As more details emerge of the SEC’s failure to detect the Madoff fraud, much is becoming clearer. One big question, however, remains.
First, the clarity:
- The SEC was NOT asleep at the switch. On the contrary, the organisation investigated Madoff no fewer than eight times over the years (WSJ), interviewing him twice and his niece Shana and sons Peter and Mark once. Unfortunately, it was usually looking for the wrong scam.
- The widespread conviction that Madoff was front-running was crucial to his Ponzi’s success. It provided an explanation for returns that few smart people could explain. But when regulators went looking for that infraction, there was nothing to find.
And now the remaining big question:
The SEC’s last investigation was triggered by Harry Markopolos’s assertion that Madoff was running a Ponzi scheme. The SEC said explicitly that it investigated to see if Madoff was running a Ponzi scheme. And, yet, it found nothing other than a few minor trading violations.
The key question, therefore, is how the SEC failed to detect the Ponzi scheme even when it went looking for it. Did it not look broadly or deeply enough? (Probable, but everything is obvious in hindsight) Was Madoff’s fake documentation so good that it was nearly impossible to find proof? (Possible) Did the SEC not have people on staff who were expert enough in investment returns to understand how rare and unlikely Madoff’s performance was? (Apparently)
These questions are important because they will determine whether the SEC failed because it was incompetent or because Madoff’s ruse was nearly perfect. We suspect the answer is a combination: The SEC made mistakes, but Madoff’s combination of broker-dealer, reputation, track record, happy clients, twin sets of books, sophisticated explanations, and patient approach would have required a highly aggressive investigation to uncover.