Regulators’ Actions Against Inadequate Procedures Aimed at Making Quick Money in Hard Times. The Madoff Scandal

2. The SEC is under investigation for its failure to investigate the fraud despite the fact that whistle-blowers had alerted it to warning signals. The SEC enjoyed cordial relationships with Madoff. Meanwhile, Madoff’s niece Shana Madoff, a compliance lawyer at Madoff’s firm, is married to Eric Swanson, former SEC assistant director in the office of compliance inspections and examinations. Swanson started his romantic relations with his wife-to-be only after the compliance team he helped to supervise inquired about Bernard Madoff’s securities operations.

3. In 2008, Bernard L Madoff Investment Securities had US$700 mln of equity capital and had dealt with 10% of New York Stock Exchange trading volume. A suspiciously small number of employees operated his investment strategy, a warning sign in itself. Madoff claimed that he had made 10-12% a year on a consistent basis and he was clever enough to reduce the return slightly in bad years to make it seem more plausible. Madoff had seemed to achieve the steady returns using what he called the split-strike conversion strategy with options, which is also known as a collar. He sold out-of-the-money call options and bought out-of-the-money put options, both on the S&P 100 index, while holding stocks correlated to that index. The sale of the call options would offset gains of the underlying stock portfolio beyond a certain level and the purchase of the put options would similarly offset losses.

4. An obvious warning sign was that Madoff conducted his own custodian and administrator functions, and traded his managed accounts through his own broker-dealer, meaning there were no independent checks. Madoff did not answer questions or see many customers. Madoff did not provide customers with electronic account access as other brokers do, he sent only paper tickets, sometimes without time stamps.

5. The collar strategy he declared he had chosen was too expensive for a portfolio the size of Madoff’s according to the financial investigators. If implemented, it would have led to more volatility than his returns suggested. There are a lot of questions with regard to the Madoff’s case which need further clarification, including whether he had been front-running, which means using information from market making to trade securities ahead of placing client orders, and whether he had been operating alone. One overwhelming issue is how the SEC missed the Madoff’s scandal and similar frauds. Boston accountant Harry Markopolos first told the SEC in 1999 that he suspected Madoff’s business was a Ponzi scheme, he had a small group of investigators working on the case, and kept trying to warn the SEC – without success. The SEC is no doubt under-resourced and its staff are not always sufficiently skilled or experienced to recognize a scam, but the legitimate question has arisen whether the SEC has had the will to investigate high-profile Wall Street figures generally.