Wednesday, August 26, 2009

The Madoff Exception

On September 4th, 2009, the Securities and Exchange Commission’s Inspector General revealed that Wall Street’s watchdog agency failed to adequately investigate six "detailed and substantive complaints" that, if properly pursued, could have exposed Bernard Madoff’s massive Ponzi scheme. The real issue is why the SEC did not pursue these leads?
Clearly Madoff had enormous influence at the SEC. Since the 1980s, he had served on its advisory panels and was constantly consulted by its top officials on issues such as computerized trading. During one investigation of his own firm, he confided to a SEC investigator that he was on "the short list" to be the next SEC Commissioner, which would make him his boss. While Madoff was not appointed to the SEC, that investigation was, as the SEC inspector general points out, prematurely terminated Madoff had become so closely identified with the SEC by the early 2000s that a controversial SEC short-selling exception that benefitted Madoff became famously known on Wall Street as "The Madoff Exception."
Even as early as 1992, Madoff had become such a trusted figure in the eyes of the SEC officials that he was able to help them dispose of what appeared to be a possible Ponzi scheme. The alarm bells were set off when SEC investigators discovered that an unregistered investment company named Avellino and Bienes was offering "100% safe investments" . As noted in the Inspector General’s report, such "high and extremely consistent rates of return over significant periods of time to "special" customers" were viewed by at least 4 SEC examiners as "red flags" of a fraud involving over $441.9 million, which in the early 1990s was a sizable sum in the investment world. Indeed, it was reminiscent of the now infamous Charles Ponzi in the 1920s who paid the guaranteed "interest" to old investors out of the funds of his new investors. Neither Frank Avellino or his junior partner Michael Bienes had been licensed to sell securities, yet they and their associates had sold these guaranteed notes to 3100 investors between 1962 and 1992. The different rates they offered was yet another red flag. Larger investors got a guaranteed annual return of a 20 percent– which in some years was more than ten times the banks’ interest rate– while smaller investors got between 13.5 and 15 percent. Adding to the SEC’s concern, the firm was unable, or unwilling, to produce financial records with Avellino telling the court appointed auditors that he did not keep detailed records because "My experience has taught me not to commit any figures to scrutiny." He insisted that furnishing his own trading data was unnecessary since "every single dollar, it is invested in long-term Fortune 500 securities" with a single broker, who makes every investment decision/ And that broker was Bernard Madoff, with whom he had 5 accounts. To prove no money was missing, Avellino provided the SEC examiners with the most recent statements he received from Madoff. The New York Enforcement Staff Attorney handling the case did not find "Avellino and Bienes’ testimony altogether convincing." The next step was to verify the statements with Madoff. When on November 16, 1992, SEC examiners conducted an examination of Madoff’s firm "to verify certain security positions carried for the accounts of Avellino & Bienes," Madoff was well prepared for their visit/ He provided them with putative copies of records from the Depository Trust Corporation (DTC) showing that he had made the trades listed in the Avellino and Bienes accounts. Madoff’s stock record exactly matched the DTC statement. The examiners did not go any further. They concluded that there was no Ponzi scheme, and merely fined Avellino and Bienes $500,000 for their illegal brokerage business, which they closed down.
What the SEC did not do was to go to the DTC and verify that the records Madoff gave them were authentic. If its investigators had merely made a phone call to the DTC, they would have discovered in 1992 that those records were hastily forged and that the Avellino and Bienes accounts were only a small part of Madoff’s much larger Ponzi scheme.. As we now know from the testimony of Frank DiPascali, Jr , Madoff somehow knew the SEC examiners were about to descend on his office and demand these records. In his 2009 debriefing by the SEC, Dipascali specifically identified the SEC’s Avellino & Bienes investigation as an occurrence when "Madoff scrambled to ... fabricate credible account records to corroborate the purported trading in the accounts." The rush to fake the records described by DiPascalini suggests that Madoff might have had advance knowledge as to the SEC’s actions.
In any case, the SEC’s failure to verify Madoff’s records is difficult to explain in light of Madoff’s long-term relationship with Avellino’s firm. Madoff and Avellino had both worked together in the small accounting office of Madoff’s father-in-law Sol Alpern, who was deeply involved, if not the organizer, of the money-raising operation. Alpern also helped set up Madoff’s brokerage operation in 1960 by providing him with $50,000 to finance it and then funneling into it the guaranteed investments his firm sold. When Alpern retired, Avellino and his junior partner, Michael Bienes, took over the business and changed its name to Avellino and Bienes.
That Madoff’s name is not even mentioned by the SEC actions against Avellino and Bienes, even though his records were central to the quashing of the case, may be some indication of the influence he had developed at the SEC. Such influence would also explain why six subsequent complaints against Madoff himself were not fully investigated and why the SEC consistently neglected to verify Madoff’s accounts against the readily-available DTC records. But how could Madoff have such influence over his regulators? As Madoff’s dealing with the Fairfield Greenwich Group in 2006 demonstrates, he had advanced knowledge about the SEC’s moves. In that investigation, the SEC was dealing with an allegation that he was hiding his role as a money-manager for its funds. According to phone records that came to light in a lawsuit filed by the state of Massachusetts, Madoff called two of Fairfield Greenwich’s top executives in Bermuda, and informed them of the question that SEC investigators would ask them about their relation with him. He then furnished the answers that would satisfy them without revealing Madoff’s true role. As for the SEC investigators themselves, he pointed out, "They work for 5 years for the [SEC] Commission and then become a compliance manager at a hedge fund." The implication here was that SEC officials had a powerful incentive to be cooperative in this matter since their future lay with hedge funds, not the SEC.
He clearly had one or more reliable sources. The SEC kept to the Madoff script and, when it got the answered he provided, it did not pursue the investigation. Such high-value feed-back, which could have come from unwitting sources or from someone cooperating with him. In either case, it would explain how Madoff evaded SEC scrutiny. ***
[UPDATE 9/5/2009]