The SEC Flagellates Itself For Epic Madoff Failure

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SEC Inspector General David Kotz has turned over a 450-page report to the agency’s chairman Mary Schapiro, in which he details how the regulators screwed up with Bernie Madoff, failing to uncover the fraud.

The SEC released a portion of the report today and it’s pretty incriminating for the agency, corroborateiong what whistleblower Harry Markopolos told Congress in February. It also comes at a time when the administration is trying to reshape the financial regulatory system (uber regulator or no uber regulator?).  This report might push Congress, which returns from its August recess next week, to act faster and in a more drastic way.

What’s pretty clear, is that–at least in the case of Madoff–the SEC was just clueless, gullible, incompetent and yes, plain stupid.

The report found that between June 1992 and December 2008 when Madoff confessed, the SEC             received six substantive complaints that raised significant red flags concerning Madoff’s hedge fund         operations and should have led to questions. The SEC did conduct two investigations and three                 examinations based upon the complaints, but never verified Madoff’s trading through an independent         third-party. 

The relatively inexperienced enforcement staff failed to appreciate the significance of the analysis in the     complaint, and almost immediately expressed scepticism and disbelief. Most of their investigation was     directed at determining whether Madoff should register as an investment adviser or whether Madoff’s         hedge fund investors’ disclosures were adequate.

As with the examinations, the Enforcement staff almost immediately caught Madoff in lies and                 misrepresentations, but failed to follow up on inconsistencies. They rebuffed offers of additional                 evidence from the complainant, and were confused about certain critical and fundamental aspects of         Madoff’s operations. When Madoff provided evasive or contradictory answers to important questions in     testimony, they simply accepted as plausible his explanations.

The report also mentions Markopolos’ presentation of his complaint to the SEC, which the staff clearly didn’t understand.

When he testified before Congress in February, whistleblower Harry Markopolos who had been warning the SEC for a decade, made a point saying the agency was financially illiterate and way too chummy with many it was suppose to regulate.

From Markopolos’ testimony:  When I pointed out that the SEC likely didn’t have any PH.D staff with         derivatives trading experience who truly understood how these financial instruments worked, because a     true derivatives expert couldn’t afford to work for SEC pay, she [SEC NY branch chief Meaghan                 Cheung] ignored me.

As it typical for the SEC, to many of the staff lawyers lack any financial industry expertise or training to     conduct investigations.

The only question that remains is whether the regulators will be held accountable.

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