SEC Skipped Normal Inspection of Madoff Hedge Fund

So how did Madoff get away with his $50 billion fraud? Time will tell when and how it started, although I’d hazard the dot com bust. Madoff may have been unwilling to report losses, and assumed (initially) that no one would be hurt if he fibbed if he could eventually trade his way out of trouble. But given the freakish consistency of his returns, it could have been phony from the get go.

The critical bit was that Madoff’s firm executed its own trades. No nasty third-party records to diverge with what the customer statements showed.

But another shocker came to light today: the SEC, via its own protocols, should have inspected the Madoff Ponzi operation prior to the end of 2007 and failed to. Why? Evidently, due to Madoff’s good reputation in the industry.

What is particularly curious (if my assumptions are correct) is that Madoff kept his registered status, which meant he would at some point have the SEC knocking on his doors. I am assuming he registered in 2006 because that is when the SEC has an initiative underway to register hedge funds with over $25 million in assets under management. Some evaded it by getting investors to agree to 2 year+ lockups (that put them in a different category). But the registration requirement was nullified when a hedge fund manager sued successfully, claiming that the SEC was misusing its statutory authority under the Investment Advisers Act of 1940. Most hedge fund then removed themselves from registration; for some reason Madoff did not. Did he somehow think he could bluff the SEC, or did he have a death wish? (Note: I am assuming the Madoff investment operation was considered to be a hedge fund, otherwise, it should have been registered as an investment adviser long ago).

In any event, that particularly day of reckoning did not come to pass.

A former Madoff employee called me, in many ways as gobsmacked as everyone else about the massive fraud. He said that the firm was very compliance oriented in the other aspects of its business, and was if anything overly zealous. That squeaky-cleanness in the activities visible to the marketplace in retrospect served as useful cover.

But the former employee also said that even at the time, some things that did not add up, although since the rest of the firm was on a separate floor from the investment operation, they didn’t think about them too deeply.

1. The returns were too good, too consistent. “it meant Bernie was either a genius or a crook.” Since Bernie had been an innovator and was genuinely (by appearances) a really nice guy, it was hard to see him as a crook.

2. The operations types in the investment arm were way way overpaid (someone had seen the pay stubs) and seemed not very smart and not very good. Many were related (ie, family members, but not the Madoff family)

3. The investment arm was peculiarly secretive and what they said about its strategy did not mesh with the returns.

The former employee is also pretty certain that the Madoff family members were in the dark and not part of the fraud.

From Bloomberg:

Bernard Madoff’s investment advisory business, alleged to be a Ponzi scheme that cost investors $50 billion, was never inspected by U.S. regulators after he subjected it to oversight two years ago, people familiar with the case said.

The Securities and Exchange Commission hasn’t examined Madoff’s books since he registered the unit with the agency in September 2006, two people said, declining to be identified because the reviews aren’t public. The SEC tries to inspect advisers at least every five years and to scrutinize newly registered firms in their first year, former agency officials and securities lawyers said….

“Given what the SEC claims is the magnitude of the fraud, this is something you would hope an inspection would have uncovered,” said Mercer Bullard, a University of Mississippi law professor and former mutual-fund attorney at the SEC. “It’s hard to imagine a fraud of this alleged size not being accompanied by significant and pervasive compliance problems.”…

More than a decade earlier, in 1992, Madoff faced regulatory scrutiny as part of a lawsuit the SEC brought against two Florida accountants, whom it accused of raising $441 million while selling unregistered securities over three decades, according to SEC statements and a press report at the time.

Madoff told the Wall Street Journal at the time that he had managed the funds unaware they had been raised illegally. The SEC determined that the investors’ money was all accounted for, and didn’t accuse him of wrongdoing, according to the report….

Such a large Ponzi scheme — in which early investors are paid with money raised from subsequent victims — should prompt lawmakers to review how the U.S. polices brokerages, wealth managers and unregistered advisers, such as hedge funds, said James Cox, a securities law professor at Duke University in Durham, North Carolina….

Barry Barbash, a former head of the SEC’s investment management division, said the agency has tried to focus its inspections on money managers who pose the biggest risks. The regulator uses criteria such as which securities a firm is buying and who its clients are, said Barbash, a partner at Willkie Farr & Gallagher LLP in Washington.

“Given the state of SEC resources and given the way that they go about determining whether an inspection is necessary, it wouldn’t surprise me that a newly registered firm wasn’t inspected,” Barbash said.

Any suspicions about Madoff may have been dampened because of his association with industry groups, watchdogs and politicians.

He sat on a committee of academics, regulators and executives formed in 2000 by former SEC Chairman Arthur Levitt to advise the agency on new stock-market rules in response to the growth of electronic trading. Madoff has led the trading committee at the Securities Industry Association, Wall Street’s biggest trade group, and served as chairman of the Nasdaq Stock Market.

Since 2000, he has given at least $100,000 to the Democratic Senatorial Campaign Committee and more than $23,000 to the party’s candidates, including Senator Charles Schumer of New York and Senator Frank Lautenberg of New Jersey, who leads a charitable foundation that invested with Madoff.

“You can see where people would pull the shades down over their eyes in terms of recognizing what could be one of the great frauds of our time,” Levitt said in a Bloomberg Television interview. “I’ve known him for nearly 35 years, and I’m absolutely astonished.”

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  1. Glen

    When do the class actions start. Probably why the banks aren’t lending money – can be used against then to fund good lawyers!

  2. Roger Bigod

    It looks like Madoff is a case of a good boy gone bad. The recurring example is in the factoring business. A factor lends money to a businessman using accounts receivable as collateral, applying a discount up front. The problem isn’t deliberate fraud, since the customer is a respected businessman with a good reputation. It’s that he has a bad month, decides to submit false accounts receivable to the factor and straighten it out when cash flow improves. He may do this a few times without a problem. But at some point, he can’t make it up the next month, so he rolls over the bad paper, and is it turns into a Ponzi scheme with one customer. The discount charged by the factor has a risk component for this sort of thing.

    A fictional equivalent is the Jack Lemmon character in the flick “Save the Tiger”. His business gets in trouble and he’s cooking the books, so he considers torching one of his plants for the insurance. A decent, sympathetic guy caught up in a desperate situation.

    It looks like Madoff was an honest guy who started a fund to help out friends, family and worthy causes. When the returns came up short one month, he decided to put out some funny numbers and make up the difference the next quarter. After a few years he was in way over his head. It may be possible to reconstruct the accounts and see when he started putting out phony reports.

    It isn’t the career of the classic con man. They have the account in the Caymans before the first hire. And they don’t waste time sitting on boards.

    The interesting twist here is his dual role as head of a big market maker firm on NASDAQ. It raises the question of front-running or otherwise favoring the trades of his advisory fund over those of the general public. A market maker can do this for any proprietary account, so the public is disadvantaged either way. But the supposition that this was going on may be why so many of the clients of the hedge fund accepted his suspiciously steady returns. If so, a little schadenfreude is in order.

  3. Kevin de Bruxelles

    The question of how Madoff maintained this scam is probably linked to the equally intriguing question of where the real part of the $50 billion went. Surely Madoff was investing at least a portion of his clients funds into the construction of a firewall between himself and the regulators. While his overt contributions to politicians are significant, there must be a much larger covert flow of cash to key players that explains the lack of oversight.

    So far we are being presented with a “lone-nut” theory on the Madoff Ponzi scheme. I find it highly unlikely that one man alone could run the first known fractional-reserve hedge fund. On the other hand Madoff obviously compartmentalized the scam fairly well as evidenced by the length of time he was able to operate with impunity. It will be interesting to see if his sons really are innocent or if Madofff is playing the “patsy” to protect them.

    Many of these suddenly empty-handed Madoff investors are not going to take their sudden relegation to poverty without putting up a fight. And that fight will mean calls for a US taxpayer bail-out since the SEC was obviously sleeping on the job and not protecting these hard-working, small Madoff investors from their own reckless greed.

  4. Anonymous

    I am confused. Didn’t we have a legal test, hedge fund vs. SEC, that overturned the SEC registration requirement, thus leaving it in limbo since 2006. The hedge funds didn’t want to be regulated and thus so, won the battle.

    The implications there are that their “sophisticated investors” understand risk better than what the SEC believes them to understand, consequently, investors will be rewarded for the risk.

    This leads me to the part I don’t understand. Why is everyone blaming the SEC here? They actually tried to address the problem in 2004 and were thwarted.

    It’s rich peoples’ money and they know what to do with it. If they want to avoid regulation, that’s their choice, caveat emptor. The Fidelity mutual funds were just as accessible to them.

    I’m not saying the situation should lend to con artists setting up Ponzi schemes, but in effect, the hedge funds, at the height of their power, set themselves up for this. It’s hard to shed tears for them, and worse, blame the SEC.

  5. Richard Kline

    So Yves, your surmise of a steepening downhill slope under Madoff’s shoes from the bust gibes with my own first suspicion. But that can’t be all of it. He had this profile of too steady returns, secretive ‘investing’, and hovering questions/investigations/allegations about him. He reminds me, in his m.o., much of Robert Maxwell, who bought and ran profitable companies, but never hesitated to dip into assets and cash flows to tinker, invest, or paper over a bad patch of rot elsewhere in his web of deceit. I suspect Bernie Madoff got used to shifting money around under the table to make his numbers look good and keep his big time investors onboard and asleep long before things really went sour. —But then he took big losses, beyond what he could cover if he really had everyone cash out, and got desperate for outsize returns to catch-up. Of course that’s not in the cards, and once he cannibalized his investor base past a certain point, he could never possibly make it up. The guy must have known for four-five years how it was going to end, but he wouldn’t and couldn’t get off the train. Only the bubble ‘saved him,’ allowing him in the process to expend _all_ of his stakeholders stakes back in ‘profits’ rather than just one-third or one-half. What a story.

    And I have really no sympathy with anyone who lost money with him. His outfit stank, but no one was willing to ask any questions as long as their payment arrived and cleared, and he knew that very, very well. Now they know what it cost them.

  6. Anonymous

    Were there no independent audits of the funds ? Wow.

    How can our laws allow a firm to be a market maker or an exchange official, without routine oversite, review, and audit. Like a bank.

    This is another incredible story that illustrates how far the financial coup has been allowed to go. Frankly, external terrorism appears to be much less of a threat than our own government and business interests.

    What is really going on with the banking bailout ? There does not appear to be any oversite and the government is enforcing a veil of secrecy. A government version of the LIAR loans. How can Chrysler show up with it’s hand out and refuse to provide any financial disclosure ?

  7. John Haskell

    Yves and posters above:
    Please reconcile your "good guy gone bad" theory with the following facts:

    1. Freakish returns reported to "investors" in the early and mid 1990's, well before any dot com blowup;

    2. Refusal from the very start to manage any account that was not custodied at Madoff;

    3. Maintenance from the very start that he would not take 2&20 but only wanted "commissions on the trades."

    Take your time answering- you'll need it.

  8. Anonymous

    I keep reading in the press that Madoof was a “nice guy” Pulllease, he was a crook. This character used his rep as a former NASDAQ insider to manipulate the system for his own aggrandizement. Remember before the Mafia guy “offs” you he befriends you by telling you that you are going to be a “made guy”. Sheer nonsense about him being a “nice guy”

  9. Kevin de Bruxelles

    There will be a motive for some to claim Madoff was legit for as close to the present as possible. This is because anyone who recently redeemed investments would be required to return the money, since it would have resulted from fraud, subject to statute of limitations laws. Others will feel a cultural affinity towards Madoff; seeing his charitable work as expressing his true character instead of readinging it for the obvious façade building exercise the more cynical of us so clearly recognize.

    The sad truth is that Madoff is a sociopath, the financial world’s version of a Ted Bundy. Madoff was investigated for fraud in 1992, and escaped unscathed. With all we know today is it reasonable to doubt that this man has always been a criminal, a fraud, a schemer? It will be very interesting to find out exactly where he has stashed away portions of this $50 billion, and whether his sons know the where to find their inheritance.

  10. wondering

    How do people here react to Josh Marshall’s suspicion that “the difference between Madoff’s and the other investment implosions we’ve seen over recent months will turn out to be so clearly one of kind rather than degree…. was he another operator who was massively over-leveraged, made a bunch of bad calls (you don’t have to make many if your leverage is high enough), lost virtually everything but then was able to keep operating and taking in money and claiming high returns because he had such insanely tight control over his books?”

  11. Anonymous

    I’m with John Haskell on this one.

    1. As Andrew Lo of MIT has shown, lengthy monthly return series of linear consistency are provably false. Combine that with the fact that from the start Madoff insisted on custody of assets at his firm and you can see that there was nefarious intent from the start.

    2. Just because Madoff was a respected member of the NASDAQ market making community doesn’t mean much to me, ethics-wise. NASDAQ has always been a dog-eat-dog, wild west operation, particularly back in the early days of the 1970s and 1980s.

    Josh Marshall’s just totally out to lunch on this one.

  12. Roger Bigod

    John and Kevin,

    OK, I was a sentimental weenie with the good-guy-gone-bad theory. I guess I took too many liberal arts courses.

    It it was a scam from the beginning, even at my most gullible I have trouble with the idea that it was a one-man operation. Did he keep all the books and mail out all the checks? And the first time he was confronted, he calmly stated that it had all been a Ponzi scheme?

  13. Tiger Woods

    I agree with Anon of 4:57

    In early 2005, giving the industry a one-year heads up, the SEC mandated that all hedge funds with more than 14 clients or $25 million in AUM (I think those were the metrics) to register as a Registered Investment Advisor (RIA) by January 31, 2006. The deadline was later extended to Feb 28th, 2006.

    Not only was an SEC audit skipped within the first two years of registration, but Madoff’s fund didn’t become registered prior to the deadline. That, in and of itself, should have triggered an early audit. The SEC was also focused on size, with larger funds representing greater systemic risk. $17 billion was large enough to creat a second reason for an audit.

    At the time, I was running a $50 million hedge fund, registered by the deadline, and was audited only six weeks later. In general, the SEC was intent on quickly auditing a broad sweep of hedge funds, and staffed up to do so. It would have taken either extreme luck or political clout to get the hall pass that Madoff did from the SEC.

  14. Anonymous

    Anyone besides me wondering what Oliver North could have done with this kind of financial engineering, to fund black programs for his President? Wondering what little financial diversions for political or military secret work may turn up now as the swamp is effectively draining itself and all the muck is being exposed to light and air for the first time in fifty years?

    It’s probably about time for a Reichstag Fire if we’re going to see one.

  15. Anonymous

    The US government is corrupt as hell no surprise here it;s simply a banana republic run by the oligarchs, it has been for years and that will continue.

  16. Anonymous

    if the 50bn was used for paying out returns, eveybody has received their money back by now. although they are not as rich as thought they were, they maybe did not actually loose a lot

  17. Anonymous

    in fact, the oldest investors maybe still earned money. Imagine someone giving 1 mln to madoff 15 years ago, receiving a steady return of 100k (10%) each year, he reveived 1.5 mln after 15 years. He now finds out he lost his original million, but he might still have earned more money that investing that 1 mln in stocks or bonds 15 year ago.

  18. Anonymous

    From Fairfield Greenwich’s website concerning their due diligence process…..

    FGG’s Due Diligence Process

    FGG’s due diligence process is deeper and broader than a typical Fund of Funds, resembling that of an asset management company acquiring another asset manager, rather than a passive investor entering a disposable investment.

    A number of areas of inquiry are examined by a team of FGG professionals who specialize in evaluating respective areas of risk. Typically, a manager has been investigated and monitored for six to 12 months before that firm can be accepted onto the FGG platform. Long negotiating periods enable FGG to be more confident of its decisions before proceeding with a manager. Areas of examination are centered around the following:

    1. Portfolio Evaluation, Investment Performance, and Financial Risks:

    A core area for further analysis is to attempt to dissect and further understand investment performance, how a manager generates alpha, and what risks are taken in doing so. As portfolio management and risk management incorporate elements of both art and science, FGG applies both qualitative and quantitative measures. FGG:

    Examines independent prime broker trading records
    Conducts detailed interviews to better understand the manager’s methodology for forming a market view, and for selecting and exiting core positions
    Analyses trading records
    Conducts a number of qualitative and quantitative tests to determine adherence to risk limits over time
    Confirms portfolio loss risk controls, diversification and other risk-related control policies, as well as any experience regarding unexpected or extreme market events
    Reviews the risk and return factors inherent in the strategy
    Evaluates capacity issues, which may affect alpha, as well as expected opportunities going forward within each candidate’s strategy
    Analyses the various drivers underlying a particular portfolio’s risk
    Evaluates credit risk and market risk both at the instrument and portfolio level
    Assesses the extent to which leverage is used by a manager, as well as how it is used, the funding sources, and the impact on the risk profile of the fund
    Investigate whether or not private or special registration securities are held, and determine how the daily trading volume and inventory held compares to the float and/or daily trading volume for a given security
    FGG also conducts many quantitative reviews of investment performance in light of:

    Fees and fee structure
    Historical draw-downs
    Return volatility
    Commissions earned
    Performance return in calm versus volatile markets
    Current/historical correlation of the fund under consideration with standard industry benchmarks, peer groups, and other FGG or competitor funds used as benchmarks
    FGG attempts to understand the return attribution for individual securities in the portfolio, and conducts a full suite of VaR analyses and stress tests to model the loss distribution function under extreme market scenarios. Leverage, concentration limits, and long/short exposures are examined over time to assess whether they have remained within operating guidelines.

    Style fidelity is another key area of inquiry; the manager’s trading pattern over time and through various market environments, FGG determines whether the manager is prone to trade outside of their area of expertise.

    2. Personal Background Investigation:

    FGG examines the abilities and personalities of the individuals involved in managing the fund through extensive interviews, as well as background investigations.
    FGG verifies:
    Personal credit standing
    Litigation and regulatory background
    Track record
    Other indicators

    FGG explores the manager’s experience and qualifications relative to the strategy being managed. Prior professional associations of a manager’s key personnel can be crucial in understanding a person’s experience and character and how they run their investment management business.

    3. Structural and Operational Risk:

    “Operational risk” refers to the risk of loss resulting from inadequate or failed internal processes, human resources, or systems, or from external events. Operational failures, including misrepresentation of valuations and outright fraud, constitute the vast majority of instances where massive investor losses occur. Other operational risks include staff processing errors, technology failure, and poor data.

    Pricing models, as well as the adequacy, independence, and transparency of valuation procedures, contingency plans, and other trading and settlement procedures are all matters for close scrutiny by FGG professionals.

    FGG seeks a sound understanding of whether a hedge fund possesses key controls in the areas of portfolio management, conflicts of interest, segregation of duties, and compliance. FGG carefully assesses the controls and procedures that managers have in place and seek to determine actual compliance with those procedures, often suggesting modifications, separations of responsibilities, and remedial staff additions.

    4. Legal, Compliance, and Regulatory Risk:

    FGG’s legal, compliance, and accounting teams specialize in investment management regulation, securities compliance, corporate operations, and tax issues. Hedge fund managers function within an ever more complex legal and regulatory landscape, and the role of this part of the diligence exam is to determine the seriousness of any deficiencies in this area which may cause risk of sanction, loss, or reputational embarrassment.

    Both in-house and retained legal professionals interview the management and staff of the manager, research regulatory filings, and review corporate organizational documents, as well as fund memoranda and related material contracts.

  19. Anonymous

    There is too much in this story that doesn’t add up.

    Without anyone (SEC, FBI, etc.) suspecting a crime was being committed, Madoff confesses of committing a crime? And without any kind of investigation, they just happily charge him with committing a crime?

    Hundreds of men confessed to killing the Black Dahlia yet none of them were arrested. Merely confessing to a crime isn’t enough to get one charged with a crime. Where is the proof on this?

    And why would Madoff come out with this if he wasn’t under investigation? It just doesn’t make sense. There must be some payoff for Madoff for him to do what he did. Is he expecting a Bush pardon in a couple of weeks?


    How can you not feel sorry for the “rich” people who invested. Many of them are not economically educated and follow what friends or advisers say. How could an individual possible have known?
    This gives me no confidence in the Treasury dealing with something a bit larger – the US/world economy. These knuckleheads are going to do massive damage. Check out – it will make your day!

  21. Yves Smith

    Anon of 2:20 PM,

    Why did Madoff turn himself in? Presumably because he had or was about to run out of dough. If he was at all levered, he’d be sitting on losses, and if he had significant redemption notices (almost certain, even with his supposedly good returns because investors are hurting and are having to liquidate investments to pay bills of various sorts), he was going to be exposed. Indeed, the initial reports say that he tried siphoning the last bit off to employees and family (that would only have gotten everyone in hot water, not just Madoff, if they had spent the dough).

    As to the “lone wolf” theory, did you read the comments from the former employee? It appears he did not operate alone (duh), had compliant and overpaid operations staff for the fund. But that was a small portion of his operation, in terms of the number of bodies. They guys in his market-making and proprietary trading businesses were on a different floor, saw little of Madoff, not involved in the fund operations.

    As to the debate about “good guy, bad guy”, this reflects something called the halo effect. Studies have repeatedly shown that people have a propensity to seen individuals (and companies) as all good or all bad. Humans are disinclined to separate out attributes. For instance, our minds recoil at the idea that, say, someone could be great at mentoring his employees and give a lot to charity but beat his wife. Having learned that he beat his wife, most people would deny that he was generous in other aspects of his life (they’d portray it as a cynical cover-up of his home life).

  22. tompain

    Yves, I believe I may be able to shed some light on the apparent absence of a SEC inspection. Note that the exact wording from Bloomberg is that the SEC has not inspected him SINCE he made this particular unit subject to inspection in 2006. The way the SEC works is that they are only able to inspect entities that are subject to their jurisdiction. Madoff’s brokerage business would have been subject to inspection and may indeed have been inspected. But if the SEC showed up say in 2005 for inspection, and he had not registered this “asset management” unit yet, they would not have been able to require inspection of that unit. Had they wanted to inspect it, normally what they would do is ask him to voluntarily open it up. He could say no but that would be unwise. In any event, it is not necessarily surprising that the SEC had not been back in to inspect since the time of the unit’s registration. They might have inspected and been very satisfied with the brokerage business many times, and therefore they may not have put a high priority on a return visit just because the new unit had been recently registered – they would probably have figured they would take a look at it when they went back for the next routine visit, whenever that was going to be.

    The SEC does appear to be overwhelmed in its capacity to inspect newly registered firms. They have no choice but to prioritize because they don’t have the personnel to meet their target inspection timings.

  23. Yves Smith


    I welcome other reader comment, but the article indicates that newly registered investment advisers in their first year after registration. That schedule was clearly missed,

    I would be almost 100% certain that the SEC has different inspectors and timetables for broker-dealers. They have different compliance issues than investment advisers.

  24. tompain

    The SEC has a target of getting to new RIAs within a year. It doesn’t make that target – this is not really disputed – and it cannot do so with its current personnel. So instead what they do is prioritize who they ought to get to. If they already know that Madoff Securities has been visited in the past couple of years and passed with flying colors, and maybe has passed lots of other times with flying colors, it would make sense for them to decide that Madoff’s new investment mgmt unit was not a high priority. I don’t know whether they have different staffs but I do know that they coordinate on audits, ie when Madoff comes up for audit, they go audit whatever they want to audit, they don’t just say, “we are the brokerage guys, we will only look at the brokerage business, and the investment advisor guys will get around to that unit whenever they get around to it.” I know this first hand. If you work at a multi-unit fund, when the SEC shows up, they are just the SEC, not the SEC broker-dealer guys or the SEC investment management guys. They bring the team they need. They have researched who you are and what you do before they show up.

    Note that Madoff was primarily a broker dealer. He has this IM unit, but from what I have seen in the press he was not running a hedge fund (or at least the majority of the money was not in a hedge fund), but was instead running individual discretionary accounts. A hedge fund generally would have required an audit that probably would have caught the fraud. Discretionary accounts would not necessarily get audited that way.

    An SEC audit is not at all the same as a financial audit. I know it sounds crazy, but I would not assume that even an SEC audit of the IM business would have figured out that the assets just were not there. They ask you for records and they look at what you give them. They seem to focus on other stuff, from what I can tell. They obsess over “best execution” and whether you have properly disclosed everything you need to disclose to your investors.

  25. Anonymous

    Anon of 2:20,

    Madoff’s crowd (largely wealthy Jewish residents of Florida and New York) are by and large Democratic supporters, so what’s this about a Bush pardon?

    You can’t attribute everything bad to Bush, you know. I think you’ll miss him after he’s gone… you’ll have to think about why things happen instead of reflexively blaming the bogeyman.

  26. Yves Smith

    I have assumed Madoff was organized as a hedge fund because if he was an investment advisor, he would have been subject to the ’40 Act and subject to registration LONG ago. Anyone who knows any other ways Madoff might have been able to escape registration prior to 2006 is encouraged to speak up.

  27. tomatoe

    A letter posted by the NY Times (From Aksia to its clients) had this to say about Madoff's auditors:

    "The feeder funds had recognized administrators and auditors but substantially all
    of the assets were custodied with Madoff Securities. This necessitated Aksia
    checking the auditor of Madoff Securities, Friehling & Horowitz (not a fictitious
    audit firm). After some investigating, we concluded that Friehling & Horowitz
    had three employees, of which one was 78 years old and living in Florida, one
    was a secretary, and one was an active 47 year old accountant (and the office in
    Rockland County, NY was only 13ft x 18ft large). This operation appeared small
    given the scale and scope of Madoff’s activities."

  28. tompain

    Yves, I am just guessing, but I think that probably he was registered as broker dealer but somehow this new asset management unit was not. As I mentioned before, the wording of the press report is specific – that he was not visted by SEC SINCE the new unit has become registered. I have not seen a report so far that says he was not registered in any fashion with the SEC prior to 2006 – he had to have been registered as a broker, and if he wasn’t, we’d surely have heard about that by now. You can go on and look his firm up – if he was registered, he will be there.

    Note that, as reported, he apparently did not charge a management fee but instead ostensibly was getting paid (aside from stealing) from the brokerage commissions his trades were generating. He may have somehow relied on this absence of fee to somehow manipulate his registration requirements, perhaps saying that he was only a broker dealer and not an investment adviser. I am not sure about the rules but if you are say a Series 7 registered rep with discretionary authority, do you have to also be an RIA?

    There have been press reports saying he was not a hedge fund, and it seems to me that probably is the case, since normally a hedge fund would get an annual audit that would probably catch the fact that the money was missing. Also most hedge funds do not hold custody themselves, but instead engage a third party – often the prime broker – to be custodian.

  29. Yves Smith


    He absolutely had to be registered as a broker/dealer, but that is a separate legal entity.

    If he was managing money for more than a very small number of accounts (I believe the max is 10, but I am not current on the rules here), he HAD to register as an investment adviser. The only other option I can think of is that every one had a brokerage account under the b/d, but then they would have been included in the periodic SEC audits. By all accounts, the SEC did not supervise the investment operation until it registered (and then it did not get around to doing so until too late).

    The accounts have all said his investment management was physically and operationally separate from the b/d.

    The term “hedge fund” is used very loosely to refer to a 2 and 20 fee structure and other conventions, such as a monthly net asset value report.

    However, I am referring to the legal aspects of a hedge fund (the form of agreement with the customer, the legal domicile). He could have organized himself in a legal fashion that mimicked hedge funds to escape SEC registration requirements without having their fee structure or customary monthly reporting. In fact, the fund started when hedge funds were solely for the rich, and conventions were not as well defined as now.

    Put more simply, just because Madoff did not call himself a hedge fund or charge fees like one does not mean that he did not use a similar form of organization to avoid SEC registration. I am having trouble coming up with any other explanation as to how he could NOT have been registered prior to 2006.

  30. Tompain

    I understand what you are talking about.

    Madoff Securities has been a registered broker dealer since 1960.

    If he was a hedge fund, there has to be an offering document for those securities. That doc would have info about custody arrangments, audit requirements etc. What makes a fund a fund rather than a discretionary account is the creation of a security, usually but not always by commingling client funds and selling clients interest in a legal entity that will in turn hold other securities. The fact that you have created an entity to own the other securities, and then sold an interest in that entity, means that you have offered a security that would be subject to securities regulation.

    He is reported to have run discretionary brokerage accounts. These do not involve the creation of a new security. He may also have created a fund in addition to those discretionary accounts, perhaps with the intent of managing sums he deemed too small to merit individual management. I have seen no press reports to suggest that, so far.

    The ADV he filed when he became a RIA says that he has 23 clients and 17 billion under management. It also says that his sole form of compensation comes from commissions. We don’t know what happened to trigger his need to register as a RIA in September 2006, but we do know that he was managing discretionary money in large sums prior to that; that money was largely if not entirely in discretionary brokerage accounts rather than in a fund; he was for many years a registered broker dealer prior to registering as an RIA as well.

    You are required to register as an investment adviser if you give advice in exchange for compensation of any kind (among other criteria). However, there are exemptions. One exemption is if the investment advice is incidental to your business. This exemption is available to numerous types of other entities that are regulated in other ways. One of the types of entities that can use this exemption is a broker dealer.

    I suspect that Madoff took the position that since he was getting paid only via brokerage commissions he did not have to register as an RIA. the client each had a brokerage account, and Madoff’s brokers exercised discretion over them.

    As you point out, yes, then those accounts would have been included in the periodic SEC audits of the b/d operation. Sadly, that does not mean the SEC would have uncovered the fraud during those audits. The brokerage business was huge. It reportedly had EXCELLENT compliance in place and was viewed as squeaky clean (surely they went to a lot of trouble to ensure this). The SEC would have come in and checked on all the things it checks on for broker dealers. They might have seen this IM business as “incidental” and overlooked it entirely, or been provided fraudulent documentation etc.

    Again, I would highlight the fact that the SEC surely was in there to look at the broker dealer operation in the last few years. Knowing this, the SEC in 2006 might have seen this new IA registration, but figured “it’s a new entity being registered, but it’s not new to us because we were in there before and we know he does investment management and we know he is squeaky clean, so we should focus first on getting to all these new entities where we’ve never had anyone on site before.” Seems like a big mistake, but only if you assume that the fraud would have been caught in that audit, which I think is an errant assumption. Indeed, if I am right about the discretionary accounts, the SEC WAS in there while the fraud was taking place but still did not catch it. As I said before, this is not all that surprising. Based on my experience, that’s not what the SEC is focused on during the audit. Also, even if they are, it is easy enough to mislead them if you are ok with providing them false documents. Look, he was the custodian for the securities. There was no third party for the SEC to go to to check if the securities were there, even if they wanted to. Their job is to make sure he discloses he’s the custodian. He did – it’t right there in the ADV. Their job is to make sure he’s got processes and checks in place to ensure no one runs away with the securities. Ok, he shows them a bunch of processes and procedures, and some phony documents. What are they going to do, ask to see every stock certificate he is supposed to have? If fraud were so easy to uncover, it wouldn’t ever happen! It’s always obvious in hindsight (Enron, Worldcom, Tyco…) of course.

    The HUGE mistake that clients of Madoff made was to allow him to be the custodian. There’s just no reason for him to have insisted on this. However, it is not at all surprising that his clients – even if they were a bunch of “sophisticated” rich people – would not know the ins and outs of how assets ought to be custodied. All they knew is that their friends got 10%/yr every year and had always been able to get their money back when they asked for it. You can accuse them of willful ignorance, but I think simply ignorance fits the bill better.

    HOWEVER, the fund of fund guys who were invested with this guy are another story entirely. They themselves are at best utterly incompetent, or at worst guilty of fraud in claiming to do due diligence at all. These guys had enormous incentive to look the other way because the PERFECT fund for a FoF is one that delivers steady returns all the time. It delivers nice fees to the FoF manager with no complaints from the clients. My guess is that some of the FoF guys knew in their heart of hearts that something was wrong. They probably thought Madoff was just doing inside trading or something like that. I hope these leeches are sued for every penny of fees they ever took.

    BTW, I know of several hedge fund managers who did register when it looked like doing so was mandatory. Once registered, they stayed registered but many of them have not yet been visited by the SEC, a further demonstration of the fact that the SEC is currently unable to achieve the target it set for itself.

  31. Anonymous

    Off the record, I may be able to clarify a few points. tompain is correct, in that SEC examinations for combination broker-dealers and investment advisers (as well as investment companies) are combined. All relevant units of the company will typically be examined at the same time by a combined examination staff.

    I do not have any special information on why Madoff was not examined in 2006. As indicated, the goal is to have newly registered I/As examined in the first year. That examination, however, is typically a very short examination, just a day or two of interviews with key personnel to attempt to get a feel for the firm. The full examination typically does not come until later, some time within the next five years (sooner if there are risk indicators for the firm), when the heavy lifting of auditing documents happens.

    If there is one area that merits further attention, it is why Madoff did not have an examination in the first year. I do not know the answer to that, although I do know that it is under discussion at the SEC. I suspect, with tompain, that the New York office felt that they knew the company well enough, from their broker-dealer examinations, that they essentially had the information that would have been gathered in that first abbreviated exam. I also suspect that they simply scheduled the I/A unit for examination at the same time as the next scheduled B/D exam (routine practice), which would have probably been some time in the next couple of years.

    There is also the question of if they should have been registered earlier. I don’t know the full structure of Madoff’s firm, but I am to understand that a large number of the people for whom he was managing money had an informal arrangement–e.g., no investment advisory contract. In other words, the number of investment clients reported to the SEC (less than 20, if I recall) was a lie. People claiming he had managed money for them seem to be coming out of the woodwork; if he had been managing money for these people all along, and many of them do not qualify as “sophisticated” investors, he should have been registered long before now.

    So why did he not get examined in 2006, or why were there not questions about his management of other peoples’ money before then? The key issue is staffing. The SEC simply does not have the staff to examine every new I/A (or B/D or I/C) in the first year of registration, nor does it have the staff to go sniffing around for investment advisers doing business unregistered. It relies on complaints to generate leads–and in this case, the returns were good enough that there seem to have been very few complaints. But then, that’s how Ponzi schemes always work.

  32. dd

    Oh stop my aching sides from laughing. The Drexel audit of 25 years ago had the regional dweebs demanding an investigation but hey it went nowhere but DC who blocked the investigation jumped on the Levine train. The regions lost their independence and were captured by headquarters. Yeesh. The SEC was sold long ago. No surprises here.

  33. dd

    And yes there was a time when the SEC demanded every certificate, every trade ticket, every transfer order and then re-verified the transactions to establish the audit trail. The hard work of verification was painstaking, cost/benefit negative and effective. There were many of us who understand computer generated transactions were mere electrons until verified.

  34. Steve

    Bloomberg is reporting that Madoff “ran an unregistered money-management business alongside his firm's brokerage and investment-advisory units, two people with knowledge of the inquiry said.''

    “Clients of the undisclosed business appear to have included hedge funds…''

    Also: “People with knowledge of the probe who initially said they suspected the loss estimate was too high now say it may be roughly accurate.''

  35. Anonymous

    “The regions lost their independence and were captured by headquarters.”

    I wish you were right, but the reality is exactly the opposite; the regions are virtually independent of HQ and run their own operations, with HQ only playing a supporting role. Hopefully any regulatory overhaul will address that issue.

  36. Anonymous

    “Also, even if they are, it is easy enough to mislead them if you are ok with providing them false documents.”

    Documents provided by the registrant have to be cross-checked against documents from independent sources; ideally an independent custodian, but at least an independent audit.

    Look, he was the custodian for the securities. There was no third party for the SEC to go to to check if the securities were there, even if they wanted to . . . What are they going to do, ask to see every stock certificate he is supposed to have?

    Which is why custody of assets is a huge risk factor, and which is why there is a long list of potential issues to check for if an I/A has custody of client assets.

    But you are correct, the SEC cannot completely verify safety of client assets–which is why any investment adviser with custody is required to have a full independent annual audit; which gets back to the questions surrounding the accounting firm associated with Madoff. This is certainly an area that will merit further investigation. In any case, the SEC requires, and looks at, the independent audit as providing the verification necessary to ensure safety of client assets.

    I can’t say for certain if a full SEC examination would have caught the fraud. But I can say for certain that certain critical factors–custody of client assets, secrecy of operations, dominance of one individual within the firm–would have raised red flags.

  37. Anonymous

    Bernard Madoff is a stench in the nostrils of every decent law abiding investment professional.

    Madoff’s scam most likely began when he became fearful of losing his first big client and used another client’s money to pay the redemption. He soon became comfortable with his scam and used his stature to mask his crimes.

    Market regulators treated him as a “sacred cow” therefore he had no fear of being exposed. Madoff worked overtime to generate new clients. He had to hustle so Peter could rob to pay Paul.

    One day his luck run out and he started shitting in his pants. The markets tanked, his clients demanded their redemptions; the party was over.

    The ‘street’ will always attract other Madoffs. If it isn’t an advisory service it will be something else.

    The solution is for market regulators to do their duty.

    There is much truth to the old adage: “Bad things happen when good people look the other way”.

  38. tompain

    Yves, if ever a comment deserved immediate deletion from your site it is the one by Anon 10:32. One presumes you do not wish to provide a forum for racist slimeballs to air their repugnant views

  39. Richard Smith

    tompain – yup, bad stuff. His occasional stock tips aren’t so great either, but at least they’re worth hanging on to for comedy value.

  40. Anonymous

    There were no SEC inspectors. A senate panel held a hearing that included the usual suspects, Bernanki, Paulson SEC chairman COX, and an economist as ombudsman.

    In that hearing it was disclosed that COX cut back SEC auditors from 134 to just ONE in the SEC NYC office.

    Folks, I hate to rain on the parade of those pretending this is all the result of some organic cycle, over regulation, under regulation, or the always lame “too complicated” for the muggles who will be paying for this for generations to come.

    It was planned – like WMD in Iraq, like liquid bombs that were technically impossible from the get go to implement – to profit the few at the pain of the many.

    Welcome to the face of fascism sops! You have arrived and there is no intellectual rational or explanation that will make it better or help you get out. You should have been paying more attention a long time ago.

    There is nothing to understand except that we are stupid, disposable slaves of a machine we allowed. The SEC did not do this. The Fat cats with our treasure blinging the walls of their palaces did not do this. We did it. We confused assets with wealth and we have condemned ourselves to the FEMA camps.

    Welcome to our failure!

  41. Anonymous

    What is all the hub-bub about? In my business wanderings since 1975 in America and many parts of the World. This is SOP, from the top down. To get ahead you have to play lose with the law or even break it. It goes on everyday, fudged records on fleet vehicles (trucks and planes), all of sales(have to make my target) and so forth, its endless.

    The problem is not the system/s it’s, our species and our ability to be manipulated or forced to conform/adapt to survive from birth till death. Until we are willing to allow our selfs to be examined for disorders before becoming leaders were screwed.

    In a previous post, some one said, all university students must complete a liberal arts degree before setting off on other I agree. To manufacture creatures of profit with out the knowledge of the mistakes of mankind in History, is a big mistake.


  42. dd

    Anon at 12:22am you are dead wrong. Enforcement at the regional level was totally independent but had to await DC “comments” before moving cases forward. Now it’s under the Division of Enforcement umbrella. The Regional Administrators reported directly to the Commission now they are reduced to “Regional Directors” subjected the political nightmare that is DC. Before there were direct lines of access; now the politicos control it all. Give it a rest.

  43. Anonymous

    It is likely that Madoff fabricated trade confimations and statements and mailed them to the accounts over which he had power of attorney.
    Is there no standard method by which a regulator can verify that statements mailed by a registered broker dealer reflect the actual financial condition of the account? If so, how often are such checks performed. If not then the efficacy of the US financial regulatory system is fundamentally flawed.

  44. Anonymous

    A scam longer and bigger than Pnnzi.. He’ll get the new moniker.

    It is elitism and the effects with elitists’ halo effect.

    smart adviser

  45. Golden Bulls

    I recently got ‘laid-off’ so I started a new business.

    Unlike the SO smart and So rich people who got ‘Made-off’…SUCK-IT-UP.


    Hey you can buy some of my Bernie Madeoff’ art when you get a job.

  46. Hal

    The whole mess is astounding to me. Makes investing scary. So many well off people got snookered who you would think would have known better, so what’s a regular guy like me to do. I’m already spending enough time trying to make money but now I really don’t trust anyone to manage my investments.

    I think the whole things stinks to some of the highest levels of government to tell you the truth.

  47. Anonymous

    Agree with many comments posted already. This whole thing is very scary and Madoff should be locked up and the key thrown away!

    Thought would share a recent book I read on this subject called Hedge Fund Operational Due Diligence Understanding the Risk written by Jason Scharfman. It was a good interesting read related to this whole due diligence topic. Would recommend it!

    Maybe some Madoff lawyer will read it because it’s clear no one at the SEC would even bother to….

  48. Anonymous

    I can’t believe all this talk. This guy is very smart and knew how to use this system. He is a crook no matter how you look at it. Also someone had to turn their back or get paid off to look the other way on this fraud. Our government officials have been their too long. There need to be term limits for all memebers not just the President.

    So much corruption!!!!!

  49. HeroicLife

    The case of Bernie Madoff is a typical case study in how the SEC encourages fraud. Investors figured out that Madoff couldn’t possibly make the profits he claimed, and have been writing the SEC since 1999, urging them to put a stop to Madoff’s Ponzi scheme. However, Madoff used his close family ties to the SEC, and was instrumental in founding key regulatory bodies – and then nominated his family members to serve on their boards. When skeptical investors inquired about the irregularities in his fund, Madoff told them that the SEC had already investigated and cleared him over a period of three years.

  50. Eliot Bernstein / Iviewit

    Did I hear Proskauer Rose is involved in Madoff (involved many clients too) and acted as Allen Stanford’s attorney. Investors who lost money in these scams should start looking at the law firm Proskauer’s assets for recovery. First, Proskauer partner Gregg Mashberg claims Madoff is a financial 9/11 for their clients. Then, Proskauer partner Thomas Sjoblom former enforcement dude for SEC and Allen Stanford attorney, declares PARTY IS OVER to Stanford employees and advises them to PRAY, this two days before SEC hearings. Then at hearings he lies with Holt to SEC saying she only prepared with him but fails to mention Miami meeting at airport hanger. Then Sjoblom resigns after SEC begins investigation and sends note to SEC disaffirming all statements made by he and Proskauer, his butt on fire.

    Proskauer Rose and Foley and Lardner are also in a TRILLION dollar FEDERAL LAWSUIT legally related to a WHISTLEBLOWER CASE also in FEDERAL COURT. Marc S. Dreier is also a defendant in the Federal Case.

    The Trillion Dollar suit according to judge Shira Scheindlin is one of PATENT THEFT, MURDER AND A CAR BOMBING. For graphics on the car bombing visit

    The Federal Court cases

    United States Court of Appeals for the Second Circuit Docket 08-4873-cv – Bernstein, et al. v Appellate Division First Department Disciplinary Committee, et al. – TRILLION DOLLAR LAWSUIT

    Cases @ US District Court – Southern District NY

    (07cv09599) Anderson v The State of New York, et al. – WHISTLEBLOWER LAWSUIT

    (07cv11196) Bernstein, et al. v Appellate Division First Department Disciplinary Committee, et al.

    (07cv11612) Esposito v The State of New York, et al.,

    (08cv00526) Capogrosso v New York State Commission on Judicial Conduct, et al.,

    (08cv02391) McKeown v The State of New York, et al.,

    (08cv02852) Galison v The State of New York, et al.,

    (08cv03305) Carvel v The State of New York, et al., and,

    (08cv4053) Gizella Weisshaus v The State of New York, et al.

    (08cv4438) Suzanne McCormick v The State of New York, et al.

  51. Shock Exchange

    The media and the investment communities have focused on the details of “how” and “why” Madoff and Stanford orchestrated these schemes. The common thread amongst Madoff, Standford and Charles Ponzi (“Ponzi Scheme was named for him) is (i) they all offered returns to investors that was higher than the competition’s and was seemingly too good to be true, (ii) they had outsized reputations for business acument and (iii) they “looked the part”.

    Corporate swindlers succeed within Corporate America because they have what is known as “executive presence” and they prey on corporations’ penchant for looking only at the surface of things. If a group of innercity kids from Brooklyn can figure it out then why can’t adults? To learn more go to

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