The SEC And The Madoff Scandal: Can The Commission Restore Confidence In Its Ability To Protect Investors?

Disclosures regarding the Madoff scandal continue to paint a grim picture for the SEC’s ability to fulfill its statutory obligations. The Senate banking committee sent the SEC an extensive document request in preparation for hearings about the agency’s role in the Madoff matter. What will be produced in response? At a minimum, the response should include documents from the 2006 informal inquiry opened to investigate claims that Mr. Madoff ran a Ponzi scheme and deceived the SEC staff which closed by the New York office after talking to Mr. Madoff and one of his largest hedge fund clients with a recommendation of no enforcement action.

The Senate hearings into what happed when the SEC investigated and inspected the operations of Mr. Madoff are beginning with a letter to the SEC by the Senate Committee on Banking, Housing and Urban Affairs. That letter, dated January 5, 2009, requests the production all document relating to prior SEC and FINRA examinations and investigations of Bernard L. Madoff, LLC (“BLM”) including: 1) complaint letters from market participants regarding Mr. Madoff and his operations; 2) a complete list of SEC and FINRA examinations of Mr. Madoff’s firm; 3) all internal communications regarding BLM; and 4) all e-mails between SEC staff and personnel at the Madoff firm.

What will the Committee find as a result of its document request? At a minimum, the Committee should review the opening and closing documents to a 2006 informal inquiry into BLM by the SEC’s New York office — and that will be more than enough to spark many questions about the SEC’s investigations.

The internal SEC documents from that investigation establish that that, beginning in January 2006, the SEC’s New York Regional Office opened and closed an investigation involving Bernard L. Madoff Securities LLC and two of its largest hedge fund clients. According to the Case Opening Report, the informal inquiry began with a report that BLM “operates an undisclosed multi-billion dollar investment advisory business … as a Ponzi scheme.” The evidence is from an undisclosed source who had provided helpful information in the past, according to the SEC documents.

Although the report from the confidential informant lacked detail, in view of the amounts involved, the staff obtained the production of documents BLM and the two hedge fund customers. Those customers were Fairfield Sentry Limited and Greenwich Sentry, L.P., affiliates of Fairfield Greenwich Group. In addition, a voluntary interview of a BLM officer was conducted.

Based on the then-available evidence, the Case Opening Report concludes that: (1) BLM was an undisclosed investment advisor to the hedge funds; (2) during an examination of BLM by the staff “Bernard L. Madoff — mislead the examination staff about the nature of the strategy implemented in the Sentry Funds’ and certain other hedge fund customers’ accounts, and [3] also withheld from the examination staff information about certain of these customers accounts … .” Finally, the report notes that BLM acted as an unregistered investment advisor to other hedge funds. This evidence warranted further inquiry according to the Case Opening Report.

The scope of the subsequent inquiry can be ascertained by reviewing the Case Closing Recommendation form which summarizes the available evidence and conclusions from the inquiry. Investigators took the informal testimony of two additional witnesses — Bernard Madoff and a representative of Fairfield. At that point, investigators recommended that the inquiry be closed.

The conclusions in the Case Closing Recommendation largely reiterate those from the Case Opening Report: 1) BLM acted as an investment advisor to certain hedge funds, institutions and high net worth individuals without complying with the registration requirements of the Investment Advisor’s Act; 2) Fairfield’s disclosures to its investors did not adequately describe BLM’s advisory role; and 3) during a recent examination of BLM by the New York Regional office, Mr. Madoff “did not fully disclose to the examination staff either the nature of the trading conducted in the hedge fund accounts or the number of such accounts at BLM.”

Despite finding violations of the federal securities laws and a lack of candor by Mr. Madoff, the report recommends that the inquiry be closed. This conclusion is based on the fact that BLM and Fairfield voluntarily remedied the violations and “because those violations were not so serious as to warrant an enforcement action.”

Neither the Case Opening Report nor the Case Closing Recommendation discusses the accusation by the confidential informant that the unregistered investment business of Mr. Madoff was a Ponzi scheme. In fact, the Ponzi scheme allegation in the Case Opening Report is not specifically mentioned or discussed in the Case Closing Recommendation. While that Recommendation does state that the confidential informant claimed the investment returns for hedge fund clients were the result of fraud, it does not discuss or analyze that allegation. Likewise, the Recommendation does not mention what investigative steps, if any, were taken to explore either the Ponzi scheme or fraudulent returns questions.

Even if these are the only documents furnished to the Committee, SEC officials will have more than enough questions to answer when they appear for testimony. And, perhaps more importantly, the SEC will have a lot to do to convince a panel of skeptical Senators and the investing public that it can in fact fulfill its statutory mandate and protect investors in the future.