There are, clearly, some striking regulatory failings regarding the estimated $50bn fraud propogated by Bernard Madoff.
That the SEC didn’t recognise what was essentially a Ponzi scheme is worrying in itself. What’s more frightening, however, is that the US agency had so many near-misses, including a previous investigation for front-running, in identifying it.
Of note is this document from Aksia, via Clusterstock. In it the advisory firm clarifies why for years it steered clients away from Madoff’s company. Its range of “red flags” are strikingly simple — from models that could not be replicated or understood to aging auditors. Of note:
The Madoff feeder funds marketed a purported “Split-strike Conversion” strategy that is remarkably simple; however its returns could not be nearly replicated by our quant analyst.
The feeder funds had recognized adminstrators and auditors but substantially all of the assets were custodied with Madoff Securities. This necessitated Aksia checking the auditor of Madoff Securities, Friehling & Horowitz (not a fictitious audit firm). After some investigating we concluded that Friehling & Horowitz had three employees, of which one was 78 years old and living in Florida, one was a secretary and one was an active 47 year old accountant (and the office in Rockland Country, NY was only 13ft x 18ft large). This operation appeared small given the scale and scope of Madoff’s activities.
There was at least 13bn in all the feeder funds, but our standard 13F review showed scatterings of small positions in small (non-S&P100) equities. The explanation provided by the feeder fund managers was that the strategy is 100% cash at every quarter end.
Madoff’s wevsite claimed the firm was technologically advanced…and the feeder managers claimed 100% transparency. But when we asked to see the transparency during our onsite visits, we were shown paper tickets that were sent via U.S. mail daily to the managers. The managers had no demonstrated electronic access to their funds account at Madoff. Paper copied provide a hedge fund manager with the end of the day ability to manufacture trade tickets that confirm the investment results.
So at least one advisory firm appears to have picked up on the discrepancies.Why did others, including Nomura which was selling Madoff’s services to clients according to Clusterstock, (presumably) not? Not to mention the regulators?
The key seems to be the structure of Madoff’s business. Madoff wasn’t running a hedge fund (at least, it wasn’t registered) — but a securities firm, allowing him to keep custody over customers’ accounts and process trades himself. His only check would have been the tiny auditor outlined by Aksia above. What’s really perplexing though, is that entities like Nomura, which are audited by legitimate firms, did not find the fraud as Aksia did above. Judging by the red flags outlined above, this isn’t just the SEC’s failing but the failing of anyone silly enough to have invested in the scheme with out properly looking into it first.
We haven’t yet heard the SEC’s side of the story, but is it any surprise we’re already hearing rumblings like this , via Marketwatch?
“Of course, the fact that the SEC routinely audited Madoff’s investment company and found nothing wrong is further proof that government regulation of the securities industry is ineffective and has done more harm than good,” he said. “Rather than protecting investors, it merely lulls them into a falls sense of confidence. If government stayed out, private-sector due diligence would do a much better job of ferreting out such massive and poorly conceived scams.”
Related links:
How we knew Bernie Madoff was a fraud – Clusterstock
Madoff said to use unregistered side-unit for clients – Bloomberg