Bernard Madoff’s Ponzi scheme of the ages resulted in a sentence for the ages. Yesterday, after Mr. Madoff faced some of his victims for the first time, the court imposed the statutory maximum 150 year sentence. That sentence far exceeds the 12 years Mr. Madoff sought and even the 50 year recommendation of the federal probation department. It also far exceeds those handed down in other recent white collar cases, such as Jeffery Skilling of Enron and Bernie Ebbers of Worldcom, each of whom is serving 25 years.

The preliminary forfeiture order issued on Friday also dwarfs those in other actions. Under that order, Mr. Madoff will forfeit over $170 billion. His wife will be left with about $2.5 million, which could not be “sufficiently linked” to the fraud, according the U.S. Attorney’s Office. There is no assurance that the SEC or others may not try to attach the assets left with Mrs. Madoff, however.

The jail term and the forfeiture order confirm that Mr. Madoff will never leave prison and will not profit from his crimes beyond the lavish life style he enjoyed until caught. At the same time, the huge jail term and forfeiture order do not resolve the two key questions about the Madoff Ponzi scheme: 1) how did the SEC fail to uncover the massive fraud despite multiple opportunities? (2) who else was involved?

How the SEC failed to uncover the Madoff fraud is virtually impossible to understand. With multiple opportunities beginning as early as 1992, and a virtual road map to Madoff and his scheme as discussed here, the fraud should have been detected and the carnage stopped much earlier. To be sure, no law enforcement agency can halt fraud from the start. And, Ponzi schemes can be difficult to detect, although it is hard to make that argument given the number of these cases brought in recent weeks. In the case of Mr. Madoff however, the size and scope of the scheme coupled with the repeated opportunities and road map should have been more than sufficient.

The answer to this question is more than academic. It is fundamental to reforming and rejuvenating SEC enforcement. Perhaps the answer to this question will be in the forthcoming report of the SEC Inspector General who reportedly has interviewed Mr. Madoff.

Equally important is the question of who else was involved. The answer to this question is important to law enforcement and the victims. Law enforcement needs to unravel this issue not just to bring the appropriate actions, but as part of the self-evaluative process of how the scheme was missed earlier. The victims need to identify the other beneficiaries of the scheme to try and salvage some of their investment. It is clear that the Madoff Trustee will not recover anything close to the amount the investors lost. The number in the DOJ forfeiture order, while headline grabbing, has no relation to the amount of money available for investors who are faced with recovering cents on the dollar.

Mr. Madoff has steadfastly insisted that he acted alone. The size and scope of the fraud belie this claim. The cases brought to date against the auditors by DOJ and the SEC (discussed here) and two feeder funds by the SEC (discussed here) offer some insight into the Madoff scheme. The auditors were apparently paid for producing audit reports while doing virtually no auditing. The feeder funds were paid for soliciting investor cash and turning the money over to Mr. Madoff while doing no real investing or fund management. The formula is straight forward: assist Madoff, do little and get paid very well. It can be easy to turn a blind eye to what is really happening when there is so much money involved.

Just how many others prospered from Mr. Madoff’s fraud under this formula will be the subject of intense investigation in the coming weeks and months. The huge sentence yesterday closed one chapter of the Madoff saga. Key questions which must be answered for the benefit of everyone remain, however.

During the legislative hearings which lead to the passage of the Private Securities Litigation Reform Act of 1995 (“PSLRA”), Congress was repeatedly told that “the merits don’t matter” in private securities litigation. That settlements routinely occurred which were all out of proportion to the merits of the case. That even frivolous cases resulted in huge settlements because of the cost of litigation the potential liability if a case could reach the jury. A law review article cited in the legislative materials reflected this theme. Janet Cooper Alexander, Do The Merits Matter? A Study of Settlements in Securities Class Actions, 43 Stan. L. Rev. 497 (1991).

A recent stock manipulation case lost by the Commission raises this same question about SEC enforcement. The Commission’s case against former Morgan Stanley broker Richard Kwak is detailed in an article by Joe Nocera. “Chasing Small Fry, S.E.C. Let Madoff Get Away,” New York Times at B1 (June 27, 2009) (available here, registration required). According to the article, following a three year investigation, an enforcement action was brought against Mr. Kwak and seven others for stock manipulation. The manipulation supposedly involved the shares of Competitive Technologies, a company which marketed university patents. According to the SEC, the seven broker defendants engaged in coordinated trading to push up the price of the stock. While there were numerous phone calls back and forth among the group, there was no evidence about the conversations or if the calls were even received. Trading records did not substantiate the claims by the SEC of coordinated trading and the defendants ended up with huge losses.

Nevertheless, for the most part this case ended the way most SEC enforcement actions conclude: with settlements. Four of the defendants settled immediately. Three went to trial in 2007, including Mr. Kwak. Mr. Kwak and defendant Stephen Wilson were found not liable on one charge but the jury hung on a second. (A third defendant who did not have counsel lost). In 2008, Mr. Wilson was retried. The SEC lost. In March 2009, Mr. Kwak was retried. The SEC lost. Although Mr. Kwak won, he lost. Now he is out of the securities business, cannot get a job and is in debt from the legal fees.

Mr. Nocera points to this case as an example of the SEC only going after the small fish while not pursuing huge fraudsters such as Bernard Madoff. This is not the first time this question has been raised. To be sure, the point is worth considering.

The prosecution of Mr. Kwak raises a more fundamental question however: Do the merits matter in SEC enforcement? Every year the Commission brings hundreds of enforcement cases. Most settle. Pundits trying to gauge the success of the program look at the number of cases, the number of settlements and the amount of money extracted in those settlements. The meaning of those numbers is debatable at best, however.

In fact, far too often settlements obtained by the SEC are no different than those complained of during the 1995 congressional hearings on the PSLRA. Regulated entities such as brokers, investment companies and investment advisers rarely litigate with the SEC. Public companies almost never litigate with the Commission. Rather, a business judgment is made about the impact of the continuing litigation on the company, the adverse publicity, the potential effect on credit lines and customers, the lost executive time and a host of other business factors. In the end, the company decides that the only prudent business decision is to settle on whatever terms the SEC is offering. Litigating with the Commission simply is not a option.

For individuals it is not much different. Again virtually all of the cases settle. Few individuals can afford to litigate with the Commission absent an indemnification from the company or a D&O policy to pay the legal fees. As Mr. Kwak’s case illustrates, winning without such coverage can be losing. Even where there is coverage for the legal fees, executives are often reluctant to litigate. More typically a business decision is made that it is better for the company and the individual to get the deal done and move on.

To be sure the SEC views its actions as meritorious and based on fact. No doubt many have merit and the settlements do in fact reflect the facts. As Mr. Kwak’s case illustrates however — and it is not an isolated instance — sometimes the Commission’s cases do not reflect the facts. This happens not so much because of a bent to pick on small fish as Mr. Nocera suggests, but perhaps because of the way enforcement operates.

In Enforcement, the facts are typically gathered by the junior staff members who are the least experienced. The evidence is summarized in an Action Memorandum which is reviewed by supervisors, senior staff and ultimately set to the Commission to approve the institution of an action. This means that the actual evidence is frequently only reviewed by the junior most members of the Enforcement Division. As a GAO report issued in March 2009 suggests (discussed here), the Division of Enforcement is top heavy with layers of supervisors. Those supervisors spend their time reviewing memos and attending meetings where they are briefed, not reading evidence. Under this system, it is not to hard to see how a case is brought against someone like Mr. Kwak alleging “coordinated trading” — a buzz phrase in manipulation cases — when in reality the facts only show “coordinated phone calls.”

Once the case is brought, little changes. While the SEC typically files lengthy “speaking complaints” it is not unusual for the agency to gloss the facts regarding key elements with conclusions such as “the defendant transmitted material nonpublic information” or the defendants “engaged in coordinated trading” rather than reciting the actual facts. Stock phrases such as these are substituted for facts — a pleading technique which can conceal the fact that the SEC is inferring that the claimed event happened, but has no hard evidence to support its supposition.

In a private securities action under the PSLRA a plaintiff would not be permitted to use this pleading technique — the court would demand the facts or dismiss the case. While the PSLRA does not apply to the SEC, the agency is supposed to plead fraud with particularity under Rule 9(b). More often than not however courts do not rigorously apply that standard to the SEC, despite the fact that the agency should have the facts from its typically lengthy investigation. All of this encourages settlement for the came reason the private cases settle — years of discovery takes its toll in cost and many other ways.

In revamping and rejuvenating enforcement the new Chairman and her team should begin by making sure that the merits do matter — return to basics, focusing on the evidence. Reorganizing the Division should start by getting staff members out of meetings and down in the trenches, reviewing the actual documents and analyzing the testimony. Equally important is a meaningful dialogue during the Wells process as the case moves toward a prosecutorial decision. In that process, the merits should be carefully considered and evaluated by both sides rather than just rushing forward to settlement.

In the end, the only way to ensure that the resolution of a Commission enforcement action reflects the merits is if the facts are the key focus starting from the Director’s office on down through the Division. The chairman reportedly has a sign on her office door which says “how does it help investors?” Perhaps the Enforcement Director should have one which say “what are the facts?”