Of all the mysteries of the Bernard Madoff scandal, the most confounding may be the failure of the Securities and Exchange Commission (SEC) to detect it earlier. Not only did the SEC seemingly ignore knowledgeable whistleblowers for years, but the SEC’s own examinations found no significant wrongdoing.

Having been through three SEC audits as a compliance officer, in my opinion it is not inconceivable that Madoff was able to deceive even the SEC examiners. But what is a SEC audit really like?

Under normal circumstances, the SEC does not swoop in unannounced; they provide a firm a few days’ prior notice and a list of records and documents they want to examine. Upon arrival, the auditors are sequestered in a conference room and a “point person” from the firm is assigned to answer questions and attend to the auditors’ needs. The SEC does not have the run of the firm, and interviews firm personnel only under controlled circumstances. In the context of their information requests, they see and hear basically what the firm wants them to see and hear.

The SEC undoubtedly has personnel with industry experience, but auditors are often just beginning their careers and have been taught how to perform an audit but not necessarily the nuances of the securities world. They are able to literally interpret the audit data but lack the background to understand the context of that data and to make important inferences. Every firm and every audit has its unique aspects, and the SEC auditors may be encountering those circumstances for the first time. When my fixed income firm was being audited, the auditors, who had previously only audited equity firms, brought with them a textbook on fixed income investing and literally learned on the job.

The documents and records requested by the SEC are commonly known, as are the “hot button” issues in the industry that receive additional scrutiny. Given Madoff’s high regard on Wall Street, his tight control on his investment management operations separate from his brokerage business and the long tenure of the fraud, it is easy to imagine him giving the SEC all the information and answers they wanted to hear.
None of this, of course, excuses the SEC from not asking any critical questions. Most troubling is the recent assertion by the trustee appointed to unravel the Madoff mess that there was no indication the money manager bought any securities for his clients. Securities trades should be simple to confirm, and if true this finding contradicts claims by some of the “feeder funds” that sent client funds to Madoff that they received verification of Madoff trades from the Depository Trust Co., an independent company that settles institutional trades. Clearly there is much more to be revealed about this orchestrated fraud, perhaps from the 7,000 boxes of records at a Queens warehouse that go back more than a decade.

Part of the problem is that Madoff positioned himself in a regulatory “crack” so that he had to respond only to specific SEC questions rather than a full-blown audit. He avoided full registration by claiming less than 15 clients, since individual clients were first funneled through a small number of feeder funds. Even after registering in 2006, after an SEC investigation into the number of ultimate clients, Madoff did not undergo a complete examination. The SEC prioritizes examinations based on the appearance of risk, or judging books by their covers. From 1998 to 2002, the SEC’s goal was to examine every adviser once very five years and new advisers in their first year, but a 50% increase in the number of advisers scuttled that goal. According to Lori Richards, director of the SEC’s Office of Compliance, only the 10% of advisers with high-risk characteristics are examined on a regular basis, with others examined at random or when there is cause. Despite growing evidence to the contrary, Madoff avoided the appearance of risk by claiming to engage in simple trading and reporting steady but unspectacular returns.

Rather than solely rely on the government for protection (never a good idea), to protect themselves investors should heed the many warnings that were too easily overlooked or dismissed in the Madoff case.

• Illogically small staff – While disclosing $17 billion under management, Madoff claimed only five or fewer employees who performed investment management functions, including research.
• Extreme secrecy – Madoff was well known for refusing to answer questions about his business or investment strategies and for restricting on-site due diligence. Existing clients that pressed for information were even expelled from the firm.
• Paper tickets – Madoff had built his career on technological innovations in his trading business, but only paper trade tickets with no time stamps were provided, by mail, to some of the feeder funds.
• Lack of segregation of responsibilities – Madoff’ operations, rather than an unaffiliated service provider, produced client statements and reports, violating a cardinal rule of investor security.
• Lack of disclosure – Since Madoff claimed to be exempt from SEC registration, he never provided even the basic disclosures required of most investment managers.
• Obscure auditors – Madoff’s auditing firm worked out of a tiny office outside of New York City. The firm, which had Madoff as its only client, had only three employees, including a secretary and a 78-year old living in Florida.
• Excessive market size – The basis of the whistleblowers’ complaints was that Madoff’s reported strategies were impossible because they would have exceeded the total of all trades executed in those securities.

While such in-depth research may be beyond the capabilities of most investors, anyone can ask themselves whether the picture presented makes sense. If not, always err on the side of caution.