The Securities and Exchange Commission released the full report from its inspector general on the bungled investigations of Bernard L. Madoff a little after 5:00 p.m. on the Friday before Labor Day. How’s that for timely disclosure.
The report goes into excruciating detail on how the commission missed numerous opportunities to uncover the enormous Ponzi scheme, which Mr. Madoff himself admitted he thought would happen a few years earlier during one investigation.
For those who like autopsies, this one goes on for almost 500 pages, and it shows a government agency that failed to take basic investigatory steps that allowed a fraud to continue far longer than it should have. While it is easy to identify how the S.E.C. became more dysfunctional as it overlooked Mr. Madoff’s fraud despite numerous red flags, finger-pointing will not get any money back to investors. And the S.E.C.’s sins were more those of omission rather than commission, so it is unlikely a lawsuit against the agency or its staff would go anywhere.
The more important issue is what lessons the commission will draw from the inspector general’s report.
I present four fairly simple lessons, in no particular order, that the S.E.C. might learn from its flawed Madoff investigations so that the chances of another significant failure will be diminished. (In the interest of full disclosure, I worked in the S.E.C.’s enforcement division from 1987 to 1991 as a staff attorney.)
Lesson 1: Communicate.
Between 2004 and 2008, the S.E.C. conducted two examinations and one investigation of Mr. Madoff’s investment advisory arm through which the Ponzi scheme operated, and never even got a whiff that he was conducting the biggest fraud in history. One reason appears to be that the various S.E.C. offices never really spoke with one another about his operation or its suspect practices. In fact, one set of examiners in the Office of Compliance, Inspections and Examinations didn’t even learn about the other examination until Mr. Madoff himself told them.
Not telling one group what another has already done, and being candid about it, clearly allowed Mr. Madoff’s scheme to continue unabated. When the enforcement division began its own investigation, those who conducted one of the examinations were concerned that the new investigation would make them look bad, so they downplayed any problems uncovered at Mr. Madoff’s firm.
The S.E.C. received numerous tips raising legitimate questions about whether Mr. Madoff’s operation was on the level. It does not appear, however, that any one person ever looked at all the information that had come in about the investment advisory operation to see the pattern emerging. Communication includes making information available so that someone on the staff knows that it is not just one tipster making wild allegations or who may have an ax to grind.
Bureaucratic rivalries are nothing new, and the S.E.C. is certainly not one big happy family. But when an agency’s goal is to protect investors, it needs to ensure that everyone is working toward that end. Opening up the lines of communication both within and between divisions, and encouraging them to work with one another and share all information rather than view others as potential rivals, is a much better way to operate.
If one of the Madoff inquiries had picked up whether the other left off, rather than viewing each as a separate endeavor, it may have mitigated at least some of the damage.
Lesson 2: If You Hire Good People, Support Them.
A review of the report’s discussion of the two S.E.C. examinations shows that those who were dealing with Mr. Madoff, and putting up with his obstructive behavior, wanted to follow up on their suspicions about his investment advisory business. But senior management asked them to keep the review limited, at one point telling them to keep their “eyes on the prize,” which did not include trying to figure out whether it was all a sham.
Even when Mr. Madoff was most obstreperous, S.E.C. managers didn’t support efforts to gather information from him. At one point, a recommendation to contact outside investors was blocked because, at least according to staff members, a manager expressed concern about being sued.
The inspector general’s report makes much of the inexperience of the S.E.C. staff, but that’s nothing new at an agency with high turnover. Managers are the ones with the knowledge and background to oversee investigations so they don’t become bogged down, but when the goal is simply to push things through the system and come up with a quick resolution, important issues will be easily overlooked. Even in an era of limited resources, sometimes it’s good to let a staff person follow a hunch to see where it might lead.
Lesson 3: Think About the Unthinkable.
Mr. Madoff was highly respected on Wall Street, and it may well have been unfathomable that he could operate a scheme for years that cost investors billions of dollars. Thus, the examinations and investigations of his operation were quite limited, like the focus on “front running” as a means to explain his unusual returns. By keeping the investigatory review narrow, the S.E.C. missed the much bigger picture because it does not appear that anyone stopped to ask whether his entire operation was a fraud — despite tips that it was.
Sometimes it is hard to believe there are significant problems when a company appears to be so successful. Remember that Andrew Fastow was named “CFO of the Year” by CFO Magazine in its October 1999 issue, while the company was planting the seeds of its downfall during that quarter when it engaged in the infamous Nigerian barge transaction.