SEC Must Defend Its Existence After Madoff Lapses

Date: Monday, January 5, 2009
Author: David Scheer, Bloomberg.com

The U.S. Securities and Exchange Commission may come under fire from lawmakers today for failing to quash Bernard Madoff’s alleged $50 billion Ponzi scheme after an investor alerted the agency to the suspected fraud.

The House Financial Services Committee is scheduled to hear from one of Madoff’s alleged victims, securities law experts and the SEC’s inspector general, David Kotz, who’s probing the agency’s handling of the matter. Harry Markopolos, the former money manager who says regulators didn’t act on his tips about Madoff, canceled his appearance.

“The SEC will have to defend its existence,” said Donald Langevoort, a former agency attorney who teaches securities law at Georgetown University in Washington. The meeting is “a way of sending a message to the SEC of Congress’s anger and dismay that this happened, especially given all the things that have happened in the last six to eight months,” such as the collapse of investment bank Lehman Brothers Holdings Inc., he said.

Markopolos, 52, a former chief investment officer at Rampart Investment Management in Boston, is now a financial fraud investigator for institutional investors. Other witnesses include Stephen Harbeck, president of Securities Investor Protection Corp.; Allan Goldstein, a retiree who invested with Madoff; Leon Metzger, a former executive with hedge-fund firm Paloma Partners LLC; and Boston University law professor Tamar Frankel.

Kotz is the only SEC employee set to testify. Markopolos withdrew, citing an illness, according to the office of Representative Barney Frank, the committee’s chairman. SEC spokesman John Nester declined to comment on the pending hearing.

‘Substantial Rewrite’

Madoff’s firm was examined at least eight times in 16 years by regulators following up on e-mailed tips that described his business practices as “highly unusual,” the Wall Street Journal reported earlier today. Madoff himself was interviewed at least twice by SEC officials, the newspaper said.

The hearing, scheduled for 2 p.m. in Washington, will help guide Congressional leaders as they weigh a “substantial rewrite of the laws governing the U.S. financial markets,” Representative Paul Kanjorski, a Pennsylvania Democrat who leads a subcommittee overseeing capital markets, said in a Dec. 31 statement. In a speech last month, President-elect Barack Obama said the Madoff scandal shows “how badly reform is needed.”

Whether the agency should be beefed up or dismantled will be a likely topic at meetings this year about the SEC’s future. “It would be a big mistake for the hearing to start focusing on throwing more money at the SEC, until the question has been answered about whether the agency is using the resources that it has adequately,” said Jacob Frenkel, a former SEC attorney now at Shulman Rogers Gandal Pordy & Ecker in Rockville, Maryland.

Free on Bail

Madoff, 70, was arrested Dec. 11 and charged at federal court in Manhattan with securities fraud after allegedly telling his sons his investment advisory business was a Ponzi scheme, in which early investors are paid with money from subsequent participants. Madoff is free on bail and hasn’t formally responded to the charges or entered a plea.

Madoff’s clients included banks, hedge funds, charities, universities and wealthy individuals. They had about $37 billion with Bernard L. Madoff Investment Securities LLC, according to a Bloomberg News tally of disclosures and press reports.

SEC Chairman Christopher Cox said Dec. 16 that he asked Kotz to review how the agency responded to tips about Madoff and to find ways to improve internal policies. The staff failed to act for almost a decade on “credible and specific” allegations and never recommended commissioners take action, Cox said. The SEC closed a Madoff probe in 2007 that Markopolos helped trigger.

Florida Accountants

The SEC’s investigators had a brush with Madoff in 1992 while suing two Florida accountants for allegedly selling $441 million in unregistered securities. The regulator, then headed by Republican Richard Breeden, said the accountants began raising money in 1962 and placing it with Madoff while promising investors returns of 13.5 percent to 20 percent, according to court documents obtained by Bloomberg.

Auditors hired to unravel the case asked Madoff for copies of account statements, which he provided, the records show. He wasn’t accused of wrongdoing.

Markopolos raised his concerns with an examiner in the SEC’s Boston office in 2000, saying that Madoff’s returns were too good to be true, and pressed the agency to scrutinize Madoff’s business until last year, the Wall Street Journal reported Dec. 18. In a 17-page memo from November 2005, three months after Cox became chairman, Markopolos laid out a list of “red flags,” and claimed Madoff must either be trading ahead of client orders, a practice known as front-running, or, more likely, running the world’s largest Ponzi scheme.

Front Running

SEC investigators in New York, where Madoff’s firm is based, focused on front-running, and after encountering obstacles didn’t finish verifying trades Madoff said were for advisory clients, a person with knowledge of the agency’s efforts said last month.

His company’s trades were cleared through a single account at Depository Trust & Clearing Corp., making it difficult to distinguish transactions specifically for Madoff’s advisory business, the person said.

Some transactions were completed through foreign brokerages, which meant the agency would have had to persuade other regulators to collect the data. Instead, SEC investigators closed the case in 2007 after Madoff agreed to register his investment advisory business.

The SEC was facing criticism before Madoff’s arrest. Last year’s collapse of investment banks Bear Stearns Cos. and Lehman Brothers tarnished the agency’s reputation as a market watchdog, and senators such as Connecticut Democrat Christopher Dodd and Iowa Republican Charles Grassley have questioned its vigilance in enforcing securities laws.

Cox, a Republican appointed by President George W. Bush, has said he will leave office at the end of the Bush administration. Obama on Dec. 18 announced his choice of brokerage regulator Mary Schapiro to succeed Cox.

To contact the reporters on this story: David Scheer in New York at dscheer@bloomberg.net; Ian Katz in Washington at ikatz2@bloomberg.net.