How could the SEC have missed all the warning signs about Madoff?
Understand that I don’t have a dog in this hunt. Although I’m a securities lawyer by training, I never worked at the SEC and, so far as I know, I’m not close to anyone who lost serious money with Madoff. But as reports have come out this past week about the bungling revealed by the internal investigation, you have to ask yourself what adult supervision was in place at the Commission.
If you, like me, have been wondering about this, I’ve been reading all I can in an effort to arrive at an hypothesis to explain it. And I only report this because I think (fear?) it has potential lessons for all of us.
A few days ago,The New York Times summarized
it thus (emphasis mine):
The report details six substantive complaints against Mr. Madoff received by the agency, which were followed by three investigations and two examinations. Yet the agency never verified Mr. Madoff’s trading through a third party. Time and again, it was noted that the volume of his purported options trades were implausible. When the enforcement staff received a report showing that Mr. Madoff indeed had no options positions on a certain date, the agency simply did not take any further steps.
In fact, the string of lapses was capped by a staff lawyer receiving the highest performance rating from the agency, in part for her “ability to understand and analyze the complex issues of the Madoff investigation.”
Here are a few other selective nuggets:
Mr. Kotz recounted incidents in which investigators seemed hopelessly out of their depth, far too credulous and perhaps just plain lazy.
One investigator described Mr. Madoff as “a wonderful storyteller” and “a captivating speaker” after the 2005 encounter in which Mr. Madoff, a former Nasdaq chairman, boasted of his ties to people high up in the S.E.C. and said he was on the short list to be the next agency chairman.
…
The inspector general revisited the failure of the S.E.C.’s Boston office to take seriously the warnings of Harry Markopolos, a private fraud investigator who had been trying since 1999 to get the agency to investigate Mr. Madoff. The failure to heed Mr. Markopolos was almost inexplicable, except that some agency officials did not like him personally, Mr. Kotz said.
…
From 1992 until the Madoff empire imploded, one inquiry after another went nowhere, the inspector general said. Some investigators “weren’t familiar with securities laws,” and some seemingly refused to believe their own ears even when Mr. Madoff contradicted himself or offered illogical answers to questions.
…
At one point, investigators drafted a letter to NASD seeking independent trade data, “but they never sent the letter, claiming that it would have been too time-consuming to review the data they would have obtained,” the inspector general wrote.
And from the Wall
Street Journal:
On May 21, 2003, an unnamed hedge-fund manager sent an email to an SEC examiner laying out concerns that Mr. Madoff’s self-described trading strategy didn’t add up. The manager said the strategy wasn’t duplicated by anyone else in the market, Mr. Madoff’s accounts were in cash at month end, and there was “always replacement capital.” These could be “indicia of a Ponzi scheme,” he wrote.
However, the SEC didn’t open an examination until December 2003, and an agency memo said the focus would be on front-running, a potentially abusive trading practice. The memo didn’t raise questions cited by the hedge-fund manager, such as why there was an apparent lack of volume in the market to reflect Mr. Madoff’s supposed trading strategy.
Senior examiner John McCarthy told the inspector general that it wasn’t a mistake to focus solely on front-running “because that’s where my area, my team’s area of expertise led,” according to the report.
We learn today that
over five years ago the SEC reviewed internal emails from Renaissance Technologies
(James Simons’ hedge fund firm) that raised serious questions about Madoff
including what Simons’ son Nathaniel called “several strange characteristics”
of Madoff’s operation including unusually low fees, rumors that Madoff cherry-picked
profitable trades for favored clients, and (from Renaissance’s “chief scientist,”
Henry Laufer) questioning Madoff’s timing in selling investments to exit the
market and holding primarily cash to avoid losses hitting competitors: The
timing of the moves, Mr. Laufer said, was almost statistically impossible. “We
would have loved to figure out how he did it so we could do it ourselves,” he
testified this year to the SEC. “And so that was very suspicious.” He
added that unearthing Mr. Madoff’s fraud “is not rocket science,” and was dismayed
the SEC had failed to do so.
What do these various exercises in laziness, incompetence, terminal blindness, and general on-the-job abominations add up to?
- People staying vehemently within their “comfort zones” regardless of plain evidence in front of their very eyes that should shock them out of it (pursuing “front-running” instead of a potential Ponzi schedme because “that’s my area, my expertise.”
- Not sending a letter whose results would have been “too time-consuming” to analyze.
- Preferring the “capitivating storyteller” over the black and white facts.
- Discounting the warnings of someone because we “didn’t like him personally.”
- And finally, being so intellectually lazy as to specifically commend a staff lawyer with the “highest performance rating” for her supposed understanding of the Madoff Ponzi scheme when, of course, the truth was that she had no clue about any such thing.
The easy reaction would be to dismiss government bureaucracies as terminally incompetent, but you should know by now that I’m constitutionally allergic to dismissive rationales, and besides, we’re talking about tragic consequences to the SEC’s failure to police Madoff, be it in 1992, 2003, or even 2006. Fortunes were tragically lost and lives were potentially ruined (although I do not for a moment equate losing a fortune with ruining a life).
No, I’m looking for a deeper explanation. Because this is too big a story to dismiss as run of the mill human incompetence.
Could part of the explanation simply be the audacity of the Madoff fraud? That
it almost defied belief, even after it was fully disclosed? Perhaps. Similar
theories, of course, have been advanced about our various intelligence agencies’
failures to foresee 9/11: The notion that Al Qaeda (or anyone) would
fly two fully-loaded jetliners into the Trade Center towers might have seemed
too preposterous to worry about seriously. Yet, by analogy to the SEC/Madoff
tragedy of errors, it turns out in hindsight that there were plenty of glaring
clues–such as flight school students who couldn’t be bothered with troublesome details about the exotic maneuver known as “landing.”
And
even before the first (1993) bombing of the Trade Center, the head of security
at Morgan Stanley/Dean Witter, Rick Rescorla, a British-born Vietnam vet (originally from Cornwall, who served in the British Army before emigrating here), with
a ribald take-no-prisoners approach to life and work (I was a mere securities
lawyer at the firm), told me Islamic radicals would love nothing more than
to destroy this conspicuous symbol of Western capitalism. Tragically,
Rick was one of only three people at the firm who died on 9/11–he was
staying behind to make sure everyone else got evacuated: There’s a memorial to Rick in Cornwall, which you can see here.
So it’s not that preposterous.
What, then, explains it?
I hesitate to invoke “the banality of evil,” and I’m slightly misapplying
it when I do so, but I believe that’s what we’re dealing with. To my
mind, there’s no question Madoff qualifies, in spades, for the title “evil,”
so my focus is on banality. Not–here’s my misappropriation of the
phrase–the banality of Madoff, but the banality of the SEC’s behavior.
Can’t we see in hindsight that everyone at the agency appeared to be behaving
in an eminently reasonable manner, oh-so-dutiful and correct? After all,
if your “team’s” expertise is front-running, how can you be expected to delve
into indications of a Ponzi scheme? What’s wrong with discounting news
from a disfavored source? Being capitivated by a storyteller? People
behave like this in our homes, churches, schools and universities, on our athletic
fields and in the media, and–in our offices,
It’s all so so banal, isn’t
it?
What’s missing, of course, is the indispensable ingredient of Critical Thinking.
Truth time: How do you measure your own personal performance on this
score? That of your team? Of your firm?
Critical Thinking can cover a lot of territory, but it’s often postulated
as the core justification for our entire higher education industry:
- Being able to think past what the author asserts;
- Evaluating “facts” for plausibility, alignment or dissonance with other
conditions or characteristics we know to be true; - Testing analogies, metaphors, syllogisms, and other argumentative techniques
for rigor and internal consistency; - Abstracting from the source (the alternative is to shoot, or muzzle, the
messenger); - Trying to square assertions with prior and subsequent statements–or
finding good and sufficient reason for new developments; - Being so familiar with pleasant and familiar tropes that bid to explain
so much that we prefer not to see past or beyond them (e.g., “our human heritage
of nomadic hunter-gatherers on the savannah explains sexual and economic
behavior to this day”); - Having the imagination to ask “child-like” questions about bedrock assumptions
so profound we rarely even articulate them; - And, above all, getting out of our intellectual “comfort zone” to do the
hard work of rigorous analysis.
How good are you, really, at this? I can report from first-hand experience
it’s a tall, even life-long, assignment. But worth it. Fortunes,
and even lives, could be at stake.
