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Watchdog: Regulators Ignored Madoff Red Flags

Thursday, 03 Sep 2009 08:54 AM

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BOSTON/NEW YORK -- U.S. securities regulators missed "numerous" red flags that may have led to Bernard Madoff's $65 billion Ponzi scheme and never did a "thorough and competent" probe despite complaints dating to 1992, a federal watchdog has concluded.

The U.S. Securities and Exchange Commission's inspector general said in a blistering report that despite five probes and having caught Madoff in "lies and misrepresentations," the SEC failed to follow up on inconsistencies.

"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," Inspector General David Kotz wrote.

Kotz said the SEC's "most egregious" lapse was its failure to verify Madoff's purported trading with any independent third parties, even after it took testimony from Madoff in May 2006.

Madoff later admitted that he thought it was "game over" after testifying to having cleared his trades through the Depository Trust Co, part of the U.S. Federal Reserve, and provided his account number. He said he was "astonished" that the SEC did not follow up.

Kotz quoted one senior-level SEC examiner as saying, "Clearly, if someone ... has a Ponzi and they're stealing money, they're not going to hesitate to lie to create records," and thus "some independent third-party verification" such as through the DTC would be essential.

He said the SEC had made a "surprising discovery" earlier this decade that Madoff's hedge fund business was making far more money than his better known market-making business, but no one thought this was a "cause for concern."

Madoff pleaded guilty in March to orchestrating the Ponzi scheme, which used money from new investors to pay old ones, He is serving a 150-year prison term.

Prosecutors have said that Madoff appeared to be rewarding his customers with steady returns, but he was faking their account statements and did not place trades on their behalf.

Kotz said SEC staffers were at times too inexperienced or narrowly focused, and resisted whistle-blowers' efforts to expose Madoff.

He said his investigation had not found evidence of improper ties between the SEC and Madoff that interfered with the SEC's examination or investigatory work.

And he said he had not found that former SEC Assistant Director Eric Swanson's romantic relationship with Madoff's niece, Shana Madoff, had influenced the SEC's conduct.

A 22-page summary of the report was released on Wednesday, and posted on the SEC's website here. The full 450-page report is expected on Friday.

FAILURE LEADS TO REFORMS

The SEC's lapses in dealing with Madoff have prompted the agency to implement reforms, including increased use of subpoenas.

Mary Schapiro, who became SEC chairman after Madoff's fraud was uncovered in December 2008, said in a statement on Wednesday that while the reforms should help, "the public deserves a full accounting of why the agency did not detect the Madoff scheme."

There had been five SEC chairmen between 1992, when the complaints to the SEC about Madoff started, and Madoff's arrest: Richard Breeden, Arthur Levitt, Harvey Pitt, William Donaldson and Christopher Cox.

"There were clearly lapses on the part of the SEC staff, which accounted for the failure to uncover Madoff's Ponzi scheme," Pitt said in an emailed statement.

"I had proposed, back in 2003, a better way to conduct examinations and inspections, and Chairman Schapiro is now in the process of implementing those ideas, which should avoid some of the problems the SEC encountered.

"What happened in the Madoff situation was a tragedy of enormous proportions," Pitt said, "and no one who cares about the SEC can be anything but saddened by the missed opportunities.

"But the true test of a regulatory agency is how it responds to a crisis of this sort, and I think Chairman Schapiro is doing an outstanding job of getting the SEC back on the right track," Pitt said.

Linda Chatman Thomsen, the SEC enforcement chief when the Ponzi scheme was uncovered in December 2008, is now a partner at Davis Polk & Wardwell LLP in Washington, D.C. She did not return a call seeking comment.

Harry Markopolos, who tried to warn the SEC about Madoff and later testified before Congress about his efforts, was not available for comment.

Rep. Paul Kanjorski, a Pennsylvania Democrat who heads a House subcommittee on capital markets, said the scandal "highlights the need to adopt new securities laws to reward internal and external whistleblowers."

Schapiro observed in her statement that the SEC wanted a way to reward some whistleblowers.

"We have sought legislation to enable us to compensate whistleblowers for providing substantial evidence of wrongdoing," she said.

Christopher Dodd, chairman of the Senate Banking Committee, has scheduled a hearing for September 10 on Kotz's findings. "We will use this report to learn what went wrong and figure out how best to get things right," the Connecticut Democrat said.

Sen. Charles Grassley, an Iowa Republican, called the report evidence of the SEC's "culture of deference toward the Wall Street elite," and said the SEC must be transformed so it can be "the tough cop-on-the-beat that the public needs."

The SEC's Schapiro wrote in a letter to Grassley that Kotz's report would be redacted only if it might harm an ongoing law enforcement matter. "I do hope, however, to safeguard the names of junior staffers who did not play a central role in the examinations or investigations," she wrote.

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