Why Didn’t SEC Look Closer At Madoff?

December 16, 2008 1:50 p.m.

The Bernie Madoff fiasco is looking more and more like a serious regulatory failure by the Securities and Exchange Commission.

The Washington Post confirms that, despite several complaints dating back to 1999, the SEC never examined Madoff’s investment advisory business. And it pieces together a preliminary explanation for why that might have been the case.

First, Madoff appears to have had a cozy relationship with regulators. After helping to create the NASDAQ, which was the first electronic stock exchange, he went on to advise the SEC on electronic trading.

In this video from a roundtable discussion held last year about the future of the stock market, he brags: “I’m very close to regulators. In fact my niece just married one.” (It’s at the 1-hour, 51-minute mark.)

In addition, Madoff’s investment business was organized as a private investment pool, which is subject to limited oversight by regulators*. And, says the Post, “Madoff constructed his investment business to avoid most of it.”

But part of the problem may be the way the SEC is set up — including a lack of resources. Reports the Post:

The SEC does not have the resources to examine investment advisers on a regular schedule. Instead, the agency prioritizes examinations of companies based on their risk profile, which is basically a process of judging books by their covers. People familiar with the process said the SEC tends to focus on high-risk investment strategies, such as trading in derivatives.

Lori A. Richards, director of the SEC’s Office of Compliance Inspections and Examinations, said that only 10 percent of the 11,300 investment advisers registered with the SEC are examined on a regular basis — those with high-risk characteristics. They are examined every three years. Others might be examined randomly or where there is cause, Richards said.

From 1998 to 2002, the SEC aimed to examine every adviser at least once every five years and to examine newly registered advisers during their first year, but a 50 percent increase in the number of advisers since 2002 ended that practice, Richards said.

Still, there were warning flags that the SEC should have caught, some experts told the Post:

The brokerage arm of Madoff’s firm had generated consistent complaints going back to 1999 for its unusually consistent returns, and had been reviewed by the SEC several times (but had largely been given a clean bill of health).

In addition, Friehling and Horowitz, the firm acting as Madoff’s outside auditor had only three employees, one of whom was a secretary and another of whom was a 78-year old living in Florida. Only a few auditing firms have the resources to audit a company managing $17 billion on assets — which is what Madoff had reported to the SEC — and Friehling and Horowitz was certainly not among them.

There are still more questions than answers though — not least about exactly what Madoff’s alleged scam consisted of. We’ll keep you posted as things become clearer.

* This sentence originally, and incorrectly, stated that Madoff’s investment business was organized as a hedge fund. In fact, as the New York Times reported Friday:

Mr. Madoff was not running an actual hedge fund, but instead managing accounts for investors inside his own securities firm. The difference, though seemingly minor, is crucial. Hedge funds typically hold their portfolios at banks and brokerage firms like JPMorgan Chase and Goldman Sachs. Outside auditors can check with those banks and brokerage firms to make sure the funds exist. But because he had his own securities firm, Mr. Madoff kept custody over his clients’ accounts and processed all their stock trades himself.

So that distinction helps further explain why Madoff escaped scrutiny for so long.

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