When Bernie Madoff’s Ponzi scheme imploded in December 2008, it unleashed two major scandals. One was simply an issue of money. Lots of losses because there were lots of victims. The tens of billions of dollars that went up in smoke rocked the financial world, thanks to the sheer size of the fraud and the fact that Madoff had snookered so many people (and institutions) for so long. The other great indignity (and arguably the bigger one) is that the world’s biggest financial con survived for years under the nose of America’s top regulatory agency: the Securities and Exchange Commission.

Harry Markopolos and a few colleagues continually warned the SEC about Madoff for nearly a decade. Markopolos recounts the details in his book No One Would Listen: A True Financial Thriller, a biting but engaging yarn about uncovering the Madoff fraud and the frustration of failing to convince the SEC to act on the information. As Markopolos writes,

It all began in 1999 when my friend Frank Casey first brought Madoff to my attention. I was confounded by the Wall Street mogul’s financial successes, and had to know more. I tried but couldn’t replicate his results. I later concluded it was impossible. One red flag led to another, until there were simply too many to ignore.

In May 2000, I turned over everything I knew to the SEC. Five times I reported my concerns, and no one would listen until it was far too late.

Madoff would end up being exposed, but not until December 2008, when his giant scam collapsed. What was the trigger? It wasn’t the SEC. Rather, it was the financial crisis in late-2008 that brought down Madoff. “You don’t know who’s swimming naked until the tide goes out,” Warren Buffett once observed. In December 2008, the tide had finally gone out on Madoff. What if the economy and markets had continued to rise? Perhaps Madoff would still be in business today.
History turned out differently, of course. It’s been 18 months since Bernie Madoff’s multi-billion-dollar Ponzi scheme disintegrated. What have we learned? What’s changed at the SEC? In search of some answers, I recently talked with Markopolos by phone. I asked what he thought of the “new” SEC, which has had a house cleaning of sorts. The Commission recently published a list of post-Madoff reforms, announcing that “the agency is continuing to reform and improve the way it operates.”
“They’re making evolutionary changes at a rapid pace,” Markopolos says of the changes at the SEC. Those changes have arrived “much more rapidly than any government agency has made in the past.” That’s not surprising, of course, considering that the SEC “came close to being put out of business,” according to Markopolos.
The threat of death is a great motivator. And certainly there have been leadership changes in the upper ranks. The SEC is also asking Congress for expanded powers to investigate, regulate and prosecute securities fraud. An encouraging start, but not nearly enough, explains Markopolos, a certified financial analyst (CFA) and certified fraud examiner (CFE). “They’ve replaced several people at the top, but now we need to go through the middle ranks. We need people who can spot fraud from across the trading floor.”
In essence, the basic reform challenge for the SEC remains, he asserts, advising that the Commission is still overpopulated with lawyers. But uncovering securities fraud in the 21st century requires financially savvy investigators with a deep understanding of Wall Street. The SEC is “run by lawyers,” Markopolos says. That’s fine to a degree. But the guts of finding fraud amid complex derivatives trades, structured products and a host of other complicated strategies requires a high level of financial expertise. And on that front the SEC has yet to make convincing progress, he charges. “They need people with [financial] industry experience.”
Markopolos also thinks that SEC investigators need financial incentives that are up to the task at hand. “There are only disincentives to fighting fraud” on Wall Street. “If you do big cases, you create waves.” The solution, he believes, is to create a “bonus system” with a Wall Street-type compensation plan to reward the SEC sleuths searching for crimes. That will put investigators on an equal playing field with the fraudsters, who can earn millions of dollars from their scams.
I also asked Markopolos about the SEC’s ongoing case against Goldman Sachs. As we discussed previously on these pages, the investment bank was charged in April with “defrauding investors” for selling a subprime mortgage product and failing to “disclose to investors vital information,” according to the SEC’s announcement. Was this an encouraging sign of the new and improved SEC?
Markopolos says he’s impressed that the SEC went after the “biggest player” on the Street. “They showed aggressiveness.” He also believes that Goldman is “guilty of bad ethics.” Yet he also says that “it seems that the criminal violations were in the packaging of the subprime securities. Banks had to know these loans were toxic.” By charging Goldman in the way it did—focusing on technical violations—the SEC is overlooking the bigger violation, he opines. “It’s almost like they’re letting the investment banks off the hook.” The creation, financing and securitization of the securities was the “bigger crime,” he asserts.
The SEC, in short, has a long way to go with its post-Madoff reforms, says Markopolos. Yes, the Commission has made a strong start. But the tougher changes still lie ahead, including firing a fair amount of the middle ranks in the Commission, hiring financially savvy investigators and giving them sufficiently large financial incentives to uncover securities fraud. “If they’re not willing to fire anyone, people’s confidence in government will go down,” he says. Yes, new regulations are coming, he admits. “But if we get new regulations with the same old people, that’ll be a crying shame.”