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Why the Sec Failed to Uncover the Madoff Fraud Essay

The topic for my research paper is Why the SEC failed to uncover the Madoff fraud. I believe this topic is important to the accounting world due to the fact that this has been going on for 80 or 90 years. Even though there have been well known ponzi schemes, this type of fraud still persist. It is important for the accounting industry to be aware of this type of fraud in order to prevent it in the future. The Madoff fraud is the biggest so far even though people had been warning the SEC for years. I believe I will find in researching this subject the historical basis for the Ponzi scheme. How it has developed over time and the methods used to detect it today. I will also look at how the various government agencies are investigating and dealing with this type of fraud. I will start with a history of the Ponzi scheme leading up to Bernie Madoff. The $50 billion Ponzi scheme allegedly masterminded by former Nasdaq chairman Bernard Madoff punctuated a miserable year for Wall Street in the worst possible way: by underlining, yet again, that savvy market-makers can harness arcane financial instruments as weapons of mass destruction.

Left in Madoff’s wake are bankrupt investors, mortified regulators and a raft of unnoticed red flags. Madoff’s methods previously had been investigated by the SEC, and in 2001, a prescient article raised questions about his inscrutable strategies. But for investors pocketing windfalls, the lure of easy money outstripped suspicions raised by Madoff’s shroud of secrecy. When that shroud was lifted, however, Madoff’s investment fund stood revealed as a classic Ponzi scheme: a con game in which the illusion of solvency was created by paying off early investors with capital raised from later entrants. As long as new investment continued to come in the door, the earlier adopters reaped fat rewards; once markets tumbled and investors withdrew, however, the whole thing collapsed like a house of cards.

Though a Boston businessman named Charles Ponzi was the scam’s namesake, he wasn’t its original practitioner. The reigning king of the “rob Peter to pay Paul” scam was a New York grifter named William Miller, who bilked investors out of $1 million — nearly $25 million in today’s dollars — in 1899. After drumming up interest by claiming to have an inside window into the way profitable companies operated, Miller — who earned the nickname “520 percent” due to the astonishing rate of return he promised investors over the course of a year — salted his scam by paying out the first few investors. After his racket was exposed by a newspaper investigation, he was sentenced to 10 years in prison. His creditors got just 28 cents back for every dollar they’d invested.

Ponzi was a charismatic Italian immigrant who, in 1919 and 1920, coaxed thousands of people into shelling out millions of dollars — including a staggering $1 million in a single three-hour period — to buy postage stamps using international reply coupons. This strategy, Ponzi promised, enabled one to purchase postage at European currencies’ lower fixed rates before redeeming them in U.S dollars at higher values. A person could buy 66 International Reply Coupons in Rome for the equivalent of $1. Those same 66 coupons would cost $3.30 in Boston, where Ponzi was based. But there weren’t enough coupons in circulation to make the plan workable. The ploy bore the hallmarks of both Miller’s scheme and others to follow it: it trumpeted the possibility of massive gains (Ponzi promised a 50% return in just 90 days), parried questions about its legitimacy by paying out the first few investors, and collapsed when Ponzi couldn’t rustle up enough fresh marks to keep up with the money going out the door.

Ponzi, who was released from prison and deported back to Italy in 1934, set the standard in the genre. But the golden age of Ponzi and pyramid schemes didn’t arrive for decades. (The two highly similar cons are often conflated, though in Ponzi schemes, a ringleader facilitates the entire enterprise; in a pyramid scheme, rungs of collaborators recruit new investors.) In the boom years of the 1980s and ’90s, as traders developed increasingly sophisticated investment vehicles, the cons cropped up with increasing regularity. In 1985, a San Diego currency trader named David Dominelli was revealed to have fleeced more than 1,000 investors to the tune of $80 million. During the 1990s, a Florida church called Greater Ministries International bilked nearly 20,000 people out of $500 million in a pyramid scheme hatched by leader Gerald Payne, who claimed God would double the money of pious investors. (Dominelli pleaded guilty and was sentenced to 20 years in prison, while Payne was convicted and sentenced to 27.)

The spate of incidents wasn’t limited to the U.S., either. When communism crumbled in Eastern Europe, one of the earliest side effects of free-market capitalism was the proliferation of people looking to get rich quick. In Albania, under Communism the poorest nation in Europe, citizens sank some $1.2 billion dollars into pyramid schemes in 1996. When they collapsed the following year, investor outrage brought down the government. This ignominious group has had some high-profile recent entrants, including Democratic fundraiser Norman Hsu, who was charged in October with operating a $60 million Ponzi fraud, and former boy-band impresario Lou Pearlman, who in addition to foisting N’Sync on an unsuspecting public also stole $300 million in investor capital over two decades. Minnesota businessman Tom Petters was indicted by a federal grand jury on 20 counts of fraud, conspiracy and money laundering stemming from his alleged role in a 13-year, $3.5 billion Ponzi ring. Still, the $50 billion fraud Madoff allegedly perpetrated is the most egregious Ponzi scheme to date. | I will now look at who Bernard L. Madoff, is and why the SEC failed to uncover this fraud.

Bernard L. Madoff is currently serving a 150-year sentence in federal prison, orchestrated a multi-billion dollar Ponzi scheme that swindled money from thousands of investors. Unlike the promoters of many Ponzi schemes, Madoff did not promise spectacular short-term investment returns. Instead, his investors’ phony account statements showed moderate, but consistently positive returns — even during turbulent market conditions. In December 2008, the SEC charged Bernard Madoff and his investment firm, Bernard L. Madoff Investment Securities LLC, with securities fraud for the multi-billion dollar Ponzi scheme he perpetrated on advisory clients of his firm for many years. The SEC filed emergency motions to freeze assets and appoint a receiver, and worked to return as much money as possible to harmed investors. Madoff had been a prominent member of the securities industry throughout his career.

He served as vice chairman of the NASD, a member of its board of governors, and chairman of its New York region. He was also a member of NASDAQ Stock Market’s board of governors and its executive committee and served as chairman of its trading committee. Madoff founded his investment advisory firm in 1960. After the Madoff fraud came to light and through subsequent investigations, it was found that between June 1992 and December 2008 when Madoff confessed, the SEC received six substantive complaints that raised significant red flags concerning Madoff’s hedge fund operations and should have led to questions about whether Madoff was actually engaged in trading. Finally, the SEC was also aware of two articles regarding Madoff’s investment operations that appeared in reputable publications in 2001 and questioned Madoff’s unusually consistent returns.The first complaint, brought to the SEC’s attention in 1992, related to allegations that an unregistered investment company was offering “100%” safe investments with high and extremely consistent rates of return over significant periods of time to “special” customers.

The SEC actually suspected the investment company was operating a Ponzi scheme and learned in their investigation that all of the investments were placed entirely through Madoff and consistent returns were claimed to have been achieved for numerous years without a single loss.The second complaint was very specific and different versions were provided to the SEC in May 2000, March 2001 and October 2005. The complaint submitted in 2005 was entitled “The World’s Largest Hedge Fund is a Fraud” and detailed approximately 30 red flags indicating that Madoff was operating a Ponzi scheme, a scenario it described as “highly likely.” The red flags included the impossibility of Madoff’s returns, particularly the consistency of those returns and the unrealistic volume of options Madoff represented to have traded.In May 2003, the SEC received a third complaint from a respected Hedge Fund Manager identifying numerous concerns about Madoff’s strategy and purported returns, questioning whether Madoff was actually trading options in the volume he claimed, noting that Madoff’s strategy and purported returns were not duplicable by anyone else, and stating Madoff’s strategy had no correlation to the overall equity markets in over 10 years.

According to an SEC manager, the Hedge Fund Manager’s complaint laid out issues that were “indicia of a Ponzi scheme.”The fourth complaint was part of a series of internal e-mails of another registrant that the SEC discovered in April 2004. The e-mails described the red flags that a registrant’s employees had identified while performing due diligence on their own Madoff investment using publicly-available information. The red flags identified included Madoff’s incredible and highly unusual fills for equity trades, his misrepresentation of his options trading and his unusually consistent, non-volatile returns over several years. One of the internal e-mails provided a step-by-step analysis of why Madoff must be misrepresenting his options trading. The e-mail clearly explained that Madoff could not be trading on an options exchange because of insufficient volume and could not be trading options over-the-counter because it was inconceivable that he could find counterparty for the trading. The SEC examiners who initially discovered the e-mails viewed them as indicating “some suspicion as to whether Madoff is trading at all.”The fifth complaint was received by the SEC in October 2005 from an anonymous informant and stated, “I know that Madoff [sic] company is very secretive about their operations and they refuse to disclose anything.

If my suspicions are true, then they are running a highly sophisticated scheme on a massive scale. And they have been doing it for a long time.”The sixth complaint was sent to the SEC by a “concerned citizen” in December 2006, advising the SEC to look into Madoff and his firm as follows: Your attention is directed to a scandal of major proportion which was executed by the investment firm Bernard L. Madoff . . . . Assets well in excess of $10 Billion owned by the late [investor], an ultra-wealthy long time client of the Madoff firm have been “co-mingled” with funds controlled by the Madoff company with gains thereon retained by Madoff. In March 2008, the SEC Chairman’s office received a second copy of the previous complaint, with additional information from the same source regarding Madoff’s involvement with the investor’s money, as follows: It may be of interest to you to that Mr. Bernard Madoff keeps two (2) sets of records.

The most interesting of which is on his computer which is always on his person.The two 2001 journal articles also raised significant questions about Madoff’s unusually consistent returns. One of the articles noted his “astonishing ability to time the market and move to cash in the underlying securities before market conditions turn negative and the related ability to buy and sell the underlying stocks without noticeably affecting the market.” This article also described that “experts ask why no one has been able to duplicate similar returns using [Madoff’s] strategy.” The second article quoted a former Madoff investor as saying, “Anybody who’s a seasoned hedge-fund investor knows the split-strike conversion is not the whole story. To take it at face value is a bit naïve.” The complaints all contained specific information and could not have been fully and adequately resolved without thoroughly examining and investigating Madoff for operating a Ponzi scheme.

The journal articles should have reinforced the concerns about how Madoff could have been achieving his returns.The results of these complaints were that the SEC conducted two investigations and three examinations related to Madoff’s investment advisory business based upon the detailed and credible complaints that raised the possibility that Madoff was misrepresenting his trading and could have been operating a Ponzi scheme. Yet, at no time did the SEC ever verify Madoff’s trading through an independent third-party, and in fact, never actually conducted a Ponzi scheme examination or investigation of Madoff.The first examination and first Enforcement investigation were conducted in 1992 after the SEC received information that led it to suspect that a Madoff associate had been conducting a Ponzi scheme. Yet, the SEC focused its efforts on Madoff’s associate and never thoroughly scrutinized Madoff’s operations even after learning that the investment decisions were made by Madoff and being apprised of the remarkably consistent returns over a period of numerous years that Madoff had achieved with a basic trading strategy.

While the SEC ensured that all of Madoff’s associate’s customers received their money back, they took no steps to investigate Madoff. The SEC focused its investigation too narrowly and seemed not to have considered the possibility that Madoff could have taken the money that was used to pay back his associate’s customers from other clients for which Madoff may have had held discretionary brokerage accounts. In the examination of Madoff, the SEC did not seek Depository Trust Company (DTC) (an independent third-party) records, but sought copies of such records from Madoff himself. Had they sought records from DTC, there is an excellent chance that they would have uncovered Madoff’s Ponzi scheme in 1992.In 2004 and 2005, the SEC’s examination unit, OCIE, conducted two parallel cause examinations of Madoff based upon the Hedge Fund Manager’s complaint and the series of internal e-mails that the SEC discovered.

The examinations were remarkably similar. There were initial significant delays in the commencement of the examinations, notwithstanding the urgency of the complaints. The teams assembled were relatively inexperienced, and there was insufficient planning for the examinations. The scopes of the examination were in both cases too narrowly focused on the possibility of front-running, with no significant attempts made to analyze the numerous red flags about Madoff’s trading and returns. During the course of both these examinations, the examination teams discovered suspicious information and evidence and caught Madoff in contradictions and inconsistencies. However, they either disregarded these concerns or simply asked Madoff about them. Even when Madoff’answers was seemingly implausible, the SEC examiners accepted them at face value.In both examinations, the examiners made the surprising discovery that Madoff’s mysterious hedge fund business was making significantly more money than his well-known market-making operation.

However, no one identified this revelation as a cause for concern. Astoundingly, both examinations were open at the same time in different offices without either knowing the other one was conducting an identical examination. In fact, it was Madoff himself who informed one of the examination teams that the other examination team had already received the information they were seeking from him. Both examinations concluded with numerous unresolved questions and without any significant attempt to examine the possibility that Madoff was misrepresenting his trading and operating a Ponzi scheme. The investigation that arose from the most detailed complaint provided to the SEC, which explicitly stated it was “highly likely” that “Madoff was operating a Ponzi scheme,” never really investigated the possibility of a Ponzi scheme.

The relatively inexperienced Enforcement staff failed to appreciate the significance of the analysis in the complaint, and almost immediately expressed skepticism and disbelief. Most of their investigation was directed at determining whether Madoff should register as an investment adviser or whether Madoff’s hedge fund investors’ disclosures were adequate. As with the examinations, the Enforcement staff almost immediately caught Madoff in lies and misrepresentations, but failed to follow up on inconsistencies. They rebuffed offers of additional evidence from the complainant, and were confused about certain critical and fundamental aspects of Madoff’s operations. When Madoff provided evasive or contradictory answers to important questions in testimony, they simply accepted as plausible his explanations. Although the Enforcement staff made attempts to seek information from independent third-parties, they failed to follow up on these requests.

They reached out to the NASD and asked for information on whether Madoff had options positions on a certain date, but when they received a report that there were in fact no options positions on that date, they did not take any further steps. An Enforcement staff attorney made several attempts to obtain documentation from European counterparties (another independent third-party), and although a letter was drafted, the Enforcement staff decided not to send it. Had any of these efforts been fully executed, they would have led to Madoff’s Ponzi scheme being uncovered.The Enforcement staff effectively closed the Madoff investigation in August 2006 after Madoff agreed to register as an investment adviser. They believed that this was a “beneficial result” as once he registered, “he would have to have a compliance program, and he would be subject to an examination by our [Investment Adviser] team.”

However, no examination was ever conducted of Madoff after he registered as an investment adviser.After Madoff was forced to register as an investment adviser, the Enforcement investigation was inactive for 18 months before being officially closed in January 2008. A couple of months later, in March 2008, the Chairman’s office received additional information regarding Madoff’s involvement with the investor’s money from the same source. The previous complaint was re-sent. This updated complaint was forwarded to the Enforcement staff that had worked on the Madoff investigation, but immediately sent back, with a note stating, in pertinent part, “[W]e will not be pursuing the allegations in it.”As the foregoing demonstrates, despite numerous credible and detailed complaints, the SEC never properly examined or investigated Madoff’s trading and never took the necessary, but basic, steps to determine if Madoff was operating a Ponzi scheme.

Had these efforts been made with appropriate follow-up at any time beginning in June of 1992 until December 2008, the SEC could have uncovered the Ponzi scheme well before Madoff confessed?The results of these investigations were that the SEC itself was investigated for its mishandling of this case. These are the results of that investigation. The OIG investigation found that the SEC received numerous substantive complaints since 1992 that raised significant red flags concerning Madoff’s hedge fund operations and should have led to questions about whether Madoff was actually engaged in trading and should have led to a thorough examination and/or investigation of the possibility that Madoff was operating a Ponzi scheme. However, the OIG found that although the SEC conducted five examinations and investigations of Madoff based upon these substantive complaints, they never took the necessary and basic steps to determine if Madoff was misrepresenting his trading.

We also found that had these efforts been made with appropriate follow-up, the SEC could have uncovered the Ponzi scheme well before Madoff confessed.The OIG found that the conduct of the examinations and investigations was similar in that they were generally conducted by inexperienced personnel, not planned adequately, and were too limited in scope. While examiners and investigators discovered suspicious information and evidence and caught Madoff in contradictions and inconsistencies, they either disregarded these concerns or relied inappropriately on Madoff’s representations or documentation in dismissing them.

Further, the SEC investigators and examiners failed to understand the complexities of Madoff’s trading and the importance of verifying his information with third parties.The OIG did not find the failure of the SEC to uncover Madoff’s Ponzi scheme was related to the misconduct of a particular individual or individuals, and found no inappropriate influence from senior level officials. We also did not find that any improper professional, social or financial relationship on the part of any current or former SEC employee impacted the examinations or investigations. Rather, there were systematic breakdowns in the manner in which the Sec conducted its examinations and investigations, and for that reason, the OIG is issuing under separate cover two audit reports providing the SEC with specific and concrete recommendations to improve the operations of both OCIE and Enforcement. |

References:
http://www.irs-taxes.org/1320/madoff-trustee-irs-set-pact-on-bogus-taxes/ http://money.cnn.com/2011/11/23/news/companies/madoff_ponzi/index.htm http://www.sec.gov/answers/ponzi.htm
http://www.time.com/time/business/article/0,8599,1866680,00.html#ixzz1gjEKtMtd http://www.sec.gov/news/studies/2009/oig-509.pdf


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