CHARMED BY MADOFF, SEC LATER TIGHTENED RULES
Until Bernie Madoff’s scheme came crashing down and the biggest Ponzi scheme in Wall Street’s history came to light, he appeared as a charming wizard with a Midas touch. His investment advisory business attracted a devoted legion of clients, including A-list celebrities, rewarding them with steady returns that defied market fluctuations.
But he not only conned investors, he seduced regulators. The Securities and
Exchange Commission esteemed him as a Nasdaq Stock Market chairman and prominent Wall Street figure — and failed to detect his fraudulent scheme despite receiving warnings and credible complaints over 10 years. After it was exposed in December 2008, a shaken SEC scrambled to put controls in place to prevent such episodes from recurring and uncover them early.
Madoff was sentenced to 150 years in jail for his crimes. He died behind bars Wednesday at age 82.
For years, Madoff was a bright star in the SEC’s constellation, a legendary investment manager with celebrity clients, as well as multitudes of ordinary investors. He was chairman of the Nasdaq Stock Market in 1990, 1991 and 1993. He sat on SEC advisory committees.
All the while, the financier was running a multibillion-dollar Ponzi scheme: the classic swindle in which early investors are paid with later investors’
money rather than actual profits on their investments. By all accounts, Madoff’s scam wasn’t terribly sophisticated or hightech, utilizing phony account statements sent to clients, for example. But it wiped out thousands of people’s life savings.
In Madoff’s words in 2009, it seemed “it never entered the SEC’s mind that it was a Ponzi scheme.” Agency examiners “never asked” for basic records to corroborate his operations, he said in a prison interview with the SEC inspector general.
Did the relationship cause the SEC to ignore Madoff’s conduct? That was the question posed in Washington after Madoff was arrested and confessed in December 2008, when the SEC already was dealing with the worst financial crisis since the Great Depression that struck in the previous fall. Top SEC officials were hauled before Congress. Lawmakers from both parties said Madoff’s fraud exposed
deep, systemic problems at the SEC. The agency’s enforcement and inspections staff had received credible complaints about Madoff, including specific red flags on his operations from financial analyst whistleblower Harry Markopolos and his investigators, which were conveyed to SEC staff in Boston, New York and Washington headquarters.
Criticism mounted from lawmakers and investor advocates that Wall Street and regulators in Washington had grown too close. Some called for a shakeup of the SEC.
A 2009 report by the inspector general detailed how SEC investigations of Madoff were bungled, with disputes among inspection staffers over the findings, lack of communication among SEC officials in various cities and repeated failures to act on legitimate complaints from outside the agency.
An internal review by the Financial Industry Regulatory Authority, the securities industry’s regulator, found a breakdown on the part of the organization in the Madoff case. Like the
SEC, FINRA made periodic examinations of Madoff’s brokerage operation, which functioned separately from his secretive investment business, and did not catch wind of Madoff’s fraud.
Under public pressure, the SEC took a series of actions and made rule changes, starting in 2009. The most significant were changes in how the agency carries out inspections of investment advisers and brokerage firms. It also took steps aimed at providing better protection of customers’ assets held by brokerages and advisers against theft and abuse. Investment advisers were pushed toward putting clients’ assets in the custody of an independent firm, something Madoff hadn’t done. Also, the SEC and the stock exchanges were given greater oversight of how brokerages manage custody of their clients’ funds.
Inspection practices were revised to focus more closely on assessing potential risk to investors, and financial firms were required to submit more information.
In addition, the agency put in a centralized electronic system for taking tips and complaints to help detect fraud. And the enforcement division was reorganized to emphasize more significant cases; specialized units were created, including one for asset management. Industry experts were hired to work with staff attorneys and accountants.
“The examinations and inspection systems and programs have all been enhanced,” says James Fanto, a professor at Brooklyn Law School who specializes in banking and securities law. “Moreover, the specific problem in the Madoff case — verifying what an adviser does with the assets — was specifically addressed, and we have had few problems at the level of Madoff since then.”
Even in Madoff’s case, the SEC likely would have found the problems if staff had done a thorough inspection, Fanto noted. “Things have improved but SEC examiners run the risk of missing problems in successful firms because the success deters them from actually seeing the problems before them,” he said.