It has taken me time to get round to reading the Office of the Inspector General’s report on his investigation into why, despite numerous warnings, tip offs and even formal complaints, the SEC failed to uncover Bernie Madoff’s Ponzi scheme before he eventually confessed. The incredible story it tells should be required reading for anyone who imagines that regulation alone will ever be able to prevent fraud, even on the massive scale that Madoff was able to perpetrate over the best part of two decades.
Despite the SEC missing numerous opportunities to detect the Madoff scam, the Inspector General insists that he found no evidence that anybody at the SEC was bribed or improperly influenced into turning a blind eye to the evidence it received. Nor was anyone paid to bungle the laughably ineffective investigations that it undertook; one investigator, incredibly, was even promoted for doing good staff work.
All the incompetence, In other words, was entirely the SEC’s own doing, and judging by the evidence the report presents, this assumption looks only too plausible. One of the main findings of the report is that, true to bureaucratic form, the way the SEC handled its Madoff work displayed a remarkable tendency to bark up the wrong tree at almost every point.
For example, when first tipped off that the business was a fraud, with an options-based investment strategy that couldn’t possibly be what it was described to be, instead of asking for independent trading records that would have proved immediately whether this was the case, the SEC’s investigators concentrated instead on trying to discover whether what he was doing was front-running his client’s dealings (which he wasn’t).
The main reason given for this misplaced focus is that front running was something that the investigating team knew about, whereas the complexities of options strategy were patently not. This only underlines the point that for any bureaucrat, the tendency is to prefer the devil you know to the one that you don’t. As Charlie Munger, Warren Buffett’s business partner, likes to say: “to a man with a hammer, every problem looks like a nail”.
In another later investigation, the enforcement staff, reports the Inspector General, had two main ambitions. One, also true to bureaucratic form, was to discover not what Madoff was doing, but whether he had made the right disclosures. This is something they sought to establish by comparing what he had told the investigators with what he had told his investors. As he had fabricated both sets of information, this approach did not lead very far.
The second ambition was to establish not whether Madoff was a crook, but whether he should be registered as an investment adviser, something he finally agreed to do in August 2006. Having won this battle, the staff promptly closed the investigation. The triumph of process over substance resulted in the staff attorney working on the investigation being awarded the SEC’s highest performance rating for good work.
Other familiar themes emerge from the report. Inter-departmental communication was poor. As well as being ignorant of basic investment strategies, the investigators, many of whom were inexperienced, seemed overawed by Madoff’s personality and standing on Wall Street. Given a choice they preferred to believe his blustering and lies to alternative explanations.
When the whistleblower Harry Markopolous tried for a second time to tip the SEC off about his detailed list of suspicions, the investigating team took a dislike to him and (hilariously) dismissed his findings on the grounds that he ”doesn’t have the detailed understanding of Madoff’s operations that we do”.
After bluffing his way through a session with the SEC in 2006, during which he blithely attributed his remarkably consistent returns to his “gut feel” for the market, Madoff himself later said that he was “astonished” that nobody had bothered to check with the Depository Trust Corporation whether the trades he reported in his customers’ statements had actually taken place, something that would have rumbled him immediately.
The SEC’s worst failing, it is clear, came as long ago as 1992, when it closed down a firm that had been channelling funds towards Madoff without thinking to go on to ask some basic questions about his own operations that could have nipped the fraud in the bud before it got out of control. Madoff’s funds were secretive and opaque, pursued an impossible trading strategy and lacked a reputable auditor. But the SEC was asleep at the wheel, as regulators always will be when faced with smart and determined fraudsters.