Why did the SEC fail to spot the Madoff case?

By Mark Williams
January 6, 2009

mark_williams– Mark T. Williams, a finance professor at the Boston University School of Management, is a risk-management expert and former Federal Reserve Bank examiner. The views expressed are his own. –

With Congress now probing the Bernard Madoff case, some claim the SEC missed the risk because of under staffing. Even if that’s an issue, one SEC enforcement officer using basic risk-management skills, asking probing questions, searching for clear answers, and exercising timely follow up could have helped in detecting this fraud before it grew to such a staggering size.

The central flaw at the SEC is that its current oversight approach is not sufficiently risk focused. Moreover, any changes in approach have tended to be in response to a specific event instead of incorporating an overall risk-based approach across all areas under their regulatory purview.

The SEC is responsible for overseeing registered broker-dealers, transfer agents, clearing agencies, investment companies and investment advisers, yet there is not a consistent risk approach used in all of these examinations. For example, in 2003, after widespread unlawful trading practices surfaced in the mutual fund industry, the SEC took steps to take a more risk-based approach.

Yet these higher examination standards were not viewed important enough to be applied to investment advisers such as Bernard Madoff. The weakness in the SEC’s existing examination approach can be best highlighted by the fact that, in the last 16 years, while Madoff’s firm was investigated 8 times, no fraudulent activities were ever uncovered.

As part of their broad regulatory mandate, the SEC is responsible for overseeing over 10,000 investment advisers. This agency needs to adopt a “where there is smoke there is fire” approach. The SEC must become risk focused in the scope and frequency of its monitoring and surveillance operations. Given the significant number of investment advisers, even if we assume that 99 percent are low risk, that still leaves 100 that need to be closely monitored and scrutinized.

The SEC should keep a detailed list of the top risky investment advisers and use it to prioritize and set review frequency. Currently, there is no clear indication that the SEC links review frequency or scope of exam with level of perceived riskiness. Former SEC Chairman Arthur Levitt recently indicated that only 10 percent of investment advisers are examined every three years. A wealth of new fraud can be dreamed up, hatched, and perpetrated at such firms in the interim.

Instead, the SEC must develop a stronger risk filter that will quickly flag investment advisers which exhibit higher risk characteristics. Such red flags should center on corporate governance issues such as level of independence and checks and balances. For example, does the investment adviser clear its own trades or do they use an independent third-party? Who is this third-party? Are they well known and do they have a good reputation? Who is the accountant for the investment adviser and what is their reputation and size?

Other warning indicators can come in the form of formal as well as informal complaints. What is the nature and frequency of such complaints and is a particular firm being consistently implicated?

Importantly, the SEC needs to develop a better “whistleblower” framework so it can quickly identify and respond to such complaints. If managed properly, the thousands of e-mails the SEC gets annually can be a powerful risk management tool to identify and respond to potential risk.

The SEC maintains a website to collect complaints and tips. However, the fact that whistleblower tips about Mr. Madoff’s firm were received as far back as 1999 and yet they were never fully vetted speaks to the weakness in the SEC’s risk filtering and response system. The SEC must be able to quickly sort through creditable allegations. Once such allegations have been identified, they must be prioritized, investigated and resolution reached in a timely manner.

Internally, the SEC should revise policy and include a clear action plan, process, and timeframe to address whistleblower complaints and tips. This would establish immediate accountability. To further encourage SEC investigators to comply with new response policy, standards must be directly linked to annual employee performance reviews.

In 1920, long before the SEC was established, Charles Ponzi was able to keep his scam running and undetected for only eight months. Fortunately, this fraud quickly unraveled when local media began to raise and followed up on some basic risk-related questions. The Madoff case and the failure of early detections is a further indication that the SEC should move to a more risk-focused approach.

Doing so, when coupled with timely follow up and consistent risk-based examination practices will help restore market confidence that the SEC can and will protect us against investment fraud.

29 comments

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Good work Mark. The SEC should never have let it get this far, if we had adopted a “where there’s smoke there’s fire” approach they might have been able to stop this from happening. I mean, if you are obviously making a substantial return that is significantly higher than everyone else supposedly in the same market as you, have done it consistently year after year, then something doesn’t add up. Don’t they have a team or teams risk management auditors that should have been able to pick this up? Also, what about the institutions and people that actually contributed millions of dollars through his feeder funds or directly, don’t they have a responsibility in researching where their money is going? I know, I myself, if I was investing 5 million to Madoff who supposedly told me he could earn a 12% return on my money, would want to know exactly how he was doing it, not that I could take my money and do it myself to avoid his fees but it just should have smelled fishy from the start. Hopefully we are on the right track now too safeguard these types of losses and schemes that these unethical businessmen are causing.

Posted by Damian Palmares | Report as abusive

Look! It is really quite simple. The Bush Administration loathes most forms of government regulation. They underfunded the SEC, kept staffing at low levels, and made sure that the SEC didn’t interfere with the “efficiency” of the market place. ‘Anything that interferes with the reckless pursuit of profit in the marketplace by any means is inherantly harmful to society as a whole….’ I would love to blame it on the conservatives who did so much harm during their time in office. In fact however, we have to ask ourselves, ‘How did these morons get into office?’ You know the answer. We elected them and supported them as they undermined the economic foundations of our country.

Posted by Hugh Powell | Report as abusive

It would also stand to reason that any one of Madoff’s influential clients wouldn’t want the SEC poking around their golden goose either.

It would appear easy to sit on the sidelines after the fact and say what actions a moral, ethical business man would do prior to making a deal. However the bottom line is – he made people money. You’d have been in there like a dirty shirt on laundry day. Being with Bernie was a social status accolade. Odds are, you couldn’t even of invested with Bernie if you had $5 million – he was selective. Thats why he was able to pull it off for so long.

Madoff has just earned the Ponzi Cup. If these estimates of $50 billion are anywhere close to reality of the amount he swindled out of people, then he should be made US Secretary of the Treasury. Only someone like Madoff could resurrect the US economy now.

The foxes are already in the henhouse, might as well promote competition – its good for business in a free market economy after all!

Posted by Baron von Lufthoven | Report as abusive

It is all about skills , or the lack thereof. The global investment market has become so complex and intimidating that none of the beaurocrats really understands what is needed in the context of effective supervision.

The bad news….it is likely to get worse because our high profile educational institutions are not equipping people with the skills so desparately needed.

Posted by anton kleinschmidt | Report as abusive

The SEC does more harm than good because it creates a false sense of security in the investing public. The SEC has ALWAYS been reactive, improving and enforcing regulations only after an embarrassing fraud has been uncovered. The failure of the SEC is not due to underfunding or failed risk management policies. It is simply a result of overarching government policies that put corporate welfare far above the welfare of individual citizens. Wall Street has never represented a level playing field. In crises like the S & L scandal or the failure of Enron great public displays are made by the regulatory organizations yet shockingly little money is ever recovered and what does gets squandered on lavish salaries and bloated beaurocracies of the regulators themselves.

Posted by Fred Schmertz | Report as abusive

Crap article. It wasn\’t that the SEC had too many other responsibilities. Tons of evidence has come out lately showing the SEC was on notice that major misdeeds were occurring. It\’s that the investigators either lacked the requisite derivatives expertise to recognize the allegations were inescapeably valid or they had personal agendas that led them to turn a blind eye.

Posted by The Amazing Loredana | Report as abusive

Yup I agree.

Posted by Maria | Report as abusive

I agree with the writer that there’s obviously got to be a new approach of the SEC. And I also agree with the comment posted above that something was probably felt, personally felt, to be fishy from the start – for those high rollers that were receiving the 12 per cent return. There’s no doubt that several of the 8 reports from Industry people (the notifications to the SEC to go and have a look at Madoff’s operation)were founded on the suspicion that something had to be going on for that tyep of sustained performance throughout the turbulent market years, for example the tech boom and bust. Anyway, here’s my point. And it relates to the duration of time that this went on. Ponzi got away with it for a whole 8 months, while Madoff in 2008 got away with it for years. That’s a scandal in the larger sense – because, for that to happen in this day and age, despite these calls upon the SEC to investigate, the scandalalous nature of this falls over the SEC and it’s performance also. Not only should it change its approach and outlook, but it change its people. If ever there was a case that called for widespread resignations it’s this. There will not be that type of accountability – it just doesn’t ever happen in America these days – so maybe I’m making a moot point, I don’t know. I guess the other remark I’d like to make pertains again to the longevity of the Madoff scheme and this idea that some investors had to suspect something was up, let’s call that self-deception and self interest. Well, I guess the longer a Ponzi scheme goes, the more internally robust it can become. The favored investors, the early investors perhaps – consistently get their returns, and appear to be doing well. There comes a point when the period for questions to be asked (when suspicions become personally salient: “This is great, but how are you doing it, Bernie?”) don’t get asked. Just take the money and go upon my way, don’t ask for trouble in the face of a good thing. Anyway, the spectacle of the prestige and the word getting out of these consistent returns for those in this rarefied club – all then becomes the fodder and the attractive element for newer investors and further investment from the old guard. And this old guard are a powerful lot, forming an establishment whose collective self-deception is better not messed with. Implicitly, then, the SEC becomes part of that complex. Part of the problem – in fact half of it, as far as I’m concerned.

Lets face it the system is corrurpt. It’s not that like there has never been a savings and loan, junk bonds, tech bubble, Enron, Woprld Cm, Tyco etc. What did the SEC do to protect investers? NOT A THING. Its business as usual for these guys and they found a better way then taking stock options just take a HUGE BONUS for a job well done. Go America.

Adendum to Rocchetti – AUDITORS. Where in the heck were the accounting geeks (independent CPA firms)? AICPA where are you? SOX??? What a mess. Much like the risk approach described above for brokers/dealers etc., CPA fimes, Big 4 or whomever, should also be publically scored relative to their connection to frauds. Further, I believe the velvet hand of the law toward white-collar crime needs to change. The concequences need to be more severe. Mad(e)-Off may face small jail and a small fine (relative to the alleged size of the fraud).

Let me just point out that it was the Republicans who kept warning about fannie mae and freddie mac, and the Dems that said let them alone…… AND to blame the Bush administration for the SEC is just silly. What was different under Clinton?

Its about GREED and lack of accountability. The SEC does not take a risk management approach because they are not accountable if they don’t manage the risk. There are no consequences. They even have immunities that private companies do not have if they did such a bad job.

All over the country this year, there are tons of smaller “Madoffs” who “MADE-OFF” with millions of dollars from trusting investors where they have lost their life savings by giving their $$$$ to a broker at a registered brokerage company and the $$$ end up as part of a ponzi scheme. Its called “selling away” and often results from lack of supervision by the brokerage company.

The SEC has not done enough to daylight the selling away practices, much less question Madoff, who duped some of the best financial minds around

Finally, maybe it sounds too simple, but I am not sure its corruption, but rather lack of risk management, lack of accountability blinded by simple greed and fueled by stupidity?

Solution: Get Smart. Be accountable. Keep the beast of greed at a respectable distance, like superheros do.

Posted by greedo | Report as abusive

What we need is for the new Congress to pass sweeping oversight legislation to ensure that the American investors are never again duped by crooked CEOs who are out to take their life savings.

Wait a minute!! They already did that with Sarbanes-Oxley following the Enron tragedy. SOX has cost businesses, and therefore the consumer, countless millions and doesn’t prevent anyone from being a crook. All the SOX legislation did was punish the 99.9% of honest companies that were burdened with useless paperwork.

Please, no more useless oversight reporting, Senators!!! Just ensure that the SEC auditors are competent, accountable and rewarded for routing out the guilty.

Been There, Filed That Paperwork.

Posted by Texas Tom | Report as abusive

First does anyone in their right mind believe a low level SEC employee such as Cheung had the last word on whether to pursue an investigation into Madoff Securities?

Second does anyone believe that even the SEC Chairman would have the last word? Bernie Madoff had HUGE influence in the financial industry and it would have taken huge influence to investigate him.

Thirdly I would suggest that every SEC employee directly or remotely involved be aggressively interrogated under oath, and be made aware that any false statement will result in severe criminal penalties and imprisonment.

Lastly the questions should inquire about any undue pressure to circumvent and shut down an SEC investigation based upon the evidence provided by Harry Markopolos.

There must be SEC accountability, and those who dropped the ball need to be charged under criminal law. Is anyone ever going to pay a real price (besides a bailout) for destroying the USA’s and worlds financial markets? It should be those at the top of the ladder.

Posted by Thomas B | Report as abusive

The SEC wont even force Wall St and Hedge Funds to Settle all the fakes shares of stock they sold into the market place(naked short selling) They are a disgrace they all know the DTC or our Settlement System is Broken. This is going on years. go to http://www.deepcapture.com read for yourself

Posted by cathy | Report as abusive

I totally agree with Hugh Powell’s response, above. The government’s role as a whole has been systematically undermined, politically and financially, over many years (remember Reagan’s phrase, “government IS the problem”?). How can we expect good performance from the SEC when it and run by the current administration’s loyalists, who seem to turn a blind eye to mischief in the market? Too many major scandals have erupted over the past several years (Enron, derivatives, dot com bubble, savings & loan, to name a few); those events should have tipped us off that little, if anything, has been done to protect the investors. We’re pretty much on our own.

We need solid reforms to prevent wholesale fraud, as well as to enforce the laws currently on the books.

Posted by Jean | Report as abusive

You have to be kidding. Another article today that the SEC caught a 50 million ponzi shows that they can do their charter if they wish. Its about corruption and incompetence, not innocent oversight.

Posted by R Wilkinson | Report as abusive

Where was Greenspan at that time? Is he not expert enough to detect that or is he sleeping only and drawing big fatsalary.

Posted by Herman | Report as abusive

Individuals and companies have credit risk. Why not investment advisers?
1. When you deal with an adviser you should be able to get free an easy from a governamental site a FICO like score in regards of their knowledge and reputation AND personal assests and assests under management.
2. The advisers should be liable with their personal assets in case of fraud. A min. of 5% of managed assests value should be kept in a special fund to recover any wrong did by that adviser.
Tought rules which can keep out of this business many good but not rich advisers. On the other hand, if an adviser makes mistakes, you want to recover the loses. From a poor adviser there is not too much to recover.

Posted by Alexandru Dolghiu | Report as abusive

Okay, so Maddoff’s scam hurt some very rich people — who were GAMBLING, by the way — not investing other rich people’s money. They all couldn’t have been that STUPID, but most of them were greedy enough to keep playing with their money and all their investors’ money, too.

But the results of Maddoff’s scam, on top of the mortgage disaster, are not hypothetical — not an interesting set of questions to consider. Right now, in this cold New England night, many families are homeless, many people are living on food stamps, food pantries are running out of food, schools are cutting programs including science, math, libraries, staff benefits. The state of MA is cutting out programs that for years have buoyed up people from drowning in the deepest mud. People in this country and the rest of the world will suffer both directly and indirectly, they will continue to lose ground, especially the poor and their children will suffer from lack of food, shelter, clean water, other essentials. It’s way too much of a coincidence that some people got filthy rich from both the mortgage mess and Madoff charade. Congress knew about the impending mortgage crisis years before the last slam dunk, but did nothing. Nothing. They ignored the mortgage issue and pretended that they had no responsibility for it. Well, my Aunt Sara says that when someone ignores warnings and knowledge of a crime, he’s as guilty as the person who committed it. And the SEC’s inaction on Madoff looks suspicious when you examine who benefited and who lost everything. Those agencies that people depend on to keep us safe have been keeping their one good eye closed, so they can say, “I didn’t see anything.” These financial fiascos didn’t cause most people slight inconveniences. We’re talking about a nose dive off the back end of
the diving board straight into the cement. The U.S. will print up a few trillions to cover our needs for a few months.

This crime hurt millions of people. I agree with Thomas B. that we need an investigation to question SEC staff under oath and with serious penalties for wrongdoing. Government employees who allow this kind of devastation of the world’s economy must be held responsible for what they did. If they went along with the duplicity because they were afraid to lose their jobs, I don’t feel bad for them, didn’t they sign some kind of loyalty and ethics agreement when they were hired? When the truth is out, I Believe the basis for this mess, similar to the Valerie Plame fiasco, we’ll find Cheney’s creepy Goehring smile along with ex-president’s Bush’s downhome good ol’ boy grin. Laissez-faire in this case meant laissez-faire my rich pals.

We know we can’t trust our Congress because they’re getting too fat on the spoils left by the lobbyists, so let’s watch every move they make, and hold them to a hard line. They deserve it — they certainly don’t receive my respect.

Jekyll Island, “my sh!! don’t stink” @sshole bankers and a Congress with NO BA!!S……..tats why.

All broker transactions that I do in my IRA and individual accounts have an SEC fee. If all investors read the statements from their broker or mutual fund the SEC fee’s indicate how much trading is going on.

It would be a self check if there were no fee’s paid to the SEC but the mutual fund said they traded successfully to beat the market the SEC payment would show immediately the facts don’t match the hype.

In addition it would allow the SEC to quickly register a complaint % based on paid fees for brokers. IE = Broker A has 5 complains / million SEC fee paid, vs Broker B with 12 complaints / million SEC fees paid.

No new regulation but applying statistics and common sense to existing regulation.

From what I gather a MadeUP fund will show a fraudulent amount of SEC payments and that can put a spotlight on fraud before it gets to the billions.

Posted by Chris Hamilton | Report as abusive

I’ll bet my bottom dollar the SEC was well aware of Mr. Madoff. He seems like small fish compared to the derivatives scandal that is being covered up. Madoff seems like the patsy in this. Now the fed’s are going to claim need for more control and regulation and the public is buying it. Sounds just like what we need here in the land of the free.

Posted by jason | Report as abusive

I am not so surprised when I hear about these “scandals” anymore. I don’t blame any one political party more than the other. I can’t even really blame the regulatory agencies that were otherwise stripped of their authority by those “in power.” (Who are invested in making money too ex. see corporate/banking/insurance lobbyist) How long are we going to pretend that the US hasn’t been on a crash course? We can’t just let corporations and lending institutions go unregulated and trust they are looking out for whats the best practice, they are looking out for maximum profit. And when they fail we (taxpayers) bail them out- which by the way is the antithesis of a free market economy!! And average American consumers are fine just so long as they can keep buying stuff they don’t really need because it makes them feel as though they’re keeping up with that family on the TV. But when they fail they can go hungry and homeless. As a citizen of the United Corporations of America, the “oh my! oh no!” just rings so hollow. I am not so surprised anymore.

Posted by KAS | Report as abusive

I agree with the column, but I think the SEC’s biggest failing came with the failure to properly regulate trading itself in the markets. The unbelievable leverage being applied, both short and long, had to have set off some warning bells.

The markets have become one big casino, where insiders are the house, and everyone outside became unwitting gamblers–that would be pension funds, 401ks, mutual funds and just about everyone else who’s seen their life savings halved.

Even today, the SEC hasn’t re-instituted common sense trading rules that worked for decades.

Mr. Jason above, complains about the mess, and then makes remarks to the effect that more effective oversight is not warranted in the land of the free.
He is being inconsistant. “Land of the free”, does not mean “We trust you not to be a thief”. Madoff a patsy?
I’ll use that excuse in the future.

Mr SRk,
I didn’t complain just stated a fact that I believe. Mr. Madoff is being used as a patsy. I think the derivatives scam is the beast they want to cover up as soon as they can. If they can focus the public attention on one thing they can get away with another. I absolutely believe that honest enforcement of the rules we already have will be sufficient. More regulation and consolidation is not the answer. Here in the land of the free we should be alot less friendly to federal government centralization of our financial laws. A very consistent statement Mr. SRK. We need to obey the laws we have not to create more.

Posted by jason | Report as abusive

[...] permalink Originally Posted by erikbj Madoff ran a non-registered product which is not the SEC’s responsiblity to supervise. however in the next year you will see non-registered products (aka Hedge Funds) come under the watch of the SEC. The problem is that 99% of teh people at teh SEC are not smart enough to know waht they are looking for. Not exactly true. SEC has jurisdiction over investment advisory firms. See this article from Reuters: January 6th, 2009 Why did the SEC fail to spot the Madoff case? [...]

50 billion and he never executed one trade. The SEC was paid to look the other way through political contributions. Madoff was a big dollar donor. 50 billion is a drop in the bucket compared to the real organised crime (AIG Merrill Countrywide etc) that has crippled the world economies. I agree with others this is a smoke screen for the real theft which is in the multi trillions. Repackaging worthless subprime paper into vehicles that were sold to inocent investors eclipses this scheme by a landslide and no one is going to jail or even being investigated. Credit default swap Translation ponzi scheme. Risk managment? What managment? These are the same firms we are giving bonuses/bailouts to. The SEC is corrupot dont fool yourselves into thinking otherwise if it looks like a duck quacks like a duck its a corrupt duck. An 8 year old could have figured out Madoff was a theif. Now we are hearing he acted alone come on people people wake up. Brokers were supplying extensive documentation detailing the ponzi scheme and the SEC ignored them. Repeatedly. Does this sound like regulation to you? I believe the last estimate on the sub prime debackle was 4 trillion dollars this make 50 billion look like a bad joke. Dont get me wrong Madoff should be in jail for the rest of his life but the real crime isnt even being looked at because as I said earlier the SEC is corrupt and all of wall street was involved.

Posted by RICH | Report as abusive

Prof Williams seems to equate size with quality: “Who is the accountant for the investment adviser and what is their reputation and size”.
Can he cite any research correlating size of accounting firm and reduction in risk of loss?
According to the anecdotal evidence at my disposal, more has been lost in undetected frauds committed by clients of the Big Five – oops, post-Enron, make that four – than to clients of their smaller competitors.

Posted by Colin | Report as abusive

I sympathize with all of you guys.Just few remarks.
SEC or any other regulation will not/would not/can not save your money from fraudsters.Only you can. Dont trust blindly to any adviser, diversify your investments, invest in ETFs, dont trust in high return funds.What comes up must come down sooner or later.
Educate yourself, there are huge collection if good books in the USA. Best wishes to you all from Croatia

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