Last week, we reported that Bernie Madoff once bragged that he was in the running to become head of the Securities and Exchange Commission. While future historians may argue about whether the disgraced financier and Ponzi schemer would have used his ill-gotten expertise to increase the SEC's effectiveness, there's little doubt that he had a very clear understanding of how it ran.
The SEC released a 477-page report late last week that explained how it had missed Madoff's massive fraud. In so doing, it also took the first institutional steps toward explaining the apparent incompetence of the two groups that should have caught on to Madoff's scheme: the government and the companies that fed him clients.
In the case of the government, the answer seems to be a combination of bureaucratic ineptitude and insufficient resources. This potent mix dates back to 1992, when the SEC launched its first investigation into Madoff's activities. At that time, it took action against two Florida accountants who were feeding him money but decided against investigating Madoff himself.
This pattern would be repeated again and again. In 2003, the SEC even received a tip that Madoff was running a Ponzi scheme -- yet it chose to investigate him on charges of "front running" stocks, because that was where the investigator's expertise lay. That's like a carpenter refusing to perform any task that requires a saw, because all he has is a hammer.
As time went on, Madoff's reputation itself became a barrier to investigation. Although a hedge fund decided to withdraw its money from Madoff in 2004, it didn't report its concerns about his business model, because surely the SEC had thoroughly vetted him.
While the SEC saw Madoff as a responsible investor, his perceptions were a little less clouded. In a phone call with Amit Vijay, chief risk officer of the Fairfield Greenwich Group, Madoff expressed his contempt for the SEC. On Wednesday, Massachusetts's secretary of state released a transcript of the conversation. Madoff states, right off the bat, "Obviously, first of all, this conversation never took place." He then goes on to tell his listener how to deal with SEC investigators, suggesting a low-key approach laced with humor: "They ask you a zillion different questions [...] and we laugh, and we say, 'Are you guys writing a book?'"
Madoff's strategy was to keep the risk officer in the dark. "The less you know about how we execute," he tells Vijay, "the better you are." He suggests that Vijay, if questioned, should allude to Madoff's reputation: "You [...] say, listen, Madoff has been in business for 45 years, you know, he executes, you know, a huge percentage of the industry's orders [...] We make the assumption that he's -- he's doing everything properly."
While this strategy apparently got Vijay off the hook with the SEC, it later ended up costing his firm $8 million. Earlier this week, the Commonwealth of Massachusetts settled with Fairfield on accusations that the company was basically acting as a feeder fund to Madoff.
The Vijay/Madoff transcript helps answer the most troubling question of the Madoff affair. the problem wasn't that nobody knew what Madoff was doing, but that those who should have known better did little or nothing. While the SEC ignored accusations that would have been difficult to investigate, people like Vijay -- who was tasked with protecting the safety of his clients -- were too busy making money to worry about where the money came from.
Take the first steps to building your portfolio.View Course »