Wall Street's regulator: Asleep at the wheel?

The scale of Bernard Madoff's alleged fraud has shocked investors, who are already demanding to know how US regulators could have let it happen. Stephen Foley reports

December 18, 2008

"Madoff Securities is the world's largest Ponzi Scheme." This was the conclusion of the Securities and Exchange Commission, Wall Street's regulator, when it charged Bernard Madoff with a fraud of $50bn (£32.2bn) proportions last Thursday, a day after the veteran trader's sons called the police and turned him in.

But hang on, the quote is not from the SEC. It is from Harry Markopolos, a fast-talking Boston accountant, from a letter he wrote to the SEC in 1999 after he began snooping around Mr Madoff's firm. Mr Markopolos wrote again and again – but for nine years, the SEC failed to investigate and failed to uncover what now looks like the biggest scam in Wall Street's history.

To say the failure is an embarrassment would be to understate it. For an organisation already fighting for its survival, and assailed for facilitating the Wall Street free-for-all that has now trashed the credit markets, this is a new crisis it could do without.

Little wonder that SEC chairman Christopher Cox has got out the cat o' nine tails for a little self-flagellation. (Strictly, not self-flagellation. He is casting blame not on the politically appointed commissioners but on full-time staff members.)

"The commission has learnt that credible and specific allegations regarding Mr Madoff's wrongdoing, going back to at least 1999, were repeatedly brought to the attention of SEC staff, but were never recommended to the commission for action," he said. "I am gravely concerned by the apparent multiple failures over at least a decade to thoroughly investigate."

Mr Markopolos is something of a character in the Boston finance industry, an accountant famed for his analytical skill, who worked until 2004 at local investment management firm Rampart. He first looked into Mr Madoff's trading strategies in 1999, when Rampart was considering a rival investment product, and decided the returns Mr Madoff claimed were too good to be true.

In 2005, he wrote again to the SEC. According to the Wall Street Journal, which has seen the letters, he said: "Bernie Madoff's returns aren't real and, if they are, then they would almost certainly have been generated by front-running customer order flow from the broker-dealer arm of Madoff Investment Securities." He last wrote as recently as last year. The SEC conducted two minor investigations of the broker-dealer business but never ventured on to the other floor of Midtown Manhattan's lipstick-shaped skyscraper, where Mr Madoff kept his investment management operations. It was here, under lock and key, that he kept his records – the real accounts and the fictitious set he showed to investors. The fraud was a classic Ponzi scheme, Mr Madoff confessed last week. Old investors were paid using money from new ones. The returns were "all just one big lie" and now, with investors clamouring for their money, there is nothing left. Giant banks, august hedge funds, private investors and struggling charities are all nursing catastrophic losses. And it all happened under the SEC's nose.

Now a furious Congress is asking to examine the watchdog's teeth. There will be hearings in the House of Representatives, and the Senate's banking committee has asked for an independent investigation. Wall Street fears a regulatory crackdown similar to that which came out of Congress in the wake of the collapse of Enron.

Jack Reed, a Democrat senator, offered a taste of what's to come yesterday. "Chairman Cox was carrying out the intent of the President, which was basically, give everyone wide latitude and let the markets rule," he said. He is seeking speedy recommendations on improving regulation.

"These events have only further weakened already battered investor confidence in our securities markets," said Paul Kanjorski, who chairs a House committee on the capital markets. "And they have raised even more troubling questions about the effectiveness of our regulatory system." Republican senator Chuck Grassley said the SEC had "failed the American people".

The investigations into the SEC's role will examine whether a certain chumminess between Mr Madoff and his regulators led them to take too much on trust. In a career spanning almost five decades he had become a Wall Street grandee, a major force in the foundation of the Nasdaq stock market and its former chairman.

His reputation for speaking his mind made him a go-to guy when the SEC was examining regulatory issues surrounding electronic trading. He even served on one of its advisory panels.

At the very least, the investigations will touch on the debate about "regulatory capture", which has raged during the implosion of the credit markets. Academics have argued that the close contact between regulator and regulated creates a "groupthink", while the regulated industry spends time heavily lobbying for a particular kind of regulation that has no counter-balancing lobbying from outside.

At a business round-table meeting last year, Mr Madoff boasted of his relationship with the SEC. "There's always this friction between the regulation side of the industry and the practitioners about where you draw the line. I'm very close with the regulators, I'm not trying to say what they do is bad – as a matter of fact, my niece just married one."

That marriage is now going to be part of the internal investigation that Mr Cox promised on Tuesday. Shana Madoff, the niece, worked in her uncle's business as a compliance lawyer. Last year, she married Eric Swanson, who was until 2006 an SEC attorney in charge of overseeing stock exchange regulation of electronic trading. His team carried out one of the investigations into her uncle's firm, although the couple began dating later, his representatives said. Mr Cox has demanded that "any SEC staff who have had more than insubstantial personal contacts with Mr Madoff or his family" recuse themselves from the investigation. In a parallel development yesterday, the US attorney general, Michael Mukasey, removed himself from the Department of Justice criminal investigation because his son, Marc, is representing Frank DiPascali, a senior official at Mr Madoff's firm.

Although the broker-dealer arm of Madoff Investment Securities has always been registered with and regulated by the SEC, the investment arm was not required to formally register – a grey area that will be examined by Congress. Mr Madoff only registered it in 2006, and the SEC – citing pressure of resources – says only 10 per cent of the 11,300 investment advisers registered are examined on a regular basis.

Mr Markopolos's letters might have been a reason to push Mr Madoff's firm to the front of the inspection queue. Amid all the mysteries, why the SEC failed to act may be the one that yields the most enduring lessons.

House arrest: Madoff tagged and confined to Manhattan apartment

A week ago, he was one of the most well-connected men on Wall Street. Yesterday, Bernard Madoff was unable to find even two wealthy friends to co-sign his $10m (£6.5bn) bail bond.

As a result, a Manhattan judge toughened up the conditions of the alleged fraudster's bail, ordering him to wear an electronic tag and to observe a curfew that will confine him to his plush Upper East Side apartment between 7pm and 9am. Only his wife, Ruth, and brother Peter – both of whom worked with him at his collapsed firm Madoff Investment Securities – ultimately came forward to co-sign his bond. That meant he was unable to fulfil the original bail terms set after his arrest in New York last Thursday.

Yesterday's bail hearing was cancelled following the new deal between Mr Madoff's defence attorneys and prosecutors. Under the new deal, Ruth Madoff is required to surrender her passport and put up as security two properties in her name in Montauk, New York, and Palm Beach, Florida.

Mr Madoff scuffled with photographers and ran the gauntlet of TV crews and reporters as he returned home yesterday wearing a baseball cap – and a fixed smile.