Questions About The SEC And A Warning For Investors

The Bernard Madoff $50 billion scheme is, according to the SEC, unprecedented in size and duration. Perhaps what makes it all the more unbelievable is that it Mr. Madoff has for decades been a key Wall Street player, well known and trusted. All this raises many questions, not the least of which was: where was the SEC? It also raises a cautionary note for investors.

This scheme was not discovered by the SEC or federal prosecutors. By all accounts, it was virtually self-reported when Mr. Madoff confessed to associates and his sons. They apparently reported the alleged fraud to authorities. Now, the SEC has issued a press release and filed a law suit. Prosecutors have filed criminal charges as discussed here. Unfortunately, this all was too little, too late for the markets and the investors.

Why did the SEC just discover this massive fraud if it has been going on for years? This is not a scheme that the SEC had to look far to find. It was right in its own backyard. This scheme, according to court papers, was run out of the broker dealer that Mr. Madoff founded in New York City. Broker dealers are among the most heavily regulated businesses in the world, with an overlay of federal regulation by the SEC and oversight by self-regulatory organizations. All this regulation did not find the fraud.

By all accounts, Mr. Madoff ran what was in effect a multi-billion dollar fund like a secret hedge fund. According to the court papers, he managed it from a secret set of books he kept outside the normal broker dealer records. Those records were kept under lock and key. While it is not totally clear, it appears only he had access. While the contents of the records were secret, the fact that they existed was not. Secret records of billions of dollars in securities trades should have raised at least a red flag for the SEC and SRO officials even if the fund was unregulated. Apparently it did not.

There is more, however. For years, Mr. Madoff has had a secret investment strategy. Some called it a “black box.” For years, Mr. Madoff obtained returns with the “black box” that nobody could match for their consistency. Year in and year out, market up and market down, he reported steady profits. Rumors swirled about a trading method nobody quite understood and returns that no one could duplicate. Some raised questions about the trading technique and the authenticity of the results. No one investigated.
There is more, however. As early as 1992 Mr. Madoff and his secret, ultra-successful fund, came to the attention of the SEC. Then, his fund became entangled in an enforcement investigation. Everything was accounted for. No one investigated.

The red flags went unheeded. The rumors continued. The SEC and SROs were nowhere to be seen. Investors poured in the cash.

To be fair, Mr. Madoff had an impeccable reputation. His investors were happy. They got account statements every month and got paid when they asked. Still, secret books, billions of dollars, a black box trading scheme and results that could not be duplicated seem worth at least a look. Unfortunately nobody did – until way too late.

Now, investors in Mr. Madoff’s fund are now scurrying about to see what can be salvaged. Undoubtedly there will be lawsuits against many. What investors will recover is anyone’s guess at this point.

For all investors, no doubt their already shaken confidence from the current market crisis will only be further shaken by this incident. The failure of the regulators here clearly leaves questions about the billions of dollars invested in unregulated hedge funds. At the same time going forward investors should remember regardless of what the regulators do or don’t do, there is no substitute for skepticism: if the trading system cannot be understood there is a reason; if the returns are too good to be true, they probably are.