Friday, October 02, 2009

The Report of SEC Inspector General Kotz.

October 2, 2009

Re: The Report of SEC Inspector General Kotz.

As Ron Stein may have intimated in his excellent recent piece about the Kotz report, you cannot really get the full flavor of the SEC’s staggering malperformance in the Madoff situation unless you read the entire report. The Executive Summary alone, as excellent and shocking as it is, cannot give you the full flavor: relatively few such summaries do, and here there are just too many facts, too much staggering malpractice over too long a period, to get the full flavor from a summary. Those who litigate, and perhaps as well some of those who seek legislation, will likely master the whole report because that kind of mastery is what will really enable one to understand what happened and to effectively use such understanding.

In addition to Kotz’s nonetheless excellent Executive Summary, there have been a few other summaries which list some of the huge number of items of malpractice. They include Kotz’s written and oral testimony to Congress recently and some newspaper articles.

In this essay, I shall not attempt to summarize Kotz’s 457 page report. What shall be done instead is to discuss a particular perception the report induced in me, plus some points in the report that struck me forcibly and contributed to the perception but often seem not to have generally been picked up elsewhere or to have received only brief or minor mention elsewhere. I think the perception, and especially the points which induced it, will, like points that were widely picked up elsewhere, be valuable and important to know, both for litigation and for those who seek legislation.

* * * * *

It is striking to me that, if SEC personnel had deliberately set out to insure that Madoff would not be caught and halted, and had deliberately set out to sabotage the antifraud policy of the SEC’s own statute, they would have done many of the very things they in fact did. That is why I term their misconduct defacto intentional (as I told Ron Stein, who was kind enough to give me credit for the phrase).

You know, human thinking is often governed by words and phrases (except for geniuses like Einstein and Dirac who thought in pictures, and some other people like ones who see colors or other things when they hear music). For most of us, words limn our categories of thought.

In law there are words, and therefore categories of thought, related to negligence that could be relevant here. There is “negligent” conduct itself. There is conduct which is worse, and is called “willfully negligent” or “intentionally reckless” (exemplified by driving down side streets, on which kids play, at 50 miles an hour). Also, there is conduct which is not negligence, is beyond mere negligence of any type, and rather is “intentional.” But there seems to be no phrase which is meant to cover the situation where you don’t want something to happen but your negligence is so high that you act exactly as if you do want it to happen. (Maybe the phrase “intentionally reckless” conduct comes close). Yet that is what occurred here. And, since most people think in words and phrases, it would be helpful to the thought process to have a phrase which covers what happened here.

“Defacto intentional” strikes me as such a phrase. It is applicable here because, even though the SEC did not want a Ponzi scheme to succeed, its negligence and malperformance were so high that it acted exactly as if it did intend Madoff not to be caught and stopped, as if it did want him to succeed, and it did the very things one would do if one were trying to enable Madoff not to be caught and were thereby attempting to destroy the antifraud policy of the statute that the SEC is instead supposed to enforce. I suggest, therefore, that we use the phrase “defacto intentional” in future communications about the SEC’s misconduct because it will give people an apt way to think about the situation, and will better enable the media, the public and Congress to grasp what happened.

I note, by the way, that Senator Schumer seems to have caught on to what really happened at the SEC -- to the defacto intentional failures to stop Madoff. In a recent hearing he said: “It almost seems they had an attitude that they didn’t want to find things.”

Schumer also understood that it wasn’t inexperience that caused the disaster. It was negligence of a mind-blowing degree. At the hearing, he said, “The most rudimentary -- in other words, if you sent a 15-year-old, you know, a sophomore in high school, and said, ‘Here’s what’s going on. Figure out -- you know, just follow it through,’ as a homework assignment, they’d know to do some of these things” that the SEC didn’t do. Schumer later continued, “you don’t have to be Albert Einstein to figure out you ought to get some third-party verification and not accept the potential defrauder at their word.”

What, then, are some of the SEC’s acts or failures to act discussed in Kotz’s report (and often not picked up on generally by the media) that cause one to say the SEC acted as if its actions were defacto intentional because it did things you would do if you did not want Madoff to be caught and stopped and if you were deliberately trying to sabotage the statute’s anti-fraud policy.

• The failure to catch and stop Madoff is defacto intentional when it would take only a single phone call to the Depository Trust Company to learn that Madoff never held the securities positions he claimed to have held, but for sixteen years, through six complaints and five investigations, not a single member of the SEC, not a single one of its supposed investigators, ever made that single phone call. (It was made after Madoff was arrested, and it uncovered the truth almost immediately.)

• The failure to catch and stop Madoff is defacto intentional when you could request relevant records from the NASD and other organizations, records that would show that Madoff never did the trading he claimed to have been doing, but through 16 years, six complaints and five investigations not a single member of the SEC ever requested the records. The failure to catch and stop Madoff is equally defacto intentional when a request for records was once drawn up but was never signed or sent because it would be too much work [for the lazy SEC personnel] to inspect the records if they received them.

• The failure to catch and stop Madoff is defacto intentional when SEC personnel knew that Madoff had lied to them and had told them deeply inconsistent stories, but not a single investigator tried to learn the truth despite the knowledge of lies and important inconsistencies.

• The failure to catch and stop Madoff is defacto intentional when Madoff tells you he acts through Barclay’s Bank, but Barclay’s says there has been no activity in his account, and you make no effort to plumb this discrepancy. The failure to catch and stop Madoff likewise is defacto intentional when the Royal Bank of Scotland says it is willing to provide documents if Madoff agrees and you simply blow off RBS’ offer.

• The failure to catch and stop Madoff is defacto intentional when the SEC asks the NASD whether Madoff owned options on a particular date, the NASD says he did not, and the SEC then does nothing.

• James Simons is perhaps the most successful hedge fund manager of the 21st Century. Twice in the last few years he has made 2.5 billion dollars and once 1.7 billion dollars. The failure to catch and stop Madoff is defacto intentional when you find out that his company has deep suspicions about Madoff’s bona fides, but you do nothing -- you do not even bother to contact his firm to learn what it knows or believes, including why it says that it has knowledge that Madoff’s execution of trades is unusual.

• The failure to catch and stop Madoff is defacto intentional when the use of options is central to Madoff’s claimed method of trading, but he tells you he no longer uses options, yet you do nothing. The failure to catch and stop Madoff is defacto intentional again when you know his statement is at least partly a lie because you know that for some clients he is using options, yet again you do nothing.

• The failure to catch and stop Madoff is defacto intentional when experts let you know there are not enough options in the world to support Madoff’s claimed trading, yet, though the use of options is central to his strategy, you do nothing.

• The failure to catch and stop Madoff is defacto intentional when you start an investigation of Avellino & Bienes because you fear a Ponzi scheme, but, when the money invested with Avellino and Bienes is paid back (by Madoff), you never even ask where he got the money to pay back the Avellino and Bienes investors. The failure to catch and stop Madoff is again defacto intentional when you swallow, without extensive further investigation, the preposterous claim, and/or practice, of Avellino and Bienes that they never keep any records -- no records for 440 million dollars(!!) (which in today’s money is probably a billion dollars or more).

• The failure to catch and stop Madoff is defacto intentional when you -- the government’s then highly respected regulator and watchdog, the SEC -- suck people into investing or remaining in Madoff by announcing through the Wall Street Journal in 1992 -- by announcing as you otherwise never do -- that you have found no evidence of fraud -- by making a public announcement (based on a thoroughly negligent investigation) that inevitably would and did cause people to leave money in Madoff, to add money to Madoff, or to invest with Madoff for the first time.

• The failure to catch and stop Madoff is defacto intentional when an anonymous person, who obviously has some kind of inside knowledge judging by what he says, sends you a letter saying that Madoff has commingled Norman Levy’s money with Madoff’s, and tells you that Madoff keeps two sets of books, the more important of which are on his personal computer which is always on his person, but you almost wholly dismiss the tip from the obvious insider by doing no more than asking Madoff if he is an investment adviser for Levy and then fully accept his counsel’s false negative answer to the question without any further inquiries even Madoff is known to have lied to your agency previously about important matters. (In one of the recent books on Madoff, one of the Madoff company’s chauffeurs in effect verifies the commingling by discussing the multimillion dollar checks he regularly took to Levy (every day if I remember correctly). As for the computer, no doubt it was one that Madoff retained access to for many months after he was indicted -- and which he no doubt attempted (successfully?) to wipe clean, thereby impairing the search for funds to repay defrauded victims).

• The failure to catch and stop Madoff is defacto intentional when you require him to register as an investment advisor because you learn that, contrary to years of lies to you, he is acting as an investment advisor for more than 15 people, and newly registered investment advisors are supposed to be inspected within a short period of time but the SEC never undertakes the required inspections.

The foregoing list does not exhaust the items discussed in Kotz’s report which show that the SEC acted in a way that can and should be described as defacto intentional: i.e., the SEC did things it would have done if it didn’t want Madoff to be caught and stopped and if it wanted to destroy the antifraud policy of its statutes. Nor does the list give chapter and verse of each of the items on the list, giving only capsule summaries of them instead. But the list does make clear why the SEC’s misconduct was so horrid, its degree of negligence was so high, that it has to considered defacto intentional, has to be considered to be exactly the same as what the SEC would have done had it wanted Madoff to continue succeeding with his Ponzi scheme and wanted to destroy the antifraud policy of its own statute.

* * * * *

From the time Madoff was arrested on December 11th until today, and no doubt continuing on into the foreseeable future, there have been and will be those who say the victims were at fault for investing with Madoff. For one reason or another, the victims should have known better, is the attitude. This is in some ways curious, not just nasty, vengeful and wrong.

Just to take my own case as an example of what I think was typical of many people, I had no idea, and had no reason to think or understand, the things that gave pause to some Wall Street insiders who had the knowledge and capacity to do extensive due diligence, Wall Street insiders who were aware, as the average investor was not:

• that on Wall Street itself rumors were rife that something was not right at Madoff;

• that for various reasons it seemed quite possible to Wall Street insiders that Madoff was not buying and selling securities, as he claimed to be doing, and that his supposed trades and positions could not be “seen” in the markets, where they should have been “visible” if he was trading the huge volumes he claimed;

• that there were not enough options in the world to support his claimed trading, and people who traded options said they had not been doing business with Madoff;

• that his accountant was a one man shop;

• that there were other Wall Street firms which used the same strategy he claimed to be using (a strategy which, we now learn, is claimed to be a common garden variety strategy on Wall Street), but who could not replicate his results;

• that even though his strategy made sense in principle, and was said by some knowledgeable persons to be plausible in principle even after he was caught, Wall Street insiders who were mavens in mathematics and derivatives maintained that -- however plausible in principle -- his results were statistically impossible in practice and this could be (and was) shown by the spreadsheets of the experts.

• That many of us small fry victims, I would bet, like me, did not even know Madoff was running money for hedge funds and banks, but instead thought he was only investing for a relatively small number of persons who initially had been confined to some friends, relatives and long time investors -- just as ironically, and in reverse, even Harry Markopolos, if memory serves, did not know he was investing money for small fry, but thought he was investing only for hedge funds, investment banks, and some extraordinarily wealthy individuals. Such lack of knowledge is the result of the secrecy and non-transparency of companies like Madoff’s -- of so-called hedge funds (I insist, as I wrote early-on, that for a number of reasons Madoff’s was not truly a hedge fund but everyone else calls him that) -- which Congress and the SEC allowed to be secretive, a secrecy and consequent fraudulent disaster for which Congress too bears responsibility because it permitted the secrecy and nontransparency.

So there are a host of reasons -- including some I have not mentioned here but have previously discussed extensively, such as the understandable belief that Madoff was a conservative investment, a relatively low earning and a highly taxed investment when compared to the mutual funds, stocks and hedge funds so prevalent on Wall Street in the 1990s and 2000s -- why the small fry could have no idea that something might be rotten in the state of Denmark, as Shakespeare once said. Speaking for myself, but speaking for lots of other small fry too I’m sure, I can say that had I ever obtained any inkling that there were not enough options in the world to cover the huge trading in securities that Madoff supposedly was doing -- trading of an amount completely unknown to those of us who had no idea he was running money for huge funds and banks rather than just investing for relatively small circles of friends, relatives and long time investors -- then I would have been out of Madoff entirely, or at minimum would have drastically reduced my investment with Madoff, in the proverbial New York minute, after attempting to verify but being unable to verify that he was covering all his trades with options, as he claimed to be doing. For I (and others) understood -- as one can see from early writings here that quoted what I was personally told by Frank DiPascali -- that the options were central to the claimed strategy, and that without the options there was not a conservative strategy, but only non-conservative bets by Madoff on which way the S&P 100 would move.

If one could not verify the use of options to cover trades, the strategy that had attracted us was false, made no sense, and one should have, and I would have, fled or at minimum greatly reduced my investment, would have cut it by three-fourths or more, as soon as it became clear that the options were not being used. (The only reason for keeping any part of one’s investment in Madoff, as illustrated below in connection with James Simons, is that Madoff appeared to have a long track record of success whether he was covering all his trades with options or not, and he had been given a clean bill of health by the SEC -- although by the late 1990s one might have wondered whether at least the 1992 encomium from the SEC was out of date because Madoff could conceivably have secretly changed what he was doing somewhat since 1992.)

It should be needless to add that had any of us small fry had an inkling that Madoff was not even making the trades he claimed to be making, again many of us would have been out of Madoff in a New York minute, as soon as claimed trading proved unverifiable, because he not only was not doing all that he claimed to be doing (viz, he was not buying options), but he was not even buying and selling securities.

Now, what makes all this so piquant, what makes it so wrongheaded, vicious and, let’s face it, sometimes anti-Semitic for persons to blame the small fry victims for investing with Madoff, is that some of the world’s most sophisticated and greatest investors put money with him even though they knew much or all of this and even knew far more than the points described above. The case of James Simons’ company is instructive.

Simons, for reasons alluded to earlier, has to be considered one of the most brilliant and successful investors of recent years. And, as detailed extensively in Kotz’s report, Simons’ company developed deep suspicions about Madoff’s bona fides for many of the very reasons set forth above, plus several other, often very sophisticated, reasons as well. Yet despite its suspicions, Simon’s company left half its investment in Madoff until it later removed that half for (unstated) reasons that were unrelated to a possible fraud. Despite all its knowledge of things that didn’t add up, knowledge wholly outside the ken of innocent small fry and going far beyond points discussed above, Simons’ company (Renaissance Technologies) could not bring itself to believe Madoff was a fraud, because he had been inspected and given “a clean bill of health” by the SEC. As Kotz said (emphasis added):

Nat Simons, the portfolio manager for Renaissance’s Heritage fund, a hedge fund of funds, who held a Madoff managed investment in 2003 and whose e-mails triggered the 2005 NERO examination (as described in detail in Section IV above), cited their understanding that the SEC had looked at Madoff and given him a clean bill of health as a reason they did not initially divest themselves of their Madoff-related investment. Simons Testimony Tr. at p. 28. Renaissance understood from Madoff that the SEC had examined “the whole business.” Id. at p. 17. Renaissance research scientist Henry Laufer agreed, “What was also on our minds … was that Madoff had been investigated – and cleared” by the SEC.

Laufer Testimony Tr. at pgs. 35-36.

Renaissance also doubted Madoff could be engaged in fraud because he operated through highly regulated brokerage accounts, stating:

[B]ecause of the nature of the fact that these were brokerage statements, and he had a big broker dealer business and big market-maker and – you just assume that someone was paying attention to make sure that there was something on the other side of the trade. … I never, as the manager, entertained the thought that it was truly fraudulent. And it again was because … it would have been so easy to prove that it was fraud if it was just managed accounts that were set up. It would have been so – again, forgive me here, but you know, it would have been pretty straightforward. We felt that he was sufficiently in the eye of the regulators that it was just hard for us to envision that that was the case.

Simons Testimony Tr. at pgs. 28, 39-40.

Simons further explained that one reason they did not report their suspicions to the Commission directly was that they felt all of the information they were using in their analysis was readily available to the Commission.

So there you have it. Some of the greatest and most sophisticated investors in the world invested with Madoff, and continued to do so despite serious suspicions that something might be wrong there (suspicions discussed from pp. 145-161 of Kotz’s report), because the SEC had checked out Madoff, had access to the pertinent information, and had given Madoff a clean bill of health, a motivating factor for Renaissance Technologies which is discussed at several places in Kotz’s report.

When even Renaissance Technologies left money with Madoff because of the SEC, and did so despite extensive and highly sophisticated suspicions (which you really should read about in Kotz’s report), it is truly indecent -- it is absolutely vicious -- for people (like Joe Nocera, his investment guru buddy Jim Hedges, and lots of ignoramuses who write the kind of utter crap one often finds in comments on the internet) to blame the innocent, small fry victims for investing with Madoff; it is indecent and vicious to blame people who, unlike Renaissance, knew nothing that excited suspicion.

* * * * *

Let me make one last point, which does not come from Kotz’s report and has been written of before here, but which is very important in light of the SEC’s defacto intentional misconduct.

The SEC’s misconduct not only resulted in continuation of, and enormous growth over the years in the size of, Madoff’s Ponzi scheme, but also resulted in a dramatic reduction in the amounts of money available to victims when the fraud finally collapsed in December 2008. It has been claimed that, because of the market collapse that began in that year, twelve billion dollars was pulled out of Madoff by skittish investors in the last six months. Before that Madoff apparently never had to face waves of major redemptions, so that major percentages of the funds that he had taken in remained in his account. Some was taken out for his own use and that of his family members, some to float the market-making side of his firm, and some likely went to the Mafia, various secret services (American, British, Israeli or whatever) or to whomever else was a background part of the deal. (Why did Madoff pay out six billion dollars to a guy who invested only 1.5 billion dollars -- to Picower. Where did that money go and why? Was it for a secret service?) But the amount of invested money left in Madoff was apparently gigantic until close to the end, as will be shown by records now being kept secret by JP Morgan Chase, by Picard, by the FBI and by the U.S. Attorney’s Office. By defacto intentional conduct that resulted in Madoff’s Ponzi scheme staying alive until it collapsed due to billions upon billions of dollars being redeemed by investors due to the greatest economic collapse since the Depression, the SEC’s defacto intentional conduct resulted in investors losing repayments of many billions of dollars -- losing repayments of 12 or 17 billion dollars, or even 20 billion dollars or more, that would have been readily available to repay them from Madoff’s account in JP Morgan Chase had the Ponzi scheme been exploded by the SEC even as late as, say, 2004 or 2005 or 2006 or 2007, had it been exploded by the SEC before “the great redemption” caused by the economic disaster that began in 2008.

So the defacto intentional misconduct of the SEC resulted, as I say, not only in the growth of Madoff’s Ponzi scheme from “only” about 500 million or a billion dollars in 1992 to the 65 billion dollars reported on the November 30th statements, but also resulted in a fantastic reduction of billions of dollars in the amounts available to repay innocent defrauded victims. What is more, when you consider that a large amount of the redemptions in the final stages of the Madoff fraud appear to have been by people who were complicit in the fraud and who would therefore have had no right to any money after the fraud was discovered -- Picard is in toto going to sue them for something in the neighborhood of 12 or 15 billion dollars -- you can see that, if the SEC had ended the fraud, and had done so when it should have, the amounts available to repay innocent investors could very conceivably been close to, equal to, or even more than the amounts that they actually invested (their cash-in), could even have covered payments to innocent investors of portions of the income they thought they had earned from Madoff. For these reasons too, it is the SEC, and therefore the US Government, that is responsible for the dire poverty which now afflicts so many innocent Madoff victims.*

This posting represents the personal views of Lawrence R. Velvel. If you wish to comment on the post, on the general topic of the post, you can, if you wish, email me at

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