The SEC Inspector General has concluded that, despite numerous credible and detailed complaints, the SEC never properly investigated Bernard Madoff’s trading and never took the necessary steps to determine if Madoff was operating a Ponzi scheme. Had these efforts been made with appropriate follow-up at any time beginning in June of 1992 until December 2008, said the Inspector General’s report, the SEC could have uncovered the Ponzi scheme well before Madoff confessed. The IG emphasized that perhaps the most egregious failure in the Enforcement investigation of Madoff was the failure to verify his purported trading with any independent third parties. However, the IG’s investigation did not find any evidence that any SEC personnel who worked on an examination or investigation of Bernard L. Madoff Investment Securities, LLC had any financial or other inappropriate connection with Bernard Madoff or the Madoff family that influenced the conduct of their examination or investigatory work.
The investigation found that 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 or investigation of Bernard Madoff and his firm 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. Between June 1992 and December 2008 when Madoff confessed, the SEC received six substantive complaints that raised significant red flags concerning Madoffs hedge fund operations that should have led to questions about whether Madoff was actually engaged in trading. The SEC was also aware of two articles regarding Madoff’s investment operations that appeared in reputable publications in 2001 and questioned Madoffs unusually consistent returns.
The report noted that the fact that Madoffs hedge fund business had not been registered at the time of the examinations would not have been an impediment to the examiners' ability to obtain information from Madoff since, at all relevant times, the SEC had authority to examine all of the Madoffs firm's books and records, whether they were related to market making or hedge fund clients.
The IG found that 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. This was problematic since an expert retained by the IG as part of its investigation revealed that the most critical step in investigating a potential Ponzi scheme is to verify the subject's trading through an independent third party. Indeed, the IG posited that a simple inquiry to one of several third parties could have immediately revealed the fact that Madoff was not trading in the volume he was claiming.
In 2004 and 2005, the SEC's examination unit conducted two parallel cause examinations of Madoff based upon a 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 examinations, SEC 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. In both examinations, the examiners made the surprising discovery that Madoff’s 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, continued the IG, 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. 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 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 other 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.
The IG also found that investors who may have been uncertain about whether to invest with Madoff were reassured by the fact that the SEC had investigated and/or examined Madoff, or entities that did business with Madoff, and found no evidence of fraud. Moreover, Madoff proactively informed potential investors that the SEC had examined his operations. When potential investors expressed hesitation about investing with him, Madoff cited the prior SEC examinations to establish credibility and allay suspicions or investor doubts that may have arisen while due diligence was being conducted. Thus, the fact that the SEC had conducted examinations and investigations and did not detect the fraud, noted the report, lent credibility to Madoff’s operations and had the effect of encouraging additional persons to invest with him.
The Enforcement staff effectively closed the Madoff investigation in August 2006 after Madoff agreed to register as an investment adviser. They believed that this was a "beneficial result" as once he registered, "he would have to have a compliance program, and he would be subject to an examination by our [Investment Advisor] team." However, no examination was ever conducted of Madoff after he registered as an investment adviser.