What the SEC Should do to Prevent Another “Madoff” Scandal[1]
Introduction and Background
Bernard L. Madoff died recently[2]. I knew Bernie and want to explain why he was so successful at keeping regulators at bay. I also think that the Securities and Exchange Commission (“SEC” or the “Commission”) needs to do more to prevent another “Madoff” scandal.
Bernie was a world class crook – I would rename the “Ponzi” scheme as the “Madoff” scheme, in recognition of the scope of his treachery. Saying “I knew Bernie” was always a conversation starter at a cocktail party. Inevitably, the person with whom I was speaking would ask, “Could you tell he was a crook?” My answer was always, “No, of course not.”
The Madoff fraud is a lot more complicated than the versions I have read in several different accounts. Very few have explained why Bernie not only fooled his “investors,” but how he managed to fool the regulators for so long. Most people don’t have the patience for the details. If you want to understand what separated Bernie from your average fraudster, you need to understand the context. Below are my recollections, as best as I can remember them, with additional discussion to put them in context.
Background on How I Knew Bernie and Peter Madoff
Among my reviewers’ helpful suggestions for this article was that I needed to explain the basis for my interactions with Bernie Madoff. Bernie Madoff is a household name, albeit a disgraced one. Stuart Kaswell is not a household name, so I agree that some explanation of my background may be helpful.
I graduated from law school in 1979 and began my career at the U.S. Securities and Exchange Commission’s Division of Market Regulation, now known as the Division of Trading and Markets (“Division”).[3] In 1975, Congress enacted the Securities Acts Amendments that overhauled many aspects of securities trading and processing in the U.S.[4] One of the most important provisions, Section 11A of the Securities Exchange Act of 1934 (the “Exchange Act”), directed the SEC to foster the development of a National Market System for securities. Congress also added Section 17A of the Exchange Act, which directed the SEC to facilitate the establishment of a national system for the prompt and accurate clearance and settlement of transactions in securities. The SEC assigned the Division of Market Regulation primary responsibility for adopting rules to implement these two congressional mandates.
Initially, I worked on the clearance and settlement issues, staring as a staff attorney and later becoming a special counsel. After a few years, I moved over to become branch chief of the over-the-counter regulation, which meant primarily oversight of the National Association of Securities Dealers (“NASD”),[5] Although I did not have primary responsibility for National Market Systems issues, I was involved with them to some extent. Certainly, I was aware of the Division’s extensive work on that topic.
It was during my years at the SEC that I first became acquainted with Bernie and Peter Madoff. As a freshly-minted lawyer, my more experienced colleagues made clear to me that they held Bernie and Peter Madoff in very high regard.
After more than six years, I left the SEC and became Republican securities counsel for the Committee on Energy & Commerce of the U.S. House of Representatives from 1986 to1990. (The Commerce Committee had securities jurisdiction at that time.) During that time, the Committee focused on issues such as insider trading and the 1987 Stock Market Crash.
After ten years of government service, I accepted a position as an associate at the law firm of Winthrop Stimson Putnam & Roberts (now Pillsbury Winthrop). One of my clients was the Securities Industry Association (“SIA”), now called SIFMA. SIA was the primary trade association for investment banking and retail brokerage.
In 1994, Marc Lackritz, President of SIA, appointed me Senior Vice President and General Counsel of SIA. During those years, the SIA had a leadership role with a broad range of issues, such as market structure, litigation reform, federal/state regulation, Y2K, decimal conversions, computerization of retail brokerage, and Regulation Fair Disclosure. Like any trade group, one of SIA’s main functions was to interact with regulators and Congress on issues of keen interest to its members. I worked with senior personnel at the SEC and NASD, and other self-regulatory organizations, and worked with members of the House and Senate, as well as their staffs.
As SIA’s chief legal officer, I would interact with senior executives and lawyers at many member firms, including the Madoffs. Again, like most trade associations, SIA staff worked with its members on a continuous basis as SIA developed its policy positions. Bernie, Peter, and Shana Madoff were very active participants in SIA’s board or committees. The Madoffs sought to have their firm’s interests reflected in SIA’s policy agenda. To be clear, I was never involved in the day-to-day business of any SIA member firm, including Madoff.[6]
I left SIA after nearly ten years, to become a partner at the law firm Dechert, LLP. I saw the Madoffs from time to time at industry conferences or elsewhere, but I never represented them. After private practice, I became Executive Vice President and Managing Director, General Counsel at the Managed Funds Association (“MFA”). MFA hired me in December 2008, just as the Great Recession was unfolding and before the Madoff scandal broke. As an experienced Washington lawyer, MFA hired me to help the hedge fund industry navigate the political fallout from the 2008 financial crisis. In my role as general counsel, I helped guide legislators and regulators in the U.S. and E.U. to develop a workable framework to regulate hedge fund managers. I don’t recall any interactions with the Madoffs after joining MFA. I retired from MFA in 2018.
I was privileged to hold these positions during my career and am proud of the work that I did. Because of my role in public policy, I worked on a regular basis with Bernie and Peter, along with many other senior people in the financial services industry and in government. As I discuss below, I only was aware of the Madoffs’ broker-dealer, not the so-called investment adviser.
The Madoff Scandal – Background
Back in the 1970s, when companies (“issuers”) went public and matured, their stocks would trade in increasingly liquid and prestigious markets. Most issuers started with market makers trading their shares in the Over-the-Counter Market, originally called the Pink Sheets. The Pink Sheets, literally pink pieces of paper, listed yesterday’s closing stock prices in thinly traded stocks. The prices were stale before the ink dried. Market makers would call around on telephones and try to get the best price they could when buying or selling for a customer. (The market was a dealer market, meaning dealers sold out of inventory; they rarely acted as agents putting a buying customer and a selling customer together.) It was a primitive trading environment and even the most diligent dealer would have a difficult time finding the best price.
In 1971, Gordon Macklin, who was the head of the NASD, wanted to use the new electronic computer systems to trade over-the-counter (“OTC”) stocks.[7] The NASD created Nasdaq, which was an early computer linkage of dealers with screens showing prices. The dealers still had to execute by phone, but at least they had a more accurate picture of the market than they could get by making a few phone calls.[8] In 1972, the SEC adopted Rule 17a-15,[9] which created the framework for a consolidated tape, i.e., a central repository of the prices of executed trades. The SEC attempted to adopt a consolidated quote rule, i.e., a rule that would require markets to display their prices in a central facility. Many in the industry opposed the creation of a consolidated quote until Congress insisted.[10]
As issuers progressed in size and breadth of ownership, they would abandon the OTC market and list on the American Stock Exchange (“Amex”). Amex was a step up from the Pink Sheets and Nasdaq, but was still the minor league. The next step was the New York Stock Exchange (“NYSE”) or the “Big Board.” America’s best-known companies listed on the NYSE, notwithstanding the high fees and lack of competition. The NYSE, like the Amex, relied on specialists or market makers – individuals on the trading floor whose participation helped ensure price continuity.
At the time, the NYSE probably had the most liquid and deep markets for trading stocks. But not all of those advantages were the result of innovation and competition; the NYSE’s rules helped undermine competitive alternatives. Its “off board” trading rule, Rule 390, prohibited NYSE member firms from trading of NYSE listed stocks other than on an exchange. NYSE Rule 500 made it nearly impossible for a company voluntarily to delist and move to another market. The net effect was to make it difficult for broker-dealers to trade stocks NYSE listed stocks anywhere but at the NYSE or for an issuer to go elsewhere.
Of course, the NYSE had public policy justifications for its off-board trading rules. The NYSE argued, correctly, that concentrating the trading interest in one place would ensure that the most buy and sell orders would interact, achieving the best price.[11] That’s true to a point. If I want to sell my car and I put a sign on it in front of my house, I won’t know if someone on the other side of town would like to buy it. As the saying goes, “liquidity begets more liquidity.” But rules like Rule 390 eliminated competition among marketplaces. Moreover, the NYSE was very astute politically and worked hard to protect its market share. New York State was very powerful politically in Congress. The NYSE was not embarrassed about seeking support for a home town industry.
In 1975, Congress enacted the Securities Acts Amendments of 1975 (1975 Acts Amendments),[12] a major overhaul of the federal securities laws that Congress first enacted during the New Deal. Although Congress left the basic framework of the securities laws intact, it expanded and modernized a number of provisions. Congress added Section 11A of the Exchange Act, which directed the SEC to facilitate the development of a national market system.[13] The system for trading equity securities was antiquated and anti-competitive. Congress enacted Section 11A with instructions to modernize the system. Congress did not specify the changes that it wanted in a National Market System; it only stated the objectives and granted the SEC new authority to implement those changes. In general, Congress is wise not to enact laws that will have the effect of micromanaging an industry. Nonetheless, Congress often wants to avoid hard decisions and the ensuing political fallout over resolving complex debates with significant economic implications. Accordingly, it punts complex issues to the regulator, in this case the SEC, and lets the agency sort it out. Bernie exploited that situation for his benefit.
Armed with its mandate to facilitate the development of the National Market System, the SEC had to proceed carefully, so as not to antagonize powerful political players.[14] Confronting the NYSE directly was politically dangerous, possibly suicidal. More importantly, the SEC did not want to wreck the crown jewel of American capitalism as it explored different approaches to improving market structure. On the one hand, concentrating liquidity improves the price discovery process. On the other hand, competition among stock markets, like any market competition, encourages innovation and lower prices. Striking the balance between concentrating orders and fostering competition among markets is not easy. The stakes were high and the price of failure was formidable.
Rather than trying to implement sweeping reform, the SEC tried a step-by-step approach. Section 19(c) of the Exchange Act allowed the SEC to rewrite the rules of a self-regulatory organization (other than a clearing agency). In other words, in addition to adopting SEC rules, Congress gave the SEC the authority to revise the stock exchanges’ own rules. The SEC adopted Rule 19c-3 under the Exchange Act.[15] That Rule required exchanges to allow trading in stocks other than on the exchange where the issue is listed for stock listed after April 26, 1979. The SEC “grandfathered” existing listings subject to the NYSE’s Rule 390. But Rule 19c-3 provided that newly listed NYSE stocks could trade elsewhere.
Years before, Bernie had established a broker-dealer, Bernard L. Madoff Investment Securities (“BLMIS” or “Madoff”), that was a market maker. It was not a NYSE member firm, so it could ignore the NYSE’s rules. Over time, BLMIS attracted orders from other broker-dealers by paying them for their orders, called “payment for order flow.”[16] It was, and is, an entirely legal practice. When equities traded in eighths of a point, Madoff could pay for order flow and still provide better pricing (better executions) than other market makers or the NYSE. Madoff embraced computer technology ahead of others and could price stocks quickly and aggressively. Peter, Bernie’s brother, was also active in running the business. Both Bernie and Peter were involved in many SIA meetings and also participated in many regulatory meetings. It was clear that Bernie was the head of the firm and Peter was not co-head. But Peter was fully involved in running the broker-dealer and participated in regulator meetings.
The SEC loved the idea that Madoff provided a road map to creating more competition for the NYSE, which would help the SEC accomplish the congressional mandate in Section 11A. Bernie and his brother Peter were fixtures at the SEC, explaining the intricacies of trading to the lawyers and inviting SEC staff to visit his trading room. Recall too that most SEC lawyers, with the possible exception of a few like Richard G. (“Rick”) Ketchum, Director of the Division only understood the theory of stock trading, not the nitty gritty of how it actually worked. Bernie and Peter were happy to share their knowledge. Of course, the staff understood that the Madoffs were trying to grow their own business and shape regulation to their benefit. Nonetheless, it was a happy coincidence that their interests generally coincided with the SEC’s goals. Everyone in the Division though the Madoffs were great guys who were extremely helpful.
I remember participating in an SEC staff trip to New York City sometime in the early 1980s to visit various broker-dealer trading operations. Peter Madoff gave a tour of his nice, but relatively small, trading room to perhaps half a dozen Market Regulation staffers. Peter patiently explained what his firm was doing to a group of us baby lawyers who were clueless. On the primitive screens of the day, he bought or sold 100 shares of some issue to demonstrate what his firm did. I remember that a chime in the room kept pealing and Peter would turn to his colleagues and shout “Phones!” I realized that other broker-dealers were calling and instead of a conventional telephone ringer, Madoff had a more civilized chime. Peter was not happy that his traders were not answering the calls quickly. By inviting SEC staff to visit the Madoff trading room, Bernie and Peter were demonstrating that they had nothing to hide and welcomed the opportunity to educate the staff. Of course, we were junior regulatory staff members, not staff from the SEC’s Division of Enforcement.
Rule 19c-3 was just one milestone in a long journey to alter the market structure for trading equity securities. The battle over 19c-3 was part of the evolution of the relationship of broker-dealers and stock markets. The SEC made additional changes as the years progressed. Over time and with other developments such as Reg ATS,[17] competition among market centers became much more fierce.[18] When Congress originally established the self-regulatory system in the original Exchange Act in 1934 and 1938, the exchanges and the NASD were creatures of their members. As SROs, the exchanges and the NASD had quasi-governmental authority to supervise their members. By the 1980s, the broker-dealers saw the exchanges more as competitors, and less as their advocates. As competition grew, it became increasingly difficult for the NYSE to maintain its anti-competitive rules. Eventually, the NYSE could no longer stem the tide and agreed to rescind Rule 390[19] and Rule 500.[20]
When the stock market crashed in October 1987, the Reagan Administration,[21] Congress, the SEC, the Commodity Futures Trading Commission, and others all rushed to figure out what went wrong. Nasdaq was embarrassed since critics charged that market makers didn’t answer their phones as prices plummeted. Nasdaq established a committee to examine Nasdaq’s role and to suggest improvements. Nasdaq appointed Bernie as co-chair of its committee to study the problems on Nasdaq and to recommend improvements.[22] It’s important to remember that Nasdaq must have appointed Bernie because he had stature and expertise in the market operations. Bernie’s presence enhanced the credibility of Nasdaq’s efforts. By the same token, Bernie further burnished his credentials as an industry leader. Bernie didn’t shrink from the spotlight; on the contrary, he sought it.
My next interactions with Bernie and Peter came a few years later. In January 1994, I became Senior Vice President and General Counsel of SIA. Bernie was on the Board of Directors and served on the Federal Regulation Committee, the SIA committee that had the greatest impact on formulating the association’s views on SEC issues. Bernie also chaired or served on various trading committees.
Bernie always participated in SIA meetings and always was fully prepared. Trading committees included representatives from firms trading floors, who understood market structure issues as well as Bernie. Bernie may have been the only CEO at those meetings, but other members could go toe to toe with Bernie on the divisive market structure issues.
By contrast, whenever SIA’s Board considered a market structure issue, Bernie simply overwhelmed everyone else. The Board had a cross section of the industry – a person (usually a man) who had made his career as an investment banker or head of retail sales, knew very little about market structure minutiae. Bernie knew more than everyone and could discuss market structure in excruciating detail.[23] The Board simply would defer to Bernie on market structure issues.
At the same time, Bernie never over-played his hand. Market structure issues were particularly divisive. Firms had differing perspectives, depending on their business models. Bernie didn’t try to “roll” the Board and push through issues on which there was not consensus. In the trading committees, he would try to find a middle ground, such as offering a market-wide trade through rule. His approach was shrewd – if he had pushed the Board to adopt positions with which their firms disagreed, he would have damaged his own credibility once the other firms realized what Bernie had tried to do. Such a strategy would have made it even more difficult for SIA to play any role in market structure issues. Bernie didn’t always get everything he wanted, but he sought to shape consensus and used his SIA relationship astutely.
At one SIA Board meeting in New York, Richard (“Dick”) Grasso, the CEO of the NYSE, came to address the Board. Market structure issues were among the contentious issues between some SIA members and the NYSE. Of course, Bernie was the most outspoken SIA member on trying to dismantle the NYSE’s huge market share and add competition. At the end of his presentation, Dick walked around the entire board room and warmly shook hands with all of the board members and staff. Everyone watched when Dick came to Bernie. They embraced like two Mafia Dons in a scene from The Godfather. The whole room erupted in laughter.
Bernie also was involved in the regulatory details and did so conspicuously. The SEC often invited him to participate in roundtables on market structure issues. At one of the roundtables,[24] the topic was transparency of limit order books. Bernie said that most market makers want to see what other market makers were holding, but were reluctant to share the details of their own limit order books. Bernie said, in other words, it’s a matter of “if you show me yours, maybe I’ll show you mine.” Everyone laughed. Bernie also testified before Congress on market structure issues.[25]
Bernie was involved in issues beyond market structure. There had been a dispute between the state securities regulators and the big broker-dealers over access to books and record. When state regulators came in for an inspection, the regulators would demand to see the records. If the inspection occurred at a local office, i.e., in another state, of a big New York-based firm, the firm would say that they didn’t have the records and that they were in New York. Frankly, the firms were not always speedy about providing records to a regulator at another state. The state regulators got frustrated and working through their trade association, NASAA, they started to consider passing state laws to require broker-dealers to keep records within that state. If they had been successful, every state could have instituted its own unique record keeping rule for broker-dealers. The result would have been a nightmare of expense and complexity.
Fortunately, Congress intervened and enacted the National Securities Markets Improvements Act of 1996 (“NSMIA”). Section 103 of NSMIA preempted states from adopting their own broker-dealer book and records rules or capital rules. At the same time, Congress directed the SEC to work with the states to develop a rule for books and records that would accommodate the states’ legitimate need for access to books and records. The SEC organized a meeting in New York City, a few weeks after 9/11, to hammer out a compromise with the firms and NASAA. Bernie was the only CEO who attended and participated in detailed discussion of record keeping rules.
BLMIS frequently sponsored SIA events. SIA always needed member firms and other vendors to sponsor conferences and meetings. Bernie was willing to step up, often on new conferences that had little or no track record. Of course, he was looking for other firms, particularly the retail wire houses, to route customer orders to his firm for execution. Nonetheless, his sponsorship was part of his camaraderie and effort to demonstrate that he was trying to help the industry and not just his own parochial interests. After every SIA conference, I came home with Madoff canvas bags, notebooks, or binoculars. Our kids slept in Madoff tee shirts.
As I have noted elsewhere, after the 9/11 attack when the lawyers in SIA’s New York office needed an alternative place to work, Bernie offered space at his midtown office. I had offers from other firms that were sincere, but I felt the most comfortable accepting Bernie’s offer. I figured that SIA’s lawyers would encounter fewer difficulties than if they went to another firm. When Bernie, as the CEO, issued the invitation, nobody was going to question who the SIA lawyers were and why were they taking up space at the firm. Other, much bigger firms, had much bigger bureaucracies to traverse, even if a very senior executive at that firm issued the invitation. No doubt those firms would have sorted out the mechanics, but I figured it would just be easier. Plus, I just liked Bernie.
SIA had an annual meeting at the Boca Raton Resort and Club. It was a very lavish affair and it attracted many of the most senior people in the securities industry. SIA sponsored entertainers like Ray Charles and Tony Bennett, and speakers, like John Major, Joe Torre, and Walter Cronkite. The meeting included an annual election of officers and a Board meeting, which was my responsibility. It was my responsibility to ensure that the chairman of the SEC attended to give a keynote address at the meeting. I also organized a meeting with the SEC chairman, the heads of the SROs, and SIA leadership. There was a dinner with the SEC chairman, Board, and SRO heads. Although the surroundings at Boca were luxurious, I had many responsibilities over the course of the meetings.
For reasons that I can’t recall, one evening at Boca, my wife Sherry and I were at loose ends for dinner, as was Bernie. We had dinner together, which was not something that I would have expected. As a staff guy, I was not a peer of Bernie and dinner with me would do nothing for his business. Nonetheless, we had dinner together and he was charming. He told us a self-deprecating story of how his family rented a house in Tuscany for a summer. One day, Bernie drove off to do an errand and in the days before Waze, got completely lost. He also realized he had not brought the address or the telephone number of the rental house. Bernie said that he got so lost that he was afraid that he would have to pull into a hotel and stay overnight until he could reach his secretary, Eleanor, when she was back in the office. She would have to provide him with the address and phone number of the rental house. Eventually, he found his way back later that day.
One year, I remember Bernie introducing me to his wife Ruth briefly at the lobby of the “Tower” i.e., one of the hotel buildings at Boca. I also remember asking if Bernie was staying in the Tower, but he said that he was on his yacht that he had docked nearby.
Peter’s daughter, Shana, an attorney, was head of compliance at BLMIS. She also was a member of the SIA Compliance and Legal (C&L) Division, and served on its Executive Committee.[27] Shana was very active in the Division and attended the monthly Executive Committee meetings and at other SIA conferences or committee meetings. I also remember meeting one of Bernie’s sons at an SIA meeting in New York, but I can no longer remember which one. All of these actions helped establish the Madoff family as thoughtful industry leaders, with Bernie as the great statesman.[28]
Proximity to, and familiarity with, regulators achieved two goals for Bernie and Peter Madoff. First, the regulators trusted Bernie and Peter. As a result, regulators were much less likely to scrutinize BLMIS’s activities than they would have with a firm unknown to them. Second, Bernie and Peter’s familiarity with regulators conveyed a sense of legitimacy to investors. A quick internet search would have revealed Bernie and Peter’s working relationships with the SEC and Congress. It also would have shown their leadership roles with organizations such as Nasdaq[29] and SIFMA.[30] Absent more information, it would have been logical for investors to assume that Bernie and Peter were completely honest.
The Madoff Scandal – The News Breaks
On December 1, 2008, I started as general counsel at the Managed Funds Association, just as the Great Recession was under way. Shortly thereafter, Bernie announced that his investment adviser was a Ponzi scheme. The SEC charged him on December 11, 2008. When the news broke, I was in shock. I called my wife Sherry and said “You won’t believe the news.” We both reacted with “Not Bernie!” Friends of mine in the securities industry had exactly the same reaction.
The news reports indicated that Bernie’s Ponzi scheme employed his investment adviser. I didn’t know that Bernie had an investment adviser; I only knew about the broker-dealer.[31] As far as I knew, the broker-dealer, which he used to innovate and compete with the NYSE, was legitimate.[32] A few weeks later at an MFA conference, I heard some fund of funds’ operators say that they didn’t invest with Madoff because the numbers were too good to be true. I never heard anyone say that before the scandal broke.[33]
Certainly, competitive pressures and regulatory changes reduced market makers’ profits. For example, in the late 1990s, SEC Commissioner Steven Wallman[34] and Congressman Mike Oxley[35] and others began to pressure the securities industry to move from pricing stocks in eighths or even sixteenths and adopting decimal pricing.[36] The market makers weren’t excited about that change, partly because of the cost of implementation, but more importantly because it would hurt their profitability. They argued that pricing in decimals would mean less liquidity at each price interval, such that the over price of executing a big order might not be less with decimal pricing. Nobody cared. The only real issue was that the timing for the conversion was not great. The securities industry had to adopt the changes for decimal pricing at the same time as preparing for Y2K. No doubt that the pressures of decimalization reduced the profitability of BLMIS, along with other market makers.
But the competitive and regulatory factors pale before the size of the fraud relating to Madoff’s so-called investment adviser. In fact, BLMIS, the broker-dealer, was “deeply insolvent,” as a result of the Ponzi scheme. According to the expert that the Securities Investor Protection Corporation trustee retained, BLMIS was insolvent from at least December 11, 2002, by over $10 billion.[37] The Report states that “there is strong evidence to suggest that BLMIS was insolvent even decades before December 2002.”[38]
The Expert Report and indeed the whole scandal raise the obvious question of “When did Bernie stop running a legitimate broker-dealer and start defrauding his advisory customers?” Did the fraud begin when Bernie and Peter were working with the Division of Market Regulation on market structure issues in the late 1970s and early 1980s? BLMIS supposedly used a “split strike” options trading strategy. The trading strategy, when done legitimately, involves using options to hedge positions in large cap stocks.[39] In one interview, Bernie said that “by 1994 or 1995, I basically stopped doing the split strike entirely. I just had the money housed in treasuries.”[40] Bernie was an experienced liar, so it is difficult to know whether this statement was accurate. Nonetheless, this statement seems consistent with other information, such as his sworn allocution as part of his guilty plea.[41]
Would it matter if the Madoffs were engaged in a pyramid scheme starting in the late 1970s and 80s, i.e., when Bernie and Peter were giving public policy advice to the SEC regarding the National Market System? Even if that were true, the development of the National Market System had nothing to do with the fraud. Of course, Bernie and Peter were urging the SEC to make policy decisions that would favor their business. Nearly everyone who submits a comment letter to the SEC does that. Nonetheless, their insights (along with others) and their market making (again, along with others) demonstrated that U.S. equity markets could be more competitive. Their market structure advice had nothing to do with the fraud conducted through the investment adviser.
The SEC’s failure to uncover the fraud was unrelated to SEC rulemaking. The OIG Report documents repeated oversight failures. If BLMIS had been using the split strike strategy, it would have held large positions in equities and options, Unfortunately, the SEC never verified whether BLMIS owned the amounts of securities that it claimed. The OIG Report notes:
A January 2005 statement for one Madoff feeder fund account, which alone indicated that it held approximately $2.5 billion of S&P 100 equities as of January 31, 2005. On the contrary, on January 31, 2005, DTC records show that Madoff held less than $18 million worth of S&P 100 equities in his DTC account
Similarly, the SEC’s Division of Enforcement failed to pursue inconsistencies about BLMIS that it uncovered. When the SEC’s Division of Enforcement asked colleagues in the Division of Market Regulation to inquire whether BLMIS held a large position of options on May 16, 2006, the Division of Market Regulation reported that they “had found no reports of such options positions for that day.” Unfortunately, the Enforcement Division did not seek further information about the discrepancy.[42] In other words, the public policy advice that Bernie and Peter Madoff gave to the SEC had nothing to do with the fraud.
Because of the Enforcement staff’s inexperience and lack of understanding of equity and options trading, they did not appreciate that Madoff was unable to provide a logical explanation for his incredibly consistent returns. Each member of the Enforcement staff accepted as plausible Madoff’s claim that his returns were due to his perfect “gut feel” for when the market would go up or down.[43]
Further, Bernie’s understanding of trading allowed him to overwhelm SEC Enforcement staff that did not have adequate expertise. “The Enforcement staff’s lack of experience not only contributed to their failure to understand that Madoff’s returns could not be real, it also was a factor in their failure to conduct an effective investigation regarding how Madoff was creating those returns.”[44]
In summary, BLMIS was a simple Ponzi scheme and did not depend on the SEC’s National Market System rulemaking. Bernie used his knowledge of markets and carefully cultivated his reputation with regulators to avoid close scrutiny for years. According to the OIM’s report, the Madoffs intimidated SEC Enforcement Division staff, who lacked expertise and were embarrassed to admit that they did not understand what Bernie was claiming.[45] It was a perfect storm of failure.
The Madoff Scandal – Aftermath
As Bernie’s lies unraveled and the news media revealed the scope of the fraud, everyone I knew who had respected Bernie felt like a fool, including me. I came to realize that Bernie was a world class “confidence man” who astutely exploited human weakness to achieve his goals. I was in good company.
After telling people that I knew the Madoffs, the next question was inevitably, “Did you lose any money?” The answer was “No,” because I didn’t know that he had his crooked investment adviser. I wondered why Bernie never invited me to invest. Had I known, I would have given him every cent I had. When I raised this question with colleagues, I posited that the amount I would have “invested” with Bernie was too little for him to bother about. A more flattering view was that Bernie was afraid that I would figure out that he was running a fraud. Before the scandal broke, my friend and former colleague, Stephen Blumenthal, Esq. told me that Norman F. Lent (R-NY), by then a retired Member of Congress for whom we both had worked, told Steve that he (Norm) had invested his retirement money with Bernie. Steve wondered, if Bernie is so smart that he can produce such high, consistent returns, why does he need Norm Lent’s money? Why indeed?
Bernie created a persona as a person above reproach who wouldn’t steal a postage stamp.[46] Bernie’s proximity to senior regulators and Members of Congress further enhanced his credibility. He established credibility with regulators and legislators by working with them constructively on broker-dealer regulatory issues, particularly the vexing market structure matters. Bernie and Peter understood both Wall Street and Washington, D.C. They operated with great skill in both milieus, which is rare.
Bernie did a stunning amount of human as well as financial damage across the world. He caused particularly great harm to numerous Jewish communities, both at the individual level and to Jewish philanthropic organizations. He employed the well-established technique of “affinity fraud.” He used his shared religious connection to cause people to trust him, when they otherwise might have been suspicious or undertaken more due diligence.[47]
After the scandal erupted, everyone involved pointed fingers at everyone else.[48] For example, in a hearing examining the Madoff scandal, the Senate Banking Committee asked FINRA if its examinations of Madoff’s broker-dealer revealed any fraud. FINRA responded that their:
Examination staff reviewed books and records related to the Madoff broker-dealer’s activities and areas of our examination focus. BLMIS did not record any of Madoff’s investment advisory business on its books and records. Consequently, those books and records did not indicate that Madoff was engaged in a Ponzi scheme through his separate advisory business.[49]
Precisely. FINRA (and the SEC’s oversight of FINRA) could not reveal the fraud because BLMIS’s records made no mention of it. Only a fool would have shown evidence of the fraud on the broker-dealer’s books and records. Because Bernie, and to a lesser extent Peter, had established themselves as statesmen, the regulators never suspected anything, notwithstanding the concerns that some repeatedly raised.[50]
The SEC subsequently produced a list of reforms that it instituted to prevent a repetition. These and other changes are important. Nonetheless, I hope that the SEC takes my advice and amends Rule 206(4)(2) its custody rule.[51] The SEC should require that all SEC registered investment advisers use a custodian that is unaffiliated with the adviser. Nothing can prevent another Madoff fraud with complete certainty, but ensuring that the adviser does not control the custodian broker-dealer would make a similar fraud much more difficult to achieve.[52] It also would help reduce the chance of another Madoff pulling the wool over the eyes of regulators and legislators.
Perhaps the more vexing issue that the Madoff scandal raises is the challenge of how regulators can prevent seemingly helpful regulatees from deflecting meaningful oversight of their activities. Regulators need public input on proposed regulations to ensure that the rules they adopt will work well and balance competing concerns.[53] Regulators need comments from those whom the regulation will most directly affect, including affected industries. Regulated industries often provide essential information to regulators about how those industries operate as a practical matter and the real-world implications of a proposed rule. Regulators may choose to ignore industry comment, but without it, they are likely to overlook important information.
It is important for regulators to distinguish BLMIS’s views on public policy questions, with its actual practices. Bernie was able to use the goodwill he generated to deflect close regulatory scrutiny of his fraudulent activities. Examiners need to evaluate carefully the activities of all market participants, including those who have cultivated a good relationship with regulators on policy questions or other matters. Bernie’s manipulation of regulators should serve as a warning to all.
[1] © 2021 Stuart J. Kaswell, Esq., who has granted permission to the ABA to publish this article in accordance with the ABA’s release, a copy of which is incorporated by reference. Mr. Kaswell wishes to thank the following persons for their assistance and suggestions: Stephen A. Blumenthal, Esq., Grant Callery, Esq., Marc Lackritz, Esq., and John H. Sturc, Esq. All of the opinions and recommendations in this article are the author’s alone and do not reflect the views of any reviewer or of any current or prior clients or employers. Any errors are the author’s alone.
[2] Bernard Madoff, Architect of Largest Ponzi Scheme in History, Is Dead at 82, D. Henriques, N.Y. Times, April 14, 2021, updated April 15, 2021. Ms. Henriques wrote The Wizard of Lies, Bernie Madoff and the Death of Trust (2011, 2012), (“Wizard of Lies”) which HBO adapted for a movie.
[3] On November 14, 2007, the SEC renamed the “Division of Market Regulation” the “Division of Trading and Markets.”
[4] See discussion below.
[5] NASD, a self-regulatory organization (“SRO”), is registered with the SEC under Section 15A of the Exchange Act. Pub L. No. 291, 48 Stat. 881, 73d Cong., Sess. II (June 6, 1934). In 1938, Congress amended the Exchange Act by adding Section 15A to provide for the registration of securities associations as SROs. Pub. L. No. 719, 52 Stat. 1070, 75th Cong., 3d. Sess. (June 25, 1938), commonly referred to as the “Maloney Act.”
[6] After serving as general counsel of two trade associations, my experience is that members do not share their trade secrets with the association staff or other members, their competitors. Further, at both trade associations, I instituted strict antitrust policies and procedures.
[7] In 1964, Congress added what is now Section 15A(b)(11) of the Exchange Act, which provides that the rules of an association must “include provisions governing the form and content of quotations relating to securities sold otherwise than on a national securities exchange which may be distributed or published by any member or person associated with a member, and the persons to whom such quotations may be supplied.” Pub. L. 88–467, Subsec. (b)(12). Pub. L. 88–467, §7(a)(7), added par. (12). Congress renumbered paragraph 12 as paragraph 11 in the 1975 Acts Amendments. 89 Stat.128. See also Phillips and Shipman, An Analysis of the Securities Acts Amendments of 1964, 1964 Duke L.J. 706.
[8] See Interview with Joseph Hardiman, Conducted by Kenneth Durr, Securities and Exchange Commission Historical Society, on October 29, 2009, discussion of Gordon Macklin and the early days of Nasdaq. (Hardiman Interview).
Over time, the NASD spun off Nasdaq as it grew. Eventually, it obtained registration as a stock exchange, like the NYSE. Its trading model differs from the NYSE, but it is a world class market. For reasons unrelated to trading, NASD reorganized itself and is now called FINRA. See Becker, Kaswell, et Al., Is it Time to Revamp the Current Regulatory Structure of the Markets?, Journal of Investment Compliance December 2000. Nasdaq management must have concluded that the Nasdaq brand was very valuable and have kept it, even though its original parent organization changed its name.
[9] The SEC adopted Rule 17a-15 in Exchange Act Release No. 9850, (Nov. 8, 1972), 37 FR 24172 (Nov. 15, 1972). The adopting release notes that the rule requires “registered national securities exchanges, national securities associations and broker-dealers who are not members of such organizations to make available through vendors of market transaction information price and volume reports as to completed transactions in securities registered on such exchanges.”
Using its authority under the 1975 Acts Amendments, discussed infra, the Commission substantially expanded the display standards for trade reporting. Section 11A(c)(1) of the Exchange Act grants the SEC authority over the manner in which vendors display quotations. It redesignated the rule as Rule 11Aa3-1. Exchange Act Release No. 16589 (Feb. 19, 1980); 45 FR 12377 (Feb. 26, 1980).
In 1981, the Commission adopted rules the effect of which was to designate approximately 40 over-the-counter securities as national market system securities and to require that transactions in such securities be reported in a real-time system and that quotations for such securities be firm as to the quoted price and size. Exchange Act Release No. 17549 (Feb 17, 1981); 46 FR 13992 (Feb. 21, 1981).
In 2005, the Commission again revised the rule and redesignated it as Rule 601. Exchange Act Release No. 51808 (June 9, 2005); 70 FR 37496 (June 29, 2005), at 37569.
[10] Harman, The Evolution of the National Market System—An Overview, The Business Lawyer, American Bar Association, Vol. 33, No. 4 (July 1978), at 2275, 2285.
[11] It also argued that it would allow execution of trades without a dealer, another objective of the Exchange Act. See Section 11A(a)(1)(C)(v) of the Exchange Act. See also SEC, Report on the Feasibility and Advisability of the Complete Segregation of the Functions of Dealer and Broker, 1936.
[12] Pub. L. No. 94-29; 89 Stat. 97; June 4, 1975. The unfixing of commission rates played an important role in expanding securities trading. The SEC adopted Rule 19b-3 to allow market forces to set commissions. The rule took effect for most transactions on May 1, 1975. Exchange Act Release No. 11203 (Jan 23, 1975); 40 FR 7394 (Feb. 20, 1975). The 1975 Acts Amendments also deregulated commissions. 89 Stat. 107; 89 Stat.128.
[13] Section 11A(a)(2) states that “the [Securities and Exchange] Commission is directed, therefore, having due regard for the public interest, the protection of investors, and the maintenance of fair and orderly markets, to use its authority under this title to facilitate the establishment of a national market system for securities…’
[14] The 1975 Acts Amendments added Section 11A(c)(1) of the Exchange Act, which granted the SEC new authority over the manner in which vendors display quotations. In 1980, the Commission substantially revised the provisions of Rule 17a-15, and redesignated it at Rule 11Aa3-1. Exchange Act Release No. 16589 (Feb. 19, 1980); 45 FR 12377 (Feb. 26, 1980).
In 1981, the SEC took another major step in implementing its mandate to facilitate the development of a national market system. The Commission adopted a rule, “the effect of which was to designate approximately 40 over-the-counter securities as national market system securities, to require … that transactions in those securities be reported in a real-time system, and that quotations for such securities be firm as to the quoted price and size.” Exchange Act Release No. 17549 (Feb 17, 1981); 46 FR 13992 (Feb. 21, 1981). The release included conforming changes to Rule 11Aa3-1.
In 2005, the Commission again revised the rule and redesignated it as Rule 601. The SEC consolidated a number of market structure rules into Rule 601 of Regulation NMS. Exchange Act Release No. 51808 (June 9, 2005); 70 FR 37496 (June 29, 2005), at 37569.
[15] Exchange Act Release No. 16688 (June 11, 1980); 45 FR 41125 (June 18, 1980). See also Opening Remarks of the Honorable Harold Williams, Chairman, SEC, at the Occasion of the Commission’s Consideration of Rule 19c-3, Proposed in Securities Exchange Act Release No. 15769, June 5, 1980.
[16] Active trading in AMC Entrainment Holdings, Inc. and GameStop Corp. has brought new interest to the practice of payment for order flow. Michaels and Osipovich, SEC to Review Market Structure as Meme Stocks Stir Frenzy, WSJ, June 9, 2021. The article notes that SEC Chairman Gary Gensler “who took over the SEC in April, renewed his criticism of the system that sends many of the orders placed by individual investors to be filled by high-speed traders known as wholesalers, including Citadel Securities and Virtu Financial Inc., instead of routing them to public exchanges.” See also FINRA Reminds Member Firms of Requirements Concerning Best Execution and Payment for Order Flow, FINRA Regulatory Notice 21-23, June 23, 2021.
[17] 17 CFR § 242.300 et. seq.
[18] Nasdaq, Liquidity Across Markets.
[19] Exchange Act Release No. 42758; 65 FR 30175 (May 10, 2000).
[20] Exchange Act Release No. 41634 (July 21, 1999); 64 FR 40633 (July 27, 1999).
[21] E.g. Report of the Presidential Task Force on Market Mechanisms, Jan., 1988 (the “Brady Report”).
[22] Hardiman Interview, supra, at 22.
[23] Bernie was patient with those who knew less than he did. For example, at some SIA meeting I asked Bernie to explain a marketable limit order. I wasn’t embarrassed to ask or fearful that he would criticize me in front of others for not knowing something that was very basic for him.
[24] It probably was on April 21, 2004.
[25] Statement of Bernard L Madoff Investment Securities, Hearing on Regulation NMS before the Committee on Banking, Housing, and Urban Development, U.S. Senate, July 22, 2004.
[27] The C&L Division is a professional society for compliance and legal professionals. As SIA’s general counsel, I was an ex officio member of the C&L Executive Committee.
[28] I am not commenting on whether members of the Madoff family, other than Bernie or Peter, had any knowledge of the fraud. I have no first-hand knowledge about what they did or did not know.
[29] Bernie Madoff was a chairman of Nasdaq. Bernie Madoff Dead at 82; Disgraced Investor Ran Biggest Ponzi Scheme in History, D. Rothfeld and J. Baer, Wall St. J., April 14, 2021.
[30] Peter Madoff resigned from SIFMA’s board after the scandal broke. Family Filled Posts at Industry Groups, E. Williamson and K. Scannell, Wall St. J., Dec. 18, 2008.
[31] I was not alone in not knowing about Madoff’s so-called money management firm. In 2001, Barron’s reported:
Folks on Wall Street know Bernie Madoff well. His brokerage firm, Madoff Securities, helped kick-start the Nasdaq Stock Market in the early 1970s and is now one of the top three market makers in Nasdaq stocks. Madoff Securities is also the third-largest firm matching buyers and sellers of New York Stock Exchange-listed securities. Charles Schwab, Fidelity Investments and a slew of discount brokerages all send trades through Madoff.
But what few on the Street know is that Bernie Madoff also manages more than $6 billion for wealthy individuals. That’s enough to rank Madoff’s operation among the world’s five largest hedge funds, according to a May 2001 report in MAR Hedge, a trade publication.
What’s more, these private accounts, have produced compound average annual returns of 15% for more than a decade. Remarkably, some of the larger, billion-dollar Madoff-run funds have never had a down year.
When Barron’s asked Madoff how he accomplishes this, he says. “It’s a proprietary strategy. I can’t go into it in great detail.”
Arvedlund, Don’t Ask, Don’t Tell: Bernie Madoff is so secretive, he even asks his investors to keep mum, Barron’s May 7, 2001. As discussed infra, BLMIS was not a hedge fund. In a letter from Bernie Madoff responded to some questions from the SEC, he notes that “neither Madoff Securities, nor any entity affiliated with Madoff Securities, manages or advises hedge funds.” Bernard L. Madoff to Eric J Swanson, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, Jan. 16, 2004. Mr. Swanson later married Shana Madoff, Peter’s daughter. The SEC’s Office of Inspector General’s (OIG) report into the Madoff scandal stated that “the OIG also did not find that former SEC Assistant Director Eric Swanson’s romantic relationship with Bernard Madoff’s niece, Shana Madoff, influenced the conduct of the SEC examinations of Madoff and his firm.” Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme – Public Version, OIG, SEC, Report No. OIG-509, Aug. 31, 2009, (OIG Report) at 20. See also Exhibits.
[32] Many news reports and other accounts of the Madoff scandal referred to Madoff as a “hedge fund.” E.g., The 10 Biggest Hedge Fund Failures, Investopedia. That description is incorrect for two reasons. First, BLMIS purported to invest its clients’ money in individual securities. It did not purport to create a fund. The sine qua non of a hedge fund is that the investors purchase shares in a pooled investment vehicle that, in turn, invests in various securities. Investors in the fund do not own individual securities in the fund’s portfolio. Second, BLMIS was not running a hedge fund, separate account, or any other legitimate activity. It was a fraud.
[33] In fairness, the OIG Report indicates that some hedge fund managers reported to the SEC that they believed that Madoff’s investing strategy was too good to be true. Unfortunately, the SEC did not pursue these reports adequately. See discussion below.
[34] SEC Historical Society, Transformation & Regulation: Equities Market Structure, 1934 to 2018 (Transformation & Regulation).
[35] I had worked for Congressman Michael G. Oxley (R-OH) when I was counsel to the Committee on Energy & Commerce of the U.S. House of Representatives between 1986 and 1990.
[36] According to the SEC Historical Society:
[In 1997,] third market market-maker Bernard Madoff, not yet known as a fraudster, was upset that the NYSE was not sending order flow his way. He contacted the SEC and threatened to “break the eighth” if that continued. Division of Market Regulation Director Rich Lindsey told him, “Go ahead.” Madoff’s resulting move to sixteenths was taken up by all other exchanges within days.
Transformation & Regulation, supra [citations omitted].
[37] Securities Investor Protection Corporation v. Bernard L Madoff Investment Securities, LLC, U.S. Bankruptcy Court, Southern District of New York, Adv. Pr. No. 08-01789 (SMB), Expert Report of Bruce G. Dubinsky, Exhibit 2 at 161 (11/25/2015) (“Expert Report”).
[38] Id. at note 11.
[39] N. Abe, Split Strike Is a Valid Strategy, Despite Madoff Scandal, Seeking Alpha, Dec. 22, 2008.
The split strike strategy involves buying a basket of stocks, then writing call options against those stocks, and finally using the proceeds from writing the call option to purchase a put option.
The strategy, in theory, should provide market returns minus extremely bullish or bearish results, depending on how far out of the money the call and put options are. For example, a manager might buy the S&P 500 (which we’ll use the SPYs as a proxy for) at $91 and sell the January 09 $95 strike calls for $2.22 and buy the January 09 $87 strike puts for $2.92. In effect the manager is paying $0.70 for the insurance that the SPY position will not be worth less than $87 and not more than $95 on Jan 16th 2009. Rinse and repeat this every month and the performance of this manager will more or less be market performance minus the cost of insurance. It would be impossible, as Madoff critics point out, for the manager to avoid losses in months where the market goes down.
[40] Soltes, Why They Do It, Inside the Mind of the White Collar Criminal (Inside the Mind), 2016, at 296.
[41] Transcript of March 12, 2009 Allocution in the Matter entitled U.S. v. Madoff, Case No. 09 CR 213, U.S. District Court for the Southern District of New York (March 12, 2009), also cited in OIG Report, at note 30. See also Wizard of Lies at 92: “As the 1990s began, Bernie Madoff was running a legitimate and apparently successful brokerage firm, with 120 employees and profits approaching $100 million a year.” Ms. Henriques cites an NASD examination letter as evidence.
[42] OIG Report, at 39-40. The report explains how the SEC overlooked several reports that indicated it was impossible for BLMIS to achieve the results it claimed using the split-strike strategy. Id., at 66.
[43] Id., at 39
[44] Id. at 369.
[45] Id.
[46] Bernie’s ability to manipulate regulators and investors was extraordinary. For example,
For some time he had cultivated the impression that new investors simply couldn’t get in – he had all the money he wanted; he wouldn’t even discuss the business with would-be clients. It was akin to winning the lottery if he agrees to add you hedge fund to his coterie of institutional clients. This approach was masterful, of course. It proved that Groucho Marx’s famous rule also worked in reverse: everyone wanted to join the club that wouldn’t let them in.
Wizard of Lies at 116-117.
Yet despite Bernie’s shrewd judgment of human weaknesses, he largely excused his own massive fraud as not that bad and no different from “the prevailing norms in the financial industry.” Inside the Mind at 304.
[47] The SEC’s Investor.gov website describes “affinity fraud” as follows:
Affinity frauds target members of identifiable groups, such as the elderly, or religious or ethnic communities. The fraudsters involved in affinity scams often are – or pretend to be – members of the group. They may enlist respected leaders from the group to spread the word about the scheme, convincing them it is legitimate and worthwhile. Many times, those leaders become unwitting victims of the fraud they helped to promote.
[48] Senate Banking Hearing; SEC Office of the Inspector General, Investigation of Conflict of Interest Arising from Former General Counsel’s Participation in Madoff-Related Matters.
[49] Response of Stephen Luparello, Interim Chief Executive, FINRA, to written questions, The Madoff Investment Securities Fraud: Regulatory and Oversight Concerns and the Need for Reform, Hearing before the Committee on Banking, Housing and Urban Affairs, United States Senate, 111th Cong., 1st. Sess. Jan. 27, 2009, at 111.
[51] Kaswell, Congress and the SEC Should Enhance the Regulation of Investment Advisers, Business Law Today, American Bar Association, June 23, 2020. See also Petition from Stuart J. Kaswell, Esq., to the SEC recommending that the Commission amend Rule 206(4)(3) under the Investment Advisers Act of 1940.
[52] SEC Complaint against David Friehling, Friehling & Hororwitz, CPA’s PC and Plea Agreement.
[53] The Administrative Procedures Act, 5 USC Part I, Ch. 5. Subchapter II. Among other things, this legislation requires federal agencies to seek public comment on proposed rules. The U.S. Constitution’s Due Process Clause also requires public notice. Cf. Panama Refining Co. v. Ryan, 293 U.S. 388 (1935).
