Bernard Madoff's firm managed $17.1 billion in assets, he declared this past January in his investment adviser filing with the SEC. He also checked the box showing that he had between one and five employees who performed investment advisory functions, including research, at the firm.
"That's unheard of," Peter Henning, a former SEC attorney and prosecutor, told ProPublica. "You wouldn't have a mutual fund run by one person. You have to have someone out there doing the research."
But there's no evidence that anyone paid much attention to the filing. According to reports, the SEC never inspected Madoff's firm, which first registered as an investment adviser in September 2006. That's despite years of suspicion of Madoff's remarkably consistent returns.
One whistleblower, a former exec at a rival firm, wrote the SEC as early as 1999 to warn that Madoff was running the "world's largest Ponzi Scheme." He repeated his warnings to the SEC through this past April. There were other critics and naysayers, including a 2001 article in Barron's questioning Madoff's unrealistically consistent returns.
The inspection likely never happened, the Washington Post reports, because the SEC "does not have the resources to examine investment advisers on a regular schedule." Instead, they target certain firms that use high-risk investment strategies -- and Madoff's didn't fit the profile. It also didn't hurt that he was a prominent fixture on Wall Street, a former chairman of the Nasdaq stock exchange. Only 10 percent of the 11,300 investment advisers registered with the SEC are examined on a regular basis, an SEC official tells the Post.
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If the SEC had taken a look at Madoff's investment adviser business, a number of red flags might have warned them of the scheme. There's the lack of staff, as we noted above. There's also Madoff's auditor -- a shoestring operation run out of New City, N.Y. A "former SEC enforcement official" tells the Post that there are only a few accounting firms with the sophistication to audit an investment adviser of Madoff's size.
But the SEC didn't follow up on the complaints and suspicion. One reason, Henning said, might be the lack of any complaints from any of Madoff's clients. "One of the things you look for is a victim. That was the brilliance of what Madoff did. Everyone was making money so no one complained." The sheer scope of the fraud might have also been beyond imagining. "No one ever looks for a $50 billion Ponzi scheme. What he did is anything short of amazing."
In the SEC's defense, regulatory gaps kept Madoff off the radar screen for most of the years that he operated...
Calls to beef up the SEC's authority and staff are a natural response now. But I think, with some further reflection, they are misplaced.
It seems clear, in retrospect, that there were bright red flags around Madoff (in particular, the lack of respectable auditor), and that thoughtful investors would have steered clear of him. Investors who didn't were, simply (if understandably), greedy -- they looked at his returns and wanted in. This is not to understate, or ignore, the human tragedy, only to face the reality. The question, then, is, whether blinded-by-greed investors ought to be subsidized by taxpayers. Which, frankly, is what is being called for.
Instead of spending hundreds of millions to beef up the SEC, why not simply prepare an informational pamphlet for potential hedge fund investors, with useful factoids like "Be wary of investing in funds without respectable auditors" or "Be wary of investing in funds whose investment process and strategy, you do not understand" and the #1 rule, which tragically too many people ignored "Never ever put all your eggs in one basket"?
Tangentially, this also illustrates how optimistic it is to expect government regulators to provide sensible oversight. It seems like the SEC employed a fundementally flawed heuristic for determining the riskiest funds to target. I think more thoughtful regulators would have recognized that "shoestring auditors" was a brighter red flag then nominally "high risk investment strategies". On the contrary, it seems evident to me that a fund engaged in fraud would not advertise itself as pursuing a high risk investment strategies.
In the end, this is just the latest sign that, as a society, we are rapidly losing any trace of personal responsibility or accountability. That the question we are asking is "How did the SEC miss this?" rather than "Why are people suprised that an opaque investment with shyster auditors turn out to be a fraud?"
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