The SEC’s Madoff Report


The SEC decided to take a look at how it failed to uncover the Madoff fraud. The SEC’s Inspector General has been running an investigation and compiling information. The SEC Inspector General, H. David Kotz, released a public version of their report on August 31: Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme – Public Versionpdf-icon

The big question being whether it was case of internal corruption or just incompetence. Of course, hindsight is 20/20 and the fraud looks so obvious, you have to wonder how they missed it. I think it is more important to learn from the mistakes so they can avoid this happening again. But people are still looking for heads to put in the guillotine.

Senate hearing

Of course, politicians are looking to blame someone. Today at 2:30, the Senate Banking Committee will hold a  hearing concerning Oversight of the SEC’s Failure to Identify the Bernard L. Madoff Ponzi Scheme and How to Improve SEC Performance. The witnesses currently slated are:

  • H. David Kotz, Esq., Inspector General of the U.S. Securities and Exchange Commission;
  • Mr. Harry Markopolos, Chartered Financial Analyst and Certified Fraud Examiner;
  • John Walsh, Esq. Acting Director, Office of Compliance Inspections and Examinations, SEC
  • Robert Khuzami, Esq., Director of the Division of Enforcement, SEC

Was there corruption?

The investigation did not find evidence that any SEC personnel who worked on an SEC examination or investigation of Madoff had any financial or other inappropriate connection that influenced the conduct of their examination or investigatory work. The report also concludes that former SEC Assistant Director Eric Swanson’s romantic relationship with Bernard Madoff’s niece, Shana Madoff, did not influence the conduct of the SEC examinations of Madoff. The report concludes that no senior officials at the SEC directly attempted to influence examinations or investigations of Madoff and that there was no evidence of interference with the staff’s ability to perform its work.

How much did the SEC know?

The Inspector General found that the SEC received more than ample information over the years to warrant a comprehensive investigation of Madoff. Despite three examinations and two investigations being conducted, a thorough and competent investigation or examination was never performed. Between June 1992 and December 2008 when Madoff confessed, the SEC received six substantive complaints that raised significant red flags concerning Madoff’s operations. There was enough for SEC to question whether Madoff was actually engaged in trading.

What about private investors?

I found it unusual that the Inspector General includes information from private parties about their due diligence findings of Madoff’s operations. Many sophisticated investors gave significant money to Madoff. But there were traders, funds, investment banks, and other investors who thought something was not right with Madoff. They were concerned about the suspiciously consistent returns, the lack of transparency, the use of a small captive auditing firm, and the lack of an independent custodian.

The decisions to not invest were made based upon the same red flags that the SEC considered in its investigations, but ultimately dismissed. The Inspector General concludes:

The SEC examination program should analyze the approaches utilized by private entities who conducted due diligence of Madoff’s operations and apply these methods to strengthen their program. They should also seek to learn from these private entities through training mechanisms and in fact, several private entities informed the OIG that they would be willing to conduct training of SEC examiners in their due diligence approaches. Learning from private sector efforts would improve the SEC’s ability to conduct meaningful and comprehensive examinations and detect potential fraud.