Thursday, September 3, 2009

SEC OIG Report On Madoff Affair: A Tale Of Redemption

"Madoff's firm never had to face redemption." That observation, one among many noted by a hedge fund manager in a 2003 complaint filed with the SEC regarding suspect activity of Bernard L. Madoff Investment Securities, struck me as the most ironic sentence in the Executive Summary of the report of the SEC's Office of Inspector General Released yesterday (Sept. 2) on: "Investigation of Failure of the SEC To Uncover Bernard Madoff's Ponzi Scheme" (The full report, said to number 450 pages, is expected to be released by the SEC later this week.)

By definition, a Ponzi scheme uses new money to pay off old investors or fund redemptions. Madoff's undoing was largely due to a spike in redemptions during the credit crisis of 2008, particularly following the events in the financial markets during Sept. 2008, as noted in para. 48 of the SEC's Complaint against Madoff CFO Frank DiPascali, who pleaded guilty earlier this year to his role in the fraud, and was sentenced to a 125-year jail term.

Madoff, who earlier this year began serving a 150-year prison term after being found guilty of his self-confessed multi-billion dollar Ponzi scheme, is now presumably seeking another kind of 'redemption.'

And, the SEC is seeking redemption for its repeated failure to catch Madoff in the act, as detailed further below.

Major Findings in the OIG's Report

Right up front, the report puts to rest the more sensational accusations that had surfaced since Madoff's confession last December. "The OIG investigation did not find evidence that any SEC personnel who worked on an SEC examination or investigation of Bernard L. Madoff Investment Securities, LLC (MBIS) had any financial or other inappropriate connection with Bernard Madoff or the Madoff family that influenced the conduct of their examination or investigatory work," begins the report. "The OIG also did not find that former SEC Assistant Director Eric Swanson's romantic relationship with Bernard Madoff's niece, Shana Madoff, influenced the conduct of the SEC examinations of Madoff and his firm. We also did not find that senior officials at the SEC directed attempted to influence examinations or investigations of Madoff or the Madoff firm, nor was there any evidence any senior SEC official interfered with teh staff's ability to perform its work."

"The OIG investigation did find, however," continues the report, "that the SEC received more than ample information in the form of detailed and substantive compalints over the years to warrant a thorough and comprehensive examination and/or investigation of Bernard Madoff for operating a Ponzi schme, and that despite three examinations and two investigations being conducted, a thorough and competenet investigation or examination was never performed. "

In brief, the SEC OIG's report noted that in spite of the SEC having received at least "six substantive complaints that raised significant red flags concerning Madoff's hedge fund operations... [which] should have led to questions about whether Madoff was actually engaged in trading," the SEC's Office of Compliance Inspections and Examinations, Division of Enforcement, and regional offices repeatedly focused their efforts - in a series of investigations between 1992 and 1998, on searching for evidence of 'front running,' and eventually making the case that Madoff needed to register as an investment adviser, but failing to do rudimentary "common sense" investigative work to follow up allegations of a purported Ponzi scheme. Additionally, the OIG's report noted repeated instances of use of relatively inexperienced or untrained staff on investigations, and failing to coordinate investigative efforts between and among the Commission's various divisions and offices.

Among the complaints filed with the SEC about Madoff, noted in the report, are those submitted by Harry Markopolos, author of the detailed roadmap of red flags he saw in Madoff's house of cards, which he and other tipsters pointedly viewed as a likely Ponzi scheme. Markopolos, and other senior SEC staff, testified at a Feb. 4 hearing convened by the House Financial Services Committee, Subcommittee on Capital Markets, chaired by Rep. Paul Kanjorski. SEC Inspector General H. David Kotz and others testified at a Jan. 5 hearing of the full House Financial Services Committee, chaired by Rep. Barney Frank.

A sampling of some of the findings in the SEC OIG report (reformatted in bullets from original report):

  • "The sixth complaint received by the SEC regarding Madoff, sent by a 'concerned citizen' in 2006, said: '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 [investor], an ultra-wealthy long trime client of the Madoff firm have been 'co-mingled' with funds controlled by the Madoff company with gains thereon retained by Madoff
  • ...In March 2008, the SEC Chairman's office received a second copy of the previous complaint, with additional information from the same source....'It may be of interest to you ...that ... Madoff keepts two (2) sets of records. The most interesting of which is on his computer which is always on his person.'"
  • In 2004 and 2005, the SEC's examination unit, OClE, conducted two parallel cause examinations of Madoffb ased 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 frontrunning, with no significant attempts made to analyze the numerous red flags about Madoffs 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 Madoffs answers were seemingly implausible, the SEC examiners accepted them at face value
  • In both examinations, the examiners made the surprising discovery that Madoffs mysterious hedge fund business was making significantly more money than his well known market-making operation. However, no one identified this revelation as a cause for concern.
  • Astoundingly, both examinations were open at the same time in different offices without either knowing the other one was conducting an identical examination. In fact, it was Madoff himself who informed one of the examination teams that the other examination team had already received the information they were seeking from him.
  • 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.
  • In the second examination, the OClE Assistant Director sent a document request to a financial institution that Madoff claimed he used to clear his trades, requesting trading done by or on behalf of particular Madoff feeder funds during a specific time period, and received a response that there was no transaction activity in Madoff's account for that period. However, the Assistant Director did not determine that the response required any follow-up and the examiners testified that the response was not shared with them.
  • 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."

Similar scenarios with changes in some of the players and venues among SEC investigative teams and sources of tips were found to repeatedly occur, as noted in the report.

[Note: I worked at the SEC from Dec. 1999-Jan. 2004 in the Office of the Chief Accountant, but was not involved in any matter relating to Madoff. However it pains me to write about the findings in the SEC OIG report, and I suspect other bloggers who are alumni of the SEC staff must feel the same way.]


SEC Chairman Mary L. Schapiro issued a statement on Sept. 2, noting issuance of the OIG report, and emphasising some of the efforts already under way to address the shortcomings noted in the SEC's handling of the Madoff affair. Schapiro said:

"[The OIG] report makes clear that the agency missed numerous opportunities to discover the [Madoff] fraud. 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....

"When I took office in January in the wake of the Madoff fraud, I decided that we would not simply wait for the Inspector General's report before taking action. Instead we have been reviewing our practices and procedures, addressing shortcomings, and implementing the lessons learned.

"The findings contained in the report reinforce my view that the many changes we have made since January will help the agency better detect fraud.

"We have streamlined our enforcement procedures and are putting more experienced staff on the frontlines. We also have bolstered our inspection program, started to revamp the way we handle hundreds of thousands of tips received annually, begun to hire new skill sets, increased internal training, and sought more resources to keep pace with financial fraudsters."

Schapiro's statement as published by the SEC includes a link to an SEC 'spotlight' page on: The SEC['s] Post-Madoff Reforms, which lists 13 major initiatives to strengthen the SEC's ability to successfully handle future investigations the likes of Madoff. Some of the initiatives were mentioned in Schapiro's remarks, including strengthening the Enforcement Division, and recent rulemaking relating to investment advisors.

Among additional points in the SEC's Post-Madoff Reforms which I found of interest were that "The SEC is conducting programs to train hundreds of staffers to become Certified Fraud Examiners, and expanding the availability of programs for staffers to become [Chartered] Financial Analysts." [NOTE: even if you have not sat for the CFE exam, you can become an associate member of the ACFE and receive their publications and certain other member benefits, info is at Separately, info about the CFA designation is at (note: corrected from our original post which said .com) ]

Also of interest is the SEC's Industry and Market Fellows Program, in which the SEC: "is hiring new staffers who are highly seasoned financial experts to keep pace with the practices of Wall Street and protect investors. These experts would provide other staffers with new information and perspectives to help them identify emerging issues and understand the ways the industry is changing." [See info about Careers at the SEC.]

It appears the SEC will receive support in Congress for its efforts to ramp up staffing, training and technology to not miss the next Madoff. Rep. Kanjorski issued a statement on Sept. 2 following release of the SEC OIG report, saying:

"In response to the Madoff scandal, Chairman Schapiro has moved swiftly and vigorously to propose and adopt new safeguards. We must, however, still do more. The findings in the report will therefore help to guide our current legislative efforts to reform financial services regulation.

...In particular, this massive Ponzi scheme highlights the need to adopt new securities laws to reward internal and external whistleblowers.

In response to this scandal, the investor protection legislation that I am drafting will also enhance the authorities of the Public Company Accounting Oversight Board, improve the effectiveness of the Commission's Fair Fund program to return money to defrauded investors, and update the law governing the Securities Investor Protection Corporation."

It is possible that SEC IG Kotz will be called upon to reprise his testimony at a Congressional hearing, once the full 450-page report has been released.

Speaking of redemption, those of you reading the headline of this post referencing the Madoff "Affair" thinking this was about that other alleged Madoff Affair, will have to read about that one elsewhere, like in the New York Post or 'Bernie Madoff's Blog'. I am curious, though, if Sheryl Weinstein's remarks at Madoff's sentencing, noted in this article, could have unduly influenced Judge Denny Chin in light of her non-disclosure (at the time of sentencing) of her alleged affair with Madoff.

Niemeier Announces Intent to Leave PCAOB

In other regulatory news, the Public Company Accounting Oversight Board issued a press release on Sept. 2nd noting that PCAOB board member Charles Niemeier intends to leave the PCAOB "in the near future."

Unlike certain other press releases when SEC or PCAOB senior figures have announced their intent to leave, the PCAOB press release does not say if Neimeier intends to rejoin the private sector. This makes me wonder if Neimeier, who prior to coming to the PCAOB served as Chief Accountant in the SEC's Division of Enforcement, and was one of the rumored candidates for Chief Accountant of the Commission earlier in this year (prior to Schapiro naming Acting Chief Accountant Jim Kroeker to the position of Chief Accountant last week), may ultimately return to the SEC, or take another position in public service.

However, in an interview with Michael Corkery which appeared in the WSJ Deal Journal Blog after the PCAOB announcement, Niemeier said: "The original date for my term to end was last year. I’ve continued to serve for the 10 months beyond that. It’s simply time to move on. I have stayed focused on the best job I could do here. I haven’t spent anytime on what is next.”

In other PCAOB news, see PCAOB Publishes Staff Q&A on References to Authoritative Accounting Guidance in PCAOB Standards. (This relates to the FASB Codification.) As previously reported, the SEC issued its own interpretive release a couple of weeks ago, relating to the FASB Codification.

UPDATE 9/4/09: check back to this blog post to see comments posted in the comments section from the CFA Institute and the Association of Certified Fraud Examiners (ACFE). We will also post a link to the full 450-page SEC OIG report when it is released.

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Edith Orenstein said...

I invited comment from the CFA Institute on the SEC OIG report, and specifically on the reference in the SEC's Post-Madoff Reforms, to SEC's plan to, among other training initiatives, "provid[e] opportunities to SEC staff to become Chartered Financial Analysts (CFAs)."

Below is the response I received from Kathy Valentine, APR, Director of Public Relations (the Americas) of the CFA Institute

-At the outset this is not really “ news”. All of these concerns have been discussed in detail previously and the SEC has acknowledged it failed miserably in its oversight and investor protection role.

-CFA Institute’s focus has been on moving forward and how to fix the problem.

-First, the new SEC Chairmen has embraced the cause and is taking action to upgrade the qualifications, experience and capabilities of SEC staff. In that regard, CFA Institute offered and was asked to partner with the SEC to provide basic investment training for SEC examination staff via our Level I program.

-Second, the CFA Institute-lead Investor Working Group project has laid out several steps to improving the inspection, operation and enforcement activities of our functional regulators. Further actions by Congress are now needed on how to best streamline and make more efficient the multiple agency structure we have for securities regulation, fix antiquated securities regulations and remedy inadequate resources to ensure experienced staffing.

-Finally, the CFA has re-launched its Asset Manger Code of Professional Conduct (the AMC), a code of professional conduct and ethics that sets out critical obligations and responsibilities for all asset managers. Had investors demanded adoption and verified adherence to the AMC in the case of Madoff, it would have protected many investors from being involved in the fraud.

Anonymous said...

Interesting that there were that many compalints, and wondering how long trime teh SEC can keepts competenet senjior staff.

Edith Orenstein said...

In addition to the earlier comment from the CFA Institute, above, I also sought comment from the Association of Certified Fraud Examiners (ACFE) on the SEC OIG report, and in particular on the reference in the separate list of SEC's Post-Madoff Reforms, referring to initiatives to train hundreds of SEC staff to become Certified Fraud Examiners (CFE's).

Below is a related statement made by James D. Ratley, CFE, President of the Association of Certified Fraud Examiners (ACFE):

“The Office of the Inspector General’s report on the Madoff Investigation is a stark reminder of the importance of having trained, expert fraud examiners in a position to see the red flags and warning signs of such a devastating fraud. In the wake of Bernard Madoff’s Ponzi scheme, the SEC has announced a comprehensive list of reforms, including a partnership with the ACFE to help provide anti-fraud training and certification.

“With Certified Fraud Examiners (CFEs) in key positions at the SEC and other organizations, the odds increase considerably that the next Madoff will be detected early – or prevented altogether. CFEs must pass a rigorous exam and demonstrate anti-fraud expertise and experience. The CFE credential has been referred to as “the gold standard in the area of fraud” by A.E. Feldman, a leading executive search firm, and The FBI, U.S. Department of Defense, U.S. Government Accountability Office and the U.S. Postal Inspection Service are some of the government agencies who officially recognize the CFE credential for their fraud investigators.”

Edith Orenstein said...

Senate Banking Committee hearing slated for Sept. 10 on "Oversight of the SEC’s Failure to Identify the Bernard L. Madoff Ponzi Scheme and How to Improve SEC Performance." Witnesses scheduled to testify include:
- SEC OIG H. David Kotz
- SEC Dir. of ENF Robert Khuzami
- former fraudster (Zzzz Best) Barry Minkow
- Madoff whistleblower/tipster Harry Markopolos

Link to Senate hearing: