embattled Commission, and praising Chairman Schapiro for the job she is doing in upgrading the Commission’s staff and strengthening its mandate.

But then, Pitt would have to defend the Commission, wouldn’t he?  As would just about everyone involved with this sorry enterprise.

The OIG report finds that, as early as 1992, the SEC came into possession of information that, if followed up on in even  rudimentary fashion, would have brought Madoff’s scheme to light, and the game would have been over then and there.

Meanwhile, the Summary contains references too numerous to mention of moments where a dismally under-qualified staff of examiners actually came up with something so blatantly out of order that even they suspected it was wrong – and where senior SEC staffers overseeing the examination either failed to follow up, or specifically instructed the junior examiners to abandon a line of inquiry.

In one apparent case of routine regulatory numbskullery, a team of examiners was sent to Madoff’s offices because allegations had surfaced of improper dealings in the firm’s advisory business.  Once there, the team set about looking for evidence of front running.  When it was pointed out that this was not the reason investigators had been sent in, the SEC staffer in charge responded that, he knew that front-running was not the charge at issue, but that his team’s expertise was in analyzing front running, so they were performing a front running investigation.

(“What are you doing on your hands and knees?”

“I lost a contact lens.”

“Where?  Here on the floor?”

“No. Over there in the corner.”

“So why aren’t you looking over there in the corner?”

“There’s more light here.”)

The OIG’s Summary recounts six separate complaints brought to the SEC’s attention regarding Madoff’s business.  Two of them were from Madoff investors – which meant that even under the Commission’s own inane internal unwritten guidelines, they had to follow them up.  A third was actually submitted three times, each more detailed than the previous.

Regulators receive a lot of “tips”, many of which are so vague as to be useless – or clearly motivated by personal hostility.  One of the unwritten rules of regulatory investigations is that they can not follow up on everything, so a sort of regulatory triage takes place, in which first priority is given to allegations from insiders – partners of a money manager, C-level executives of a public company, supervisors, senior bankers or head traders in brokerage firms.  Red flag status is also accorded to tips received from immediate family – spouses are best – especially when the family member in question is part of the business enterprise.

As to other tips, unfortunately we see clearly how even the most detailed presentations were tossed aside.  We have read Markopolous’ report to the SEC.  It reads like a doctoral thesis.  For a senior SEC supervisor to toss it aside requires a significant level of willful negligence.  We hear the staffer in question had a personal animosity to Mr. Markopolous, and so she did not pass his report on to others who might take a closer look at Madoff’s business.  She no doubt taught Mr. Markopolous a lesson he won’t soon forget!

On top of the complaints, SEC examiners in an unrelated routine examination of another hedge fund came across internal emails describing with great specificity the fund’s own due diligence on Madoff, describing in detail why Madoff’s returns were not credible.  The fund’s internal emails identified red flags, including “(1) incredible and highly unusual fills for equity trades; (2) misrepresentation of his options trading; (3) secrecy; (4) auditor; (5) unusually consistent and non-volatile returns over several years; and (6) fee structure.”  The OIG report goes on to describe another internal email which “provided a step-by-step analysis of why Madoff must be misrepresenting his options trading.”

This email was neither the first, nor by any means the only report to come to the SEC’s attention raising serious suspicions as to whether Madoff was trading at all.  Many of these were based on a simple analysis that compared options volume reported by Madoff to his customers, with volume actually traded on the options exchanges on the days in question.  The presence of repeated, consistent vast discrepancies should have occasioned someone at the SEC to merely duplicate the exercise – we have heard arguments about SEC examiners being junior, not well enough trained to catch out a Madoff, but how much training does one require to pull a month’s worth of Madoff customer account statements and place a call to the CBOE to see whether the numbers match?

How about two substantial articles in well-regarded publications – Barrons’ and MAR Hedge – raising serious questions about Madoff’s operation?  The OIG report says Lori Richards – then head of Enforcement – “reviewed the Barron’s article in May 2001 and sent a copy to an Associate Director in OCIE shortly thereafter, with a note on the top stating that Arvedlund [author of the Barron’s article] is ‘very good’ and that ‘This is a great exam for us!’”

Not only did OCIE not open an investigation, the OIG report says “there is no record of anyone else in OCIE reviewing the Barron’s article until several years later.”  In other words: Lori Richards was the only person in her entire chain of command who actually read the newspapers – presumably this was part of the skills set that qualified her to head the Enforcement Division.  In keeping with her aggressive move to upgrade the Commission, we understand Chairman Schapiro intends to designate multiple Barron’s readers, to avoid a gap in coverage now that Richards is leaving.

The fact that never, at any time in any of the examinations or investigations launched by the SEC into Madoff’s business, did any SEC examiner call any third party to verify anything – not trading volume, not customer positions, not customer assets, not trades, executions, orders – nothing, means not merely that the SEC fell down on the job. 

The failure, in the course of an investigation, to independently verify any aspect of Madoff’s business is not an “oversight” or a “failure” on the part of the SEC staff.  It is not even a colossal and tragic blunder.  It is criminal negligence, pure and simple. 

We have sat through many a routine firm examination – NASD, SEC, exchanges, state regulators, we’ve dealt with them all.  Among the very first documents requested by an examiner is the trades blotter.  And one of the first steps an examination team does in a firm-wide review is to verify trading with the clearing firm or prime broker.  There are two simple reasons for doing this.  The first reason is to verify that the firm is keeping accurate records – or honest ones.  Since every firm knows its examiners will request the blotters, and that the blotters will be compared with the clearing firm’s records, there is high incentive to maintain accurate blotters.

The second reason examiners always verify a firm’s blotters with an independent source is – imagine what would happen to a regulator who failed to obtain third-party verification, and then it turned out to be a fraud?

Can you imagine such a thing?  Neither could Harvey Pitt.

Poor Harvey, sitting there ruefully wagging his head over the demise of what he characterized as a good – nay, a “great” agency.  Since part of Madoff’s scamming took place during Pitt’s tenure as SEC chair, he would naturally have to defend the staff and their actions.  This he did by speaking of how “dedicated” and “principled” so many of them are.  To be sure, Pitt also said – and it was his position historically, we recall – that the Commission was “over-lawyered”, with too many attorneys, and not enough market practitioners.

This gives us yet another opportunity to lay into one of our favorite flogging ponies – and to note that, while we continue to beat it, this horse is still far from dead.  We have raised numerous times the notion of bringing a high-visibility team of Wall Street professionals to the SEC.  The process whereby young talent goes from law school to the SEC, and thence to Wall Street, is exactly backwards and has resulted in, for one thing, Bernie Madoff.

We will briefly repeat our strong recommendation that the SEC bring in a team of industry compliance professionals and hand the examination and investigation process over to them.  In the few cases we are aware of where this has been tried, the professionals in question found themselves smack up against a brick wall of bureaucratic nit picking and internecine feuding over resources and authority occasioned by the Kafkaesque hierarchy of job grades and examination schedules.  While this is traditionally exactly the way to run a government bureaucracy, this is no way to regulate the world’s most important financial marketplace.

We are greatly encouraged by the Commission’s volte face under Chairman Schapiro.  In her Statement on the Release of the Executive Summary of the Inspector General’s Report, Schapiro mentioned that the SEC has already filed twice as many restraining orders related to Ponzi schemes as were filed in the comparable period a year ago.  Underlying all our criticizing, we have a fundamental respect for Mary Schapiro and the job she has done throughout her career. 

Where John Thain harmonized technologies to make the NYSE much more powerful, Mary Schapiro was stuck, in her tenure as NASD Chair, with having to harmonize personalities in her efforts to merge the NASD and NYSE cultures.  It is a testament to her perseverance and patience that she accomplished this thankless task.  Having spent two decades supervising these folks, we would sooner boil and eat our own scrotum than have to get a stadium full of financial professionals to work with one another.

That being said, any increase in enforcement, investigations and surveillance is an invidious comparison, when put alongside the Cox SEC.  Same store comps are going to be great when measuring against a property that was shuttered last year.  We know the Commission will be far more effective under Chairman Schapiro than under her predecessor.  The question is whether Chairman Schapiro will have the political will to make some nasty decisions – and, in the process, enemies – and whether Congress and the President will back her up.  Otherwise the accomplishments of her first year as SEC Chair will be recorded with an asterisk, and the hoped-for Change We Can Believe In will be reduced to Chump Change.

We are waiting with fearful anticipation for the full report, which we shall force ourselves to read cover to cover.  Make no mistake: while our experience dealing with regulators has frequently left us with a sense of the pathetic, we nonetheless feel an acute sting of embarrassment for an industry that has come to this sorry state, and profound personal chagrin at being a part of this, however remote from the squalid epicenter.  The shame of Bernie Madoff and his thieving associates – surely, no one believes he did this all himself – is a shame that permeates the financial industry.  The shame of those willing to benefit from Madoff’s “garden variety” fraud, who considered it “business as usual”, is a moral tragedy that tears at the very fabric of our society.  The opprobrium we heap upon the bunglers at the SEC is a shame in which we are mired too.  Truly, this brush has tarred us all.


Now it can be told.  Speaking unabashedly from the front page of the Forward (4 September, “Crazy Eddie’s Cousin, A Former Fraudster, Speaks Out On Syrian ‘Subculture Of Crime’”), Sam Antar – cousin of “Crazy Eddie” Eddie Antar – told it like it is regarding the scandal that hit over the summer.  The arrest of several dozen New Jersey politicians, together with five prominent Rabbis (and a Moslem – let’s not forget the Moslem!) sparked outrage and “I told you so” from nearly every quarter.  Speaking on condition of publicity, Sam Antar spilled what beans he held regarding corruption in certain circles within the community where he grew up, and with whom he still has close ties.

Antar, who served as CFO of Crazy Eddie’s, was indicted along with his cousin, an uncle and other officers of the company.  In a journalistic passage that cleverly parodies the cadences of penitential prayer, the Forward article describes Antar’s “almost gleeful” willingness to discuss his past misdeeds.  “He lied.  He committed fraud.  He skimmed money.  He misled investigators.”

Antar’s version of the story is, his cousin and the other family members were going to blame the whole fraud on him – so he blamed it on them.  He turned state’s evidence, and got off with a suspended sentence, while his cousin and uncle went to prison.

Antar, who continued to live in the Syrian Jewish community after the scandal, believes he was largely left alone because, even though he turned on other members of the community, they were his own family.  In this community noted for being close-knit, blood is thicker than Arak.

The mainstream financial press, meanwhile, has run stories about the Madoff trustee gearing up to go after charities and claw back monies they withdrew from their Madoff accounts in the years before the scandal broke.

Call us cynical – please! – but we are convinced that all the biggest charities that invested with Madoff knew he was doing something highly immoral – or outright illegal.  The problem was, they were betting on the wrong crime.

Bernie started his career by taking advantage of a weakness in the system.  The weakness was called Spreads, and by rebating firms for their order flow, Bernie ended up pocketing most of the spread, while filling the customers on their respective sides of the market.  The seller got the bid price, the buyer paid the offer – Bernie paid a penny to each side, and kept ten and a-half cents.  God’s in His heaven, all’s right with the world.

The fine line separating commerce and crime is a fascinating topic, and Madoff’s tale may yet prove a laboratory for the analysis.  Where does an entrepreneur who exploits a weakness in the market slip over into being a criminal?  At what point does taking advantage of a market inefficiency become immoral – and finally, illegal?  And at what point does society intervene and place boundaries to this behavior?

Financial professionals who invested serious money with Madoff did so partly on the strength of his position in the marketplace – the unassailability of the man with whom many of them had traded in earlier times, who bestrode the financial world like a colossus – one foot planted in the shadowy world of third-market trading where he could manipulate the hell out of every trade that came his way; the other crushing the windpipe of the regulators in his capacity as Chairman of NASDAQ and senior advisor to the SEC.

Then there were senior foundation officers at the charities that gave Bernie millions – tens or even hundreds of millions.  These were intelligent, dedicated and hard-working professionals, generally people who understood the working of the markets.  While they did not go to the length – quite simple, really – of third party verification of the Madoff Magic there were many who assiduously teased apart the monthly statements sent to them by Madoff & Co, and who kept coming to the conclusion that he was front running and skimming pennies off customer trades – in effect picking off his own customers, as well as pocketing the spread. 

They figured out that Bernie was committing a low-level fraud on a massive scale, taking undisclosed bits and pieces, then doling them out to this investors.  To keep the performance steady, they thought he was doling out the profit in lean months, then holding back more for himself when he had good ones.

Imagine their surprise when they discovered that – yes – Bernie was breaking the law and stealing money; but – no – he wasn’t breaking that law, and he wasn’t giving them the money.  Bernie broke an altogether different law, and he kept all the money for himself.

Aside from questioning just how “due” the due diligence was of these firms that were responsible for billions of dollars of foundation money, does it not seem reasonable that they should be clawed back on money they withdrew – especially if they believed they were receiving the proceeds of illicit activity?

As the rabbis in Sam Antar’s community can tell you, among the primary reasons God destroyed the world with the Flood in the time of Noah was the prevalence of a kind of theft we today call “victimless crime.”  It is the equivalent of skimming the third and fourth decimal places of interest-bearing bank balances; the equivalent of entering fictitious orders to manipulate the price of stock in the marketplace.  The equivalent of pocketing the spread, when no one on either side of the trade expected to share in it anyway.

These crimes are victimless, because no one gets hurt.  Actually, no one knows they have been hurt.  And isn’t that the same thing?

But someone does get rich.  How can it be that one person is becoming monumentally wealthy at the expense of others, yet the others appear to not be losing anything?

If you can figure that out, you are way too smart to work at the SEC. 

Moshe Silver

Chief Compliance Officer