I also included examples of the many strange explanations I’d heard from experienced people in the industry when I’d asked them how Madoff generated such consistent returns: I had been told he was using the information he gets by paying for order flow to earn profits for his hedge fund, that he was actually borrowing the investors’ money to use in his broker-dealer operation and paying them 15.5 percent interest for the use of that money, that he was personally subsidizing the down months to maintain low volatility of returns, and that he had perfect market timing.
And I concluded by pointing out that he did not allow outside performance audits, which no legitimate firm would have any reason to deny.
I was confident that this submission, which I would explain in detail at the meeting and answer any questions it brought up, certainly would arouse the suspicion of the SEC. Given this road map, almost any competent investigative team would easily be able to figure out exactly what Madoff was doing.
I didn’t have any idea how long the process would take. Several months, I guessed.
Well, obviously that was a number I got very wrong.
Chapter 3
Falling Down the Rabbit Hole
If possible, Ed Manion was more determined to expose Bernie Madoff’s scheme than I was. After reading my submission, he believed firmly that it was strong enough to convince the Securities and Exchange Commission (SEC) to open an investigation. And bringing down Bernie was going to be a coup for his agency. He had arranged for the two of us to meet with Jim Adelman, a senior enforcement attorney at the agency, whom he respected. Jim’s a pretty sharp guy, Ed had told me. He’ll get it.
I don’t get nervous very often, but truthfully, I was nervous. This was the first time I’d been in the SEC building, and going forward officially with this accusation represented a big step for me. If Rampart found out about this meeting, it would have caused me some serious difficulty. I suspect I would have been asked to drop the investigation, and if I had persisted it might have cost me my job. However, I knew it was the right thing for me to do. My expectation was that the SEC would find that my allegations were credible and would very quickly assign an examination team or an enforcement team to determine if Madoff was simply a financial fraud or a Ponzi scheme. I didn’t think they would ignore me; I was handing them the largest case in their history. I was giving them the headlines any government agency craves. This was a tremendous opportunity for them to demonstrate to the nation that the SEC was a bulldog when it came to protecting our financial markets.
In May 2000, Ed and I were waiting in a small conference room when Jim came in and immediately began apologizing. “I’m not going to be attending this meeting, because I’ve given my notice to the SEC,” he explained. “I’m going into private practice, but I just wanted to thank you for coming in today.” Then he was gone.
Minutes later Grant Ward, an attorney who was the SEC’s New England regional director of enforcement, walked into the room. After introductions I began my formal presentation. As I explained this massive fraud to Ward, it very quickly became clear he didn’t understand a single word I said after hello. It wasn’t entirely his fault; he never should have been put in that position. He was a securities lawyer who knew little about the financial industry. In preparing my submission I’d specifically left out all the calculus, all the linear algebra. I’d made it as bare-bones as possible so the SEC staff could understand it. But even that wasn’t basic enough. I will give Ward credit; he tried to look interested as I explained the numbers. But truthfully, if blank looks were dollar bills I would have walked out of that room a rich man. He was coldly polite, but he didn’t ask a single probing question. I never knew if that represented a lack of interest, a lack of comprehension, or simply a desire to go to lunch.
Ed was devastated. He knew how badly it had gone. It seemed clear that his faith in his agency had been shaken. He’d done his job; he’d brought in evidence of a fraud and handed it over to the division charged with investigating it. As we waited for the elevator I asked him, “You think he got it?”
Ed shook his head. “Not one single word of it.”
At that moment I still didn’t have the slightest idea how truly incompetent the SEC was. On Wall Street the real fear about the SEC was not that it would uncover hidden crimes, but rather that it would bury you beneath an avalanche of paperwork. That’s what it was best at. SEC audits consisted primarily of confirming that a checklist of documents existed, not necessarily that these documents were accurate, not even that they reflected real trades—just that you had the proper papers in your files. Firms hated these audits because they were distracting and time-consuming and rarely resulted in anything more than a deficiency notice or even a small fine for some minor compliance issue.
Nobody I knew had a lot respect for the exam teams. Most of these teams consisted of bright young accountants whose primary objective was to learn the industry at the taxpayer’s expense, then take that knowledge into the private sector where they could earn a substantial salary. Occasionally there would be a lawyer on the team, but at that level these lawyers wouldn’t understand derivatives. In fact, after Madoff was arrested, his secretary revealed that the few times SEC investigators had come to the firm most of them had asked for employment applications. That was typical. If during an exam investigators found a problem, they would report it and issue a deficiency notice or
